[Posts at The Conglomerate have helped me understand the underlying legal issues in the Goldman case, so I'll continue passing them along.]
The legal analysts for the Goldman case have turned their attention from whether investors were deceived by a failure to disclose all relevant facts to the question of whether the collateral manager was deceived. Is deceiving the collateral manager for a CDO the same as deceiving investors? Erik Gerding argues that it is, but if the collateral manager "knew or should have known that Paulson was on the other side of the transaction," the case is much weaker:
Did Goldman deceive the collateral manager? Why it matters, by Erik Gerding: In an earlier post, I wrote that the crux of the issue in the Goldman case, was whether Goldman had to disclose the Paulson hedge fund's role in selecting collateral for the CDO. Let me refine that now. Goldman will argue that ACA, the collateral manager in the ABACUS CDO, bore ultimate responsibility for picking the collateral. This is why one key battle will ultimately be whether Goldman deceived ACA.
Here’s a quick explanation:
In my last post, I argued that an insightful paper supports that investors in CDOs may not fully protect themselves against lemons even if the collateral for the CDO is fully disclosed. The structuring of the CDO may allow the sponsor to hide “lemons.”
So what do investors do? One solution is to rely on the reputation of the collateral manager – a party that acts as a kind of investment manager and selects collateral for the CDO. To reassure investors, the collateral manager is independent from the underwriter or the originator/issuer of the bonds, loans, and other collateral that are being fed into the CDO box. ...
This is why the issue of whether Goldman deceived ACA is so critical. If ACA was told that it should pick certain assets, it would want to know whether the person making the request had an adverse interest to investors. To switch metaphors: ACA was helping a bunch of investors (including, ultimately one of its affiliates) place bets on horses. The SEC is alleging that Goldman told ACA “The investors you are working for want you to pick Horses A, B, and C” when it was actually another gambler who asked ACA to place those bets because he was betting for those horses to lose. The SEC is equating deceiving ACA with deceiving all the CDO investors.
Here is my own bet – if the SEC can show Goldman misrepresented Paulson’s role to ACA, it wins (even with all the other hurdles I mentioned previously). Here is what leads me place this bet: the Goldman press release responding to the SEC Complaint asserts that Goldman never represented to ACA that Paulson was investing in the CDO.
The messiness comes if Goldman didn’t exactly say that Paulson was investing in the CDO, but didn’t exactly say the hedge fund was shorting it either. In fact, paragraphs 44-51 of the Complaint, which talk about ACA being misled by Goldman into believing Paulson would be an equity investor, don’t contain any evidence of direct statements by Goldman to this effect. Rather, it looks like ACA believed that Paulson would invest in the transaction and the Goldman employee may have been aware of this. So the question was did Goldman’s statements, actions or silence rise to the level of misleading ACA?
Now if ACA knew or should have known that Paulson was on the other side of the transaction, is the SEC case sunk? It would be severely wounded, but maybe not dead – arguably other reasonable investors would still have wanted to know of Paulson’s role in selecting the collateral and its adverse interest. ... Even if ACA was not being deceived, reasonable investors might want to know if it was selecting collateral on its own or negotiating with an adverse party. But that would be a less earth-shaking disclosure problem.
Update: See also Defending Goldman.