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It’s Not Cheating To Be Lucky Or Smart

Every time somebody sells a stock, somebody else buys that stock. Brokers put the two together. If the seller happens to unload his shares just before their value plummets, does it mean the buyer has been cheated?

This question is at the heart of the Securities and Exchange Commission’s civil fraud charge against Wall Street powerhouse Goldman Sachs. So let’s begin by answering the question: When a seller makes a killing at a buyer’s expense, is it a sign that someone did something wrong? The answer is “not necessarily.”

It is not a crime to be smarter or luckier than the party on the other side of a transaction. Most successful trades involve intelligence and luck, with the emphasis often on the latter.

Fraud requires deception, misrepresentation, or the withholding of information by one party who is under an obligation to share it with the other party. If a company president tells his sister to sell her shares right before the company announces that it is going belly-up, that’s fraud. The seller, who possesses information that the buyer needs in order to make an informed decision, is obliged either to share the information or to refrain from selling.

The SEC alleges that Goldman and one of its vice presidents behaved like the unethical seller who had inside information when it sold billions of dollars’ worth of subprime mortgages that were packaged into collateralized debt obligations, or CDOs, a few years ago. Goldman insists that it merely acted as a broker putting together two parties who wanted to take opposite sides in a bet on the market for subprime mortgages. If Goldman merely acted as an honest broker and shared all the information it was obliged to share, the SEC’s charges should not hold water.

It will be some time before we have enough information to know who is right. If Goldman, which says it will fight the allegations, changes its mind and decides to settle with the government, we probably will never know the full truth. In the meantime, what we know is mostly what the government chose to disclose when it filed its case, which it is safe to bet is the information that puts the government’s position in the strongest possible light.

My reaction is that if this is all the government has to offer, the SEC’s lawyers are going to have a hard time making their charges stand up against a powerful adversary like Goldman Sachs. It is, in any event, going to be a very interesting case.

Goldman Sachs had since 1994 worked closely with hedge fund operator John Paulson. Paulson became convinced during the housing boom that the mortgage market, particularly the market for subprime loans, was bound to implode. He enlisted Goldman to help him translate that belief into a market bet that would pay off handsomely if he proved to be correct.

At the same time, investors of all sorts, from widowed grandmothers to government treasurers and university endowments, had an enormous appetite for anything that offered higher interest rates. Most rates in the middle of the last decade were near three-decade lows, though they have since gone even lower. Investors convinced themselves that most subprime borrowers would somehow find the means to pay their loans, and that, even if they did not, the debts were secured by properties whose value was extremely unlikely to decline.

So Goldman had no trouble packaging subprime loans into a series of CDOs, which the investment firm called “Abacus.” Goldman’s investment bankers helped Paulson bet that the Abacus portfolios would decline, even as Goldman’s brokers offered the Abacus interests to the firm’s other institutional clients. Abacus CDOs were unregistered securities that were only sold to sophisticated investors; small fry need not apply.

Paulson was right. His bets earned him more than $4 billion personally when the credit crisis emerged in 2007 and intensified in 2008. Abacus investors lost an estimated $1 billion.

The SEC contends that Goldman allowed Paulson to help select the specific bundles of mortgages that were pooled into the Abacus portfolios. The government also charges that Goldman hid Paulson’s participation and his opposing position from the investors who bought the CDOs and the firms that sold insurance on the portfolios’ value. This is the key fraudulent deception, says the commission.

It seems to me that Goldman will have several strong defenses. First, it may argue that the SEC has no jurisdiction over these unregistered instruments that were sold to qualified investors. Second, it may argue (and already has said publicly) that the SEC, which tried to reconstruct events from emails and other documents turned over by the firm, simply has its facts wrong. Third, it will doubtless contend that all parties were given all the necessary information about the Abacus portfolios. Paulson may have believed those portfolios would go bad, but he did not own a crystal ball that other investors lacked. If, after looking at the same information as Paulson, they chose to buy positions that he considered worthless junk, this was neither Paulson’s fault nor Goldman’s. Goldman says it lost $90 million on its own investments in Abacus. Paulson, tellingly, is not a subject of the SEC’s charges.

Did Goldman have an obligation to tell other investors that Paulson, a successful hedge fund trader, was betting against them? The SEC seems to think so. Paulson no doubt disagrees. Hedge funds are notoriously secretive about their strategies. If Paulson was smart enough to figure out that a mortgage crisis was coming and that there was a way to profit from it, Goldman owed him a duty of confidentiality to protect his identity and his strategy.

The SEC case smacks of an attitude that anyone who made big profits from the worldwide financial meltdown probably did so dishonestly and, in any case, deserves a comeuppance. But it’s going to take more than resentment over Goldman’s big profits, big executive salaries and big egos to make a case hold up in court.

Does the SEC have the goods on Goldman Sachs? I would not bet on it.

Larry M. Elkin is the founder and president of Palisades Hudson, and is based out of Palisades Hudson’s Fort Lauderdale, Florida headquarters. He wrote several of the chapters in the firm’s book, Looking Ahead: Life, Family, Wealth and Business After 55. His contributions include Chapter 1, “Looking Ahead When Youth Is Behind Us” and Chapter 4, “The Family Business."

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One Response to "It’s Not Cheating To Be Lucky Or Smart"

  • Paul Jacobs
    April 20, 2010 - 9:07 am

    There’s a difference between an unethical act and an illegal act. The more I think about what Goldman is being accused of, the more I wonder whether the SEC has a leg to stand on. Your average broker does not act in a fiduciary capacity – they’re salesmen and their job is to sell, within the rules of course. Even if Goldman makes this case disappear, I assume the parties who invested in the Abacus CDOs won’t be investing with them in the future. One of Goldman’s main assets is its reputation, and the damage to its reputation may cost more than any fines and penalties.