04.20.10

The SEC's Dangerous Gamble

The agency, already badly scarred by the financial crisis, runs the risk of blowing its credibility with the Goldman case, writes former SEC chairman Harvey Pitt.

Goldman Sachs CEO Lloyd Blankfein will testify before a Senate panel next week. He’ll be on the hill to discuss Goldman’s role in the subprime mortgage crisis with the Senate’s Permanent Subcommittee on Investigations, but it’s expected that he’ll be asked about the SEC lawsuit against the bank as well.

Harvey Pitt, former SEC chairman, says the agency, already badly scarred by the financial crisis, runs the risk of blowing its credibility with the Goldman case.

The SEC’s recent action against Goldman Sachs gives new meaning to the expression “betting the farm.” That phrase signifies actions accompanied by huge risk, especially financial. In litigation, the expression references risks for one party to civil litigation, most frequently the defendant. It suggests a party risks losing everything if it gambles and follows a path to its logical conclusion. The expression rarely references plaintiffs, and certainly not government-plaintiffs litigating against regulated entities.

The problem with litigation is losing. But even if the SEC prevails, its reward may prove ephemeral.

But to quote Jimmy Breslin, in suing Goldman Sachs, the SEC “received immediate lacerations of the credibility.” This begs the question why, considering that this SEC litigation takes it places it hasn’t been before—

challenging the premier firm of Goldman Sachs,

about a synthetic derivative transaction,

on which Goldman lost millions of dollars,

where the parties were sophisticated and not in obvious need of SEC protection,

after a year-and-a-half investigation,

filed immediately after the President threatened vetoing financial reform legislation that doesn’t strongly regulate derivatives,

and a few hours before release of the Inspector General’s Report on SEC inadequacies in attacking Alan Stanford’s Ponzi scheme,

but apparently without giving Goldman advance notice of the filing,

or exploring possible settlement, and

splitting 3-2 along political lines in a major enforcement action.

More significantly, it comes when the SEC is badly in need of “unlacerated credibility.” Since January 2009, the SEC has done an admirable job of laying a solid foundation for restored credibility. But, its suit against Goldman could undo much—if not all—of that effort if the litigation doesn’t turn out satisfactorily, and even if it does, if reports about dissension and political splits are accurate.

Tina Brown: Ghouls of Wall Street Reduced to bare essentials, the SEC alleged a garden variety securities fraud, but for the elements listed above. It claims Goldman sold synthetic securities but didn’t disclose the package was structured by an investor intending to short it, and affirmatively misrepresented who structured it. If the SEC prevails, it might reassert its position as a player in the current financial regulatory scene. But the lawsuit carries big stakes if the SEC loses—among other things, this case will influence the reputations of both Chairman Mary Schapiro, and Enforcement Division chief, Rob Khuzami.

The problem with litigation is losing. But even if the SEC prevails, its reward may prove ephemeral. After all, there aren’t any widows or orphans in the immediate vicinity of the central transaction, and even victory could be tarnished by questions about its potential motivations regarding the manner and timing of the SEC’s decision to sue. Is that worth the potential risk? The question answers itself.

The problem isn’t—as some suggest—with the substance of the suit. If the SEC’s allegations are proved, they seem to allege fraud. Nor is there a problem with the SEC pursuing a case where the alleged victims were able to fend for themselves. After all, if a broker defrauds sophisticated investors, it might also defraud unsophisticated investors. And, many sophisticated investors represent unsophisticated investors. Moreover, there’s no entitlement under the federal securities laws to defraud sophisticated investors.

One problem is that it was in the SEC’s interest to let Goldman react before filing a lawsuit. If Goldman had had a chance to settle before being sued, the SEC could have reaped everything it wanted to achieve, without the risks it now faces. Another problem is that filing litigation on a partisan split raises questions about agency motivations. Perhaps there was no way all five Commissioners could agree. But there’s no prior history of tension among them, while news reports indicate there was just a single meeting, and then a 3-2 vote.

With rules or policy decisions, some divided votes may be inevitable. But, the agency usually doesn’t split on enforcement actions, and especially not along party lines. Could more time have produced a different result? We won’t know. But, what was the rush? After a year-and-a-half of investigation, eight months after receiving Goldman’s “Wells Submission,” was there a need to file the litigation when it was filed? Why didn’t the five Commissioners take more time to try and find common ground? What was the need that compelled the filing of the action last Friday, instead of, say, this Friday, or next? These aren’t matters that will necessarily affect the ultimate outcome, but judges pay attention to news reports, and the possibility that an action was politically motivated won’t redound to the agency’s advantage, even if it isn’t something directly contested in the courtroom.

Goldman’s lawyers should have ensured they received notice before the lawsuit was actually filed. There are no assurances, under the SEC’s Wells procedures, that notice will be given before a suit is filed, although that’s the practice. But experienced counsel often seek assurances they’ll have at least one last clear chance to settle before confronting the SEC in court. If that assurance was sought and rejected, that should have signaled to Goldman it was looking at something unusual. If no assurances were sought, that was an error of judgment.

Government suits affect the target’s share price, as occurred here, and also adversely affect its reputation and potential business. In those respects, Goldman has already lost. Arthur Andersen ultimately prevailed in the Supreme Court, after losing in the lower courts. But its victory was Pyrrhic, and came long after the real stakes had been decided. Goldman’s a strong firm with an illustrious history. But if the economic collapse of 2007-2008 demonstrated anything, any firm can falter if its credibility is called into question.

In this litigation, either the SEC, or Goldman, is betting the proverbial farm, or perhaps, they both are.

Editor’s Note: An earlier version of this article neglected to note that Harvey Pitt has done work for hedge fund manager John Paulson, who helped Goldman Sachs develop the product at the center of the SEC’s case but has not been sued in the matter.  We regret the error. Mr. Pitt noted: “I had no involvement in these transactions nor with the SEC's decision whether, and whom, to sue. My article doesn't mention Paulson or discuss its role, other than to paraphrase the SEC's allegation.”

Harvey Pitt, a former chairman of the SEC, is the Chief Executive Officer of Kalorama Partners, LLC.