Goldman Sachs Fraud Case - Research Paper Example

? Goldman Sachs Fraud Case The charging of Goldman Sachs with fraud centered on the theory that the firm had traded a German bank (IKB) a derivative debt instrument attached to the fate of mortgage-backed securities, while at the same time concealing the flaws of the securities in that subject. According to the SEC, Goldman disguised the issue by flaunting the function of a highly regarded independent firm within the selection of the underpinning securities. The paper explores the fraud case that Goldman Sachs settled with Securities Exchange Commission. Goldman Sachs Fraud Case Introduction Goldman Sachs defrauded investors by failing to reveal the apparent conflict of interest on mortgage investment it floated as the housing market became sour. The charges that were brought forward by the Securities Exchange Commission against Goldman Sachs argued of unlawful action and fraud in the trading of toxic subprime mortgage derivative securities. Nevertheless, Goldman Sachs affirmed that they were merely following normal business practices and had not committed any wrong. The Goldman Sachs fraud case elicited critical issues centering on the inadequacy of the investment banking practices, and raised the question whether it is a case of deceptive or unethical behavior (Craig & Scannell, 2010). The three-month legal ordeal erased close to $20billion of the firm’s stock-market value. A lively public discussion that followed the charge of Goldman Sachs by SEC centered on whether Goldman Sachs, broadly viewed as an embodiment of bubble-era greed, was also a lawbreaker. Questions emanated on whether Goldman bankers warranted condemnation for deliberately exploiting the naivety of investors to gain from the trading of debt instruments that were bets on a market Goldman Sachs was doomed to collapse (Whalen & Bhala, 2011). Although, the transaction entailed in the SEC’s lawsuit can be regarded as small by Goldman Sachs’ standards, its arrangement allude to weighty questions regarding the fault of the banks in driving up a market within mortgage-derived securities that lingered practically inclined to self destruction (Buell, 2011). The SEC was asking whether Goldman Sachs gained from both sides in a way that contravened their fiduciary obligation to their customers. The SEC claimed that investors essentially lost over $1billion dollars, and that Paulson’s short option debt instrument on the credit instrument derived a profit of more than $1billion (Jones, 2010). Email traffic pointed out that Tourre plus others were aware of the subprime mishap as early as January 2007 before the crisis became full blown. The SEC sought a restriction, disgorgement of profits, and sanctions with regard to interest and civil monetary penalties (Craig & Scannell, 2010). In addition to these charges, criminal prosecutors were exploring whether Goldman Sachs or its employees committed securities fraud with regard to the firm’s mortgage trading. #1 The Fraud Goldman’s case entailed four forms of securities that all played some roles amid the 2008 financial downturn: first, the residential mortgage-backed securities (RMBS) embodying a form of security derived from pooling of mortgages on residential real-estate into bonds; a credit-default swap (CDS) representing a form of insurance policy; a collateralized debt obligation (CDO) representing a debt security collateralized by debt obligation; and, synthetic CDO’s (SCDOs) equivalent to ordinary to ordinary CDOs excluding that investors own CDOs on real securities rather than the real securities themselves. The Securities and Exchange Commission (SEC) filed a civil fraud charge against Goldman Sachs & Co, as well its vice presidents for fraud for misrepresenting information meant for investors by misstating key facts regarding a financial product connected to subprime mortgages at a moment when the housing market within the United States started to crumble and lose value (Buell, 2011). This was one on of the most significant case against Wall Street since the onset of the financial crisis. The charge indicted the defendants for assembling deceptive and misrepresenting statements in respect to one of the debt instrument promoted by Goldman Sachs in 2007 grounded in subprime residential mortgage-backed securities. The SEC claimed that Goldman constituted and mis-marketed its synthetic collateralized debt obligation (CDO). The firm failed to disclose to investors critical information regarding the CDO, especially the function that a significant hedge fund took part in portfolio selection process. In this instance, a “short” position would be a choice, to bet that the traded debt instrument would lose its worth. In fact, it was Goldman Sachs that aided Paulson & Co purchase that “short” position against the identical debt instrument that Goldman Sachs was publicizing bullishly (Buell, 2011). The point to which the sub-prime debt securities failed within the market, Paulson and Co. stood to gain via their short position against those securities. Goldman Sachs failed to divulge Paulson’s adverse economic interests or its responsibility in the portfolio selection process within the term sheet, flip book, availing memorandum or other marketing materials availed to investors (Whalen & Bhala, 2011). Goldman Sachs erroneously allowed a client to manipulate and have oversight on which mortgage securities to incorporate in an investment portfolio while at the same time informing the other parties (investors) that the traded securities were backed by an autonomous, objective third party (Joseph, 2011). SEC alleged that Paulson & Co. sought the services of Goldman Sachs to structure the transaction in which Paulson & Co. could adopt short positions against mortgage securities selected by Paulson & Co. based on the belief that the traded securities would encounter credit events (Jones, 2010). The Securities Exchange Commision’s complaint registered within U.S. District Court detailed that, the marketing materials for the CDO (referred to as ABACUS 2007-ACI) all featured that the RMBS portfolio underpinning CDO was picked by ACA Management LLC (ACA), which is a third party, bearing proficiency in evaluating credit risk in RMBS. The SEC claimed that Goldman’s Vice President was directly to blame for ABACUS 2007-ACI (Craig & Scannell, 2010). The Vice President arranged the transaction, organized the marketing materials, and was in direct contact with investors. It was also alleged that, the Vice President was in full knowledge of Paulson & Co.’s unrevealed short interest in the collateral selection process directly allied with ACA’s interests. In real terms, however, their interests were evidently conflicting (Free, 2012). #2 The Corporation and/or Government Response The SEC’s complaint detailed that Paulson & Co. paid Goldman Sachs close to $15 million for structuring and publicizing ABACUS. It is alleged that investors within the liabilities of ABACUS alleged to have lost close to $1 billion. The SEC’s complaint charged Goldman Sachs and Tourre with contraventions of Section 17(a) of the Securities Act, plus contravention of the Securities Exchange Act of 1934 (10b), and Exchange Act Rule 10b-5. The commission charges detailed injunctive relief, disgorgement of profits, prejudgment interests, and financial penalties. In response to the filed suit, Goldman Sachs Group Inc. agreed to settle one of biggest penalties handed out in Wall Street history. The company agreed to settle the handed out penalty of $550 million in response to the advanced charges that it swindled clients by trading mortgage securities that were clandestinely structured by a hedge-fund unit to redeem on the housing market’s crumple (Joseph, 2011). The concurrence with the SEC put to an end a face-off that had significantly destabilized America’s most influential financial firm at a charge that observers identified as a bargain. # 3 The Core Issues behind the Fraud Goldman Sachs admitted that the entity had committed “a mistake” by failing to divulge the function of Paulson & Co to investors for its deal labeled ABACUS 2007-AC1. Goldman Sachs & Co deceived investors by characterizing that ACA picked the portfolio, devoid of disclosing Paulson’s principal role in shaping the portfolio and its undesirable and conflicting economic interests (Roge, 2010). Goldman Sachs marketing materials for ABACUS 2007-AC1 were significantly deceiving in the sense that they represented that ACA chose the reference portfolio while excluding any mention that Paulson, a party to the deal with considerable economic interest unfavorable to CDO investors, played a decisive function in the selection of the traded portfolio (Free, 2012). For instance, in a 9-page document detailing ABACUS 2007-AC1 organized by Goldman Sachs & Co around February 26, 2007, delineated ACA as the “Portfolio Selection Agent” and outlined that the portfolio was “chosen by ACA.” The documented failed to carry any declaration of Paulson, its economic interest within the transaction, or its function in choosing the reference portfolio. GS & Co misled ACA into judging that Paulson was long equity, or that Paulson was committing financial resources in the equity of ABACUS 2007 –AC1. The equity trance is mainly at the base of the capital structure and the foremost to experience losses linked to deterioration within the performance of the instrument (Joseph, 2011). # 4 Analysis of the Response Whereas the penalties handed out to Goldman Sachs can be termed as commendable, it was not enough to ensure that such an occurrence will not repeated (Jones, 2010). After the settlement of the suit, Goldman Sachs declared its intention to reinforce oversight of mortgage securities. It was disappointing that Goldman Sachs walked away with a number of victories that raised doubts over the potency of SEC’s case (Free, 2012). Goldman Sachs remained not compelled to sacrifice any of its top management, inclusive of its Chief Executive. The changes that the entity agreed to effect would not weaken its profits or its reputation as one of Wall Street’s biggest firm. The record settlement penalty only translates to just14 days of profits of the firm in the first quarter. Given the damages handed out in the case and the issue at hand, the action was unlikely to threaten Goldman Sachs. Indeed, the action appears to have served no greater public purpose than making the public know whether Goldman committed fraud, which still remained unclear. Significant parts of explanation that can be cited for this contest remain grounded in the procedural habits and economics of SEC enforcement actions (Joseph, 2011). As was the case of Goldman Sachs, such cases are settled out of trial and in most cases with the suspected perpetrator of fraud neither acknowledging nor refuting the SEC’s claims. Since the facts presented in the Goldman Sachs case were never established with any conclusiveness, and since Goldman admitted nothing, the widely publicized case of “U.S. charges Goldman Sachs with fraud” merely faded away, leaving barely a trace beyond the $550million penalty (Jones, 2010). In my opinion, the penalties handed by SEC were inadequate, besides the case did not declare the illegality of Goldman Sachs action. As such, the case cannot be said to have been brought to its logical conclusion. # 5 Steps that could have mitigated or prevented the Misconduct An effective ant-fraud strategy mainly incorporates four main components: prevention, detection, deterrence, and response. Attitudes that prevail within an organization lay the foundation for a high or low fraud risk environment. Goldman Sachs should not promote an environment that perpetuates leniency to fraud since maintain high ethical standards mainly bring lone-term benefits to the organization and its stakeholders (Agatha & Marion, 2010). Goldman Sachs should avoid or declare the conflict of interest that may yield divided personal loyalties. A code of ethics or an anti-fraud policy is insufficient to prevent fraud and must be embedded within the culture of the organization (Roge, 2010). When combined with the inappropriate corporate culture and incentives, conflicts of interest can be damaging. An effective practice for managing conflict of interest that the firm that utilize can be delineated in three diverse broad considerations: the firm needs to institute an effective process that if driven by cross-functional leadership team that highlights and understand all conflict of interest within the business model. The highlighted conflict of interest should be understood with regard to their practical business implication and their linkage to relevant legal standards. This entails the appreciation that conflicts are dynamic (Agatha & Marion, 2010). This is also critical to risk assessment and prioritization as conflicts of interest pose the greatest risk to the firm so that resources can be apportioned accordingly to mitigate (Whalen & Bhala, 2011). The second consideration entails having a good compliance and ethics program designed to address the conflicts of interest within the firm identified and prioritized. Conclusion Although Goldman Sachs settled the fines and the ABACUS deal has long been terminated, there are still a number of critical questions that remain to be answered. For instance, the extent to which Goldman bears the responsibility to divulge certain information regarding Paulson’s engagement in Portfolio selection. Similarly, in case Goldman Sachs had mentioned Paulson in the flipbook, would the mere mentioning be sufficient or would Goldman have notified investor’s of Paulson’s short position? For an entity that has made considerable steps with regard to its reputation as a “trusted consultant and an excellent investment manager,” such actions call in question the authenticity of the firm. Although, it appears that Goldman did not automatically commit fraud it is apparent that Goldman Sachs placed their interests ahead of the clients. The Goldman Sachs ABACUS 2007 –ACI embodies a scenario that raises numerous questions regarding the value of financial instruments to society, and the responsibility of a corporation to their client. Even if Goldman’s actions could not be automatically deemed as a direct contravention of the law, their actions were unethical. References Agatha, J. & Marion, M. (2010). The line between illegality & unethical behavior in the Goldman Sachs subprime mortgage securities case. International Journal of Business Research, 10 (4). Retrieved from http://www.freepatentsonline.com/article/International-Journal-Business-Research/279263006.html Buell, S. (2011). What is securities fraud? Duke Law Journal, 61 (3): 511. Retrieved from http://scholarship.law.duke.edu/cgi/viewcontent.cgi?article=3024&context=faculty_scholarship Craig, S. & Scannell, K. (2010, July 16). Goldman Settles its battle with SEC: $550 million deal ends showdown that shook street. The Wall Street Journal. Retrieved from http://online.wsj.com/article/SB10001424052748704682604575369382547871788.html Free, C. (2012). The Goldman Sachs Abacus 2007-ACI controversy: An ethical case study. e-International Relations. Retrieved from http://www.e-ir.info/2012/01/19/the-goldman-sachs-abacus-2007-aci-controversy-an-ethical-case-study/ Jones, A. (2010). Goldman v. SEC: It’s all about materiality. Wall Street Journal Law Blog Retrieved From: http://blogs.wsj.com/law/2010/04/19/goldman-v-sec-its-all-about-materiality/ Joseph, G. (2011). Case comment: The need for careful analysis of the statistical summary in the response to the complaint in the SEC v. Goldman Sachs case. Law, Probability & Risk, 10 (1): 77. Retrieved from http://connection.ebscohost.com/c/opinions/59688440/case-comment-need-careful-analysis-statistical-summary-response-complaint-sec-v-goldman-sachs-case Roge, R. W. (2010). Goldman Sachs vs. SEC-Missing the point: It’s all about fiduciary duty to your clients. Advisor Perspectives. Retrieved from http://www.advisorperspectives.com/commentaries/roge_042210.php Whalen, P. & Bhala, K. T. (2011, April 25). Goldman Sachs and the ABACUS deal. Seven Pillars Institute for Global Finance and Ethics. Retrieved from http://sevenpillarsinstitute.org/case-studies/goldman-sachs-case Read More