April 21, 2010
Commentary on the Goldman Case Turns to Contract Theory
Posted by Jeff Lipshaw
Erik Gerding over at Conglomerate continues his fine work on the Goldman matter, with posts on the question I discussed yesterday, the social utility of derivative contracts that don't act as a hedge to a real transaction, and what might constitute a misrepresentation in arm's-length negotiation between the investors and the Portfolio Selection Agent, ACA.
As to the first, I think Erik has framed the issue well. I'm curious about Lynn Stout's proposal (which I've not read) to make unenforceable over-the-counter derivatives where neither party has an insurable interest in an underlying transaction. Would the unenforceability of the transactions really end them? I'm thinking of Lisa Bernstein's iconic study of diamond brokers in Manhattan who seal their deals with mazal v'broche (luck and blessing) and don't want courts to interfere. Would an exchange really be able to deal with counter-party risk in a hedge transaction where one side is a speculator and the other is a real hedger? Moreover, I don't know enough about the standardized kinds of derivatives to know if they work to hedge most of the common exposures, but I do know that there are generally accepted accounting principles (FAS 133 - Accounting for Derivative) that require the separate reporting, in essence, for derivative transaction that are pure speculation, and those would apply to public companies regardless whether the derivatives were OTC or exchange-traded.
As to the second, I'm curious. Erik notes Goldman has asserted that the investors in the synthetic CDO, ABACUS, were able to negotiate at arm's-length with ACA, the portfolio manager. He then observes, "But to bargain at arm's length you need to know that is what you are doing.* In other words, you need to know if the party who is making requests to you ("I want this collateral - not that.") is on your side or not." I'm on record as believing that one side can create misrepresentation by half-truth even in an arm's-length negotiation between two sophisticated parties (or at least that the "anti-reliance" provisions in the agreement don't bar such a claim as a matter of law). I think, however, the idea that the CDO investors are entitled to some disclosure of the motives or agendas of the other side in an arm's-length negotiation without a trace of fiduciary obligation is beyond the pale. If I understand Erik's position most charitably, it's that it wasn't clear at the outset that the ACA-investor relationship was arm's-length. I think parties in arm's-length negotiations are entitled to the presumption that the other side isn't lying, but beyond that, it's caveat emptor! In other words, if you go into any deal thinking, without any express agreement to that effect, that the broker, the issuer of the fairness opinion, the transfer agent, or the Portfolio Selection Agent is "on your side," you're a fool, and deserve whatever consequences your foolishness entails. And that's even before reading this in the Risk Factors:
- Goldman Sachs does not provide investment, accounting, tax or legal advice and shall not have a fiduciary relationship with any investor. In particular, Goldman Sachs does not make any representations as to (a) the suitability of purchasing Notes, (b) the appropriate accounting treatment or possible tax consequences of the Transaction or (c) the future performance of the Transaction either in absolute terms or relative to competing investments. Potential investors should obtain their own independent accounting, tax and legal advice and should consult their own professional investment advisor to ascertain the suitability of the Transaction, including such independent investigation and analysis regarding the risks, security arrangements and cash-flows associated with the Transaction as they deem appropriate to evaluate the merits and risks of the Transaction.
- Goldman Sachs may, by virtue of its status as an underwriter, advisor or otherwise, possess or have access to non-publicly available information relating to the Reference Obligations, the Reference Entities and/or other obligations of the Reference Entities and has not undertaken, and does not intend, to disclose, such status or non-public information in connection with the Transaction. Accordingly, this presentation may not contain all information that would be material to the evaluation of the merits and risks of purchasing the Notes.
- Goldman Sachs does not make any representation, recommendation or warranty, express or implied, regarding the accuracy, adequacy, reasonableness or completeness of the information contained herein or in any further information, notice or other document which may at any time be supplied in connection with the Transaction and accepts no responsibility or liability therefore. Goldman Sachs is currently and may be from time to time in the future an active participant on both sides of the market and have long or short positions in, or buy and sell, securities, commodities, futures, options or other derivatives identical or related to those mentioned herein. Goldman Sachs may have potential conflicts of interest due to present or future relationships between Goldman Sachs and any Collateral, the issuer thereof, any Reference Entity or any obligation of any Reference Entity.
As I said, I'd like to be a fly on the wall when the investors get deposed on the question whether they thought about those provisions!
And here's an agency question: if ACA was an "agent," who was the principal? Goldman? The issuer? I suspect it wasn't the investors! I'm thinking about all those ordinary house hunters who think that the Selling Broker (i.e., the Realtor® they think is their agent because they walked into an office and got shown houses) is their agent, when legally, unless the buyer is smart enough to retain the Realtor® as a buyer's agent, the Selling Broker is a sub-agent of the Listing Broker (i.e., the broker who listed the house for the seller), arguably with fiduciary obligations running back to the seller!
UPDATE: This case is a godsend, given that my syllabus for Securities Regulation starting in forty-five minutes is "Elements of a 10b-5 Claim." So further to Erik's "whose side is ACA on" question, doesn't the iconic Santa Fe Industries v. Green case apply? Recall what the Supreme Court did - it refused to allow a securities claim where the allegation was that the company in a Delaware short-form merger employed a scheme or artifice to appropriate the difference between the $150 offer price and the higher value of the assets. The company had gotten a Morgan Stanley fairness opinion of $125 per share, so it was adding a premium on top of that. There was full disclosure, so the offer wasn't deceptive. Was it manipulative? The Supreme Court said, perhaps, but we're not going to federalize a state law fiduciary breach claim based on the facts here. Could you have a Rule 10b-5 claim based on a fiduciary breach? Yes, but it would have to be based on a material non-disclosure.
It seems to me that Erik's "whose side are you on" is the same kind of bootstrapping that Santa Fe prohibited. The real question is whether ACA had any kind of fiduciary obligation to the investors, and requiring the disclosure of "motivations," whether of Goldman or of ACA, is equivalent to making a securities claim out of the "motivations" of Santa Fe in tendering for its own shares at a price that might have been shortchanging its own shareholders.
[*UPDATE: Erik has clarified that the GS "defense documents" made it clear that ACA and the CDO investors were able to negotiate at arm's-length with Paulson. I'm scouring the documents now, but it looks like ACA did indeed negotiate (whether forcefully or not) with Paulson, but I don't think the CDO investors negotiated with Paulson - that would significantly weaken the SEC's case! In each case, I think my point about the "who is on your side" issue still stands.]
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True, there's a slight change that unenforceability of contracts between speculators might not end the trades completely, but the best estimate is still that the costs of doing these types of trades would rise substantially due to this restriction. If that happens, it will hurt legitimate hedgers. Opening the market to speculators generally helps hedgers, both through greater liquidity and through more accurate pricing. By increasing the costs of speculating through this artificial barrier, hedging becomes more expensive.
Posted by: Ann | Apr 23, 2010 7:18:17 AM
If the SEC wants to make the case that Paulson's role in choosing these securities was material, doesn't it have to show that the two sides had different preferences regarding portfolio composition? That's not the same as showing that the two sides were betting in different directions. Paulson had no inside information on these securities, and it's not automatic that the person betting long would prefer different securities than the person betting short, since the very securities that would do worst in some cases might do best in others.
ACA and the investors had full information on what was in the portfolio, and could decide if this was the bet they wanted to place. What else is material?
Posted by: Ann | Apr 23, 2010 7:21:58 AM