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Goldman mounts defense on SEC charges, saying clients knew its products well

By Zachary A. Goldfarb and Tomoeh Murakami Tse
Washington Post Staff Writer
Wednesday, April 21, 2010; A12

In legal lingo, it's called the "big boys defense."

In rebutting a federal lawsuit claiming that it defrauded its clients, Goldman Sachs argues that its customers were big financial firms, intimately familiar with the complex financial securities the bank was selling. The Securities and Exchange Commission says that doesn't matter: Goldman omitted details when selling the investment, and these might have deterred customers from placing their bets, which turned on the future health of the housing market, the agency charges.

A trial before a federal jury in Manhattan is still a long ways off, and the parties could still settle out of court. Goldman's top lawyer on Tuesday left the door open to an "agreeable" settlement.

The firm, however, may not be willing to settle for much. Several securities lawyers said the SEC has its work cut out in trying to prove that Goldman duped clients -- primarily New York-based firm ACA Financial Guaranty Corp. and German bank IKB.

"It's not sure-fire," said Jeffrey Plotkin, a lawyer at Day Pitney and former SEC enforcement official. "These are highly sophisticated folks who made their own determination as to the direction of the housing market."

The SEC argues that a little-known financial firm with a nondescript name was misled about an investment that Goldman was working to assemble. ACA -- or more precisely, one of its subsidiaries -- was in the business of helping banks choose which home loans to package together into a security.

In early 2007, Goldman asked ACA to help one of its clients, John Paulson, a hedge fund manager, create such an investment linked to the value of home loans. According to the agency, Goldman led ACA to think that Paulson wanted to bet on a security that would increase in value. In fact, Paulson was looking to bet on a security that would decline. Paulson helped pick home loans that would form the basis for the investment, and these were loans that the hedge fund predicted would go bad.

After the investment was created, Goldman began to market it to investors such as IKB. Another subsidiary of ACA also invested.

Goldman doesn't concede that it misled ACA. The bank says that there is no reason to believe that ACA executives thought that Paulson was going to bet that the security would go up.

But no matter, Goldman contends that even the facts as presented by the SEC don't amount to a violation of securities law. This is because of a legal concept known as "materiality." It's not enough that Goldman didn't tell clients everything possible about the deal, according to securities lawyers. It's a matter of whether that information would have led the clients to make different investing decisions.

Goldman has stressed that ACA and IKB -- as big boys in the financial industry -- would have bet on the mortgage investment even if Paulson's role had been disclosed.

"The defense that the two key investors were considered some of the most savvy also indicates that it was not really material omission because it may not have modified their behavior," said Ron S. Geffner, a partner at Sadis & Goldberg and a former SEC enforcement official.

Gregory Palm, Goldman's top lawyer, said Tuesday that ACA had evaluated every security proposed by Paulson and rejected half of them. And he said that, in the end, it didn't matter, because virtually every mortgage investment created in this period lost value.

"It didn't matter what the assets were, if you bought 2006 vintage [of loans], you got crushed," he said.

Russell Fraser, who founded ACA in 1997 before leaving the company early last decade, said he didn't know if ACA was duped. But he said the company would have likely invested, anyway.

"My feeling is that they didn't have to be tricked," Fraser said in an interview. "My feeling is that they were very hungry for business and therefore was very susceptible to an attractive deal and they had a shot at it and they got it."

ACA did not return calls seeking comment.

The SEC argues, however, that both ACA and IKB would have made different decisions if they knew the details. The SEC says IKB "was unlikely to invest in" something unless the investment had been blessed by an outside, disinterested portfolio manager such as ACA. But the agency says ACA would not have allowed Paulson to play such a large role in selecting the home loans if it was known he was going to bet against the security. That would have presented "serious reputational risk to ACA, which was in effect endorsing the reference portfolio."

The agency also says that neither IKB nor ACA would have bet on the investment if they knew Paulson had helped create it and then made a major bet against it, or shorted it, essentially by buying insurance that would pay out if the security lost significant value.

"At the end of the day, it's very hard to argue that investors wouldn't want to know that the portfolio was put together by somebody selling short," said J. Robert Brown, a law professor at the University of Denver.

For the SEC to prove materiality and prevail in court, the agency will want to present evidence that Goldman hid information from its clients because they might not invest if it were disclosed.

"If there is evidence there was active artful misleading then you can see a jury getting interested," said Donald C. Langevoort, Georgetown law professor.

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