CDO Litigation: The SEC, Goldman, and its Courtroom Cousins

By Erik Krusch (U.S.) Westlaw/Business/4-22-10

Goldman is not alone as it confronts the SEC, amidst the wavering sparkle of its Midas touch. Merrill Lynch and UBS are also pursued, by Pursuit Partners among others. Centered on failed alchemy, disclosure laxity, and the particularly flexible CDO (collateralized debt obligation) structures at issue, the group’s alleged misdeeds rankle. Not only must Goldman worry -- the markets and their advisors must beware the fallout from Goldman and its courtroom cousins.

The SEC claims that Goldman’s behavior and its disclosure on a CDO deal has been false and deceptive. Goldman is not the only bank that has been charged with constructing CDOs that were made to fail. If Goldman’s disclosure on the CDO at the center of SEC’s civil charges was materially deficient, then all of Wall Street could be up for nasty spate of litigation. CDOs, synthetic CDOs, and possible conflicts of interests between parties going long, short, and selling CDS (credit default swaps) – were the norm on Wall Street. Other titans of Wall Street, Merrill Lynch and UBS, are the focus of private litigations that turn on the same lynch pin as the SEC case. More broadly, Goldman is definitely not alone in the way it structured and disclosed CDOs, so if Goldman has a cold, then all of Wall Street might be about to catch the flu.

First, the facts as the SEC sees them in SEC v. Goldman, Sachs & Co. and Fabrice Tourre. The SEC is accusing Goldman of quite a lot: structuring a CDO that was built to fail, custom-built to a bearish investors specifications, failing to disclose the inherent issues, and throwing in a good measure of fraudulent misrepresentation to boot. Needless to say, Goldman strenuously argues these points in its responses to the SEC. All of this bears analysis, as it raises a range of questions from disclosure responsibilities to investor sophistication. Adding to the risks raised, this is all playing out in an environment of a financial system not yet fully recovered (notwithstanding outsized earnings now being reported).

In more detail, the SEC is alleging that, Goldman, at the behest of the hedgies at Paulson & Co, cobbled together a flawed, synthetic CDO that the hedge fund handpicked just so it could short subprime mortgages. The story reported by the business press goes on to claim that Goldman, knowing that no one would buy a CDO that was structured by a mortgage bear proceeded to mask the whole construct. In essence, the allegation is that Goldman then omitted Paulson & Co. from the marketing material, hired ACA Capital (a monoline insurer) to stand in as collateral agent, and “pawned” ABACUS 2007-AC1’s notes (the CDO at the center of the case) on to an unsuspecting investor. The story may be seen as tilting at windmills from the start, but there are plenty of legitimate legal landmines in the case for Goldman to stumble into.

Goldman’s case is that ABACUS 2007-AC1 is not just a CDO, but rather a synthetic CDO. In that one adjective lies the rub, as “synthetic” is Wall Street jargon for a complex structure built around the security so often made to play the villain, credit CDS. To remind, CDS act like insurance and pay protection buyers when a reference bond is downgraded or defaults. A CDO built around CDSs is structured to work differently. It is centered on CDS, as opposed to the actual residential mortgage backed securities (RMBS). The payment flow in these CDO securities is that premiums are paid into the synthetic CDO and used to settle interest and principal payments.

In the context of Goldman’s trade, this distinction matters, for several reasons. First, unlike “regular” CDOs (explained below), there are no actual assets at play in the synthetic variety. A custom portfolio of assets could be assembled with no risk to the assembler (as the actual referenced assets were never owned by the parties), and were subject to sway based on the motives of the assembling party. In this case, Goldman had no actual assets (on its books nor for that matter did Paulson) that needed to be shifted around; instead, it was effectively a way to place a bet on the overall market.

Second, any investor going long on a synthetic CDO knows or should know that there is someone short on the other side of the transaction. Additionally, they should have known that Goldman, as the initial protection buyer, is acting as broker of sorts between the two sides. Many structured credit products, like ABACUS, are marketed under SEC Reg S (Non-US Persons only) or Rule 144A. Rule 144A, purchasers must be qualified purchasers under the Investment Company Act of 1940 – meaning they are, by any account, sophisticated investors.

What the buyers did not know, but arguably should have, is that their counterparty was an extremely motivated buyer. There is a difference between Goldman entering into speculative CDS transactions with a single counterparty for around half an entire CDO issue, as opposed to selling the CDS protection to a variety of funds that want to hedge their exposure to the RMBS that underlie synthetic CDO. The very presence of a single bearish counterparty on the other side of the trade (rather than a distributed set of multiple counterparties) may also be considered material -- materiality would have dictated disclosure.

According to the SEC, Goldman completely left Paulson & Co. out of marketing materials for ABACUS 2007-AC1. Moreover, the complaint alleges the hedge fund signed off on the 90 RBMS that ABACUS 2007-AC1wrote CDS on. Given the circumstances outlined in the complaint, the investors may have found the level of Paulson & Co’s involvement material and ripe for disclosure.

Third, ABACUS used a “mere” contractual device to manufacture then-desired mortgage derivatives, notably, desired by both sides of the trade. With hindsight, however, this amounts to having manufactured toxicity along with a liquid marketplace that allowed toxicity to spread. As a result, the CDS-based trading broadens the network of players involved – not only are there buyers and sellers, intermediated by a broker, but there are insurance players, asset managers, and special purpose vehicles (SPVs), among others. The risk therefore to Goldman and its peers may be broader than first thought, as multiple parties are swept into these transactions.

As a sidebar, were ABACUS structured as a routine or “cash” CDO, CDS need not have been involved. Instead, the more routine form of CDO, in particular a subprime mortgage CDO, starts with a subprime mortgage on a house, which is then packaged, along with similar mortgages, into a RMBS. The homeowners pay their mortgages and the funds are paid to RMBS noteholders as interest and principal. To make a subprime mortgage CDO, an investment bank buys many RMBS and then structures the CDO into “tranches”, levels of seniority, and sells payment from tranches to investors in the form of CDO notes. A CDO is structured so that higher tranches are paid first and then payments flow down to the each proceeding tranche.

There is a final troubling element amidst the SEC’s complaint against Goldman – indicated by the other named defendant, Fabrice Tourre. Tourre, a Goldman vice president, is alleged to have misrepresented Paulson’s interest in ABACUS 2007-AC1 to collateral manager ACA Capital. Collateral managers are independent entities hired to choose and manage the assets. The complaint claims that ACA Capital, while working with Paulson on selecting the reference portfolio for ABACUS, was relying in some form on Tourre’s representation that Paulson invested approximately $200 million in the equity, the lowest tranche, and that Paulson’s interests in the collateral section process were aligned with ACA’s, “ when in reality Paulson’s interests were sharply conflicting.” It is worth noting that ACA, despite these representations, rejected 67 of 123 positions Paulson initially suggested and that neither ACA, which was restructured by Maryland regulators in 2008 and is currently in “runoff”, nor Paulson were named as defendants in the complaint.

Perhaps Goldman’s activity fits amidst the activities, and ethos, of its era. Hedge funds’ roles in purchasing equity tranches of CDOs certainly helped to keep the music playing in the subprime market, but these supposedly straight forward long investments are turning out to be much more complicated than initially thought. Magnetar, another allegedly bearish hedge fund, supposedly bought equity stakes in numerous CDOs, while at the same entering into CDS on more highly rated CDO tranches. Agreeing to purchase the equity tranche of CDO is called “sponsoring”. The net effect of what has been dubbed the Magnetar trade, is that hedge fund and others using a similar strategy received income from their long CDO investments during the housing boom and continued to profit handsomely even when defaults started to pile up.

Magnetar, the actual hedge fund, invested many different types of CDO: cash, synthetic, and hybrids of the two. Magnetar and other hedge funds by agreeing to buy the equity tranches on CDOs allowed banks to continue marketing CDOs, even during the twilight of the housing boom. Banks might otherwise have worried that they would get stuck with unmarketable equity tranches on their books.

One CDO that Magnetar sponsored, Norma, has landed Merrill Lynch in New York State Supreme Court. In Cooperatieve Centrale Raiffeisen- Boerenleenbank, B.A. v. Merrill Lynch & Co., the Dutch bank is suing Merrill Lynch for structuring the Magnetar sponsored hybrid CDO. The plaintiff is better known as Rabobank and alleges that Merrill sold it a CDO that was structured as a “as a tailor-made way to bet against the mortgage-backed securities market.”

The complaint goes on to outline that Norma was six percent cash and 94% synthetic. It further alleges that the subprime mortgages that were gumming Merrill’s books made up a disproportionally large amount of the cash portion of the security. Rabobank is suing Merrill Lynch for fraud, negligent misrepresentation, fraudulent conveyance, unjust enrichment, constructive trust, and conversion. It is notable that Magnetar was not named as a defendant and that, much like the Goldman case, the marketing and disclosures are what Rabobank finds lacking.

In a third case, UBS is under fire from hedge fund Pursuit Partners for alleged fraud on related to several CDOs that the bank arranged. The CDOs at the center of the case are Vertical ABS CDO 2007-1, ACA ABS 2007-2 Ltd., and TABS 2007-7 CDO. Pursuit, like other cases overlooks the sponsors, and sets its sights on the bank that arranged the CDOs and the credit rating agencies. The case relates to Goldman and Merrill, in that deals with an allegedly conflicted bank that sold securities that it knew not only might go down in value -- but may have actually known that the securities would go down in value.

In Pursuit Partners, LLC et al v. UBS AG et al, the allegations are rather simple: UBS believed the ratings agencies were about to change their rating methodology and destroy the value of CDO deals on UBS’s books, so the bank fraudulently unloaded some of these deals on Pursuit Partners. The case is pending, but Pursuit was awarded prejudgment remedy of just over $35 million on September 8, 2009. In the decision on the prejudgement ruling, Connecticut court judge John F. Blawie said of UBS actions in selling the deal amounted to:

“The difference between a risk that something might happen to change the value of an investment, which is both a fact of life and a risk shared by all parties to any securities transaction, and the undisclosed knowledge that something will happen. That type of nondisclosure, whether it is on the part of a seller or a buyer, can cross the line into actionable securities fraud, and the court finds probable cause to sustain a finding that it this instance, it did.”

It remains to be seen just how close to this same line Goldman and Merrill dance when continued to arrange CDOs into the twilight of the housing boom and the decision is one that Goldman and Merrill should keep in mind.

It remains to be seen how the Goldman, Merrill, and UBS cases will play out. Should Goldman have listed Paulson & Co front and center in the term sheet, pitch book, and other market materials? Or was this information non-material? Currently CDO disclosure is a gray area, but the pending court cases could leave arrangers, sponsors, and investors with some very bright lines.