Published: Tuesday, 1 Jun 2010 11:53 AM EST
by John Carney
Goldman Sachs may have found a way to compromise with the Securities and Exchange Commission that will allow both sides to declare victory.
The clock is ticking on the SEC’s case against Goldman Sachs. Sometime in the next few weeks, Goldman will either go to federal court with a substantive denial of the SEC’s allegations or agree to a settlement.
The two sides are still far apart. Goldman Sachs is unwilling to enter into the typical Wall Street settlement—paying a fine and agreeing not to commit further violations, while neither admitting nor denying the accusations—because it insists on denying that it intentionally committed fraud, sources familiar with the matter say. The SEC has accused Goldman of fraud under both the Securities Act of 1933 and Exchange Act of 1934 and is unwilling to abandon those claims for lesser offenses, those sources say.
Goldman is wary of settling any case while the accusation of fraud is outstanding. Part of this wariness is rooted in the reputational damage that could come from seeming to give up resisting the fraud accusation. More importantly, the company is concerned about the host of private class-action lawsuits that would surely follow any SEC settlement.
The SEC, however, cannot afford to be seen going easy on Goldman. It has managed to avoid having its authority stripped away in the financial reform process—the bills passed by both the House and the Senate largely keep the SEC independent and its authority intact—but it has been stung by criticism that lax enforcement of securities laws contributed to the financial crisis.
Despite this gap between the SEC and Goldman [GS 144.04 -0.79 (-0.55%) ] , a compromise position might not be completely out of reach. A technical legal difference in the fraud sections of the Securities Act and Exchange Act may allow both the SEC and Goldman to walk away happy.
The SEC accused Goldman with violating Section 10(b) of the Exchange Act and Section 17(a) of the Securities Act. Both are anti-fraud provisions. Like most anti-fraud statutes, Section 10(b) requires the government to prove a fraudulent intent. The first subsection of Section 17(a) also requires proof of fraudulent intent. But the second and third subsections of 17(a) do not require any proof of intent to defraud. This makes accusations based on the second and third subsections much easier to prove—and perhaps easier for Goldman to stomach.
In fact, subsection 17(a)(2) does not even employ any form of the word “fraud” or “deceit.” It makes the sale of a security or a derivative unlawful if a material omission renders the sale merely “misleading.”
The SEC’s claim against Goldman based on this subsection is its strongest and easiest to prove.
Goldman might accept a settlement if the civil charges requiring fraudulent intent or claiming a scheme that operated as fraud were dropped, a source said. That would leave open the charge of merely negligently “misleading” the investors in the Abacus deal. A source close to the matter indicated that this would be far more palatable to the company since it does not explicitly implicate Goldman in fraud.
The SEC has recently shown a willingness to cut this kind of deal. In February, the SEC settled a backdating case against Michael Byrd, the former CFO and later COO of Brocade Communications Systems, Inc.
Initially, the SEC had charged Byrd with violating both Section 10(b) and Section 17(a). In the settlement, the Section 10(b) charges were dropped, as was any charge based on the first part of Section 17(a).
The only surviving allegations--including a number of charges not involved in the Goldman case--were those that do not require proof of fraudulent intent. An earlier Brocade backdating settlement followed a similar pattern.
When it comes to the Goldman case, however, the SEC is playing its cards very close to its vest. It surprised Goldman by filing the lawsuit without pursuing further settlement negotiations. And virtually nothing about the settlement terms it is seeking have leaked out to the media.
Importantly for Goldman, most federal courts hold that Section 17(a) does not give rise to private actions. This means that Goldman would not be making itself more vulnerable to class-action lawsuits from outside investors even if it actually admitted to the charge of misleading omissions in the Abacus deal. Only the SEC is empowered to bring suit under Section 17(a).
The extent of Goldman’s monetary liability will not necessarily be affected by the exact charge it settles. So Goldman could still wind up paying a huge fine—some have estimated the fine could amount to $1 billion, the highest ever paid by a single firm. But if Goldman could avoid copping a plea to fraud, while perhaps limiting its vulnerability to class action investor lawsuits, it would likely agree to a deal.
Goldman does not seem confident that a deal will definitely be reached. As CNBC.com reported last week, sources say Goldman is still preparing a full-fledged defense even as talks with the SEC continue. The firm has been posturing behind the scenes, indicating that it believes it could uncover weaknesses in the government’s case during the pre-trial discovery phase. But it would prefer a settlement that dropped the fraud charges under the terms outlined above, sources say.