Puts and Calls: The case against Goldman

Tom Karol Occasional Political Commentator
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A new feature begins today, which will provide insight into the connection between politics and business. At a time when the major political initiatives are health insurance, financial reform and regulating emissions, perhaps Washington politicos could use a fresh perspective — a business perspective.

Of course, the hot story is the legal action initiated by the Securities and Exchange Commission (SEC) and now threatened by the Financial Services Authority (the U.K.’s answer to the SEC) against Goldman Sachs. The action centers on allegations that marketing material used by Goldman in a investment vehicle failed to disclose that an employee who chose the investments for the fund had “economic interests directly adverse to investors.” This synthetic collateralized debt obligation (CDO), “Abacus,” was tied to the performance of sub-prime residential mortgage-backed securities. The SEC alleges that some folks involved hoped the whole thing would fail.

Still awake?

So why is this case a big deal? As one of the leading financial institutions to take bailout funds, Goldman Sachs came out of the crisis in better shape than it went in. Some see it as a poster child for financial reform. Others, including the New York Times think the SEC may have picked a novel claim that could be hard to prove. Instead of claiming that Goldman made false claims about the investment — the most common grounds for securities fraud — the SEC is saying that Goldman failed to disclose how the investment was created. This will require that the SEC prove to a jury that investors would not have invested had they known all the facts, and two of the five SEC commissioners did not agree that the SEC should file the case.

Why, then, is the SEC bringing this case, rather than one against the investors that lost money  (including sophisticated German and Dutch banks)? The SEC’s complaint states, “Synthetic CDOs like Abacus contributed to the recent financial crisis by magnifying losses associated with the downturn in the United States housing market,” but this case involves only $1 billion, and the amount spent on the bailout so far exceeds $514 billion.

Goldman is not rolling over on this one, however, and Bloomberg thinks that the case may turn on the meaning of the word “selected.”

And if they want to parse a word, Goldman has hired the perfect adviser in Greg Craig, the Clinton impeachment defense counsel for whom it “depends on what the meaning of the word ‘is’ is.” Craig has also advised President Obama, Madeline Albright and Ted Kennedy, which is relevant given only the delicious irony of the new DNC ad alleging that “Republicans are working with Wall Street lobbyists to block reform.”

Some critics are suspicious of the SEC’s timing of this novel suit by a divided commission just as Sen. Harry Reid is rushing a financial reform bill directly to the floor without committee consideration. Rep. Darrell Issa, ranking member of the House Committee on Oversight and Government Reform, reportedly sent a letter to the SEC asking whether — through any sort of prearrangement, coordination or advance notice — the commission has assisted the White House, DNC or congressional Democrats.

Interestingly, Ranking Member Spencer Bachus of the House Committee on Financial Services sent a similar request to the SEC in February, after a divided SEC approved a “guidance” on climate change, while the administration took the position that, after health care and financial reform, climate change was a chief priority. Although the SEC maintained that it was taking no position on climate change, it instructed companies to report on existing and proposed laws and rules related to climate change or greenhouse gases, on the basis that this was critical issue for investors. Critics suspect that greater policy motives may have existed.

Let me disclose that I operate a company that advises on this. I may not be completely objective, but as Thursday is Earth Day, the issue may be particularly relevant. Since the guidance was issued, more than 8,000 10-K filings have been with the SEC. More than half of the filings made from March to mid-April made no mention of “climate change” or “greenhouse.” In many industries, it was far less than half.

Less than 5 percent of agriculture companies, companies in the car and truck business and mining companies included any reference to “climate change” or “greenhouse.” And the investors that supposedly were waiting for this information with bated breath? More than 1,200 brokers advisers and financial services companies filed 10-Ks and only four mentioned climate change.

Could it be that the SEC’s guidance on climate change was — as some believe the Goldman suit may be — just for show to promote some administration agenda? There is certainly no direct evidence, but if the need for this climate change was market-based, why does no one know or care that most companies have ignored the guidance. Even the social investors that moved the SEC for the guidance don’t appear to know or care that this critical information has been omitted by most filers. The SEC has certainly reviewed all of these filings and even it has determined that climate change proposals are not particularly relevant to 98 percent of mining companies, while not OK for the other 2 percent.

Perhaps someone will realize that there is potential for an even greater political and publicity show here. Maybe the next move is for a divided SEC to create some novel cause of action to file against a major financial services company. Maybe “Failure to Disclose the What the Meaning of the Word ‘Change’ is in Climate Change.”

If they do, I think I can recommend a lawyer.