There is good reason, beyond anger, voyeurism and schadenfreude, for Wall Street and “Main Street” to keep their eyes on the SEC enforcement action against investment banking firm Goldman Sachs & Co and one of its vice presidents, Fabrice Tourre

According to the SEC’s complaint (pdf), Goldman was paid by one of the world’s largest hedge funds, Paulson & Co., to structure a “synthetic” CDO comprised of residential mortgage backed securities – later called the ABACUS 2007-AC1.  Paulson played a vital role in choosing which securities would be part of the CDO.  Unbeknownst to investors, Paulson would later take short positions against the CDO it had helped design.  In other words, the SEC is accusing Goldman of structuring a synthetic CDO that would fail for the benefit of Paulson without disclosing that fact to investors. 

Although on its face, the complaint appears to be a straight-forward allegation of fraud, the regulatory implications of the SEC’s lawsuit are far from simple and potentially far-reaching for all players in the multi-trillion dollar derivative markets.  The derivatives market is, for lack of a better term of art, gargantuan.  It is, to paraphrase Willie Sutton, “where the money is” on Wall Street.  Derivatives are also credited with being one of the systemic risks that exacerbated the damage caused by the credit crisis.  By bringing the action against Goldman, the SEC will have to grapple with the notion that, by definition, “synthetic” CDOs are composed of long and short bets on the direction a real, or so-called “reference” security, is going to move.  If one party bets for a rise in value, there must be someone betting for a decline.  Goldman, in its response to the SEC’s complaint (pdf) has said that  “[a]s normal business practice, market makers do not disclose the identities of a buyer to a seller and vice versa.”

Congress is presently debating how to regulate derivatives as part of a new financial regulatory reform bill.  However, by filing the Goldman complaint, the SEC may effectively be taking on aspects of the derivatives industry prior to legislative action.  By choosing to litigate the issue of whether Goldman needed to inform the alleged victims – all sophisticated investors – that Paulson stood to benefit from the reference securities declining in value, the SEC may be after more than just whether Goldman defrauded some investors.  It may be tinkering with how derivative products, like synthetic CDOs, will need to be created, marketed and documented in the future.  For example, a significant issue at stake is whether a broker-dealer or market-intermediary such as Goldman has a duty to disclose who is on each side of a bet or which party initially wanted to place a specific wager on a particular security?  And if there is such a duty, is it material to investors who the short or long positions are held by?  These and many other critical questions concerning the legal obligations of players in the derivative markets will be at issue as this enforcement action unfolds.

Allison D. Charney contributed to this post.