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Will the Fabulous Fab Scandal Breathe Life Back into the Stoneridge Debate?

by David Sack
Eyes On Wall Street |

On Friday April 16th, the Securities and Exchange Commission (SEC) filed a civil complaint against Goldman Sachs and one of its vice-presidents, Fabrice Tourre, for allegedly defrauding investors by failing to disclose vital information about a financial product linked to subprime mortgages. Goldman's shares tumbled, dragging the markets down with it.

The instrument in question, structured and marketed by Goldman, was a synthetic collateralized debt obligation (CDO), whose performance was tied to that of residential mortgage-backed securities. Goldman told its investors, who included some European banks, that the securities underlying the CDO had been selected by an independent third party, ACA Management. The SEC alleges that Goldman failed to disclose that another firm, Paulson & Co, a big hedge-fund manager, in fact had a hand in choosing what went into the CDO.

This was a crucial omission, since Paulson & Co-run by John Paulson, who made billions in 2007-08 betting against the housing market-had taken a short position against the CDO; in other words, the firm would profit if the instrument performed poorly.

According to the SEC's complaint, Paulson shorted the portfolio it helped to select by purchasing insurance against the default of certain layers through derivatives called credit-default swaps (CDSs) it entered into with Goldman. The SEC argues that these derivatives gave the hedge fund an incentive to select mortgage securities that would bomb. And bomb they did. The deal closed in April 2007; by the end of January 2008, 99% of the portfolio had been downgraded by credit-rating agencies.

Goldman called the charges "completely unfounded in law and fact" and said it would contest them vigorously. Paulson & Co, which has not been charged, issued a statement saying that ACA, as the third-party collateral manager, had sole authority over the selection of securities in the CDO. In a more detailed response issued later, Goldman insisted that extensive information about the portfolio had been provided to the buyers, who were sophisticated investors aware of the risks.

It may seem surprising that Paulson is not named as a defendant in the SEC's complaint. However, the decision not to name Paulson as a defendant was likely influenced, at least in part, by the Supreme Court's recent landmark decision in Stoneridge Investment Partners, LLP v. Scientific-Atlanta, et al. (2008). The Stoneridge holding restricts plaintiffs from alleging 1934 Exchange Act fraud claims against "non-speaking" participants in schemes to defraud investors. Rather, investors may only sue those who issued statements or otherwise took direct action that the investors had relied upon in buying or selling stock. Thus, under Stoneridge, the SEC could not bring securities fraud allegations under Section 10(b) against Paulson without demonstrating that Goldman's investors directly relied on false statements or misleading conduct by Paulson.

Given the public and official outrage over Paulson's involvement in the Tourre scandal, recent legislative efforts to overturn Stoneridge seem timely and well taken.