Questioning the SEC’s case against Goldman Sachs

The Securities and Exchange Commission has taken a big gamble by going after The Goldman Sachs Group Inc. Wall Street's premier investment bank has the will and legal firepower to fight back.

The Securities and Exchange Commission has taken a big gamble by going after The Goldman Sachs Group Inc. Wall Street’s premier investment bank has the will and legal firepower to fight back.

In this battle of titans, one may ask whether the SEC has chosen the right opportunity to re-establish its credibility with advisers and investors as the referee enforcing the rules of investing.

Two SEC commissioners voted against bringing the case, suggesting that they were not convinced that the agency was betting on a sure thing. A victory in the civil fraud suit certainly would be good for the agency, of course, although the specifics of the case mean little to most investors since it involves knowledgeable, sophisticated institutions dealing with esoteric financial instruments. A loss, however, would further damage the SEC’s reputation.

The case, it appears, would seem to be driven largely by political motives.

First, the SEC is eager to prove that its staff understands the workings of the modern capital markets, that it can discover fraud and that it can take effective enforcement action. Perhaps that’s why it chose the most sophisticated Wall Street investment bank as its target.

Second, the SEC likely wanted to curry favor with the White House and the Democratic Congress by helping them with the debate over the financial-reform bill.

Goldman Sachs’ alleged actions — the packaging of synthetic collateralized-debt-obligation transactions — strengthen the case for reform and especially for greater disclosure of, and tighter restrictions on, derivatives transactions.

The most important motive, however, was to re-establish the SEC’s reputation with Congress, its most important constituency, as the tough cop on the Street, unafraid to take on a major firm with important connections in Washington.

Having failed to take timely action against Bernard Madoff’s Ponzi scheme and the alleged Ponzi scheme of R. Allen Stanford — despite warnings about both — the SEC did not want to appear to have missed possible fraudulent activity at one of Wall Street’s leading investment banks.

Securities law experts are divided on the strength of the SEC’s case against Goldman Sachs, which hinges on whether or not all material information was disclosed to the two institutions selling credit default swaps against a package of mortgage-backed securities that hedge fund manager John Paulson was planning to short.

Did the two institutions know that Mr. Paulson was planning to short the package? Even if they did not, would it have mattered? Mr. Paulson was, according to reports, not as highly regarded as he is today, his reputation having been burnished in part by his huge profits on the deal at issue in this case.

If the SEC wins in the first round, Goldman Sachs no doubt will appeal, perhaps all the way to the Supreme Court. Like the SEC, it’s fighting for its reputation. The case almost certainly will drag through the courts for years.

Whatever happens, it is likely to be an expensive case full of sound and fury, signifying very little for average investors, few of whom have been harmed directly by CDOs or even understand them.

And because the case bears so little impact on individual investors, even an SEC victory may be largely pyrrhic in the eyes of advisers and their clients.

While the SEC was off protecting hedge funds from Goldman Sachs, they may wonder, what was it doing to discover and prevent the next Bernie Madoff?