Goldman Sachs – Civil Fraud Lawsuit

Overview:

Goldman Sachs, the well known financial services organization with revenues in excess of US$
45bn providing investment banking, securities services, investment management and other
financial services mainly to its institutional clients having a global spread, has been in the news
off late. The firm has not been averse to controversies, be it for the European Sovereign debt
crisis or the AIG bailout controversy. Recently, it has faced allegations of fraud and
misrepresentation of facts by the Securities and Exchange Commission, a government enterprise.

The Case:

On April 16, 2010, the Securities and Exchange Commission (SEC) alleged that Goldman Sachs
materially misstated and omitted facts in disclosure documents for a synthetic CDO product it
originated called Abacus 2007-AC1. A synthetic CDO is a complex financial security used to
speculate or manage the risk that an obligation will not be paid (credit risk). The SEC alleged
that Goldman misled and misrepresented facts to ACA, an independent selection agent appointed
by it to review the mortgage package underlying the CDO. Apparently, Goldman failed to
disclose to ACA that a hedge fund, Paulson & Co., that sought to short the package, had helped
select underlying mortgages for the package against which it planned to bet, thereby creating a
conflict of interest. One of its London based executive director, Fabrice Tourre made ACA
believe that Paulson invested approximately $200 million in the equity of ABACUS 2007-ACI
(a long position) when in reality Paulson's interests were sharply conflicting.

The complaint states that Paulson made a $1 billion profit from the short investments, while
purchasers of the materials lost the same amount. The two main investors who lost money were
ABN Amro and IKB Deutsche Industriebank. IKB lost US$150 mn within months on the
purchase. ABN Amro lost US$841mn.

Goldman’s Argument:

Goldman issued a statement in its defense, saying the SEC's charges were unfounded in law and
fact. It stated that it had provided extensive disclosure to the long investors in the CDO. Also that
they themselves lost money and that ACA selected the portfolio without the knowledge that
Paulson was to be a long investor. Goldman also argued that ACA was itself the largest
purchaser of the Abacus pool, investing $951 million. Goldman also stated that any investor
losses resulted from the overall negative performance of the entire sector, rather than from a
particular security in the CDO.

Critics have pointed out that the SEC has filed this litigation for its own gains. The SEC took this
action against Goldman immediately after the US President, Barrack Obama threatened vetoing
financial reform legislation that does not strongly regulate derivatives. This was despite the fact
that investigations into the case lasted for almost 18 months. Also, Goldman Sachs was given no
prior notice of the filing neither was the possibility of a settlement explored. If the SEC prevails,
it might reassert its position as a player in the current financial regulatory scene. If the SEC
prevails, it might reassert its position as a player in the current financial regulatory scene.

Impact on Goldman:

After the SEC announced the suit during the April 16, 2010 trading day, Goldman's Sachs's stock
fell 13% to close at US$160.70 from US$184.27 on volume of over 102,000,000 shares as
compared to a 52 week average of 13,000,000 shares. The firm's shares lost $10 billion in market
value during the trading session. Apart from the monetary value, this event has affected its
reputation and potential business.

Impact on Economy:

The Goldman Sachs fraud scandal is certainly very dangerous. Stock prices which were already
at 52 week highs and markets were already selling off. This event led to a catalyst to the falling
markets. Despite the lack of significant positive Japanese economic news, the Yen (the safest
currency in the world) rose. This could only be due to foreign exchange traders seeking
defensive foreign exchange plays and unwinding riskier carry trades in higher yielding
currencies. Moreover, the financial sector is likely to face a direct hit and it will have to contend
with a newly hostile regulatory environment, reduced earnings, soaring legal costs and liabilities.
These new threats, despite being manageable in the long run could tremendously stress the sector
and the stock markets.
Senate Hearing:

Goldman Sachs chief executive Lloyd Blankfein and executive Fabrice Tourre gave evidence to
a Senate hearing on the charges leveled against the investing banking firm on 27th April, 2010.
The session lasted for 10 hours wherein Goldman argued against the charges they faced.
However, it is being widely speculated that Goldman Sachs may opt for a settlement with the
SEC in order to avoid any further loss of repute.