What the Senate Panel Got Wrong About Goldman

Chairman Carl Levin questions former and current Goldman Sachs employees during a Senate Homeland Security and Governmental Affairs Investigations Subcommittee hearing on Capitol Hill.
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Chairman Carl Levin questions former and current Goldman Sachs employees during a Senate Homeland Security and Governmental Affairs Investigations Subcommittee hearing on Capitol Hill.

Goldman Sachs was accused by the Senate investigative panel report of not accurately disclosing its short interest in complex derivatives it marketed to outside investors.

But this allegation depends on an aggressive and poorly supported reading of the law that governs conflicts of interest.

The panel says that Goldman’s offering materials advised potential investors that the firm “may” adopt a financial interest adverse to the investors in three CDOs it was selling. Those CDOS were called Hudson, Anderson, and Timberwolf.

The panel’s objection is that at the time Goldman was selling the CDOs, it was already a foregone conclusion that the firm would be taking an adverse position. Those CDOs would be profitable only if the underlying mortgages continued to perform well. Goldman was convinced that they wouldn’t.

In other words, the word “may” was dishonest. Goldman should have told its clients that the company was intending to take an adverse position, according to the Senate panel.

But the Senate panel is on very weak legal ground when it takes this stand.

The panel relies on a case decided in 2007 against a guy called Nicholas A. Czuczko who was running a penny-stock website called TheStockster. Czuczko allegedly would buy up thinly-traded penny stocks that he would then promote as “megabuys” on his website.

When investors followed his advice to buy the stock—driving up the price—Czuczko would then allegedly sell his shares and short the stock. Classic pump-and-dump.

Czuczko argued that the readers of his site had fair warning that he might short the stocks. His site had a disclaimer advising that “[o]fficers, directors, and employees of The Stockster or the financial analysts mentioned, and members of their families may hold a position[] and may, from time to time, trade in these securities for their own accounts.”

A federal trial court held that this was dishonest for two reasons.

First, Czuczko was a almost a lone operator—all that stuff about “officers, directors, and employees” was hooey. It was Czuczko himself who was both calling stocks “megabuys” and shorting them. The only other people involved with the site were a single business partner and Czuczko’s father. You can’t fool investors into thinking you’ve got a bunch of people working for you when its just you, your buddy, your dad and an internet connection.

That part of the ruling obviously doesn’t apply to Goldman—which really is a big company with many moving parts. It’s the next part of the ruling that might spell trouble for Goldman.

The court also ruled that Czuczko had made a “material misstatement” when he said he “may” trade for his own account because he knew that he, his partner, and his father regularly traded in the stocks and had a biased interest in them.

In other words—just like Goldman—they were selling positions they knew they would be shorting.

But this part of the court’s decision does not cite any law at all.

It’s just a naked assertion that writing “may trade” counts as a material misstatement when the seller knows the truth is closer to “will, definitely totally trade” in an adverse way. And the court may have just gotten the law wrong here.

The courts haven’t offered clear guidance here. At least twice, however, the SEC has issued rulings claiming that disclosures of possible adverse interest didn’t go far enough because a registered investment advisor did not inform the customer of the “nature and extent” of the adverse interest.

But those decisions depended on the conclusion that the investment advisor had a fiduciary duty toward the customer—something no one is claiming about Goldman’s relationship to the hedge funds and banks who were buying its CDOs. Goldman wasn’t acting as a fiduciary, so those decisions might be completely irrelevant.

The Senate panel appears to be attempting to rewrite the law after the fact. What’s ironic about that is that it’s unnecessary. Instead of pointing the finger at Goldman for violating a law that the Senators never made, perhaps they should consider just rewriting the law so that the kind of disclosures they believe should be made really are required.


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