By Zachary A. Goldfarb and Tomoeh Murakami Tse
Washington Post Staff Writer
Tuesday, April 20, 2010; A01
For months, Goldman Sachs and the Securities and Exchange Commission had been involved in secret talks over allegations that the Wall Street bank defrauded customers in selling them investments designed to fail.
Then, after a crucial meeting last month between lawyers for Goldman and the SEC, the agency came to a fork in the road. Even after SEC lawyers had told Goldman in writing they were prepared to file a federal suit, the firm gave no ground, declining to ask for a settlement, according to three people familiar with the case. The agency could prolong negotiations in hopes of reaching a deal Goldman would accept, as the SEC had often done in previous cases, or take the bank to court.
Endorsing the recommendation of investigators, the SEC's five-member commission voted 3 to 2 to proceed with the civil suit, taking a high-stakes gamble that pits Wall Street's top regulator against its most storied bank. The case, filed Friday,
has provoked a counteroffensive from Goldman, which says it was blindsided by the suit. Goldman's defenders are suggesting that the suit may have been designed to help make the case for the Obama administration's push this month for legislation to overhaul financial regulation.
SEC officials say that they told Goldman last summer the agency would probably bring action, and that the bank did not show any contrition. At the same time, they say they wanted to use the Goldman case to make a broader statement about the agency's renewed intention of holding prominent financial firms accountable for misconduct.
Neither SEC officials nor Goldman executives would discuss the internal dynamics of the case on the record. But people in both camps were preparing Monday for an epic court battle that could offer a chance for both sides to restore their reputations after they were sullied during the financial crisis.
Victory for the SEC, Wall Street's top regulator, would help restore credibility after it was sharply criticized for not aggressively enforcing securities laws. Victory for Goldman could help the firm answer critics who allege it epitomized the excesses that led the financial sector into its worst crisis in decades.
On Monday, the case reverberated around the world. Financial regulators in London and Germany said they would open investigations to see if Goldman's sale of mortgage securities broke local laws.
Goldman's domestic legal troubles could be compounded abroad as foreign regulators open probes into the investment. London's Financial Services Authority and Germany's BaFin regulatory agency said Monday that they were coordinating with the SEC. The Royal Bank of Scotland lost an estimated $850 million and the Duesseldorf-based IKB Deutsche-Industriebank lost more than $100 million on mortgage-related securities set up by Goldman. [Story, A7.]
The SEC's suit centers on a development central to the financial crisis: the creation of exotic investments that allowed firms to bet on the direction of the housing market.
The suit asserts that Goldman defrauded investors when it sold them a subprime-mortgage investment in 2007 that was secretly designed to lose value. The agency alleges that Goldman created and marketed the investment without telling its clients that Paulson & Co., a prominent hedge fund, had helped the bank assemble the investment while at the same time was placing bets that it would lose value. The bank received $15 million from Paulson & Co. for its services.
Goldman has denied the allegations, releasing three statements since Friday rebutting the SEC's points.
"We believe that the firm's actions were entirely appropriate, and will take all steps necessary to defend the firm and its reputation by making the true facts known," the firm said Monday.
The SEC's probe of Goldman began in August 2008, according to a memo prepared by the firm. Over the next year, the SEC interviewed five Goldman executives and collected 8 million pages of documents from the firm, the memo says.
Last summer, the SEC sent Goldman a notice that the agency's enforcement staff intended to file suit against the firm and one of its vice presidents, Fabrice Tourre, alleging securities fraud.
Goldman's lawyers responded to the warning, known as a Wells Notice, with memos arguing that the SEC's case was flawed. SEC lawyers found the arguments unpersuasive, and lawyers for both sides met to discuss the standoff.
What happened next is under dispute. Usually, if a response to a Wells Notice is rejected, the SEC lets a company or person under investigation know that a lawsuit will probably ensue. SEC spokesman John Nester said this process was followed in the Goldman case.
But people close to Goldman say otherwise. They say Goldman lawyers met with SEC officials to discuss the case against Tourre but were given no clue that the agency planned to sue the company. Talks last month yielded no result, according to three sources.
After those meetings, SEC officials decided to pursue a suit. They added the case to the calendar of the agency's commission.
Chairman Mary Schapiro, who was appointed by President Obama, and the two Democrats on the commission voted to proceed; the two Republicans opposed the move. The commission periodically splits on decisions, with Republicans often more reluctant than Democrats to take companies to court.
The decision to pursue a lawsuit, especially against a financial services firm, rather than reach a settlement is rare. Prominent SEC cases, such as those against J.P. Morgan Chase, Merrill Lynch and Salomon Brothers, were settled, costing companies millions of dollars in fines and penalties. But Schapiro and her enforcement chief, Robert Khuzami, have repeatedly said they do not like prolonged negotiations over settlements.
A high-profile settlement with Bank of America backfired last summer when a federal judge in New York rejected the agreement, which would have cost the firm $33 million. The ruling, in a case alleging the bank did not disclose details about executive compensation and financial losses, was an embarrassing setback for the agency. The SEC ultimately adjusted the terms of the settlement by adding new charges, nearly quintupling the fine and adding more sanctions.
Tse reported from New York. Staff writer Howard Schneider in Washington contributed to this report.