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Stanford Professors Assess Landmark SEC-Goldman Suit And Underscore Need For Better Regulation Of Financial Sector

Publication Date: 
May 05, 2010
Stanford Report
Bill Snyder

Two Stanford experts on the finance industry distinguished between ethical and legal issues during a public analysis of the Securities and Exchange Commission's lawsuit against Goldman Sachs' allegedly fraudulent Abacus deal. Both came down in favor of stiffer regulation of derivative markets.

Hours after Goldman Sachs executives endured a grilling by angry U.S. Senators on Capitol Hill April 27, two senior Stanford faculty members explained to a standing-room-only crowd the intricacies of the synthetic CDO market and measured the strengths and weaknesses of the Securities and Exchange Commission's landmark lawsuit against the nation's most powerful investment bank.

Although the SEC's complaint and press reports have painted Goldman's massive bets on the mortgage market as negligent at best and fraudulent at worst, the facts are complex, and it appears that the Commission may well have a difficult time proving its case. "The less people know about the market, the more likely they are to believe Goldman is guilty," said Joseph Grundfest, a professor at Stanford Law School and former SEC commissioner. But more knowledge leads to doubt about the strength of the complaint, he said, adding, "This is not the strongest case the SEC has ever filed."


Neither Grundfest nor Duffie expressed any approval of the deal or of the impenetrably complex financial mechanisms that led to the collapse of the housing market and subsequent recession. Indeed, both came out on the side of stricter regulation of the financial markets in general and the derivatives market in particular.

"The government," said Duffie, "needs to enact legislation that will make the markets safer and more transparent." Grundfest sounded a similar note but said the public perception that there were no laws on the books that could have prevented the financial collapse was incorrect. AIG (the giant insurance company bailed out by the U.S. Treasury) was in fact regulated by the Office of Thrift Supervision, "but the government did not know how to use the power it had," he said.

Their discussion was sponsored by the Arthur and Toni Rembe Rock Center for Corporate Governance, a collaborative effort of the Stanford Law School and Stanford Graduate School of Business.


Goldman vs. the SEC

To convince a judge or jury that Goldman is guilty, the SEC has a rather heavy burden, Grundfest said. It has to show that Goldman withheld information that a short seller was a key part of the deal. Goldman denies that, but even if it were true, the SEC would have to prove that the omission was material, that is, legally significant, he said.


Goldman's defense, said Grundfest, will probably include assertions that it never lied or deceived any of its clients about Paulson's role in selecting the portfolio and that he was going to be short. The company will argue that its practices were consistent with industry standards and not negligent. And it will likely say that the clients were told and should have understood that there had to be a short side of the transaction.

No matter how the suit is resolved, it's already apparent that it has bolstered the case for Democrats who argue that more financial regulation is imperative. "Agree or not, that's simply the political reality," Grundfest said.

It's also apparent that the SEC's complaint is likely to spawn further litigation by private parties, various states, and quite possibly foreign governments. Win or lose, Goldman has suffered a black eye that will take some time to heal. And the SEC is looking at other mortgage-related deals in which Goldman held short positions.

If the case is lost because the evidence was weak, it will be yet another black eye for the SEC, which is still being criticized for missing Bernard Madoff's huge fraud. But if it loses because the law was weak, it will be yet another argument for strong action by Congress, said Grundfest.