Editor's note: John C. Coffee Jr. is the Adolf A. Berle professor of law at Columbia University Law School and director of its Center on Corporate Governance. He has been listed by the National Law Journal as among the "100 Most Influential Lawyers in America." Coffee has been a member of the Legal Advisory Boards to the New York Stock Exchange and National Association of Securities Dealers, the Economic Advisory Board to Nasdaq, and the SEC's Advisory Committee on the Capital Formation and Regulatory Processes.
New York (CNN) -- The SEC's enforcement action against Goldman Sachs highlights the widening fissures that underlie Wall Street and raises important issues on three levels:
First (and least important) will be the litigation outcome. Can the SEC convince a court that a strong bias in the portfolio selection process is material to investors, even though the portfolio's contents have been adequately disclosed and approved by an independent portfolio manager?
Second, because the exposure of Goldman's conflicting interests will likely result in some reputational damage to Goldman, investment banks may need to rethink their "Black Box" business model that often places them on all sides of a transaction that they actively structure and market.
Third, the political consequences of the SEC's enforcement action could be profound. Proponents of financial reform legislation wish to move the trading of over-the-counter derivatives (including swaps) onto the exchanges and require the use of clearinghouses.
Although their purpose is to increase transparency and mandate a market check on reckless trading strategies, the practical consequence would be to deprive the major New York banks of one of their most profitable lines of business and award a windfall to the Chicago Mercantile Exchange and to other exchanges that trade derivatives. Predictably, this is the area where the banks have pushed back the hardest, and lobbyists today are clogging the halls of Congress over this issue.
The litigation odds: The Securities and Exchange Commission's civil complaint, filed last Friday, charged Goldman and one of its vice presidents with defrauding investors by failing to disclose adequately the process by which a financial product (known as ABACUS) that Goldman sold to investor clients was structured to allow another Goldman client, the Paulson and Co. hedge fund, to select the individual securities included in the portfolio. The SEC alleged that this permitted Paulson & Co. to design a product that was likely to fail (so that Paulson & Co. could bet against it).
Although the SEC need not prove any intent to defraud under the legal theory it is using, it still must prove the materiality of the alleged misrepresentations and omissions.
Goldman asserts that the identity of the counterparty (Paulson & Co.) is not material, particularly to sophisticated parties who knew that there has to be a counterparty in this particular type of transaction (a "synthetic" CDO). But this defense does not quite capture the flavor of what the SEC is alleging. The SEC's focus is on the role of Paulson & Co. in designing a portfolio that was intended to fail.
The SEC alleges that "given its financial short interest, Paulson had an economic interest to choose [residential mortgage-backed securities] that it expected to experience credit events in the near future."
Indeed, Paulson & Co.'s foresight was acute. Within six months of the 2007 closing of the ABACUS offering, 83 percent of the bonds in the portfolio had been downgraded, and within a year this number rose to 99 percent. Paulson made approximately $1 billion (and paid Goldman $15 million in fees), while Goldman's clients lost $1 billion.
Knowing that in the distressed 2007 market it could only sell its offering if it secured a seemingly objective and experienced portfolio manager, Goldman stressed to investors that ACA Management LLC ("ACA)" was an experienced portfolio manager and would make an objective selection.
In fact, Paulson & Co. selected an initial group of some 123 securities, which, the SEC charges, had "a high concentration of mortgages in states like Arizona, California, Florida and Nevada" (which were experiencing the worst of the decline). Of this 123, ACA agreed to include some 55 and proposed a list of 21 "replacement" bonds. Paulson then vetoed some eight of these replacements, apparently because they were sponsored by Wells Fargo (which was perceived as backing securities that were "too good to fail").
All the securities in the portfolio were rated Baa2 (the category preferred by Paulson and the lowest investment grade rating). Paulson nominated over 60 percent of the included securities, vetoed others, and reduced the portfolio size to 90. The SEC also alleged that ACA only accepted Paulson's nominations because a Goldman officer misled it to believe that Paulson & Co. would be a substantial investor in the highest-risk bottom "equity" tier of the ABACUS offering.
Was Paulson & Co.'s role "material" to investors? The classic standard for materiality is that an omitted fact is material if "there is a substantial likelihood that a reasonable investor would consider it important in making its investment decision."
Goldman's counsel can argue that because the underlying securities were fully disclosed and ACA did in fact approve their inclusion, investors received adequate disclosure. But if it was important to investors that ACA be an objective umpire, then it would seem material if Paulson & Co. dominated ACA. Here, the critical and still unresolved issue is what ACA actually did and how much it deferred to Paulson & Co. But, in principle, bias can be material.
The business model: For a century or more, underwriters have stood between issuers and investors in capital raising transactions, delicately balancing the interests of both sides. Although issuers of stock and investors had different interests, both sides wanted the stock price to rise.
With the rise of derivatives, however, the relationship between the two sides has become far more adversarial, and the game is essentially zero-sum: One side will lose, and the other will gain an equivalent amount. Thus, in a "synthetic" CDO, the investors take the "long" side of a portfolio of credit default swaps that reference the performance of specific securities, and Goldman passes on the ultimate risk on the short side by entering into an equivalent credit default swap with a firm such as Paulson & Co.
In such a world, conflicts of interest and biases matter more -- and can result in greater reputational damage to the intermediary in Goldman's position. Although dealers often stand between counterparties with adverse interests, the context changes when the intermediary actively structures the deal and solicits investors.
Even in the gentlemanly world of investment banking, the gentlemen compete fiercely and on occasion privately stick knives into each other's backs. Goldman can expect that its rivals will have much to say about its behavior to clients that they hope to lure away. The industry's business model may need to change.
The political context: Over the counter trading of derivatives represents the darkest corner on Wall Street. Above all, the Goldman/Paulson episode shows that unseemly things can happen in dark corners. Would exchange-trading solve these problems? Not necessarily. Fraud can occur in any market. But even if Goldman could still assemble a Paulson-influenced portfolio under the proposed reforms, its ability to sell an offsetting credit default swap to Paulson might be inhibited by the need to use an exchange.
Former Supreme Court Justice Louis Brandeis' view that "sunlight is the best disinfectant and electricity the best policeman" remains valid, but whether Congress can see the clarity of his logic in the lobbyist-clogged halls of Congress will soon be tested.
The opinions expressed in this commentary are solely those of John C. Coffee Jr.