By Alexander Bolton - 04/16/10 04:23 PM EDT
The Securities and Exchange Commission on Friday formally accused Goldman Sachs, one of the nation’s preeminent investment banks, of fraud, sending the bank’s shares plunging.
The charges against the prominent Wall Street bank set the stage for debate over financial regulatory reform that is expected to begin in the Senate next week.
In a 22-page complaint filed with the U.S. District Court for the Southern District of New York, the SEC alleged that Goldman Sachs defrauded clients by creating and selling a mortgage investment fund that was designed to fail.
Goldman’s shares fell by 14 percent shortly after the news broke.
The agency charged that Goldman and Frabrice Tourre, a vice president at the bank, had designed a special investment vehicle filled with mortgage bonds considered likely to fail.
Goldman then sold the investment, named Abacus 2007-AC1, a synthetic collateralized debt obligation, to investors, such as foreign investment firms and pension funds.
But while Goldman told these investors the bonds in Abacus would be picked by a neutral third party, the selection was heavily influenced by John Paulson, a prominent hedge fund investor who earned billions when the financial markets tanked.
Goldman picked bonds that Paulson & Co. Inc. believed were overvalued. Then Goldman and Paulson placed bets against these bonds that were then sold to investors, earning huge profits when the bonds dropped in value.
“After participating in the selection of the reference portfolio, Paulson effectively shorted the [residential mortgage-backed securities] portfolio it helped select …,” the SEC wrote in its complaint.
“[Goldman] did not disclose Paulson’s adverse economic interests or its role in the portfolio selection process in the term sheet, flip book, offering memorandum or other marketing materials to investors,” the complaint states.
Paulson paid Goldman Sachs approximately $15 million for structuring and marketing Abacus, according to the complaint.
Paulson’s fund returned an amazing 38 percent for investors in 2008, a year when the markets tumbled and wiped out many investors.
The SEC estimated that Abacus investors lost more than $1 billion.
"The product was new and complex but the deception and conflicts are old and simple," said Robert Khuzami, director of the SEC’s Division of Enforcement.
"Goldman wrongly permitted a client that was betting against the mortgage market to heavily influence which mortgage securities to include in an investment portfolio, while telling other investors that the securities were selected by an independent, objective third party."
The SEC alleges that Tourre was the prime driver behind Abacus. The agency claims he structured the instrument, prepared marketing materials and pitched it to investors.
Agency officials claim Tourre knew of Paulson & Co.'s undisclosed short interest and role in the collateral selection process. They claim he misled investors into believing that Paulson & Co. invested approximately $200 million in the equity of Abacus.
Investors thought their investment interests were aligned with Paulson & Co. when in fact they were “sharply conflicting,” according to an SEC press release.
The SEC suit helps Senate Democrats’ message strategy for next week, when Senate Majority Leader Harry Reid (D-Nev.) hopes to bring a Democratic financial reform bill to the floor.
Democrats hope to paint Republicans who oppose the Wall Street reform bill as doing the dirty work of big banks that want to avoid tighter regulation.
“Their position is very clear: They’re standing up for Wall Street, the big banks and financial institutions and we’re standing up for change, oversight and regulation,” Senate Democratic Whip Dick Durbin (Ill.) said on Thursday.