AN IMPORTANT SETTLMENT FOR THE SEC AND GOLDMAN

The SEC settled its landmark action against Goldman Sachs. The bank will pay $550 million, made an unusual admission of having faulty marketing materials, consented to the entry of a fraud injunction and agreed to a series of procedures designed to prevent a reoccurrence of the wrongful conduct. The settlement concludes the SEC’s highest profile market crisis action against a Wall Street icon. It does not end the litigation which will continue as to Goldman employee Fabrice Tourre. SEC v. Goldman Sachs, Civil Action No. 3229 (S.D.N.Y. Filed April 16, 2010). See also Litig. Rel. 21592 (July 15, 2010).

The Commission’s complaint centers on conflicts of interest and a failure to disclose critical information about the origins and formation of a synthetic collateralized debt obligation tied to the sub-prime residential real estate market. The CDO was structured at the request of Goldman client Paulson & Co. to permit the hedge fund to short the sub-prime market. It was marketed and sold to other clients of the bank using materials which stated that the portfolio for the CDO was selected by ACA Management LLC. The role of Paulson was not disclosed. Paulson reaped huge profits, while those who bought an interest in the CDO suffered significant losses. The complaint alleged violations of Securities Act Section 17(a) and Exchange Act Section 10(b) and sought in injunction, disgorgement, prejudgment interest and a penalty.

Although the SEC is entitled to declare victory here, like all settlements, the one here has something for everyone. The Commission can claim that:

• Goldman consented to the entry of a permanent injunction prohibiting future violations of Section 17(a), an antifraud provision;

• The bank made an unusual admission in the settlement papers stating “Goldman acknowledges that the marketing materials for the ABACUS 2007-ACI transaction contained incomplete information. In particular, it was a mistake for the Goldman marketing materials to state that the reference portfolio was “selected by” ACA Management LLC without disclosing the role of Paulson & Co. . . .”

• Goldman will pay a civil penalty of $535 million, which is the largest ever obtained against a Wall Street bank, portions of which will be used to reimburse the purchasers of the CDO; and

• A series of procedures to prevent a reoccurrence of the wrongful conduct will be undertaken by Goldman.

The bank will undoubtedly say little in public. Privately, Goldman can tell clients and investors that it has resolved the action without admitting or denying the fraud allegations in the SEC’s complaint. In fact, the SEC dropped the Section 10(b) fraud claim in the settlement process which it rarely does, particularly at this stage of a case, where only a complaint has been filed. While the bank did admit a “mistake” in the marketing materials, there is no admission that the factual information omitted is material or that those materials were fraudulent. This delimits the use of the statement in private actions, while the settlement precludes the underlying evidentiary materials from becoming available to private litigants through the litigation process.

Goldman can also indicate that the amount of the settlement is less than in many other Commission fraud actions and is probably a fraction of the increase in market cap it will obtain from the rise in its share price which will follow the settlement announcement. The bank can assure employees and clients that it has moved past a difficult situation which, if it continued, would only cause further adverse publicity and divert the attention of its executives from firm business.

The fact that the Goldman settlement has something for everyone does not detract from the achievement for the SEC. Settlements are by definition a compromise. Otherwise, there would not be a settlement. Still, there will be critics. Some will argue that the SEC caved in because the injunction is based on not admitting or denying, rather than an admission. This contention ignores standard SEC procedure which is to settle cases without admitting or denying the underlying facts. What is unusual here is the admission of a mistake by Goldman. Requiring this statement is significant and may in fact signal a new approach by the Commission, moving away from the traditional settlement process and toward a harsher settlement process.

Other critics will claim that the civil penalty is not large enough and indicates that the Commission had a weak case. This ignores the fact that the penalty sets a benchmark since it is the largest against a Wall Street bank and is being used to repay investors. More importantly, it ignores a critical part and perhaps more important part of the settlement which is the procedures the bank must undertake. Those procedures are critical because they require that Goldman correct the processes that permitted the conduct in the complaint to occur and ensure that similar misconduct does not happen again. This is a critical part of the SEC’s mission because it protects investors and the markets in the future.

Likewise, those who would claim that the SEC gave in to Goldman because its case is weak miss the point. Goldman chose to settle and agreed to the entry of a fraud injunction before it even filed a motion challenging the legal sufficiency of the complaint or any kind of responsive pleading. While it is true that the SEC dropped the Section 10(b) claim which is unusual, the Section 17(a) injunction, along with the other components of the settlement, are more than sufficient.

Overall, the Goldman settlement is a good one for the Commission. The SEC can and should claim not just victory, but that it is effectively policing the markets. Goldman can state that it resolved a difficult situation. Nevertheless the settlement does leave two questions. First, what will happen with the case against Mr. Tourre? Second, will the Commission continue to bring market crisis cases against Wall Street players? The resolution of each of these questions is of critical importance to the future effectiveness of SEC enforcement. For today, however, SEC enforcement has obtained an important achievement on the road to regaining its perch as the top regulator of Wall Street.

Note: This Week In Securities Litigation, which usually appears on Friday, will be published on Monday.

RULE MAKING AND REPORTS BY THE SEC UNDER DODD-FRANK

By most accounts, the Dodd-Frank Wall Street Reform and Consumer Protection Act is poised for passage. The bill is being hailed as the most significant regulatory overhaul since the great depression – clearly appropriate to address the most significant economic crisis since the 1930s.

The potential impact of the 2000 page piece of legislation is difficult to discern, however. Dodd-Frank is not the end, but the beginning. In many respects, it is a blackboard on which the regulators may or will write as the bill directs. Reportedly, the bill has over 240 rule making provisions, requires 67 one time reports or studies and directs the preparation of an additional 22 periodic reports. More than perhaps any piece of legislation in recent years, Dodd-Frank is a work in progress whose impact will not be known for years.

The big winner in the rule making sweepstakes is the SEC. There are 95 provisions in Dodd-Frank concerning SEC rule making. The GAO is the winner in the report drafting department. The office will prepare 23 different reports. In second place is the SEC. The agency will prepare 17 reports.

A review of examples of the rules and studies the SEC is required to complete provides an insight into the legislation. Rules which the Commission is required to write include:

Swaps

• Along with the CFTC, rules for real time public data reporting of swaps transactions, including price and volume;

• Along with the CFTC, business conduct standards for swap dealers and major swap participants

• For non-banking entities, along with the CFTC, rules regarding the capital and uncleared swap margin requirements;

• Rules to establish limits, including related hedge exemption provisions, on the size of positions in any security-based swap that may be held by any person;

• Along with the CFTC, final rules providing for the reporting of uncleared swaps entered into before the date of enactment within 90 days of the date of enactment;

• Not later than one year after enactment of the legislation, rules providing for the registration of security-based swap dealers and major security-swap participants;

Investment advisers

• Not later than one year after enactment of the bill, final rules defining the term “venture capital fund” to effectuate an exemption from SEC registration for investment advisers that solely advise one or more venture capital funds;

• Rules to provide an exemption from registration for any investment adviser that acts solely as an adviser to private funds and has assets under management in the U.S. of less than $150 million;

• Rules requiring each investment adviser to a private fund to file reports containing such information as the Commission deems necessary and in the public interest for the protection of investors or for the assessment of systemic risk;

• Along with the CFTC, and after consultation with the Council, within 1 year, rules regarding the form and content of reports required to be filed with both agencies by dually registered advisers;

Securities lending

• Within two years of enactment of the legislation, rules designed to increase the transparency of information available regarding securities lending;

Arbitration

• Rules making, prohibiting or limiting the use of mandatory arbitration pre-dispute agreements between broker-dealers and investment advisers;

Credit rating agencies

• For credit rating agencies, rules to prevent sales and marketing considerations from influencing the production of ratings;

• Rules with respect to the procedures and methodologies used by credit rating agencies;

• Rules that require each credit rating agency to establish, maintain and enforce policies and procedures that clearly define and disclose the meaning of any ratings symbol and that apply that symbol consistently for all instruments for which it is used;

• Rules to ensure that persons employed to perform ratings are tested for knowledge of the rating process and meet standards of training, experience and competence necessary to produce accurate ratings;

• Remove the current exemption from Reg FD for credit rating agencies;

Securitization

• In conjunction with the federal banking agencies, regulations that require securitizers of asset-backed securities, by default, to maintain 5% of the credit risk in assets transferred, sold or conveyed through the issuance of asset-backed securities (with certain exemptions for qualified residential mortgages);

• Within nine months of enactment, rules to implement a prohibition against any underwriter, placement agent, initial purchaser, or sponsor of an asset backed security from engaging in any transaction for one year after the first closing of the sale of the asset backed security that would involve or result in any material conflict of interest with respect to any investor in a transaction arising out of such activity;

• Rules requiring issuers of asset backed securities to disclose information on the assets backing each tranche or class of security;

Corporate governance

• Rules requiring companies to disclose whether employees and directors are allowed to hedge the value of any equity securities;

• Within one year, rules directing national securities exchanges and associations to require all members of a listed company’s compensation committee to be independent;

• Within one year of enactment, rules directing national securities exchanges and associations to require the compensation committee of a listed company to consider the independence of an adviser when selecting a consultant, legal counsel or other adviser;

• Rules requiring companies to disclose the relationship between executive compensation actually paid and its financial performance, including any change in the value of the company’s shares, dividends and distributions; and

• Rules requiring the disclosure of the median annual total compensation of all employees except the CEO, the annual total compensation of the CEO and the ratio of the median employee annual total compensation to that of the CEO.

Under the bill the SEC will also required to prepare reports on a variety of topics including:

• Within two years of enactment to conclude a study on the state of short selling after the recent rule changes and the incidence of failures to deliver shares sold short and the delivery of shares on the fourth day following a short sale transaction;

• Within six months of enactment to complete a study which includes public comment on any shortcomings in the standard of conduct and supervision of broker-dealers and investment advisers providing personalized investment advice about securities to retail customers;

• Within two years of enactment to complete a study of ways to improve the financial literacy of retail investors and the most effective means of communicating costs and conflicts of interest involving investments in securities;

• Within six months of enactment to complete a study on ways to improve access of investors to registration information about investment advisers, broker-dealers and their associated persons and implement any recommendation of the study;

• Within 180 days after enactment to complete a study of ways to enhance examinations for investment advisers including whether Congress should authorize the SEC to designate one or more SROs to aid the Commission’s examination efforts;

• Complete a study on the impact of applying a new test which would extend the reach of the antifraud provisions in SEC and DOJ actions and which would prevent any extension of the holding of the Supreme Court in Morrison (discussed here) in those actions to private actions;

• Within twenty-four months of enactment to complete a study of the credit rating process for structured finance products and the conflicts of interest associated with issuer-pay and subscriber- pay models and include the feasibility of establishing an independent utility or self-regulatory organization to assign NRSROs to determine credit ratings of structured finance products;

• Within three years of enactment to complete a study of the independence of NRSROs and how this affects ratings;

• Within one year to complete a study of the feasibility and desirability of standardizing credit ratings terminology; and

• Complete a study to determine how to reduce the burden of complying with SOX Section 404(b) for companies whose market capitalization is between $75,000,000 and $250,000,000.

Dozens of other sections in the bill give the SEC the authority to write rules to define and fill in the legislation.