The civil fraud charges filed by government regulators last week against Goldman Sachs Group Inc. have put the investment bank and the Securities and Exchange Commission on opposite sides of a case that has all the makings of an epic legal showdown.
But the adversaries share one thing in common -- each is scrambling for its reputation.
Goldman is trying to protect its standing among clients, who could be frightened away by any evidence that the company is cheating them.
The SEC is hoping to buff its tarnished image as the regulator that couldn’t catch Bernard L. Madoff, despite a whistle-blower and other evidence that the financier was running a massive Ponzi scheme that swindled billions from investors.
“This is a risky battle for both sides,” said Jill Fisch, a securities law professor at the University of Pennsylvania. “This is the test case for the financial crisis.”
The SEC lawsuit alleges that Goldman created and sold securities tied to subprime mortgages, while failing to disclose that a hedge fund that was betting against the investment had helped to design it.
The hedge fund, Paulson & Co., made $1 billion when the subprime housing market ruptured. The investors lost $1 billion.
The course of the litigation will depend in part on what the SEC digs up from here. It’s unknown if there were other questionable deals or if top executives were aware of them.
“I’m not sure what the SEC wants to get out of this,” Fisch said. “Is this some small case with bad facts, or do they think this is more widespread, either at Goldman or at other firms?”
The fallout from the case reverberated through Wall Street on Monday, dominating the discussion of trading floors and boardrooms.
During an earnings call with stock analysts, Citigroup Inc.'s finance chief, John Gersprach, began by saying, “Let me state the following: Citi is not involved in the matter the SEC announced on Friday.”
He acknowledged, however, that the SEC and other regulators are “conducting an industrywide investigation into a wide range of subprime-related issues.”
The comment underscored growing fear among Wall Street players that they might get hit with similar government lawsuits stemming from their dealings in subprime mortgages.
Wall Street also is bracing for an onslaught of lawsuits from private investors who may have lost money in the bad mortgage deals.
“If an investor in those transactions came to us, we would certainly be advising them to bring an action if possible,” said Fred Asquith, a securities class-action lawyer at the New York firm Wolf Haldenstein. “Reading the SEC complaint, it appears that those people -- no matter how sophisticated they might be -- were misled.”
The high-profile nature of the Goldman matter suggests that this case might not play out as other securities-fraud disputes do, experts said.
Companies often settle SEC cases as cheaply and quietly as possible. And they always do so without admitting guilt. But the Goldman case has attracted such notoriety that the company runs the risk that any settlement could be viewed as a tacit acknowledgement of wrongdoing.
Goldman has forcefully defended itself and pledged to fight the allegations. But companies generally also don’t want to fight it out in court, where the outcome is uncertain.
“It could really severely cripple Goldman’s reputation and business if it were to lose this suit,” said Lawrence Mitchell, a finance law professor at George Washington University.
Goldman spoke out at greater length Monday in its own defense. In a statement, the company appeared to shift potential blame to Fabrice Tourre, the young vice president who was the only named defendant in the suit.
“Goldman Sachs would never condone one of its employees misleading anyone, certainly not investors, counterparties or clients,” the bank wrote. “Were there ever to emerge credible evidence that such behavior indeed occurred here, we would be the first to condemn it and to take all appropriate actions.”
The stakes are just as high for the SEC, whose reputation has been damaged by repeated embarrassments over the years. In addition to failing to spot Madoff, the agency did nothing to stop the marketing of questionable mortgage securities, and it missed the accounting shenanigans at Lehman Bros., the investment bank that collapsed in the country’s biggest ever bankruptcy in 2008.
A new leadership team installed by President Obama has promised tougher enforcement. But they started inauspiciously last year when a federal judge lambasted a proposed settlement the agency had struck with Bank of America Corp. over the company’s takeover of Merrill Lynch & Co.
The judge rejected an original $33-million deal as too lenient. He later approved a renegotiated $150-million settlement but complained that it also was too soft.
If it settles with Goldman, the SEC runs the risk that critics will say it let the firm off too lightly, experts said. But the complex nature of the issues in the case could make it risky to try the case before a jury.
“The SEC can’t afford to settle,” Mitchell said. “They went after the king, and if you go after the king you’ve got to kill him. That’s enormously important to the SEC’s reputation.”