Washington: The fraud charges against Goldman Sachs that rocked financial markets on Friday are no slam dunk, as hazy evidence and strategic pitfalls could easily trip up government lawyers.
Yet that hardly matters, experts say, because the allegations will kick off a new era of litigation that could entangle Goldman and other banks for years to come.
The charges against Goldman relate to a complex investment tied to the performance of pools of risky mortgages. In a complaint filed on Friday, the Securities and Exchange Commission (SEC) alleged that Goldman marketed the package to investors without disclosing a major conflict of interest: The pools were picked by another client, a prominent hedge fund that was betting the housing bubble would burst.
Goldman said the charges are “unfounded in law and fact”. In a written response to the charges, the bank said it had provided “extensive disclosure” to investors and that the largest investor had selected the portfolio—not the hedge fund client. Goldman said it lost $90 million (Rs400.5 crore) on the deal.
That doesn’t contradict the SEC complaint, which says the largest investor selected the mortgage investments from a list provided by the hedge fund. And the fact that Goldman lost money has no impact on the fraud charges.
The charges will unleash a torrent of lawsuits, and likely signal that the government is prepared to file more lawsuits related to the overheated market that preceded the financial crisis, experts said.
“This is just the tip of the iceberg,” said James Hackney, professor at Northeastern University School of Law. “There are a lot of folks out there in different deals who played similar roles, and once it starts building steam, plaintiffs’ lawyers will figure out this is where the money is and there should be a lot of action.”
Among the legal action expected in the coming months:
• Class-action suits by Goldman shareholders, who believe Goldman’s alleged misconduct made their stakes less valuable, could come on Monday. Such suits are common when companies are accused of wrongdoing. Goldman shares fell almost 13% on Friday as the bank lost $12.5 billion in market capitalization.
• Suits by investors who believe Goldman sold them on deals that were doomed to fail. The investors in the transaction at the heart of the SEC case could sue first, followed by others who believe their losses were similar.
• Possible criminal charges, if the SEC’s civil case reveals evidence that meets the higher standard of “proof beyond a reasonable doubt”. Experts said it’s unlikely the company as a whole will face criminal charges, but evidence could emerge that would expose the Goldman executive named in the SEC complaint, 31-year-old Fabrice Tourre, to criminal prosecution.
• Charges by regulators about other mortgage investments at Goldman and elsewhere. SEC enforcement chief Robert Khuzami told reporters on Friday the agency is racking up evidence on other deals in the overheated market that preceded the financial crisis.
Already the case has provoked legal questions from foreign governments, according to published reports. That’s because the financial crisis forced many countries to bail out banks that lost money on investments arranged by Goldman.
German regulators are considering legal action against Goldman, newspaper Welt am Sonntag reported, quoting a spokesman for Chancellor Angela Merkel.
The charges would be on behalf of IKB Deutsche Industriebank AG—an early victim of the financial crisis that was rescued by the state-owned KfW Development Bank among others.
The flurry of legal activity is likely to proceed separately from the SEC’s case against Goldman, which experts said faces numerous pitfalls.
To prove its fraud case against Goldman, the government must show that Goldman misled investors or failed to tell them facts that would have affected their financial decisions. The government’s greatest challenge, experts said, will be boiling the case down to a simple matter of fraud.
“If you wanted to go after Goldman with a complaint that wouldn’t stick, this would be perfect,” said Janet Tavakoli, president of Tavakoli Structured Finance, a Chicago consulting firm. “If you look at these products, almost all of them look like hoaxes because of the junk inside.”
Legal experts pointed to the paucity of evidence in the government’s lawsuit, which contains short excerpts from emails, but lacks key information about what the various investors knew and what actions they took.
The quality of the evidence was not clear from the complaint, said Jacob Frenkel, a former SEC enforcement lawyer now with Shulman, Rogers, Gandal, Pordy and Ecker PA.
Several legal experts suggested Goldman and SEC had reached an impasse over a settlement before the charges were announced. They speculated that Goldman was unwilling to admit that it allowed the hedge fund to create a portfolio of securities that was designed to fail because that could do irreparable harm to Goldman’s reputation.
“Goldman could’ve easily paid a fine already,” said John Coffee, a securities law professor at Columbia University. “So I don’t think it’s money they’re fighting over.”
The case has been assigned to US district judge Barbara Jones of New York.
Jones is the federal judge who five years ago presided over the $11 billion criminal fraud case that toppled WorldCom Corp. and sent its former chief executive officer Bernard Ebbers to prison for 25 years.