SEC Lawyer on Goldman CDO Case Describes How the Agency Wimped Out

Susan Beck at American Lawyer (hat tip Abigail Field) has managed to get an inside view of what was going on at the SEC when it launched its case against Goldman and a Goldman vice president, Fabrice Tourre, over a Goldman CDO called Abacus that went spectacularly bad. At the time, the reaction to the filing was explosive; even though Matt Taibbi had already run his vampire squid piece, Goldman still enjoyed a stellar reputation with customers.

One of the big puzzles of the case was why Tourre was singled out. Many assumed this was an effort to target a relatively low-level employee and pressure him to testify against the higher-ups. Another was the fact that the SEC had charged Goldman on only one CDO. Goldman had sold 25 Abacus CDOs, which were pure synthetics (the assets were all credit default swaps). Goldman also sold other CDOs that were only part synthetic or all cash (the assets were a mix of CDS and bonds or all bonds). This Abacus CDO was, like all hybrid and synthetic 2005 and onward asset-backed-securities CDOs, teed up to suit the appetites of short sellers, which meant, in colloquial terms, they were designed to fail.

American Lawyer made a Freedom of Information Act filing to obtain documents, including those developed in the course of an SEC Inspector General investigation into whether the suit against Goldman was politically motivated. It shows that, quelle surprise, one of the agency’s most highly respected trial attorneys was stymied in his efforts to take the probe further and target more senior Goldman executives.

Bloomberg did a peculiar piggyback story which focused on James Kidney, the attorney that was pushing for more aggressive prosecution, without mentioning the American Lawyer story or having access to its documents. Nevertheless, Bloomberg interviewed Kidney and also gives a sense of how Kidney was seen at the agency:

James Kidney, who joined the SEC in 1986 and retired this month, offered the critique in a speech at his goodbye party… 

The SEC has become “an agency that polices the broken windows on the street level and rarely goes to the penthouse floors,” Kidney said, according to a copy of his remarks obtained by Bloomberg News. “On the rare occasions when enforcement does go to the penthouse, good manners are paramount. Tough enforcement, risky enforcement, is subject to extensive negotiation and weakening.”… 

Kidney, who was part of the initial team that was building the Goldman Sachs case, pressed his bosses in the enforcement division to go higher up the chain. He later took himself off the team after being given a lesser role, according to people familiar with the matter. 

In particular, the people said, Kidney argued that the commission should sue Tourre’s boss, Jonathan Egol. Kidney also wanted to bring a case against Paulson & Co. or some executives at the hedge fund, which helped pick the portfolio of securities that were underlying the Abacus vehicle and then bet against it… 

Stephen Crimmins, a former colleague of Kidney’s at the SEC who attended the retirement party, said he was one of the “finest lawyers ever to serve in the enforcement division.” Kidney was known for winning the SEC’s first jury trial, which was an insider trading case.

This doesn’t sound too hot…aggressive attorney eased out of an important role on a case he helped develop. But the American Lawyer account is far more detailed and damning. For instance:

Kidney was one of at least 30 SEC lawyers and officials who gave sworn testimony in the summer of 2010 as part of a probe by the SEC’s then–inspector general, David Kotz, into whether the Goldman Sachs case was politically motivated. Kotz included portions of those interviews in a heavily redacted 2010 report that concluded the case wasn’t politically motivated. But the transcripts, obtained through the FOIA, fill in many details. Not only do they reveal more fully the discord within the SEC over the handling of the case, they also suggest that the SEC’s $550 million settlement with Goldman secretly ended roughly a dozen other related investigations into collateralized debt obligations that the agency dropped.

This is more damning than it might seem. As we wrote in Was the SEC Rolled by Goldman?, this was as defacto global settlement for all Goldman CDOs, even though the settlement was formally limited to the lone Abacus CDO. Even though the formal settlement agreement was limited to the one deal, Goldman brayed on its website that:

We understand that the SEC staff also has completed a review of a number of other Goldman Sachs mortgage-related CDO transactions and does not anticipate recommending any claims against Goldman Sachs or any of its employees with respect to those transactions based on the materials it has reviewed. We recognize that, as is always the case, the SEC has reserved the right to reopen those matters based on new information..

The fact that Goldman couldn’t be bothered to play nicely with the SEC and undercut what looked to be a solid victory. $550 million for a single CDO is a lot of change, but when you figure the SEC could have sued Goldman for even more toxic CDOs it launched, $550 million was cheap to make this embarrassment go away.

This section of the American Lawyer article is critical:

When Kidney joined the Abacus team in the summer of 2009, he was dismayed at the state of the investigation, which was led by then–associate director Cheryl Scarboro and assistant director Reid Muoio. They were focused on charging Tourre, a 28-year-old Goldman vice president at the time of the deal who was tasked with marketing the CDO. “There were obvious holes in the investigation,” Kidney told Kotz. “This was not a case where there was only one low-level vice president involved.” 

Kidney was bothered by what he called Muoio’s “extreme reluctance” to take the testimony of Jonathan Egol, then a Goldman Sachs managing director who supervised Tourre. 

According to Kidney, Muoio told him he already knew that Egol would say he was too busy to pay much attention to the Abacus deal. 

“We were highly unlikely, highly unlikely to have a case against him,” Muoio told Kotz. 

Kidney was astounded by this reasoning. “It just seems to me this was the first time in my whole career here that we were not following the string,” he said. “I mean the smallest stock manipulation case, the smallest insider trading case, the smallest almost anything would go at least a little way up the supervisory chain.” Kidney said the issue of taking Egol’s testimony was raised with Scarboro, and then enforcement director Robert Khuzami, and “it wasn’t going anywhere.” 

Scarboro told Kotz she supported taking Egol’s testimony; Khuzami said he didn’t recall a dispute over taking the testimony. Scarboro, who is now a partner at Simpson Thacher & Bartlett, did not respond to a request for comment. Muoio, who is still at the SEC, declined to comment, as did Khuzami, who is now a partner at Kirkland & Ellis. 

Kidney was further angered when the case was scheduled for a vote by the five commissioners in December 2009 without Egol’s testimony. Kidney threatened to quit the case, and eventually the SEC interviewed Egol on Jan. 7, 2010. Muoio told Kotz the interview was a bust, as he had predicted all along. “We didn’t lay a glove on him,” Muoio asserted. But Kidney said he was encouraged by Egol’s testimony that he had reviewed the marketing materials, as was Lorin Reisner, who was then the deputy director of enforcement. After that interview, the SEC issued a Wells notice to Egol on Jan. 29, 2010, informing him that the enforcement staff planned to recommend charges against him. 

After a March 4 meeting with Egol’s lawyer, Frank Wohl of Lankler Siffert & Wohl, Khuzami polled the team: Kidney, Reisner and another SEC lawyer wanted to sue, according to the transcripts; Muoio remained against it. 

Khuzami had the final say. On March 23 he emailed the team: “I’m a no on Egol.” Khuzami told Kotz the decision was a “difficult judgment call,” but he concluded they didn’t have evidence that Egol had engaged in deceptive conduct. Egol’s emails weren’t as incriminating as Tourre’s.

So get this: even after hearing the pitch by Egol’s attorney, three of the four lawyers on the case wanted to proceed against him. But they were overruled by head of enforcement Robert Khuzami. Gee, why might THAT be? As we wrote in 2011:

The SEC went after Goldman only on one Abacus deal out of 25 in its program. Even though the $550 million settlement was limited to that transaction, it was widely understood that the SEC was not going to pursue Goldman on other CDOs. And it hasn’t. The SEC has gone through the motions in this arena: it poked around some Magnetar deals (not surprisingly, after the hedge fund got some real press about its destructive strategy) and negotiated a $153.6 million settlement with JP Morgan on a particularly noxious Magnetar trade, a CDO squared imaginatively called Squared. 

Look no further for an answer than the SEC chief of enforcement, Robert Khuzami, Stewart’s primary and probably sole source for this article. He was General Counsel for the Americas for Deutsche Bank from 2004 to 2009. That means he had oversight responsibility for the arguable patient zero of the CDO business, one Greg Lippmann, a senior trader at Deutsche, who played a major role in the growth of the CDOs, and in particular, synthetic or hybrid CDOs, which required enlisting short sellers and packaging the credit default swaps they liked, typically on the BBB tranches of the very worst subprime bonds, into CDOs that were then sold to unsuspecting longs. (Readers of Michael Lewis’ The Big Short will remember Lippmann featured prominently. That is not an accident of Lewis’ device of selecting particular actors on which to hang his narrative, but reflects Lippmann’s considerable role in developing that product). 

Any serious investigation of CDO bad practices would implicate Deutsche Bank, and presumably, Khuzmami. Why was a Goldman Abacus trade probed, and not deals from Deutsche Bank’s similar CDO program, Start? Khuzami simply can’t afford to dig too deeply in this toxic terrain; questions would correctly be raised as to why Deutsche was not being scrutinized similarly. And recusing himself would be insufficient. Do you really think staffers are sufficiently inattentive of the politics so as to pursue investigations aggressively that might damage the head of their unit?

Bear in mind that the path from Goldman to Deutsche Bank was even more direct than this extract suggests. Famed subprime short John Paulson worked closely with Goldman on the Abacus transaction in question. As Greg Zuckerman recounts in his book, The Greatest Trade Ever (which is less colorfully written but is a far more complete history of the subprime short story than Michael Lewis’s The Big Short), John Paulson was keen to tee up synthetic CDOs where he would select all of the crappy assets. The idea was so clearly smelly that even Bear Stearns refused to play ball. But Goldman and Deutsche were game. So following the Paulson thread, which is what Kidney and his colleagues were keen to do, would have taken them straight to Deutsche Bank and Lippmann, and thus Khuzami.

So it’s not surprising that the comparatively tame Bloomberg story also omits the most stinging quotes from Kidney’s farewell speech, which American Lawyer uses to close its story:

“For the powerful, we are at most a tollbooth on the bankster turnpike,” Kidney said. “We are a cost, not a serious expense. …The system is broken.”

People under 40 find it hard to believe that the SEC was once a respected and feared agency. It’s now widely seen as the worst regulator in Washington DC and shows how quickly effective organizations can be ruined by self-serving leaders.

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