Corporate Governance

SEC v. Goldman: The Failure of the Market and the Need for Substantive Reform (The Rogue Trader Defense?)

By J Robert Brown Jr.

The other issue is the liability of the firm. 

The complaint mentions Goldman repeatedly but only references a single employee, Fabrice Tourre.  Moreover, the complaint indicates that the transaction was the handicraft of Tourre.  As the complaint notes:  

• Tourre was principally responsible for ABACUS 2007-AC1. Tourre devised the transaction, prepared the marketing materials and communicated directly with investors. Tourre knew of Paulson's undisclosed short interest and its role in the collateral selection process. Tourre also misled ACA into believing that Paulson invested approximately $200 million in the equity of ABACUS 2007-AC1 (a long position) and, accordingly, that Paulson's interests in the collateral section process were aligned with ACA's when in reality Paulson's interests were sharply conflicting.

As for any other broader role of Goldman, only the Mortgage Capital Committee (MCC) gets any significant mention.  The MCC, according to the complaint, "included senior-level management".  Para.  40. 

The MCC apparently signed off on the transaction.  See para. 40 ("The Goldman Sachs MCC, which included senior-level management of GS&Co, approved the ABACUS 2007-AC1 on or about March 12, 2007.").   The MCC also knew about the importance of using ACA.  See para. 24 ("We expect to leverage ACA's credibility and franchise to help distribute this Transaction.").  Finally, the Committee had some information about the role of Paulson.  See Para. 43 ("the March 12, 2007 MCC memorandum describing the transaction stated, 'Goldman is effectively working an order for Paulson to buy protection on specific layers of the [ABACUS 2007-] AC1 capital structure.'').

The complaint isn't entirely clear on all of the details.  The complaint does not identify all of the recipients of the assorted communications mentioned throughout the document.  Nonetheless, the complaint does not specifically allege that anyone knew about Paulson's role except Tourre.  Specifically, there is no allegation that MCC (and its high ranking officials) knew that Paulson had any role the selection of the portfolio. 

This leaves open the possibility that Goldman may deny knowledge of the alleged misstatement and resort to the rogue trader defense.  There is precedent.  After all, it was a single trader - Nick Leeson - that brought down Barings (indeed, he later authored a book titled "Rogue Trader").  Joseph Jett, a trader at Kidder Peabody, was responsible for "non-existent profits of approximately $264 million".  He was charged by the SEC and ultimately ordered to disgorge over $8 million.  The firm was not charged.   See Securities and Exchange Commission v. Orlando Joseph Jett, LITIGATION Release No. 20273 (SD NY Sept. 11, 2007). 

The defense would seek to negate the intent element of the antifraud provisions.  Goldman would essentially be arguing that the firm could not be treated as having recklessly or intentionally misstated the terms of the transaction because of the actions of a single rogue employee. 

While it is the case that a corporation can only commit fraud through its agents, most fraud actions are based upon actions by those at higher levels of authority.  Thus, statements by executive officers or directors are typically deemed to be equated with statements by the company.  Thus, for example, Regulation FD defines this category of persons as "any senior official of the issuer . . . or any other officer, employee, or agent of an issuer who regularly communicates with" the public.  17 CFR  § 243.100(c).  Tourre doesn't fit into these categories.  See para. 9 (Tourre served as "Vice President on the structured product correlation trading desk at GS&Co headquarters in New York City during the relevant period.").  

The defense, however, has problems.  First, it essentially presumes that there was a material misstatement but disclaims responsibility through reference to the action of an isolated employee.  From the sound of Goldman's response to date, it is foremost taking the position that there was no material misstatement or omission. 

Second, even assuming that Tourre was the only one to know about Paulson's role in the determination of the portfolio referenced by the synthetic CDO, the "intent" of Goldman may turn on its procedures.  Recklessness can arise where the company knew or should have known.  To the extent that Tourre was given an excessive amount of discretion in handling the deal (and, concomitantly, an insufficient amount of supervision), intent will likely be attributed to Goldman.

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