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VI. INVESTMENT BANK ABUSES:
CASE STUDY OF GOLDMAN SACHS AND DEUTSCHE BANKC. Failing to Manage Conflicts of Interest: Case Study of Goldman Sachs
(6) Analysis of Goldman's Conflicts of Interest
The Goldman Sachs case study identifies a number of practices that raise conflict of interest concerns. Those practices include the following.
1. Shorting Its Own Securities. In Hudson, Anderson, and Timberwolf, Goldman marketed CDO securities to clients, took a substantial portion of the short side of the CDO, bet the CDO would fall in value, and profited from its short position at the expense of the clients to whom it sold the securities.
2. Failing to Disclose Key Information to Investors. In Hudson, Anderson, and Timberwolf, Goldman represented to potential investors that its interests "were aligned" with theirs or advertised its retention of a portion of the CDO's equity tranche, without disclosing that it had an even larger short position in the CDO and held a financial interest directly adverse to the investors to whom it was selling the CDO securities.
3. Misrepresenting Source of Assets. In Hudson, Goldman provided 100% of the CDO assets using CDS contracts it controlled and priced, transferred $1.2 billion of risk from its own inventory to the CDO, and told investors the assets had been "sourced from the Street," when they had been supplied solely by Goldman and not priced from transactions with third parties.
4. Failing to Disclose Client Involvement. In Abacus, Goldman enabled a client who was shorting the CDO to help select the CDO's assets, solicited investors to buy the Abacus securities without disclosing the short party's asset selection role or investment objective, and helped the client gain a $1 billion profit at the expense of the investors to whom Goldman sold the securities.
5. Minimizing Premiums. In Abacus, Goldman entered into an undisclosed agreement with the sole short party to accept a fee for arranging low premium payments by the short party to the CDO, even though low premium payments meant less money for the long investors to whom Goldman had sold the Abacus securities.
6. Selling Securities Designed to Fail. Goldman sold Hudson and Abacus securities to clients knowing the securities were designed to fall in value and benefit the short party, which was a client in the case of Abacus and itself in the case of Hudson.
7. Delaying Liquidation. In Hudson, Goldman was paid a fee to serve as the liquidation agent, but delayed liquidating assets that were losing value for eight months, enhancing its financial gain as the CDO's short party at the expense of the long parties whose losses would have been staunched if the assets had been liquidated.
8. Misrepresenting Assets. In Anderson, when clients asked how Goldman got "comfortable" with poor quality New Century loans in the CDO, Goldman worked to dispel those concerns and failed to disclose its own discomfort with New Century loans and that it held 40% of the short side of the CDO, betting its assets would lose value.
9. Taking Immediate Post-Sale Markdowns. In Timberwolf, Goldman knowingly sold Timberwolf securities to clients at prices above its own book values and then, often within days or weeks of a sale, marked down the value of the sold securities, causing clients to incur quick losses and requiring some to post higher margin or cash collateral.
10. Evading Put Obligation. In Timberwolf, Goldman was paid a fee to serve as the collateral put provider, but refused for two months to allow the purchase of default swap collateral securities, even though they meant better returns for long investors, because Goldman did not want to assume the risk that the collateral securities might lose value.
11. Using Poor Quality Loans in Securitizations. Goldman provided securitization services and warehouse accounts to lenders with a history of issuing high risk, poor quality loans, and knowingly included poor quality loans in Goldman-originated RMBS and CDO securities.
12. Concealing Its Net Short Position. From late 2006 through most of 2007, Goldman engaged in a relentless effort to sell the CDO and RMBS securities it underwrote, without disclosing to the clients it solicited that Goldman was simultaneously shorting the subprime market and betting it would lose value.
These practices raise a wide range of ethical and legal concerns. This section examines the key issues of whether Goldman had a legal obligation to disclose to clients the existence of material adverse information, including conflicts of interest, when selling them RMBS and CDO securities; whether Goldman had material adverse interests that should have been disclosed to investors; and whether Goldman had an obligation not to recommend securities that were designed to lose value. Many of these issues hinge upon the proper treatment of financial instruments, such as credit default swaps and CDOs, which enable an investment bank to bet against the very same securities it is selling to clients.
To protect fair, open, and efficient markets for investors, federal securities laws impose a range of specific disclosure and fair dealing obligations on market participants, depending upon the securities activities they undertake. In the matters examined by the Subcommittee, the key roles under the securities laws include market maker, underwriter, placement agent, brokerdealer, and investment adviser.
Market Maker. A "market maker" is typically a dealer in financial instruments that stands ready to buy and sell a particular financial instrument on a regular and continuous basis at a publicly quoted price. |2671| A major responsibility of a market maker is filling orders on behalf of customers. Market markers do not solicit customers; instead they maintain buy and sell quotes in a public setting, demonstrating their readiness to either buy or sell the specified security, and customers come to them. For example, a market maker in a particular stock typically posts the prices at which it is willing to buy or sell that stock, attracting customers based on the competitiveness of its prices. This activity by market makers helps provide liquidity and efficiency in the trading market for that security. |2672| Market makers do not keep the financial instruments they buy and sell in their own investment portfolio, but instead keep them in their sales portfolio or "trading book."
Market makers have among the most narrow disclosure obligations under federal securities law, since they typically do not actively solicit clients or make investment recommendations to them. Their disclosure obligations are generally limited to providing fair and accurate information related to the execution of a particular trade. |2673| Market makers are also subject to the securities laws' prohibitions against fraud and market manipulation. In addition, they are subject to legal requirements relating to the handling of customer orders, for example using best execution efforts when placing a client's buy or sell order. |2674|
Underwriter and Placement Agent. Underwriters and placement agents have greater disclosure obligations than market makers, because in this role they are actively soliciting customers to buy new securities they have helped an issuer bring to market.
When securities are offered to the public for sale, they are typically underwritten by one or more investment banks, each of which is a broker-dealer registered with the Financial Industry Regulatory Authority (FINRA). |2675| An underwriter is typically hired by the issuer of the new securities to help the issuer register the securities with the SEC and conduct a public offering of the securities. The underwriter typically purchases the securities from the issuer, holds them on its books, conducts the public offering, and bears the financial risk until the securities are sold to the public.
Investment banks can also act as "placement agents," assisting those seeking to raise money through a private offering of securities by helping them design the securities, produce the offering materials, and market the new securities to investors. Placement agents are also registered broker-dealers. While public offerings of securities are required to be registered and filed with the SEC, private offerings are made to a limited number of investors and are exempt from SEC registration. In the securitization industry, RMBS securities are generally sold through public offerings, while CDO securities are generally sold through private placements.
Whether acting as an underwriter or placement agent, a major part of the investment bank's responsibility is to solicit customers to buy the new securities being offered. Under the securities laws, an issuer selling new securities to potential investors has an affirmative duty to disclose material information that a reasonable investor would want to know. |2676| In addition, under securities law, a broker-dealer acting as an underwriter or placement agent is liable for any material misrepresentation or omission of material fact made in connection with a solicitation or sale of securities to an investor. |2677|
The Supreme Court has held that a fact is material if there is a "substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix' of information made available." |2678| The SEC has provided this additional guidance:
"‘The question of materiality, it is universally agreed, is an objective one, involving the significance of an omitted or misrepresented fact to a reasonable investor.' ‘[T]he reaction of individual investors is not determinative of materiality, since the standard is objective, not subjective.' ‘[M]ateriality depends on the significance the reasonable investor would place on the withheld or misrepresented information.' Although in general materiality is primarily a factual inquiry, ‘the question of materiality is to be resolved as a matter of law when the information is ‘so obviously important [or unimportant] to an investor, that reasonable minds cannot differ on the question of materiality.'" |2679|
Unlike when a broker-dealer is acting as a market maker, a broker-dealer acting as an underwriter or placement agent has an obligation to disclose material information to every investor it solicits, including the existence of any material conflict of interest or adverse interest. This duty arises from two sources: the duties of an underwriter specifically, and the duties of a broker-dealer generally, when making an investment recommendation to a customer.
With respect to the duties of an underwriter, the First Circuit has observed that underwriters have a "unique position" in the securities industry:
"[T]he relationship between the underwriter and its customer implicitly involves a favorable recommendation of the issued security. …Although the underwriter cannot be a guarantor of the soundness of any issue, he may not give it his implied stamp of approval without having a reasonable basis for concluding that the issue is sound." |2680|
With respect to a broker-dealer, the SEC has held:
"[W]hen a securities dealer recommends a stock to a customer, it is not only obligated to avoid affirmative misstatements, but also must disclose material adverse facts to which it is aware. That includes disclosure of ‘adverse interests' such as ‘economic self interest' that could have influenced its recommendation." |2681|
The SEC has also stated that, if a broker intends to sell a security from its own inventory and recommends it to a customer, "the broker dealer must disclose all material facts." |2682|
To help broker-dealers understand when they are obligated to disclose to investors material information, including any material adverse interest, FINRA has further defined the term "recommendation":
"[A] broad range of circumstances may cause a transaction to be considered recommended, and this determination does not depend on the classification of the transaction by a particular member as ‘solicited' or ‘unsolicited.' In particular a transaction will be considered to be recommended when the member or its associated person brings a specific security to the attention of the customer through any means, including, but not limited to, direct telephone communication, the delivery of promotional material through the mail, or the transmission of electronic messages." |2683|
Goldman's own compliance manual essentially incorporates this guidance and instructs Goldman personnel that a proactive effort to sell a specific investment to a specific customer constitutes a recommendation of that investment. |2684|
Once a broker-dealer, acting in the role of an underwriter or placement agent, has made an investment recommendation and triggered the duty to disclose any material adverse interest to a potential investor, it must disclose not only that the adverse interest exists, but also the "nature and extent" of the adverse interest. |2685| In addition, it is not enough to inform a customer that the underwriter or placement agent "may" have an adverse interest if, in fact, the adverse interest already exists. |2686| Further, there is no indication in any law or regulation that the obligation to disclose material adverse information is diminished or waived in relation to the level of sophistication of the potential investor. |2687|
Suitable Investment Recommendations. In addition to requiring disclosure of material adverse information, federal securities laws and FINRA rules prohibit broker-dealers from making investment recommendations that would be unsuitable for any customer. |2688|
In a recent study, the SEC explained: "[W]hile the suitability obligation under the federal securities laws arises from the anti-fraud provisions, the SRO [Self Regulatory Organization] rules are grounded in concepts of ethics, professionalism, fair dealing, and just and equitable principles of trade. |2689| For example, FINRA Rule 2010, providing Standards of Commercial Honor and Principles of Trade, states: "A member, in the conduct of its business, shall observe high standards of commercial honor and just and equitable principles of trade." |2690|
A broker-dealer violates the suitability rule if it makes a recommendation that "is unsuitable for any investor, regardless of the investor's wealth, willingness to bear risk, age or other individual characteristics." |2691| Under the applicable case law and FINRA rules, a brokerdealer is also obligated "to have an ‘adequate and reasonable basis' for any security or strategy recommendation that it makes." |2692|
Suitability rules are intended to prevent abuses that contributed to the stock crash of 1929 and the Great Depression of the 1930s, when Senators investigating investment bank activities at the time wrote the following:
"[Investors] must believe that their investment banker would not offer them the bonds unless the banker believed them to be safe. This throws a heavy responsibility upon the banker. He may and does make mistakes. There is no way that he can avoid making mistakes because he is human and because in this world, things are only relatively secure. There is no such thing as absolute security. But while the banker may make mistakes, he must never make the mistake of offering investments to his clients which he does not believe to be good." |2693|
Investment Advisers. For investment banks that act, not just as a broker-dealer, underwriter, or placement agent, but also as an investment adviser to their customers, federal securities laws impose still a higher legal duty. When acting as an investment adviser, the law imposes a fiduciary obligation on the investment bank to act in the "best interests of its clients." |2694| A person qualifies as an "investment adviser" under the Investment Advisers Act if that person: provides advice regarding securities, is in the business of providing such advice, and provides that advice for compensation. |2695| A broker-dealer, however, is excluded from the Investment Advisers Act if the performance of its investment advisory services is "solely" incidental to its business as a broker-dealer, and the broker-dealer does not receive "special compensation" for providing those advisory services. |2696| Because Goldman appears to have acted primarily as an underwriter, placement agent, or broker-dealer in carrying out its securitization activities, this section analyzes Goldman's conduct in that context and not in the context of an investment adviser. |2697|
One key issue is whether Goldman was acting as a market maker versus an underwriter or placement agent when it recommended that its clients purchase its CDO and RMBS securities, since those roles have different disclosure and suitability obligations under the law. A second key issue is whether Goldman withheld material adverse information when recommending its securities to its clients, including the fact that it was shorting the securities it was selling. A third key issue is whether Goldman violated its obligation to make suitable investment recommendations when urging customers to purchase securities that Goldman knew were designed to lose value.
Given its active role in the securitization markets, Goldman assumed a variety of roles in the development, marketing, and trade of RMBS and CDO products. At times, it acted as a market maker responding to client orders to buy and sell RMBS and CDO products. In addition, from 2006 to 2007, Goldman originated and served as an underwriter or placement agent for 27 CDOs and 86 RMBS securitizations, and sold the resulting RMBS and CDO securities to a broad range of clients around the world.
In public statements and testimony regarding the financial crisis, Goldman has often highlighted its role as a market maker and downplayed its role as an underwriter or placement agent in the securitization markets. |2698| In the April 27, 2010 Subcommittee hearing, for example, Goldman executives repeatedly highlighted the firm's role as market makers – buying and selling RMBS and CDO securities at the request of clients – while deemphasizing that the firm also originated new securities and affirmatively solicited clients to buy those new securities.
In an exchange with Senator Susan Collins, for example, executives from Goldman's Mortgage Department were asked questions about whether they were investment advisers with a fiduciary duty to their clients. While not denying this duty, they emphasized their role as market makers with more limited client obligations: |2699|
Senator Collins: Thank you, Mr. Chairman. I would like to start my questioning by asking each of you a fundamental question. Investment advisers have a legal obligation to act in the best interests of their clients. Mr. Sparks, when you were working at Goldman, did you consider yourself to have a duty to act in the best interests of your clients?
Mr. Sparks: Senator, I had a duty to act in a very straightforward way, in a very open way with my clients. Technically, with respect to investment advice, we were a market maker in that regard. But with respect to being a prudent and a responsible participant in the market, we do have a duty to do that.
Senator Collins: Mr. Swenson?
Mr. Swenson: I believe it is our responsibility as market makers to provide a marketlevel bid and offer to our clients and to serve our clients and helping them transact at levels that are fair market prices and help meet their needs.
Mr. Tourre made similar representations in his prepared testimony to the Subcommittee:
"Between 2004 and 2007, my job was primarily to make markets for clients. I made markets by connecting clients who wished to take a long exposure to an asset – meaning they anticipated the value of the asset would rise – with clients who wished to take a short exposure to an asset – meaning they anticipated the value of the asset would fall. I was an intermediary between highly sophisticated professional investors – all of which were institutions. None of my clients were individual, retail investors. |2700|
In another exchange, when Subcommittee Chairman Levin asked Goldman CEO Lloyd Blankfein about the firm's duty as an underwriter and placement agent to disclose its adverse interests when selling its CDO securities to potential investors, Mr. Blankfein responded that market makers had no such disclosure obligations:
Senator Levin: You are betting against the very security that you are selling to that person. You don't see any problem? You don't see that you have to disclose, when you have put together a deal and you go looking for people to buy those securities, it just adds insult to injury when your people think it is a pile of junk. But the underlying injury is that you have determined that you are going to keep the opposite position from the security that you are selling to someone. You just don't see any obligation to disclose that. That is what seems to be coming through here.
Mr. Blankfein: I don't believe there is a disclosure obligation, but as a market maker, I am not sure how a market would work if it was premised on the assumption that the other side of the market cared what your opinion was about the position they were taking.
Senator Levin: Do they have a belief that you, at least when you are going out peddling securities, that you want that security to succeed? Don't they have that right to assume that if you are going out selling securities, that you have a belief that that is something which would be good for that client?
Mr. Blankfein: I think we have to have a belief, and we do have a belief that if somebody wants an exposure to housing –
Senator Levin: They don't want – you are out there selling it to them. You are out there selling these securities. This isn't someone walking in the door.
Mr. Blankfein: Again, I want –
Senator Levin: You are picking up the phone. You are calling all these people. You don't tell them that you think it is a piece of junk. You don't tell them that this is a security which incorporates or which in some way references a whole lot of bad stuff in your own inventory – bad lemons, they were called. ... You are out there looking around for buyers of stuff, whether it is junk or not junk, where you are betting against what you are selling. You are intending to keep the opposite side. This isn't where you are just selling something from your inventory. This is where you are betting against the very product you are selling, and you are just not troubled by it. That is the bottom line. There is no trouble in your mind –
Mr. Blankfein: Senator, I am sorry. I can't endorse your characterization.
Senator Levin: It is a question, not a characterization. I am saying, you are not troubled.
Mr. Blankfein: I am not troubled by the fact that we market make as principal and that we are the opposite – when somebody sells, they sell to us, or when they buy, they buy from us. |2701|
Although Goldman representatives routinely emphasized the firm's role as a market maker, when asked directly if the firm also functioned as an underwriter or placement agent when selling the CDO securities it originated, its executives agreed that in some circumstances, the firm played that role:
Senator Pryor: OK. But let me ask this: When you are selling a security such as a CDO, my understanding is you are not a market maker. Isn't it true that you are placement agent and as a placement agent you have a duty of full disclosure?
Mr. Sparks: Senator, that is correct. |2702|
Similarly, in a written response to a Subcommittee question asking about the firm's role in relation to Anderson, Hudson 1, Timberwolf and other CDOs, Mr. Blankfein wrote: "Goldman Sachs or an affiliate served as a placement agent." |2703|
Despite this acknowledged fact, Goldman continued to claim it was a market maker with limited disclosure and client obligations. On May 1, 2010, for example, less than a week after the Subcommittee's April 27 hearing, an article entitled, "Goldman Sachs' Lloyd Blankfein Defends ‘Market Maker' Firm on ‘Charlie Rose' Show," described Mr. Blankfein's statements on the televised show as follows:
"Asked by Rose whether Goldman investment advisers had ever bought securities from the firm, sold them to clients, and then bet against those same securities, Blankfein paused. And after a solid six seconds of silence, sought to explain … Goldman's role as a ‘market maker.'
‘We're like a machine, that lets people buy and sell what they want to buy and sell' Blankfein said. ‘That's not the advisory business. That's just a facility for market making.'" |2704|
During the interview, Mr. Blankfein compared Goldman's activity to that of the New York Stock Exchange, claiming that the firm was a market maker taking buy and sell orders from clients. |2705| At one point, Mr. Rose asked: "Has there ever been a time when Goldman's investment advisers bought securities from Goldman for a client and at the same time Goldman was simultaneously shorting it?" Mr. Blankfein responded: "I have to explain, see this is a problem. As a market maker, we are buying and selling a thousand times a minute, probably." Mr. Blankfein also stated during the interview: "If we believed it would fail, the security wouldn't work, we would not sell it." |2706|
Under federal securities law and FINRA Rules detailed above, when a broker-dealer, acting as an underwriter or placement agent brings a specific security to the attention of a particular customer, it is considered to be recommending the security to that customer and has an obligation to disclose all material adverse information to that customer, including any adverse interest that a reasonable investor would consider material in considering the broker-dealer's recommendation. Despite Goldman's frequent efforts to characterize its CDO and RMBS sales efforts as a market making activity in response to client demand, Goldman's internal documents, emails, and interviews indicate that, from late 2006 through 2007, Goldman was not always responding to client demand, but was also aggressively soliciting customers in an attempt to sell its CDO and RMBS products.
In December 2006, for example, Goldman CFO David Viniar instructed the Mortgage Department to reduce its long position in mortgage related assets, including by selling RMBS and CDO products on its books. |2707| The Mortgage Department responded with a concerted effort to sell to clients the bulk of the RMBS and CDO products in its inventory. The Subcommittee saw no evidence that this intensive selling campaign was undertaken in response to client demand. To the contrary, the evidence shows that the sales effort was undertaken at the request of senior management, despite what was then waning investor interest in securitization products.
In December 2006, on the same day Mr. Viniar directed the Mortgage Department to reduce its long assets, Kevin Gasvoda, head of the desk that handled RMBS securities, told his staff to "move stuff out even if you have to take a small loss." |2708| In January 2007, Mr. Sparks, head of the Mortgage Department, asked a senior executive to compliment the CDO Origination Desk head and his staffer for their efforts to sell a specific CDO's securities over the prior month: "They structured like mad and traveled the world, and worked their tails off to make some lemonade out of some big old lemons." |2709| In March 2007, Mr. Sparks emailed a call for "help" to Goldman's top sales managers around the world to "sell our new issues – CDOs and RMBS – and to sell our other cash trading positions." |2710| He wrote: "I can't over state the importance to the business of selling these positions and new issues. … Priority 1 – sell our new issues and cash positions." |2711| In April 2007, the Mortgage Department issued one of many sales directives to Goldman's global sales force, placing a priority on selling certain CDO securities in its inventory, including securities from Anderson, Timberwolf, Point Pleasant, and Altius CDOs, and Mr. Sparks recommended providing large sales credits for those able to complete the sales. |2712|
The documents also show that Goldman personnel worked relentlessly to identify possible clients and pitch CDO securities to them. In March 2007, for example, the Syndicate Desk contributed a list of "non-traditional buyers" that could be targeted for CDO sales, writing that "we continue to push for leads." |2713| A Goldman sales manager suggested targeting European and Middle Eastern banks and hedge funds. |2714| In New York, a Goldman sales representative recounted that the Abacus CDO security "has been showed to selected accounts for the past few weeks. Those selected accounts previously declined participating in Anderson mezz, Point Pleasant, and Timberwolf." |2715|
When CDO sales slowed in May 2007, the Mortgage Department produced a new "target" list of four primary and 35 secondary clients for CDO sales. |2716| A few days later, a Goldman salesperson reported that he planned to contact a hedge fund about Timberwolf and Point Pleasant securities, noting that the customer was "[n]ot expert[] in this space at all but [I] made them a lot of money in correlation dislocation and will do as I suggest." |2717| In Australia, a Goldman sales representative contacted an Australian hedge fund, Basis Capital, and mounted a sustained effort to sell it $100 million in Timberwolf securities, overcoming investor concerns to make the sale. |2718| In Korea, a Goldman sales representative attempting to sell $56 million in Timberwolf securities to a Korean life insurance firm was encouraged to "Get ‘er done" and "go for it" by his superiors when he informed them "we are pushing on our personal relationships to get this done." |2719|
These and other documents show that, in late 2006 and 2007, Goldman was not acting as primarily a market maker responding to client demand when it originated and sold Hudson, Anderson, Timberwolf, and Abacus securities, or when it sold other RMBS and CDO assets that senior management wanted to remove from the firm's books due to their declining values and increasing risk. Instead, Goldman was acting as an underwriter, placement agent, or brokerdealer, aggressively soliciting its clients to purchase the CDO and RMBS products that senior management wanted to eliminate from its inventory.
Goldman's marketing and solicitation efforts to sell Hudson, Anderson, Timberwolf, and Abacus securities, along with other CDO and RMBS assets, to clients raise multiple questions about whether Goldman met its obligation to disclose material adverse information to potential investors. A related question is whether Goldman met its obligation to avoid material misrepresentations and omissions of material facts when recommending the purchase of those securities. One key issue is whether Goldman's failure to disclose its shorting activities, which would enable it to profit from a decline in the value of the very securities Goldman was recommending to its clients to purchase, qualified as an "omitted fact" that "would have been viewed by the reasonable investor as having significantly altered the ‘total mix' of information made available" about the security being recommended by Goldman. |2720|
Taking the Short Side of a CDO. In the four CDOs examined in this Report, Goldman took 100% of the short side of Hudson, 40% of the short side of Anderson, and 36% of the short side of Timberwolf. |2721| In each of these CDOs, Goldman also made a relatively small investment in the long side of the CDO by initially retaining all or a portion of its equity tranche, allowing Goldman to claim an "interest" in the CDO's long term success. |2722| In Abacus, Goldman did not intend to make any investment in the CDO itself, and instead enabled the client that had requested construction of the CDO and played a key role in selecting its assets to hold 100% of the short side of the CDO.
Goldman did not accurately or fully disclose its short interest in Hudson, Anderson, or Timberwolf to potential investors. |2723| Instead, the CDO's offering materials advised potential investors, in difficult to understand language, that a Goldman affiliate "may" adopt a financial interest or investment position adverse to the investors when, in fact, Goldman had already determined to do so. In a section entitled, "Certain Conflicts of Interest," for example, the Hudson 1 Offering Circular stated in part:
"Certain Conflicts of Interest. Various potential and actual conflicts of interest may arise from the overall activities of the Credit Protection Buyer, the overall underwriting, investment and other activities of the Liquidation Agent, the Senior Swap Counterparty and the Collateral Put Provider, their respective affiliates and its clients and employees and from the overall investment activity of the Initial Purchaser, including in other transactions with the Issuer. The following briefly summarizes some of these conflicts, but is not intended to be an exhaustive list of all such conflicts.
"The Credit Protection Buyer and Senior Swap Counterparty. GSI [Goldman Sachs International] will be the initial Credit Protection Buyer and the initial Senior Swap Counterparty. The following briefly summarizes some potential and actual conflicts of interests related to the Credit Protection Buyer and Senior Swap Counterparty, but the following isn't intended to be an exhaustive list of all such conflicts. ...
"GSI and/or any of its affiliates may invest and/or deal, for their own respective accounts for which they have investment discretion, in securities or in other interests in the Reference Entities, in obligations of the Reference Entities or in the obligors in respect of any Reference Obligations or Collateral Securities (the "Investments") or in credit default swaps (whether as protection buyer or seller) .... In addition, GSI and/or any of its affiliates may invest and/or deal, for their own respective accounts or for accounts for which they have investment discretion, in securities (or make loans or have other rights) that are senior to, or have interests different from or adverse to, any of the Investments and may act as adviser to, may be lenders to, and may have other ongoing relationships with, the issuers or obligors of Investments and obligations of any Reference Entities." |2724|
This disclosure indicates that GSI or an affiliate "may invest and/or deal" in securities or other "interests" in the assets underlying the Hudson CDO, and "may invest and/or deal" in securities that are "adverse to" the Hudson "investments." The Offering Circular, however, misrepresented Goldman's investment plans. At the time it was created in December 2006, Goldman had already determined to keep 100% of the short side of the Hudson CDO and act as the sole counterparty to the investors buying Hudson securities, thereby acquiring a $2 billion financial interest that was directly adverse to theirs. |2725|
A federal court has held that disclosing a potential adverse interest, when a known adverse interest already exists, can constitute a material misstatement to investors. |2726| In the case of the Hudson CDO, much of the profit Goldman obtained would be generated from the losses incurred by clients that bought Hudson securities, creating an actual, undisclosed adverse interest. This construct, in which Goldman's profits depended in part upon its clients' losses, created a clear conflict of interest between Goldman and the clients to whom it was selling the Hudson securities, once Goldman had decided to become a short party in the CDO it was simultaneously marketing.
In another part of the Offering Circular, Goldman stated that GSI would serve as the sole counterparty to the CDO, but that disclosure was made in the context of a common industry practice in which the CDO originator or its designate typically took the entire short side of the transaction in the first instance and was the only party that dealt directly with the shell corporation actually issuing the CDO's securities. The CDO originator, or its designate, then acted as an intermediary between the shell corporation and the other broker-dealers buying short positions in the CDO on behalf of themselves or a customer. By placing itself in the middle of each CDS contract, the originator or its designate provided stronger financial backing for the CDS contracts being issued by the CDO and obtained more favorable credit ratings for the CDO securities. In the CDOs examined by the Subcommittee, Goldman followed industry practice by designating its affiliate, GSI, as the initial sole counterparty in the Hudson, Anderson, and Timberwolf CDOs. |2727| Customers learning of GSI's role as the initial sole counterparty in the Hudson CDO would likely have assumed that GSI planned to sell its initial short position to other parties, since that was industry practice. What Goldman failed to disclose to those customers is that it planned to hold (or already held) all or a substantial portion of the short side of the CDO as a proprietary investment adverse to the interests of the customers to whom Goldman was selling the CDO securities. Had those customers known of Goldman's substantial short investment, they would likely have understood that Goldman viewed the very CDO securities it was recommending they purchase as likely not to perform.
Goldman's failure to disclose its short interest was further compounded when it told investors that its interests "were aligned" with those of the long investors or when it advertised its retention of a portion of the CDO's equity tranche. The Hudson marketing booklet stated: "Goldman Sachs has aligned incentives with the Hudson program by investing in a portion of equity and playing the ongoing role of Liquidation Agent." |2728| What made the statement misleading and what Goldman failed to disclose in the booklet was that its $6 million equity investment |2729| was far outweighed by its $2 billion short investment. |2730| In addition, Goldman later used its liquidation agent position to benefit its short investment at the expense of the long investors in Hudson. |2731| In Anderson, talking points prepared for the Goldman sales force advocated telling investors: "Goldman is underwriting the equity and expects to hold up to 50%." |2732| What the talking points left out was that Goldman's $21 million equity investment in Anderson was less than one sixth the size of its $135 million short position. |2733| In Timberwolf, the marketing booklet stated that Goldman was purchasing 50% of the equity tranche, and the collateral manager Greywolf was purchasing the other 50%. |2734| Again, the booklet failed to disclose that Goldman's equity investment was far outweighed by its short investment. |2735| In each CDO, Goldman withheld from investors information that it had a more significant financial interest in seeing the CDO decline in value than increase in value. In light of its short investments, Goldman's claims that its interests were aligned with, rather than adverse, to the investors to whom it was selling the CDO securities were misleading.
Shorting the Subprime Market. Goldman also failed to disclose to clients that, at the same time it was recommending investments in Goldman-originated RMBS and CDO securities, it was committing billions of dollars to short the same types of securities, as well as their underlying assets, |2736| and even some of the lenders whose mortgage pools were included or referenced in the securities. |2737| In February 2007, Goldman's net short totaled about $10 billion. |2738| In June 2007, its net short reached about $13.9 billion. A significant issue is whether this omitted information – that Goldman was heavily shorting the same types of investments it was recommending – "would have been viewed by the reasonable investor as having significantly altered the ‘total mix' of information made available" about the securities Goldman was recommending. |2739|
Other Adverse Information. In addition to its failure to disclose that it was shorting specific CDOs as well as the subprime mortgage market as a whole, Goldman failed to disclose other arrangements which created conflicts of interest and undisclosed financial interests that were adverse to its clients. Concerning Abacus, Goldman failed to disclose a compensation arrangement in which Goldman agreed to accept a fee for arranging low premium payments by the short party; those lower payments disadvantaged the long investors by reducing cash payments to the CDO. Concerning Hudson, Goldman failed to disclose that its dual roles as liquidation agent and sole short party meant that it could delay liquidating Hudson assets that were losing value and simultaneously increase the value of its short position; that same action increased the losses of the long investors. In Timberwolf, Goldman failed to disclose that it viewed its role as collateral put provider allowed it to refuse to consent to the purchase of default swap collateral securities and avoid any risk that the securities would decline in value – the very risk the long investors were paying Goldman a fee to assume. |2740| In each CDO, Goldman took actions that created an undisclosed conflict of interest between itself and the investors to whom it recommended and sold the CDO securities.
These types of arrangements, when undisclosed, can result in conflicts of interest that disadvantage investors. The existence, nature, and extent of such arrangements are the type of material adverse information that the securities laws were designed to ensure were accurately described and disclosed to investors.
In addition to the disclosure issues, Goldman's efforts to sell Hudson, Anderson, Timberwolf, and Abacus securities raise a set of issues related to whether Goldman met its obligation to engage in fair dealing with its clients and avoid recommending investments that were unsuitable for any investor. The focus here is on Goldman's sale of CDO securities that were designed to lose value, either because the short party selected the assets or the assets were so poor that Goldman knew or should have known they would perform poorly or fail, yet marketed them to customers anyway.
As detailed earlier, broker-dealers are required to deal fairly with their customers and observe high standards of honor in the conduct of their business. |2741| When a broker-dealer, acting as an underwriter, makes an investment recommendation to a client, it is implicit that the broker-dealer has a reasonable basis to believe that the issue is sound. |2742| A broker-dealer is also required "to have an ‘adequate and reasonable basis' for any security or strategy recommendation that it makes." |2743| Broker-dealers are barred from offering investments that are unsuitable for any investor. |2744| Goldman itself, in response to a Subcommittee question, has acknowledged that broker-dealers owe a "general suitability" obligation to its institutional investors, and "[t]his suitability duty requires the broker-dealer to determine, in the first instance, that the transaction is suitable for at least some investors." |2745| Despite those requirements, the evidence gathered by the Subcommittee indicates that Goldman did not view any of the four CDOs examined in this Report as sound investments for the clients to whom it sold the securities. |2746|
Selection of Assets by Short Party. Internal documents and emails from Goldman indicate that both Abacus and Hudson were designed with the expectation they would lose value and produce a profit for the short side of the CDOs. The sole short party in Abacus was the Paulson hedge fund; the sole short party in Hudson was Goldman itself.
With respect to Abacus, Goldman knew that the Paulson hedge fund wanted to take 100% of the short side and would profit only if the CDO lost value, yet allowed the hedge fund to play a major but hidden role in selecting the CDO assets. |2747| The Goldman employee with lead responsibility for Abacus, Fabrice Tourre, called it a "weak quality portfolio." |2748| The Paulson hedge fund executive who participated in the asset selection process acknowledged he selected assets that he expected would not perform well. |2749| A Moody's executive who oversaw CDO ratings when Abacus was rated – and testified that he did not know of Paulson's role in the Abacus asset selection process – explained that "[i]t just changes the whole dynamic of the structure where the person who is putting it together, choosing it, wants it to blow up." |2750| When Goldman began to publicly market the Abacus securities, Ed Steffelin, a Senior trader at GSC who had declined Goldman's request that his firm serve as the CDO's portfolio selection agent, sent an email to Peter Ostrem, head of Goldman's CDO Origination Desk, stating: "I do not have to say how bad it is that you guys are pushing this thing." |2751| When asked by the Subcommittee what he meant by that comment, Mr. Steffelin said that he believed the Abacus CDO created "reputational risk" for the collateral manager industry and the whole market. |2752| When Mr. Tourre later sought to book two CDS contracts referencing the Abacus securities, a Goldman salesman wrote: "seems we might have to book these pigs." |2753|
As planned, once issued, the Abacus securities quickly lost value. In October 2007, six months after the Abacus securities were issued, the credit rating agencies downgraded them, and a Goldman salesperson noted: "This deal was number 1 in the universe of CDO's that were downgraded by Moody's and S&P. 99.89% of the underlying assets were downgraded." |2754| The three investors that bought Abacus securities together lost more than $1 billion, while the Paulson hedge fund, as the sole short party, recorded a corresponding $1 billion profit. |2755| In July 2010, Goldman agreed to settle a securities fraud complaint brought by the SEC by paying a fine of $550 million and "acknowledging it was a mistake for the Goldman marketing materials to state that the reference portfolio was ‘selected by' ACA Management, LLC without disclosing the role of Paulson & Co. Inc. in the portfolio selection process and that Paulson's economic interests were adverse to CDO investors." |2756|
With respect to Hudson, Goldman designed the CDO from its inception as a way to transfer the risk of loss associated with ABX assets from Goldman's inventory to the Hudson investors. |2757| Goldman documents state, for example, that Hudson was "initiated by the firm as the most efficient method to reduce long ABX exposures," |2758| and the CDO was an "exit for our long ABX risk." |2759| Goldman created and took the short side of $2 billion in single name CDS contracts referencing RMBS securities that it wanted to short, and sold them to the Hudson CDO. The end result was that Goldman wrote 100% of the CDS contracts that made up Hudson's assets and took 100% of the short side of the CDO, which meant that Goldman would profit if the CDO fell in value. Goldman marketed the CDO without disclosing its status as the sole short party, instead telling investors that its interests were "aligned" with theirs. The Hudson securities immediately began losing value. Within a year, while the holders of the Hudson securities lost virtually their entire investments, Goldman's profits reached $1.7 billion, which it then used to offset other mortgage related losses.
In both CDOs, Goldman took actions that disguised that the transactions were designed to lose value. In Abacus, Goldman omitted mention of the Paulson hedge fund's involvement in the asset selection process and hired a well known third party portfolio agent, ACA Management, to "leverage ACA's credibility." |2760| In Hudson, Goldman omitted that it had written all of the CDO's CDS contracts and it referenced $1.2 billion in ABX assets in Goldman's own inventory, and instead told investors that Hudson's assets were "sourced from the Street" and Hudson was "not a Balance Sheet CDO." |2761|
Goldman marketed the Abacus and Hudson securities to clients knowing that each CDO had been designed to lose value and produce a profit for the short party. Given that information, Goldman marketed CDOs that it knew or should have known were not suitable for any investor.
Selection of Poor Quality Assets. Similar concerns apply to Goldman's origination and marketing of the Anderson and Timberwolf CDOs, which contained such poor quality assets that Goldman knew or should have known that they would perform poorly or fail. Yet Goldman recommended them to investors anyway. The issue is whether, by recommending that investors purchase the Anderson and Timberwolf securities, Goldman violated its fair dealing obligation and recommended investments that were not suitable for any investor.
With respect to Anderson, Goldman personnel knew before marketing its securities that the CDO had poor quality assets that were losing value. Nearly 45% of the referenced RMBS securities in Anderson were dependent upon loans issued by New Century, while another 7% depended upon loans issued by Fremont, two subprime lenders known, including by Goldman personnel, for issuing poor quality loans and poorly performing RMBS securities. |2762| On February 24, 2007, Goldman personnel calculated that the assets in the Anderson warehouse account had already lost $60 million in value from the time they were purchased. |2763| In response, Mr. Sparks, the Mortgage Department head, decided to cancel the CDO. |2764| Later, he changed his mind and rushed Anderson to market with only $305 million of the $500 million in assets that had been planned. Goldman was the largest short party, with 40% of the short interest in Anderson.
Anderson issued its securities on March 20, 2007. Goldman knew at the time that both New Century and Fremont were in financial distress. |2765| In addition, the week before, Goldman had conducted reviews of both a New Century and a Fremont loan pool on the firm's books, and found that 26% of the New Century loans |2766| and 50% of the Fremont loans |2767| reviewed had deficiencies and should be returned to the lender for refunds. Goldman nevertheless continued to market the Anderson securities. When some potential investors expressed concerns about Anderson's underlying assets, in particular the New Century loans, Goldman tried to dispel those concerns even while harboring its own low opinion of New Century loans. |2768| Goldman managed to sell approximately $102 million in Anderson securities to nine investors who lost virtually their entire investments within a year. |2769|
With respect to Timberwolf, Goldman personnel knew that the CDO's assets had begun losing value almost from the time they were acquired. |2770| Timberwolf was a CDO2 transaction comprised of 56 different CDO assets with over 4,500 unique underlying securities. |2771| In February 2007, Mr. Sparks told a senior Goldman executive that it was a deal "to worry about," and that its assets had already incurred such significant losses that they had exhausted the share of the warehouse risk held by Goldman's partner in the transaction. |2772| Despite that loss in value, Goldman continued with the issuance of the Timberwolf securities in March 2007. By May, a special CDO valuation project undertaken by the Mortgage Department found that the Timberwolf's assets had lost still more value. |2773| Despite its lower internal valuation, Mr. Sparks advised Goldman senior executives that his CDO pricing strategy was to "take the writedown, but market at much higher levels" to avoid "leaving some money on the table." |2774|
During the spring and summer of 2007, Goldman aggressively marketed Timberwolf securities to investors around the world, eventually selling about $853 million in Timberwolf securities to 12 investors. |2775| Goldman sold the securities at prices substantially above its internal book values for the Timberwolf securities. After making a sale, Goldman then, sometimes only days or weeks later, marked down the value of the securities it had sold, resulting in investors realizing losses and sometimes requiring the investor to post additional cash margin or collateral. |2776| In September 2007, an internal Goldman analysis found that, in just six months, Timberwolf's AAA rated securities had lost 80% of their value. One of Goldman's senior executives monitoring Timberwolf pronounced it "one shitty deal." |2777| The CDO was liquidated in October 2008, and the investors who purchased Timberwolf securities lost virtually their entire investments.
Goldman CEO Lloyd Blankfein said publicly about the firm's securities: "If we believed it would fail … the security wouldn't work, we would not sell it." |2778| But Goldman marketed the Anderson and Timberwolf securities to clients knowing that each CDO had poor quality assets that were continually losing value. It marketed them at the same time it was investing on the short side of the CDOs and the subprime mortgage market as a whole, and its Mortgage Department head was telling his staff that it was "Game Over" and time to "get out of everything." |2779| Within a year, the Anderson and Timberwolf securities were virtually worthless. Given what Goldman knew when marketing Anderson and Timberwolf, Goldman was recommending investments that were most likely not suitable for any investor.
This analysis examines Goldman's conduct in the context of the law prevailing in 2007. Since then, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 has established new conflict of interest prohibitions that would apply to this type of conduct, including Section 621 which bars any underwriter or placement agent of an asset backed security from engaging in any transaction "that would involve or result in any material conflict of interest with respect to any investor in a transaction arising out of such activity."
Notes
2671. Section 3(a)(38) of the Securities Exchange Act of 1934 ("The term ‘market maker' means any specialist permitted to act as a dealer, any dealer acting in the capacity of block positioner, and any dealer who, with respect to a security, holds himself out (by entering quotations in an inter-dealer communications system or otherwise) as being willing to buy and sell such security for his own account on a regular or continuous basis."); see also SEC website, http://www.sec.gov/answers/mktmaker.htm; see also FINRA website, FAQs, "What Does a Market Maker Do?" http://finra.atgnow.com/finra/categoryBrowse.do. [Back]
2672. SEC website, http://www.sec.gov/answers/mktmaker.htm. [Back]
2673. 1/2011 "Study on Investment Advisers and Broker-Dealers," study conducted by the U.S. Securities and Exchange Commission, at 55, http://www.sec.gov/news/studies/2011/913studyfinal.pdf, (hereinafter "SEC Study on Investment Advisers and Broker-Dealers"). [Back]
2674. See Goldman response to Subcommittee QFR at PSI_QFR_GS0046. [Back]
2675. FINRA is the largest independent self-regulatory organization for securities firms doing business in the United States. FINRA has been delegated authority by the SEC and a number of securities exchanges to regulate the broker-dealer industry. Its stated mission is "to protect America's investors by making sure the securities industry operates fairly and honestly." See FINRA website, http://www.finra.org. [Back]
2676. See, e.g., SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 201 (1963) ("Experience has shown that disclosure in such situations, while not onerous to the advisor, is needed to preserve the climate of fair dealing which is so essential to maintain public confidence in the securities industry and to preserve the economic health of the country."). See also SEC Study on Investment Advisers and Broker-Dealers at 51 [citations omitted] ("Under the so-called ‘shingle' theory … a broker-dealer makes an implicit representation to those persons with whom it transacts business that it will deal fairly with them, consistent with the standards of the profession. … Actions taken by the broker-dealer that are not fair to the customer must be disclosed in order to make this implied representation of fairness not misleading."). [Back]
2677. See Sections 11 and 12 of Securities Act of 1933. See also Rule 10b-5 of the Securities Exchange Act of 1934. See also SEC v. Capital Gains Research Bureau, Inc., 375 U.S. at 200 ("Failure to disclose material facts must be deemed fraud or deceit within its intended meaning, for, as the experience of the 1920's and 1930's amply reveals, the darkness and ignorance of commercial secrecy are the conditions upon which predatory practices best thrive."). See also Goldman response to Subcommittee QFR, at PSI_QFR_GS0046. [Back]
2678. Basic v. Levinson, 485 U.S. 224, 231-32 (1988) (quoting TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976)). [Back]
2679. In the Matter of David Henry Disraeli and Lifeplan Associates, Securities Exchange Act Rel. No. 34-2686 (December 21, 2007) at 10-11 [citations omitted]. [Back]
2680. SEC v. Tambone, 550 F.3d 106, 135 (1st Cir. 2008) [citations omitted]. [Back]
2681. In the Matter of Richmark Capital Corporation, Securities Exchange Act Rel. No. 48757 (Nov. 7, 2003) (citing Chasins v. Smith Barney & Co., Inc., 438 F.3d 1167, 1172 (2d. Cir. 1970) ("The investor…must be permitted to evaluate overlapping motivations through appropriate disclosures, especially where one motivation is economic self-interest"). See also SEC Study on Investment Advisers and Broker-Dealers at 55. In this recent study examining the disclosure obligations of broker-dealers and investment advisers, the SEC has explained: "Generally, under the anti-fraud provisions, a broker-dealer's duty to disclose material information to its customer is based upon the scope of the relationship with the customer, which is fact intensive." According to the SEC, when a broker-dealer acts as an order taker or market maker in effecting a transaction for a customer, the brokerdealer generally does not have a duty to disclose information regarding the security or the broker-dealer's economic interest. The duty to disclose this information is triggered, however, when the broker-dealer recommends a security. Id. [Back]
2682. SEC Study on Investment Advisers and Broker-Dealers at 56, n.252. [Back]
2683. FINRA Notice to Members 96-60. [Back]
2684. See 2/1/2001 Goldman document, "United States Policies for the Preparation, Supervision, Distribution and Retention of Written and Electronic Communications," at 9, GS MBS 0000035799. [Back]
2685. See ,e.g., In the Matter of Arleen Hughes, Securities Exchange Act Rel. No. 4048 (Feb. 1948) (holding a broker-dealer, who is also a registered investment adviser, violated the anti-fraud provisions of the federal securities laws by failing to at minimum disclose the "nature and extent" of its adverse interest); In the Matter of Edward D. Jones & Co., L.P., Exchange Act Rel. No. 50910 (Dec. 22, 2004) (settled order), at 21(broker-dealer consents to an order finding that disclosure to its customers was inadequate, because it failed to disclose the full nature and extent of its agreement, including "information about the source and the amount of the revenue sharing payments to [the broker-dealer] and the dimensions of the resulting potential conflicts of interest"). [Back]
2686. See, e.g., SEC v. Czuczko, Case No. CV06-4792 (USDC CD Calif.), Order Granting Plaintiff's Unopposed Motion for Summary Judgment (Dec. 5, 2007). In Czuczko, the defendant, who offered online investment advice, included a disclaimer on his website advising that officers, directors, employees and members of their families "may, from time to time, trade in these securities for their own accounts" [emphasis in original]. Id. at 8. Relying on SEC v. Blavin, 760 F.2d 706 (6th Cir. 1985), the court held such an assertion "is itself a material misstatement because the Defendant knew he, his father, and his business partner did trade in the stocks and had a biased interest in the recommended stocks" [emphasis in original]. Czuczko, at 8. [Back]
2687. See FINRA Rules 2210(d)(1)(A) and 2211(a)(3) and (d)(1) (by rule all institutional sales material and correspondence may not "omit any material fact or qualification if the omission, in the light of the context of the material presented, would cause the communications to be misleading."); and FINRA Rule 2310 and IM-2310-3 (suitability obligation to institutional customers). See also Hanly v. SEC, 415 F.2d 589, 596 (2d Cir. 1969) (holding that sophistication and knowledge of a broker's customers do not warrant a less stringent standard of conduct under federal securities laws); Spatz v. Borenstein, 513 F. Supp. 571, 580 (N.D. Ill. 1981) (finding investors' experience does not mitigate a broker's duty to fully and truthfully disclose material facts, nor does the potential for investors to discover information not disclosed by a prospectus vitiate any legal liability stemming from a failure to disclose material facts); Department of Enforcement v. Kesner, FINRA Complaint No. 2005001729501 (February 26, 2010) (finding sophistication of investors does not relieve a securities representative from disclosing material facts to investors). [Back]
2688. SEC Study on Investment Advisers and Broker-Dealers at 61. [Back]
2690. FINRA Rule 2010. See also Study on Investment Advisers and Broker-Dealers at 55 (broker-dealers also have an obligation under the federal securities laws and FINRA rules to deal fairly with their customers). [Back]
2691. F.J. Kaufman and Co., Securities Exchange Act Rel. No. 27535 at 5 (December 13, 1989). [Back]
2692. SEC Study on Investment Advisers and Broker-Dealers at 63 [citations omitted]. The suitability rule also requires the broker to determine that the specific security recommended is appropriate based on the customer's financial situation and needs. FINRA Rule 2310. The suitability obligation clearly applies to institutional customers, FINRA IM-2310-3 (suitability obligations to institutional customers require members have a reasonable basis for recommending a particular security or strategy), but may not apply when a broker-dealer solicits another broker-dealer to buy an investment since, under FINRA Rules, the term "customer" does not include a broker or dealer. FINRA Manual, 0120 Definition. On the other hand, the term "customer" has been given a broad definition under the securities case law. See, e.g., Department of Enforcement v. Zayed, FINRA Complaint No. 2006003834901 (August 19, 2010) ("Cases interpreting the term ‘customer' in the securities context have viewed the term broadly to encompass individuals or entities that have some brokerage or investment relationship with the broker-dealer. Specifically, courts have rejected the argument that an account is necessary to establish an investor's status as a customer." [citations omitted]). When the Subcommittee asked Mr. Blankfein whether he believed there was a difference between a "customer" and a "client," Mr. Blankfein said he had "never distinguished" between the two terms. Subcommittee deposition of Lloyd Blankfein (12/15/2009), Hearing Exhibit 4/27-176 [Sealed Exhibit]. [Back]
2693. 6/16/1934 "Stock Exchange Practices," Report of the Senate Committee on Banking and Currency, S. Rep. 73- 1455, at 88 (quoting "Who Buys Foreign Bonds," Foreign Affairs (1/1927)). [Back]
2694. SEC Study on Investment Advisers and Broker-Dealers at 15-16. [Back]
2697. The Subcommittee did not examine the extent to which Goldman was acting as an investment adviser within the meaning of the Investment Advisers Act when recommending that various customers buy its RMBS and CDO securities. [Back]
2698. See, e.g., 3/1/2010 letter from Goldman's legal counsel to the Financial Crisis Inquiry Commission, GS-PSI-01310 (discussing Goldman Sachs' "Role as a market maker" in detail and distinguishing it, in a much shorter description, from its underwriting and placement roles). Although the letter acknowledged that Goldman acted as an underwriter and placement agent for RMBS and CDO transactions, it also suggested that those transactions were commonly designed in response to client inquiries and did not discuss efforts by the firm to solicit customers to buy the securities: "Goldman Sachs' CDOs ... were initially created in response to the request of a sophisticated institutional investor that approached the firm specifically seeking that particular exposure. Reverse inquiries from clients were a common feature of this market." [Back]
2699. April 27, 2010 Subcommittee Hearing Transcript at 26-27. [Back]
2700. Prepared statement of Fabrice Tourre, April 27, 2010 Subcommittee Hearing at 1. [Back]
2701. April 27, 2010 Subcommittee Hearing at 137-138. [Back]
2703. Goldman response to Subcommittee QFR at PSI_QFR_GS0026. [Back]
2704. "Goldman Sachs' Lloyd Blankfein Defends ‘Market Maker' Firm On ‘Charlie Rose Show,'" Huffington Post (5/1/2010), http://www.huffingtonpost.com/2010/05/01/goldman%1esachs%1elloyd%1eblank_n_559606.html (video of Charlie Rose interview of Lloyd Blankfein embedded). [Back]
2706. April 30, 2010 Transcript of The Charlie Rose Show at 12-14. Mr. Blankfein made similar claims the following week on CNBC's "Power Lunch" during a one-on-one interview with David Faber. May 7, 2010 Transcript of Power Lunch at 4. [Back]
2707. See, e.g., 12/14/2006 email from Daniel Sparks to Thomas Montag, "Subprime risk meeting with Viniar/McMahon Summary," GS MBS-E-009726498, Hearing Exhibit 4/27-3; Subcommittee interview of David Viniar (4/13/2010). [Back]
2708. 12/14/2006 email from Kevin Gasvoda to his staff, "Retained bonds," GS MBS-E-010935323, Hearing Exhibit 4/27-72. [Back]
2709. 1/31/2007 email from Daniel Sparks to Tom Montag, "MTModel," Hearing Exhibit 4/27-91. [Back]
2710. 3/9/2007 email exchange between Mr. Sparks and sales managers, "help," GS MBS-E-010643213. [Back]
2712. 4/19/2007 email from Daniel Sparks to Bunty Bohra, GS MBS-E-010539324, Hearing Exhibit 4/27-102. [Back]
2713. 3/21/2007 email from Syndicate, "Non-traditional Buyer Base for CDO ASEX," GS MBS-E-003296460, Hearing Exhibit 4/27-78. [Back]
2714. 3/9/2007 email exchange between Mr. Sparks and sales managers, "help," GS MBS-E-010643213, Hearing Exhibit 4/27-76. [Back]
2715. 3/30/2007 email from Fabrice Tourre to Mr. Sparks and others, GS MBS-E-002678071. [Back]
2716. 5/20/2007 Goldman presentation, "Mortgage Department, May 2007," GS MBS-E-010965212. See also 3/1/2007 email from Michael Swenson, "names," GS MBS-E-012504595 (SPG Trading target list tiered according to likelihood of purchasing); 2/14/2007 email to Matthew Bieber, "Timberwolf I, Ltd. – Target Account List," GS MBS-E-001996121 (list of U.S. accounts "we should be directly targeting" for Timberwolf sales); 3/2/2007 email from David Lehman, "ABX/Mtg Credit Accts," GS MBS-E-011057632 (mortgage credit business shared with SPG Trading Desk "a fairly lengthy list of accounts that are considered to be ‘key'"). [Back]
2717. 5/24/2007 email from Ysuf Aliredha to Mr. Sparks and others, "Priority Axes," GS MBS-E-001934732. [Back]
2718. See, e.g., 5/20/2007 email from George Maltezos to Mr. Lehman, "T/wolf and Basis," GS MBS-E-001863555; 5/22/2007 email from Mr. Maltezos to Basis Capital, JUL 000685. [Back]
2719. 6/7/2007 email from Omar Chaudhary to Mr. Sparks and others, GS MBS-E-001866450, Hearing Exhibit 4/27-104. [Back]
2720. Basic v. Levinson, 485 U.S. 224, 231-32 (1988) (quoting TSC Industries v. Northway, 426 U.S. 438, 449 (1976)). Utilizing the SEC's guidance, the issue could also be framed as evaluating "the significance the reasonable investor would place on the withheld or misrepresented information." [Back]
2721. Goldman Response to Subcommittee QFR at PSI_QFR_GS0192. [Back]
2722. Typically, the equity tranche, which is the first to incur any losses sustained by a securitization, is retained by the originator. Equity tranches are typically not rated by the credit rating agencies and often not sold to third parties. [Back]
2723. In Abacus, Goldman also failed to disclose the role of the hedge fund in the Abacus asset selection process. See Abacus section C(5)(b)(ii)DD, above. [Back]
2724. 12/3/2006 Goldman Offering Circular, "Hudson Mezzanine 2006-1, LTD.," at 56, GS MBS-E-021821196. The Goldman offering circulars for Timberwolf and Anderson contain similar sections. See 3/23/2007 Goldman Offering Circular, "Timberwolf I, LTD.," GS MBS-E-021825371 at 427; 3/16/2007 Goldman Offering Circular, "Anderson Mezzanine Funding 2007-1, LTD.," GS MBS-E-000912574, at 623. [Back]
2725. See, e.g., Goldman response to Subcommittee QFR at PSI_QFR_GS0192 and PSI_QFR_GS00235. [Back]
2726. See, e.g., SEC v. Czuczko, Case No. CV06-4792 (USDC CD Calif.), Order Granting Plaintiff's Unopposed Motion for Summary Judgment (Dec. 5, 2007) (finding defendant made a material misstatement to potential investors when he disclosed that officers, directors, employees and members of their families "may" trade in the stocks recommended on his website, without disclosing that he, his father, and business partner were trading in those stocks and had an interest in them). See also In the Matter of Arleen Hughes, Securities Exchange Act Rel. No. 4048 (Feb. 1948) (holding a broker-dealer, who is also a registered investment adviser, had to disclose the "nature and extent" of its adverse interest); In the Matter of Edward D. Jones & Co., L.P., Exchange Act Rel. No. 50910 (Dec. 22, 2004) (settled order), at 21 (disclosure inadequate for failing to disclose full nature and extent of the broker-dealer's conflict of interest). [Back]
2727. Goldman sometimes referred to this position as the "Credit Protection Buyer" or "Synthetic Security Counterparty." [Back]
2728. 10/2006 Hudson Mezzanine Funding 2006-1, LTD., GS MBS-E-009546963, at 966, Hearing Exhibit 4/27-87. [Back]
2729. See Goldman response to Subcommittee QFR at PSI_QFR_GS0223. [Back]
2730. See, e.g., 10/30/2006 email from Mr. Ostrem, "Great Job on Hudson Mezz," GS MBS-E-0000057886, Hearing Exhibit 4/27-90. [Back]
2731. See discussion of Goldman's actions as the Hudson liquidation agent, above. [Back]
2732. 3/13/2007 email from Mr. Ostrem to Scott Wisenbaker and Matthew Bieber, GS MBS-E-000898410, Hearing Exhibit 4/27-172. [Back]
2733. See Goldman response to Subcommittee QFR at PSI_QFR_GS0192. [Back]
2734. Timberwolf flipbook, GS MBS-E-000676809, Hearing Exhibit 4/27-99a. [Back]
2735. Goldman purchased its share of the Timberwolf equity tranche in March 2007, actually held it for only two months, and then, in May, sold it to Greywolf. See also Goldman response to Subcommittee QFR at PSI_QFR_GS0226. [Back]
2736. See, e.g., 6/5/2007 email from Benjamin Case to David Lehman, GS-MBS-E-001919861 (indicating Goldman was shorting some of the assets underlying Timberwolf using CDS contracts outside of the CDO). [Back]
2737. See, e.g., Goldman spreadsheet produced in response to a Subcommittee QFR, at GS MBS 0000037361 (identifying lenders whose stock Goldman shorted). [Back]
2738. See discussion of Goldman's net short positions, section C(4)(b), above. [Back]
2739. That Goldman's own investment decisions might be material information for an investor is demonstrated by a court ruling in a famous case in the 1970s, in which Goldman, an exclusive dealer, was sued by an investor who alleged that Goldman had sold it Penn Central notes without disclosing, among other things, that Goldman had recently reduced and placed limits on its own inventory of those same notes. Alton Boxboard v. Goldman, Sachs and Company, 560 F.2d 916 (8th Cir. 1977). Although the court decided the case on another basis, the Eighth Circuit found that the materiality of the undisclosed facts alleged was a question to be decided by a trier of fact. The court took note of the testimony from two sophisticated institutional purchasers concerning Goldman's reduction of inventory in Penn Central notes. Id at n.10. One sophisticated investor "testified that this information would have been a ‘red flag' to him, and had he known of Goldman Sachs' inventory decision, he would have wanted notes from another issuer." Id. The other witness "stated he would have been concerned about such information and would have conveyed it to his customers, because it indicated that Goldman, Sachs did not have confidence in ... [the] notes." Id. [Back]
2740. Each of these matters is discussed in detail, above. [Back]
2741. SEC Study on Investment Advisers and Broker-Dealers at 55. [Back]
2742. SEC v. Tambone, 550 F.3d 106, 135 (1st Cir. 2008) [citations omitted]. [Back]
2743. SEC Study on Investment Advisers and Broker-Dealers at 63 [citations omitted]. [Back]
2745. See Goldman response to Subcommittee QFR at PSI_QFR_GS0048. [Back]
2746. See, e.g., 1/23/2007 email from Fabrice Tourre to Marine Serres, GS MBS-E-003434918, Hearing Exhibit 4/27-62 (Tourre wrote: "[S]tanding in the middle of all these complex, highly levered, exotic trades he [Mr. Tourre] created without necessarily understanding all the implications of these monstruosities [sic] !!!"). [Back]
2747. See discussion of Abacus in section C(5)(b)(ii)DD, above. [Back]
2748. 12/18/2006 email from Fabrice Tourre, "Paulson," GS MBS-E-003246145, Hearing Exhibit 4/27-107. [Back]
2749. SEC deposition of Paolo Pellegrini (12/3/2008). PSI-Paulson-04 (Pellegrini Depo)-0001, at 175-76. [Back]
2750. April 23, 2010 Subcommittee Hearing Transcript at 64. [Back]
2751. 2/27/2007 email from Ed Steffelin to Peter Ostrem, GS MBS-E-009209654. [Back]
2752. Subcommittee interview of Ed Steffelin (12/10/2010). [Back]
2753. 4/15/2007 email from Cactus Raazi to Daniel Chan, "Dan: ABACUS 07-AC1," Hearing Exhibit 4/27-82. [Back]
2754. 10/26/2007 email from Goldman salesman to Michael Swenson, "ABACUS 2007-AC1 – Marketing Points (INTERNAL ONLY) [T-Mail]," GS MBS-E-016034495. [Back]
2755. Securities and Exchange Commission v. Goldman Sachs, Case No. 10-CV-3229 (S.D.N.Y.), Complaint (April 16, 2010). [Back]
2756. SEC v. Goldman, Sachs & Co. and Tourre, Case No. 10-CV-3329 (BSJ) (S.D.N.Y.), Consent of Defendant Goldman, Sachs & Co (July 14, 2010). [Back]
2757. See discussion of Hudson CDO in section C(5)(b)(ii)AA, above. [Back]
2758. Goldman response to Subcommittee QFR at PSI_QFR_GS0249. [Back]
2759. 9/20/2006 email from Arbind Jha to Josh Birnbaum, GS MBS-E-012685289. [Back]
2760. 3/12/2007 Goldman memorandum to Mortgage Capital Committee, "ABACUS Transactions sponsored by ACA," GS MBS-E-002406025, Hearing Exhibit 4/27-118. [Back]
2761. 10/2006 Hudson Mezzanine Funding 2006-1, LTD., GS MBS-E-009546963, at 978, Hearing Exhibit 4/27-87. [Back]
2762. See discussion of Anderson CDO in section C(5)(b)(ii)BB, above. Another 8% were dependent upon loans issued by Countrywide. [Back]
2763. 2/24/2007 email from Deeb Salem to Michael Swenson and others, GS MBS-E-018936137. [Back]
2764. 2/24/2007 email from Mr. Sparks to Mr. Ostrem and others, GS MBS-E-001996601, Hearing Exhibit 4/27-95. [Back]
2765. See, e.g., 2/8/2007 email from Craig Broderick to Mr. Sparks and others, GS MBS-E-002201486 (calling New Century's announcement that it would restate its earnings "a materially adverse development"); 3/14/2007 Goldman email, "NC Visit," GS MBS-E-002048050 (stating Fremont still has cash "but not for long"); 3/13/2007 email from Mr. Ostrem to Scott Wisenbaker and Matthew Bieber, GS MBS-E-000898410, Hearing Exhibit 4/27- 172 (providing talking points for selling Anderson securities to customers). [Back]
2766. 3/13/2007 email from Manisha Nanik, "New Century EPDs," GS MBS-E-002146861, Hearing Exhibit 4/27- 77. [Back]
2767. 3/14/2007 Goldman email, "NC Visit," GS MBS-E-002048050. [Back]
2768. See, e.g., 3/6/2007 email from Joshua Bissu to Mr. Ostrem and Mr. Bieber, GS MBS-E-014597705 (talking points for Goldman personnel to respond to investor concerns about the New Century loans). [Back]
2769. See e.g., Goldman response to Subcommittee QFR at PSI_QFR_GS0223. [Back]
2770. See, e.g., 9/17/2007 email from Christopher Creed, "Timberwolf," GS MBS-E-000766370, Hearing Exhibit 4/27-106 (showing price for Timberwolf securities dropped from $94 on 3/31/2007 to $87 on 4/30/2007). [Back]
2771. 8/23/2007 email from Jay Lee to Mr. Lehman and others, GS MBS-E-001927784. [Back]
2772. 2/26/2007 email exchange between Mr. Sparks and Mr. Montag, GS MBS-E-019164799, Hearing Exhibit 4/27-71. [Back]
2773. 5/20/2007 email from Paul Bouchard, "Materials for Meeting," GS MBS-E-001863725. [Back]
2774. 5/14/2007 email from Mr. Sparks to Mr. Montag and Mr. Mullen, GS MBS-E-019642797. [Back]
2775. See, e.g., Goldman response to Subcommittee QFR at PSI_QFR_GS0223. [Back]
2776. See, e.g., example involving Basis Capital in discussion of Timberwolf in section C(5)(b)(ii)CC, above. [Back]
2777. 6/22/2007 email from Mr. Montag to Mr. Sparks, "Few Trade Posts," GS MBS-E-010849103, Hearing Exhibit 4/27-105. [Back]
2778. April 30, 2010 transcript of The Charlie Rose Show, at 14. [Back]
2779. 3/12/2007 Goldman Firmwide Risk Committee, "March 7th FWR Minutes," GS MBS-E-00221171, Hearing Exhibit 4/27-19; 3/3/2007 email from Mr. Sparks, "Call," GS MBS-E-010401251, Hearing Exhibit 4/27-14. [Back]
Back to Contents (5) How Goldman Created and Failed to Manage Conflicts of Interest in its Securitization Activities (7) Goldman’s Proprietary Investments
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