The Commission’s action against Goldman Sachs is the most significant case it has brought in years. SEC v. Goldman Sachs & Co., Case No. 3229 (S.D.N.Y. Filed Apr. 16, 2010). The case pits the once revered securities markets regulator struggling for a come-back against the Wall Street giant long known for its market prowess and deep ties to the U.S. government and others around the world. Investors are in the middle, watching intently and trying to determine if they can once again rely on the SEC to police the markets or of everyone on Wall Street is tainted with greed that devours all ethics. The stakes could not be higher.

The case is stunningly simple despite the complex transactions on which it is built. The SEC’s complaint claims:

• The deal: Wall Street hedge fund Paulson & Co. believed the sub-prime residential real estate market was about to collapse. It wanted to create an investment opportunity to profit from this belief. Paulson shopped for an investment firm to construct an entity based on residential sub-prime mortgages to implement its strategy. Some investment firms refused to consider the proposal. Goldman agreed to do the deal.

• Other clients: Goldman had other clients who held the opposite view of Paulson regarding the sub-prime residential real estate market. IKB, a commercial bank headquartered in Düsseldorf, Germany, for example, subscribed to this view. Goldman knew that the bank and others who agreed with its market assessment would only purchase shares in an investment fund tied to the sub-prime market if there was an independent portfolio selection agent.

• Constructing the fund: ACA was selected by Goldman as the portfolio selection agent. The fund – called ABACUS – was constructed in 2007. The entity was built using synthetic collateralized debt obligations tied to the sub-prime residential mortgages. The securities selected were the lowest investment grade. ACA was led to believe that Paulson would invest in the fund, essentially taking a long position.

• The role of Paulson: Paulson influenced the selection of the securities in the fund. At one point, the firm rejected all securities from Wells Fargo which had a reputation for having high grade securities tied to the sub-prime market. ACA was not told of Paulson’s influence in selecting securities for the fund.

• The marketing materials: The materials provided to potential ABACUS investors contained information regarding its construction, investments and risks. Those materials did not disclose the influence of Paulson & Co. in the transaction, including its role in the securities selection process. Goldman also did not inform ACA of Paulson’s role in that process or of its goal in asking that the fund be created.

• Purchases: Paulson essentially shorted the fund. IKB and others purchased shares in ABACUS, taking a long position. Ultimately the sub-prime residential real estate market collapsed. ABACUS shareholders suffered huge losses. ACA suffered losses. Paulson & Co. made huge profits.

• Fees: Goldman was paid a substantial fee by Paulson for constructing the fund.

• The fraud claim: The SEC claims that by failing to disclose the role of Paulson & Co. Goldman did not inform investors that it had a critical conflict of interest. The complaint suggests that investors were not told that the role of ACA as portfolio selection agent had been undermined if not completely compromised. This constitutes securities fraud. The complaint also suggests, although it does not state, that the fund was a rigged sham, crafted to fail for the benefit of Paulson, a fact investors were not told.

For the SEC the stakes could not be higher. The Commission has repeated touted its efforts to return the enforcement program to its glory days, pointing to personnel, management and structural changes undertaken to fulfill this promise. Yet, the enforcement program has been dogged by a reputation that it will not and cannot take on the major Wall Street players. In Bank of America, discussed here, the court accused the SEC of conducting a sham investigations, being in bed with the bank and of failing investors in the initial settlement.

Despite the apparent straightforward nature of its allegations, the Commission could lose. If Goldman continues to litigate there is no doubt that the bank will direct an army of talented and experienced securities litigators to attack the complaint and every claim raised by the agency. The SEC will be seriously outnumbered and will not have available anything close to the same resources as the bank’s litigation army. While the very talented litigators in the Commission’s trial unit have typically risen to the challenge, the pressure will be substantial and the battle most difficult. This is a case the SEC needs to win.

To be sure, the SEC’s reputation hinges on the overall effectiveness of its enforcement program, not just one case. Others actions such as the Rorech insider trading case, discussed here, which is currently on trial and the outcome of its current investigation of General Electric for financial fraud in the wake of a recently settled financial fraud case, discussed here, as well as others will ultimately determine if the Commission has regained its stature as Wall Street’s top cop. Nevertheless, a win or a favorable settlement in Goldman Sachs would go a long way toward restoring its reputation and reassuring investors it can effectively police the markets and safeguard their interests. A loss will only reinforce the perception that the SEC is incapable of policing the markets and protecting investors.

For Goldman, the stakes are equally high. The SEC’s claims directly attack its prized reputation for excellence and of-repeated claim that firm clients come first. Yet, litigating the case contradicts the conventional wisdom of regulated entities and many corporations. Under that approach, a quick settlement at virtually any cost is the way to go. It puts the matter and the negative publicity in the past, while permitting the company to move on to better days and more profits. It was just this type of strategy which drove the initial but failed settlement efforts in Bank of America, discussed here.

In contrast, litigation poses significant risks and uncertainties which companies, their executives, shareholders and potential investors abhor. The case will likely drag on for months if not years. The litigation costs will be substantial. Perhaps more importantly, it will require significant time and attention from senior management, diverting attention from the business of the firm. As the case continues there will be repeated blasts of negative publicity which will undermine client relations, further damaging the business of the firm. On going discovery could also result in amendments to the complaint, adding senior firm executives as defendants and further complicating the situation. And, the SEC might win at trial which would not severely damage the reputation of the business and also increase civil liability in the parallel class actions suits which will almost assuredly be filed.

Like the SEC, Goldman will also survive the resolution of this case. While a standard SEC settlement would tarnish the bank’s reputation, the institution is likely to come back. A loss at trial with a finding that firm which sits at the top of Wall Street defrauded its clients would undoubtedly have a long term impact on the firm’s business. It would also further undermine the confidence of the investing public in the nation’s capital markets, reinforcing a perception that Wall Street is an insides game driven by greed.

The SEC has thrown down the gauntlet. Goldman claims it will meet the challenge. For the SEC, for Goldman and for the investing public the stakes could not be higher.