Lloyd C. Blankfein, the chief executive of Goldman Sachs, may well be thinking of Michael Corleone’s famous line in the otherwise forgettable “The Godfather: Part III”: “Just when I thought I was out … they pull me back in.”
Judge Paul A. Crotty of Federal District Court in Manhattan issued a decision last week that will put the firm’s 2007 sales of collateralized debt obligations tied to subprime mortgages back under the microscope by refusing to dismiss an investor lawsuit accusing Goldman of making misleading statements about its ethical standards.
Rejecting Goldman’s motion to dismiss the complaint means that the plaintiffs’ lawyers will get to start digging through the firm for evidence of misconduct.
Goldman did not come out on the short end completely, however, because the judge dismissed a claim over its decision to not disclose a so-called Wells notice issued in 2009 by the Securities and Exchange Commission informing the firm that S.E.C. staff members intended to recommend an enforcement action against Goldman.
The case concerns sales of four C.D.O.’s in which Goldman has been accused of having a conflict of interest. The firm constructed the securities to be sold to its investors while failing to disclose that it was taking short positions against them.
For one deal, called Abacus, it did not disclose that its client, the hedge fund Paulson & Company, had participated in selecting the underlying mortgage-backed securities in order to take a bearish position. The firm agreed to settle an S.E.C. lawsuit by paying a $550 million penalty while admitting that it made a “mistake” in not disclosing that “that Paulson’s economic interests were adverse to C.D.O. investors.”
The plaintiffs are purchasers of Goldman stock from 2007 through 2010 claiming that the firm and Mr. Blankfein committed fraud in violation of Rule 10b-5 by making misleading disclosures about how it sought to avoid conflicts of interest like those found in the C.D.O. transactions and not providing notification about the S.E.C.’s intention to sue the firm over its conduct.
Goldman filed a motion to dismiss the case before any discovery occurred. In deciding the motion, Judge Crotty was required to accept everything in the investors’ complaint as true.
The statements at issue are fairly generic, the typical niceties issued by public companies about how much they value complying with the law. Among the statements that the investors claim were misleading were ones like: “Our reputation is one of our most important assets,” “We have extensive procedures and controls that are designed to … address conflicts of interest,” and my favorite, “Integrity and honesty are at the heart of our business.”
Goldman made two arguments why statements of this type could not be the basis for a securities fraud claim. First, it asserted that they were only opinions and, at worst, constituted statements investors would not take seriously — essentially, the salesman’s assertion that no one believes a product really is the “best,” “fastest” or “revolutionary.”
Judge Crotty was rather dismissive of this argument, pointing out in a footnote in the opinion, “If Goldman’s claim of ‘honesty’ and ‘integrity’ are simply puffery, the world of finance may be in more trouble than we recognize.”
The second argument was that the statements were not “material” because reasonable investors would not consider them important. The standard for materiality is so broad that it is almost impossible to dismiss a case on this ground, and the judge found the statements could be of enough importance to investors to allow the case to move forward.
More ominous for Goldman and Mr. Blankfein is Judge Crotty’s determination that the statements about Goldman’s ethical standards could be fraudulent. He relied in part on Goldman’s admission in the settlement with the S.E.C. that it made a “mistake” in the marketing materials for the Abacus C.D.O. as evidence that its statements about ethical standards might have been misleading, even though the firm neither admitted nor denied liability in concluding the case.
“Given Goldman’s fraudulent acts,” the judge wrote, “it could not have genuinely believed that its statements about complying with the letter and spirit of the law — and that its continued success depends upon it, valuing its reputation, and its ability to address ‘potential’ conflict of interests — were accurate and complete.”
One reason companies agree to settle cases with the S.E.C. is to avoid any finding of wrongdoing that can be used by investors in private lawsuits. Judge Crotty’s reference to Goldman’s statements in the settlement shows that companies might not get a complete free pass if the S.E.C. is able to extract at least some small admission of misconduct when it concludes a case. That is likely to cause lawyers to be very cautious about making any admission in a settlement with the S.E.C. for fear that it will come back to bite them.
The judge’s finding that Goldman’s failure to disclose the Wells notice was not a violation of Rule 10b-5 will give greater comfort to companies under investigation that decide not to disclose the status of the case.
The Wells notice is only a statement that the staff of the S.E.C. expects to seek authority to file a case, and the likelihood of litigation at that point is still too uncertain to require a company to disclose the possibility. A company only has to make a disclosure when it has information showing it is more likely that a case will be filed, a vague standard that gives management a great deal of discretion about when to tell investors.
Although it won on that issue, it is interesting to note that Goldman disclosed in its most recent 10-K filed in February that it recently received a Wells notice about one of its C.D.O. transactions. The firm seems to have changed it approach from 2010, when the S.E.C.’s lawsuit over the Abacus transaction took investors by surprise.
Judge Crotty’s decision means the case now moves into discovery, in which the plaintiffs’ lawyers will demand a raft of corporate documents and depositions from Mr. Blankfein and the two other Goldman executives named as defendants — the president, Gary D. Cohn, and the chief financial officer, David A. Viniar.
Goldman can try to stop the lawsuit by seeking permission from Judge Crotty to file an interlocutory appeal. Under a federal statute, 28 U.S.C. § 1292(b) , the judge must determine that the decision allowing the case to proceed “involves a controlling question of law as to which there is substantial ground for difference of opinion and that an immediate appeal from the order may materially advance the ultimate termination of the litigation.”
Judges are usually reluctant to authorize appeals at an early stage of a case, so Goldman faces an uphill battle to get appellate review of the case. If it cannot convince Judge Crotty to allow an appeal, then the pressure will increase to reach a quick settlement if Goldman wants to limit scrutiny of its C.D.O. sales.