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FiveThirtyEight

Politics

By now we’re all heard the SEC is suing Goldman Sachs for fraud. I’m going to walk you through my thoughts on the complaint (here’s a link to the complaint) to explain what’s there and why it’s important.

First, the document filed by the SEC is a complaint. The purpose of this document is to define the issues for trial. Usually, the person filing the complaint has done a lot of investigation before filing the document — so much so that they can more or less anticipate what the defendant will do.

The government is arguing Goldman committed fraud under the securities laws. More specifically,

(a) Use of interstate commerce for purpose of fraud or deceit
It shall be unlawful for any person in the offer or sale of any securities or any security-based swap agreement (as defined in section 206B of the Gramm-Leach-Bliley Act) by the use of any means or instruments of transportation or communication in interstate commerce or by use of the mails, directly or indirectly—
(1) to employ any device, scheme, or artifice to defraud, or
(2) to obtain money or property by means of any untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading; or
(3) to engage in any transaction, practice, or course of business which operates or would operate as a fraud or deceit upon the purchaser.

The second law the government is alleging Goldman broke is similar to the first:

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce or of the mails, or of any facility of any national securities exchange—
(a)
(1) To effect a short sale, or to use or employ any stop-loss order in connection with the purchase or sale, of any security registered on a national securities exchange, in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.
(2) Paragraph (1) of this subsection shall not apply to security futures products.

(b) To use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered, or any securities-based swap agreement (as defined in section 206B of the Gramm-Leach-Bliley Act), any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.

These laws are wonderfully clear and very easy to understand. They say very clearly that your can’t lie. Period. In addition, by making this a fraud case, the government is avoiding a discussion about complex financial instruments. Instead, this is a case that is essentially about one party lying to another person. Remember — the best cases are simple stories that everyone can understand. Lying is about as basic as it gets. Finally, material misrepresentation issues are taught to everyone taking the Series 7 exam — there is simply no way a person can obtain a securities license without knowing you can’t lie to the public. It’s just not possible and arguing you didn’t know about that law is not credible. In addition, the government has asked for a jury trial. This is a good idea, considering that Wall Street is yery unpopular right now.

There are several points to mention here.

First, it appears as though the government has done a great deal of investigation regarding this matter. The complaint presents a specific time line of events which the government has copiously documented. There are references to emails and sales literature throughout the complaint. I don’t know under what authority the investigation was constructed, but it was very thorough. That tells us the SEC has done everything they can to line up their ducks, placing Goldman on the defensive.

Second, in government based litigation, the government is going to argue more or less the same thing in a line of cases. Therefore, they usually bring their best case first to set a precedent for other jurisdictions to follow (this is what the IRS does in anti-avoidance litigation). I’m guessing this is the government’s best case in this area. In correlation, the SEC is desperately trying to re-establish itself as a potent enforcement arm. I don’t think they would bring a case right now unless they thought they had as close to a slam dunk case as possible.

Third, the government has brought allegations against Goldman and Fabrice Tourre, a Goldman employee who more or less was the primary mover behind the transaction in question. My guess is the SEC is going after Tourre directly to get him to flip on Goldman. The reason is two fold. First, this is probably not the only Goldman transaction to warrant a complaint, so the SEC wants more information from within Goldman. Secondly, the SEC is currently looking at other deals and having an inside person on one deal could shed light onto how other deals were put together. I have no basis in fact for thinking that, it’s just he’s the only person specifically mentioned in the complaint and he was intimately involved in the transaction.

Fourth, this is a civil rather than criminal case. This goes to the burden of proof. In a criminal case, the government must prove the facts beyond the shadow of a doubt. In a civil case, the government must prove the facts by a preponderance of the evidence — a much lower burden. Basically the government has gone forum shopping — as is a petitioner’s right in any case — and found the best forum for their case.

Fifth — why wasn’t Paulson (the hedge fund manager) named? Largely because Paulson doesn’t seem to have done anything illegal. Goldman was the company that lied about the contents of sales literature, not Paulson.

Sixth — how will Goldman defend themselves? The standard defense when two parties to securities litigation are “sophisticated investors” is to argue the parties were essentially big boys and knew the risks. That defense isn’t possible in this case, largely because of the statute employed. This case comes down to whether or not Goldman lied — period. Either they did or didn’t misrepresent facts. The financial standing of the purchaser of the security is irrelevant. Goldman’s only defense is to somehow demonstrate they did not lie about the transaction. Given the complaint filed, I don’t see how that argument is possible.

Finally — the complaint lays out a very easy to understand time line of events. I have no personal knowledge of the team of lawyers trying this case for the SEC, but a good trial lawyer would have a pretty easy time telling this story. It comes down to greed, hubris and lying — all committed to essentially screw people out of a lot of money. Remember — a trial is story that is told to the jury. If the case boils down to experts arguing about arcane points of law then at least one of the lawyers put on a terrible case. But if the SEC lawyers stay on track, keep the story simple and keeps the water clear from too much defendant laid chum, the SEC has a good case and should prevail.

The facts demonstrate the SEC’s attorneys are very sharp. They have chosen a forum with a lower burden of proof which makes proving their case easier. They have chosen a great statute to apply — a statute that focus entirely on Goldman and whether or not Goldman lied. This completely avoids any in-depth discussion about complicated and boring financial products. Finally, the SEC has done their research — and done it thoroughly.

Let me add this personal thought. I have very high hopes that the SEC wins this case. As I mentioned above, they have a good case. But the real reason is best illustrated by a story. This year my wife and I went to opening day at Wrigley Field (which should be a national holiday). While we were walking around the streets that surrounded Wrigley we saw a group of four cops — and I mean cops. All I could think of when I saw these guys was one of them saying to a someone, “don’t make me.” My guess is at least two of them were ex-football players. They were standing in a group talking and basically making their presence quietly felt. At this point I knew nothing bad was going to happen on that street. Why? Because of this group of cops — they would make sure nothing bad happened. In essence, you felt this quiet law enforcement presence on the street. That’s what the SEC needs to do — or more importantly, needs to establish. Right now, there is no law enforcement presence on Wall Street at all. Wall Street needs to know there is a cop on the beat to deal with excesses in the system.

Over the last few years we’ve seen evidence of a complete breakdown in the financial system. The Congressional investigation into the Washington Mutual collapse indicates the bank was corrupt at its core. On Friday, we learned the ratings agencies were complicit in the collapse. In short, the entire financial system’s integrity is gone and needs to be re-established. This case can start that process by demonstrating there is a regulator who is capable of enforcing the law. That gives the market integrity — which encourages wider participation and thereby ultimately lowers the cost of capital to the economy as a whole.

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