The government's case against Goldman Sachs revolves in part around whether the investor that selected the toxic securities at the center of the case also could be the primary victim.
ACA Capital Management was both the final clearinghouse of the portfolio of subprime mortgages and the company that took the biggest loss when the loans collapsed, according to the Securities and Exchange Commission's case against the Wall Street behemoth.
The SEC claims that Goldman Sachs failed to disclose to ACA and another key investor that hedge fund manager John Paulson was betting against the mortgages at the same time Paulson was helping put the portfolio of collateralized debt obligations together.
Sticky and complicated as the case already sounds, legal analysts say the task for the SEC could be even harder.
The doubt centers on whether Goldman needed to tell investors who bought into the package of home loans that Paulsonhad helped select the securities and stood to benefit if they would drop in value.
After all, ACA itself made the final decision on what securities would be included in the CDO, called Abacus 2007-ACI. And as CNBC reported Wednesday, Paulson aide Paolo Pellegrini told the SEC that he had informed ACA that the hedge fund was shorting the securities (click here for story).
So where's the fraud?
"Right now this case is at a phase of chumming—taking all the bloody bait and tossing it in the water," said Bill Singer, of Stark & Stark in New York, a securities attorney with more than two decades of experience in securities fraud cases. "There's a lot of blood in the water and the commission has gotten the reaction it wants—self-serving reaction from Congress, consumer interest. As a matter of law...why the hell (does Goldman) have to tell them anything?"
Even if ACA hadn't known that Paulson was shorting the securities, whether Goldman was in any way responsible for disclosing that fact is just one of several thorny issues.
The case follows a linear path in which one investment company anticipated the collapse of the subprime mortgage market and was able to get Goldman to promote a financial instrument that would help make money should those lower-quality loans fail.
Paulson approached Goldman about assembling Abacus and finding an investor that would take a long position.
Believing that investors would only buy in if a neutral third-party—which ultimately would be ACA Management—selected the loans, Goldman then convinced German bank IKB to invest in the portfolio. The bank's decision ultimately would result in a $150 million loss for IKB and a huge loss for ACA, which wrote insurance—called credit default swaps—on the mortgages.
The SEC claims that Paulson's firm played a key role in helping ACA put together the portfolio—although ACA had the final say—and says Goldman did not disclose that Paulson was taking a short position. When marketing the final Abacus product, Goldman also didn't tell IKB about Paulson's short position and his involvement in picking the securities, the SEC alleges.
Even though ACA may have been told about Paulson's short position, as a Paulson official told the SEC, it's unclear whether IKB was. The question, then, is whether Paulson's involvement was "material" to the decision an investor would make about buying into the CDO.
Neither ACA nor IKB say in the SEC complaint that knowledge of Paulson's involvement in the case would have changed their minds about the investment, an omission that legal analysts say could be a key weakness in the government's case.
The notion of "caveat emptor," or let the buyer beware, is frequently mentioned as the moral of the Goldman story.
"It looks like Paulson and the short guys were correct and it looks like IKB to some extent was being overly risky and speculative," Singer says. "I want to see what due diligence anybody did on the buy side of this deal to justify buying subprime at the end of 2007.
"At the end of the day, if Paulson or somebody had done something improper and had been named, that would have changed the whole dynamic," Singer adds. "Isn't it odd that he wasn't named?"
In a statement released Tuesday, Paulson said his firm did nothing wrong. Paulson investors reportedly are growing nervous over the prospect of a more intensified probe in the case.
Indeed, a central conundrum of the case is that only civil charges have been filed and that the SEC has not charged Paulson himself with wrongdoing.
For all the ominous headlines the case has drawn—an investor profiting on the misery of others, Wall Street's biggest fish apparently snagged in a shady deal—political overtones surround the charges.
Critics have wondered whether the SEC suit was timed to coincide with the White House's push for financial reform and just hours before a damaging report was released saying the SEC botched the investigation of alleged Ponzi schemer R. Allen Stanford.
Rep. Darrell Issa (R. Calif), for one, told CNBC Wednesday that the SEC's case against Goldman "reeks" of political motivation (click here for story).
"The underlying individuals that created this problem are not being charged," said Ryan Blanch, managing partner of the Blanch Law Firm in New York. "The tougher question is, Is this a political gambit?"
Some remain unconvinced that not letting investors know about Paulson's position meets the "material" threshold for the charges. After all, the companies knew implicitly that if they were taking a long position on the CDOs then the nature of the business is that someone else was short, and parties on the other side of such trades are rarely identified to each other, analysts point out.
"The real question comes when you have sophisticated investors is whether there was full disclosure about investment vehicles. Did the investors have the opportunity to do due diligence?" Blanch said. "If the raw information provided is accurate, I think it's overreaching at that point to say that Goldman's conduct was criminal."
From the SEC's perspective, the notion of proving that ACA was both instrumental in putting the Abacus deal together and its chief victim will be difficult, though not impossible, to prove.
"In order to have a fraud you have to have a materially false statement or...a material omission," said Vano Haroutunian, partner at Ballon, Stoll, Bader & Nadler in New York and a former lawyer with the SEC's New York enforcement division. "A point could be made that there was a material omission."
The testimony of Paulson's Pellegrini that he informed ACA his firm was going to short the Abacus CDO could cause a problem as well for the SEC. But Haroutunian said the government likely isn't showing its full hand.
"You have a lot of flexibility and a lot of that is predicated on the fact that a lot of information comes in later," he said. "The SEC attorneys who prepared the complaint are alleging the minimum that they can at this point."
The SEC has a lot riding on the case.
Its only other effort at prosecuting the subprime mortgage collapse was against Bear Stearns hedge fund managers Ralph Cioffi and Matthew Tannin. The duo ran a fund at the former Wall Street investment banking titan that failed in 2007 and cost investors about $1.6 billion.
The government also charged Cioffi and Tannin with lying to investors, but they were acquitted in November 2009.
"The devil is in the details. It's going to depend on what the particulars are, whether (disclosure) was material to reasonable investors," said Mark Astarita, partner at Beam and Astarita in New York. "My sense is that the commission is not going to go forward if it doesn't think it has a very good chance of success."