SEC Chief's Big Bet on Goldman
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By MONICA LANGLEY , KARA SCANNELL, SUSAN PULLIAM And SUSANNE CRAIG / WSJ / May 14, 2010
It was standing-room only in the windowless room where the SEC's five commissioners met last month to decide whether to sue Goldman Sachs Group Inc. for fraud. From top to bottom at the beleaguered agency, staffers and lawyers who saw the giant Wall Street firm on the confidential enforcement calendar wanted to witness the drama.
Once the enforcement team laid out its recommendation to sue Goldman—arguing that the firm had misled investors about highly complex securities linked to the cratering mortgage market—the commissioners questioned the lawyers on the strength of the evidence. They also debated whether the SEC was essentially sailing into uncharted territory by attacking a relatively new financial product. "I have serious doubts about the evidence of fraud" prevailing in court, said Troy Paredes, one of the two Republican appointees on the commission, according to two people in the room.
The enforcement staff argued that it could build a record strong enough to support the fraud charges. Finally, SEC Chairman Mary Schapiro called for a vote, even though it was obvious there was serious disagreement among the commissioners. In the end, the two Democratic commissioners voted for the case to proceed and the two Republicans against. Ms. Schapiro, an independent named by President Obama, cast the deciding vote to go ahead.
It was a career-defining moment for Ms. Schapiro, and a gut-churning roll of the dice. The suit is shaping up as one of the most explosive confrontations in Wall Street history, pitting the world's most profitable securities firm against a regulatory agency with a battered reputation as a watchdog. The decision to proceed without unanimous agreement from the commissioners—unusual in such a high-profile case—exposed the agency to accusations that its actions were influenced by politics despite its nominally independent status. The agency denies any political agenda.
There's no denying that the SEC could use a big win for its own bureaucratic health. During an April 2009 meeting with top enforcement-division lawyers, Ms. Schapiro warned that the agency needed to prove its mettle quickly in going after Wall Street malefactors. She reminded them of the SEC's failure to detect fraudster Bernard L. Madoff.
"If we don't get serious about this process, we may cease to exist," she said, according to several people at the meeting.
Ms. Schapiro—never before known as a hard-nosed enforcer during her long career as a Wall Street regulator—is gambling that she can at least extract a humbling, costly settlement from Goldman, which denies it duped investors. The lawsuit says Goldman broke the law by selling a collateralized debt obligation called Abacus 2007-AC1 without disclosing that hedge-fund firm Paulson & Co. helped to pick some of the underlying securities and was betting on the deal's decline.
At the moment, despite a case that appears far from airtight, the 54-year-old SEC chief seems to have Goldman on the defensive. Settlement talks began last week, and Goldman Chairman and Chief Executive Lloyd C. Blankfein has for the first time faced questions from investors about his whether he should continue as the firm's leader. Mr. Blankfein said at last week's annual meeting that he has no plans to step down.
This account of how the SEC decided to pursue Goldman and how the Wall Street giant responded is based on dozens of interviews with regulators, executives, traders, lawyers and other people with knowledge of the situation.
The interviews reveal that people were coming to the SEC to complain about Goldman's mortgage-related dealings at least as far back as January 2008. That's when an Australian hedge fund that blames Goldman for a $100 million loss on a bond deal showed up at the agency with a stack of documents.
Goldman has struggled to contain the damage in the wake of its initial pledge to fight the charges. Its shares have fallen 22%, wiping out more than $20 billion of the firm's stock-market value. It is facing a federal criminal probe of its mortgage business. Goldman declines comment on the criminal investigation.
The SEC's willingness to challenge Goldman represents a big shift for the agency. In recent years, it has pursued investigations that were controversial or that sought large fines only if there was consensus among its five commissioners. Some current and former SEC lawyers say employees in the trenches took this to mean that there was little appetite for tough cases.
Morale plunged when the Madoff fraud was exposed in December 2008. One ex-SEC lawyer was asked at his mother's birthday party: "How does it make you feel that your agency is absolutely incompetent?"
The roots of the Goldman case extend back to before Ms. Schapiro took over in January 2009. After the U.S. housing market collapsed in 2007, agency officials launched a subprime-mortgage working group led by Reid Muoio, now 43 years old, a veteran of bribery and insider-trading cases who had worked his way up to deputy chief of a new unit focusing on complex financial products. Within the agency, he was known for blunt talk and an aggressive style.
In January 2008, the working group got a break in its effort to understand how Wall Street profited from soured mortgage deals.
David Mapley, a former outside director for an Australian hedge fund, Basis Yield Alpha Fund, called an SEC lawyer to complain about a Goldman mortgage-related investment product called Timberwolf I Ltd.
"Our belief is the trade was portrayed in a fraudulent manner," Mr. Mapley told an SEC lawyer, complaining that Goldman misled the hedge fund about an investment that cost Basis about $100 million when housing prices tumbled. That March, Mr. Mapley and two Basis executives met with 11 SEC investigators, including Mr. Muoio, for several hours.
The SEC investigators said they already were working on a case related to Timberwolf, according to a person who attended the meeting, and that it had questioned Daniel Sparks, the head of Goldman's mortgage department, about Timberwolf.
It is unclear how the information about Timberwolf figured into the SEC's investigation of Goldman's mortgage dealings. In a January 2008 securities filing, Goldman disclosed that the SEC had requested information about subprime loans.
Prior to taking over the SEC, Ms. Schapiro had led the Financial Industry Regulatory Authority, Wall Street's self-regulatory body. It, too, had failed to detect the Madoff scandal, and enforcement fines against securities firms shrank near the end of her tenure there.
Two months after becoming SEC chief, she taped to her office door a note about the agency's work: "How does it help investors?" She began putting in 12-hour workdays, eating lunch at her desk, working Sundays and firing off emails into the early-morning hours.
Soon after being sworn in, Ms. Schapiro recruited Robert Khuzami, head of the U.S. legal division of Deutsche Bank AG, as her enforcement chief. She said she wanted someone who would help the SEC to restore its swagger. The former federal prosecutor, who had helped convict blind sheik Omar Abdel Rahman in the 1993 World Trade Center bombing case, challenged agency lawyers to either file stagnant cases or drop them.
He assembled 10 different groups to analyze how the SEC should change. A PowerPoint presentation about the shakeup of the enforcement division, circulated anonymously by SEC employees, compared Mr. Khuzami to Michael Corleone in "The Godfather."
One of Ms. Schapiro and Mr, Khuzami's biggest priorities was building what SEC officials called a "body of work" in mortgage lending by bringing enforcement actions.
The SEC's investigation of Goldman eventually yielded eight million documents, according to Goldman. It isn't clear why investigators eventually zeroed in on the $1 billion Abacus deal, completed in April 2007.
In filings related to the suit, Goldman said the SEC had interviewed five current or former Goldman employees with knowledge of the Abacus deal.
Depositions of key Goldman employees and clients began around the spring of 2009 and lasted at least through January 2010, according to a person familiar with the situation.
Last July 29, agency officials called Goldman to tell the firm it was being served with a Wells notice—a formal warning that civil fraud charges could be forthcoming. Shocked Goldman lawyers and executives took notes as the SEC laid out its accusations against the company.
In a September submission to the SEC aimed at fending off an enforcement action, Richard Klapper, a Sullivan & Cromwell lawyer representing Goldman, said, "If this matter is litigated, Goldman Sachs is confident that a fuller record—including its own discovery of all transaction participants—will underscore that no one in fact considered Paulson's role important and that no one was misled."
As tensions mounted, the SEC told Goldman that the company wasn't moving fast enough to provide documents and responses to the agency, which the SEC saw as a stalling ploy known as "slow walking."
Inside Goldman, some contended that Mr. Khuzami had a conflict of interest because of his previous job at Deutsche Bank, a Goldman competitor, according to people familiar with the situation. The German bank, like Goldman, created collateralized debt obligations.
An SEC spokesman said Mr. Khuzami's involvement in the case fully complies with ethics guidelines.
In March, Goldman's lawyers called the SEC for an update on the case. The call wasn't returned, Goldman says.
On April 14, Messrs. Khuzami and Muoio and other SEC lawyers gathered in the meeting room for commission enforcement actions. Mr. Muoio outlined the case against Goldman, laying out the SEC's strongest evidence and potential problems if the lawsuit went to trial. Then the commissioners started asking questions.
One topic of discussion was a deposition from Paolo Pellegrini, the Paulson & Co. executive who appeared to claim in one part of his testimony that he told an investor that his firm would be betting against the Abacus deal, according to someone who attended. Ms. Schapiro, who asked the last round of questions, pushed for facts that would buttress an enforcement action against Goldman, according to another person who was in the room. The lawsuit passed 3-2.
Mr. Blankfein, 55, was in his 41st-floor office at Goldman's new headquarters when the SEC announced the suit at 10:35 a.m. on April 16. Seventy-nine minutes later, Goldman said in a statement that the accusations are "completely unfounded in law and fact."
In a conference call arranged by John Rogers, the Goldman board secretary and a confidant of Mr. Blankfein, executives agreed that giving in at all would cast doubt on every CDO deal arranged by the company, according to a person familiar with the call. Over the next four days, Mr. Blankfein called hundreds of clients to answer questions and listen to suggestions.
The lawsuit set up Mr. Blankfein for another big headache: a grilling by the Senate Permanent Subcommittee on Investigations. For days leading up to the April 27 hearing, Goldman lawyers bunkered inside "war rooms" where they sifted through thousands of pages of emails and other documents. "Hot" documents considered especially damaging were stacked in one pile, according to one person close to the situation.
Goldman officials worried that lawmakers would pounce on Fabrice Tourre, the only employee accused by name in the SEC lawsuit, and would leak documents about him during the weekend before the hearing. Goldman decided to strike first. On a Saturday morning, the firm released several emails from Mr. Tourre to two female friends. In one, he described mortgage deals like Abacus that he worked on as "a product of pure intellectual masturbation…which has no purpose, which is absolutely conceptual and highly theoretical and which nobody knows how to price."
That Sunday, Messrs. Tourre and Blankfein went to Goldman headquarters in New York to prepare separately for the hearing. Mr. Blankfein practiced his answers. His goal was to provide simple answers and emphasize that Goldman's market-making role in CDOs doesn't require it to have the same view as its clients, according to the person close to the situation.
At the hearing, though, Mr. Blankfein looked defensive, tilting his head and squinting at lawmakers as they questioned him for hours. He stumbled when asked why Goldman didn't release the emails of any employees other than Mr. Tourre.
"He's the guy that's getting hung out to dry, because nobody else had their personal emails released," said Sen. Tom Coburn, an Oklahoma Republican.
"I wasn't close to the decision," the CEO answered.
The WSJ reported April 29 that federal prosecutors are conducting a criminal investigation into whether Goldman or its employees committed securities fraud in connection with its mortgage trading, people familiar with the probe say.
Since then, Goldman's public stance has begun shifting from defiance to reconciliation. Goldman lawyers met last week with representatives of the SEC in a first step toward a potential settlement of the fraud lawsuit, though they remain far apart.
Meanwhile, morale is soaring at the SEC, staffers say. After a recent meeting on proposed rules with Ms. Schapiro, two regulatory lawyers walked into the hall and fist-bumped before getting on the elevator. |
