Former SEC chairman predicts agency will prevail in Goldman Sachs case

David Ruder, Northwestern law school professor and former SEC chairman, talks about the case against Goldman Sachs. (Photo courtesy of David Ruder)

Lawmakers on Capitol Hill have been lashing out at Goldman executives in an attempt to get to the bottom of their role in the subprime mortgage meltdown. The world’s most powerful investment bank is taking a public beating since the Securities and Exchange Commission filed a civil suit alleging securities fraud on April 16.

To better understand the SEC’s allegations and implications for Goldman, I spoke with David Ruder, a former SEC chairman and professor at the Northwestern University School of Law.

Ruder said the SEC is so inundated with various tips and complaints that the problem is deciding which cases to bring forward. Having had first-hand experience from his days as chairman in the mid-1980’s, Ruder asserts that the commission had plenty of facts to justify filing the suit against Goldman. Typically, the SEC likes to file cases that send a message.

“In this case, they’re sending a message to Wall Street that Wall Street has to look out for their customers,” Ruder said.  “It’s a difficult case and we don’t have enough facts yet, but if the facts are as I understand them, they should be able to prevail.”

The SEC’s contention is that Goldman was bundling mortgages to put into a single security to sell to sophisticated investors. The agency alleges Goldman  hired a portfolio selection agent, ACA Management LLC, so buyers would be under the impression that the securities were chosen by an independent agent. However, ACA was working with John Paulson, a hedge fund manager and Goldman client, who was going to take a short position against the securities.

The question is whether, when Goldman Sachs sold these securities to their customers, they were impliedly representing that the selection agent was independent. And if they were and the selection agent was not independent because of its cooperation with Paulson, then according to the SEC, there was a misrepresentation to the buyer.

Ruder added that there’s one aspect of the SEC’s case that will be difficult to provide evidence for. The commission has alleged that Goldman trader Fabrice Tourre misled investors into believing that Paulson, who was going to bet against the transaction, had purchased some of the securities.

“Now that would be a more dramatic kind of lie than the misrepresentation regarding independence. But proof problems there are more difficult,” Ruder said.

Most troubling to Ruder  is that the investment bank was selling complicated securities to sophisticated investors and taking a contrary position at the same time.

The firm’s defense is that sophisticated buyers are aware that the investment bank not only sells securities, but takes positions in those securities and is subject to losses if the securities fail. In order to protect the firm from those losses, it will short the securities.

“The answer to that is…it’s okay to be short in the sense that you’re hedging your long positions, but you should tell us if you believe the market has turned to the point that you’re going to try to make money on the short positions that is in excess of balancing your portfolio,” Ruder said.

While politicians are using the case to push for financial reform, the proposed legislation does not strongly cover aspects involved in the Goldman complaint. According to Ruder, the only part of the legislation related to the case is that complicated derivative instruments be made uniform and either traded on an exchange or cleared in a clearinghouse.

“The interesting part of this case…is that it’s going to shed some light on what the big banks were actually doing during this credit crisis,” Ruder said. “It’s fascinating from a lawyer’s point of view to see how complicated these instruments were in which billions of dollars were being invested.”

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