Corporate Governance

SEC v. Goldman: The Failure of the Market and the Need for Substantive Reform (The Materiality Issue)

By J Robert Brown Jr.

Like any case, the resolution may turn on the ability to prove the facts alleged in the complaint.  Beyond issues of proof, we raise two possible legal issues:  Materiality and the Rogue Trader defense.  Materiality is probably defined as something that would be important to a reasonable investor.  Knowledge that the reference portfolio of the synthetic CDO was influenced by someone shorting the same portfolio would seem to meet this test. 

The issue is, however, a bit more complex.  Materiality looks to the total mix of available information.  In other words, the failure to mention Paulson's role does not of itself constitute a material ommission.  It depends what the investors purchasing the synthetic CDO also actually knew, irrespective of what appeared in the documents. 

The synthetic CDO was structured to increase its return by selling credit default swaps (aka insurance).  By selling them, the investors knew that someone would be buying them.  In other words, the investors knew that someone would be shorting the portfolio. Thus, the issue is not whether investors should have been told about the short sales (they already knew that) but whether the investors would have wanted to know the identity of the short sellers.  In most instances, that information would not be material.  It would probably not add to the total mix in most instances to identify the counterparties to the swaps.

This case, of course, is different.  Paulson not only went short on the portfolio but also allegedly helped select the underlying securities referenced in the synthetic CDO.  Presumably this will be disputed.  The complaint suggests that ACA had final say over any of the underlying investments in the synthetic CDO.  Goldman may try to prove that Paulson played no significant role in the actual selection, having merely made suggestions or provided advise on the issue. 

Assuming, however, that the Ccommission can prove that Paulson, as it says in the complaint, "played a significant role in the portfolio selection process" while shorting the same portfolio, Goldman will have a difficult time establishing that the information was not material, notwithstanding the sophistication of the purchasers.  Indeed, the sophistication of the investors suggests that they would have appreciated the significance of a short seller participating in the selection of the reference securities for the CDO and not invested.  

Full post as published by The Race to the Bottom on April 19, 2010 (boomark / email).