The government's fraud lawsuit against Goldman, Sachs & Co. could portend cases against other financial giants that turned subprime mortgages into complex securities while also accelerating a surge in private litigation against Wall Street.
In announcing the Goldman case, Securities and Exchange Commission enforcement chief Robert Khuzami said the agency was looking into similar transactions at other firms. As the SEC struggles to shed its image as the snoozing securities cop that missed Bernard L. Madoff's vast Ponzi scheme, the agency is likely to bring additional cases, said Alan Bromberg, a securities law professor at Southern Methodist University.
"The SEC has become pretty aggressive, so it's a good bet," Bromberg said. Goldman, he said, was probably chosen as the first target because of its prominence. "It is the biggest and by most estimates the best firm on Wall Street."
Goldman Sachs is accused of failing to disclose that a hedge fund that helped it create complex securities had actually placed a bet that the investment would fail. Goldman has said it provided full disclosure to sophisticated investors who knew that some other knowledgeable party was betting against them.
The suit against Goldman will undoubtedly encourage similar claims by investors, said Boston University securities law expert Elizabeth Nowicki.
Private lawyers "are going to start filing these suits like they're going out of style," she said.
It's not unusual for SEC cases to pave the way for private lawsuits. For example, the SEC's announcement that it was investigating conflicts of interest by securities analysts in 2001 triggered a wave of private litigation making the same allegation.
In the case of the mortgage-linked investments known as collateralized debt obligations, a variation of which is at the heart of the Goldman Sachs case, lawyers for investors had already begun their assault.
UBS, Morgan Stanley, Merrill Lynch and Deutsche Bank face private lawsuits alleging they misled investors in CDOs or similar investments. The firms, like Goldman, have denied any wrongdoing.
"The question is whether the SEC has uncovered the tip of the iceberg," Nowicki said.
The issue is especially important, she said, because the high-risk investments caused such huge losses for financial firms and investors around the world, magnifying the effect of the collapse of the housing and mortgage markets.
"Without these devastating transactions we would have had a regular downturn in the housing markets and not a near depression," said Nowicki, a former SEC attorney who practiced securities law on Wall Street and has testified as an expert witness in disclosure cases.
The financial crisis has spawned hundreds of lawsuits, with the targets shifting from the lenders that made dubious home loans to the Wall Street firms that transformed mortgage bonds backed by subprime loans into supposedly solid investments, Jonathan Pickhardt, a securities-law attorney, wrote in a recent legal journal article.
The suits that deal with CDOs include allegations that some of the firms creating and marketing CDOs stuffed troubled assets into them without disclosure, especially as mortgage defaults surged in 2007; improperly influenced CDO management firms that were hired to pick assets independently; and withheld key information from credit-rating firms.
The bar of proof appears higher in CDO cases than in the SEC's suits last year against former executives of Countrywide Financial Corp. of Calabasas and New Century Financial Corp. of Irvine, two major companies brought down by the mortgage meltdown.
That's because the suits against the executives, including Countrywide co-founder Angelo Mozilo, accuse them of misleading individual shareholders and other members of the investing public. Mozilo and the other defendants in these cases have denied the allegations.
In contrast, the participants in the CDO transactions were, as UBS put it in statements responding to two CDO-related lawsuits, "professional and knowledgeable" banks and sophisticated investors who knew what they were buying.
Making it tougher still to prove fraud, the transactions in the SEC action against Goldman and a private suit targeting Merrill Lynch involved so-called synthetic CDOs. Such creations don't contain actual mortgage bonds. Instead they hold insurance-like instruments tied to a portfolio of mortgage bonds. The CDOs essentially sold insurance on the bonds. Other investors bought that insurance, betting that home-loan defaults would lower the value of both the bonds and the CDOs themselves.
As a result, the structure of synthetic CDOs required outside investors to bet that the CDOs would incur losses.
For example, in a case brought by Rabobank, a large Dutch financial firm, against Merrill Lynch, now part of Bank of America Corp., the Wall Street firm said the CDO contract contained standard language obliging investors to conduct their own research on the deal and not rely on information provided by Merrill.