Should Goldman Sachs Back Down?

Wall St. and legal experts have begun to question whether Goldman Sachs Group (NYSE: GS) should settle charges by the SEC that it defrauded investors by not disclosing its role in the sale of mortgage back securities to its clients. The SEC claims that these transactions cost the clients involved  more than $1 billion.

Goldman is unlikely to dodge a court appearance on the matter. The SEC is intent on using the case, it would seem, to show that it still has the power to investigate and charge the most powerful firms and people in the financial community. The agency has been accused of missing many opportunities to discover the Bernie Madoff series of fraudulent transactions meant cover the true returns from his investment funds.

Goldman may face, even if its settles, a federal judge like Jed Rakoff who rejected a settlement by the SEC and Bank of America (NYSE: BAC) over the bonus payments made by Merrill Lynch management to some of its bankers before the deal for B of A  to buy the brokerage was finalized. Ragoff said the fines by the SEC were inadequate. The judge also said the agency had been lax in its work on the Merrill investigation and insisted that the B of A management needed to take more responsibility for the matter.

Goldman may also have trouble settling with the SEC over its charges because the agency wants to make a show of its new “tough cop” image. In that case, the SEC might make the financial bar for a settlement so high and the admission of guilt so damning that Goldman will feel it has no recourse other than to go to court. Most SEC agreements to settle major cases like the one against the investment bank allow the target of the probe to say it does not admit guilt in the matter.

The SEC could also decide to seek a ban of Goldman from certain banking activities like the trading of derivatives instruments. That would undermine a portion of the firm’s most profitable businesses.

Goldman also faces possible charges from a number of sources including NY State Attorney General Andrew Cuomo, who has developed a habit of investigating financial firms and their managements. Goldman could be sued by customers who believe they have a case for fraud beyond the SEC charges. This includes American International Group (NYSE: AIG) which was involved in a number of insurance deals covering Goldman derivative transactions. AIG says the transactions cost it between $2 billion and $3 billion

In its favor, Goldman can take advantage of the fact that SEC commissioners voted along party lines to charge the bank. The Washington Post has reported that “Behind closed doors, the two Republican members of the Securities and Exchange Commission sharply questioned senior investigators last week about whether the evidence they had assembled was strong enough to file a fraud case against Goldman Sachs.” That news may keep some Goldman customers from cutting ties with the firm, but it will do nothing to sway a judge in court.

Goldman may claim that the problems with its creation of mortgage debt derivatives were largely the work of one of its vice president Fabrice Tourre, but there is evidence that senior management at the bank was  involved in structuring and trading the instruments.

Whether Goldman settles or not, it will face a day in court either in a full trial or to get a settlement approved. A settlement may be challenged from the bench and Goldman may look back and think it should have opted for a trial. Goldman, facing those odds, won’t settle.

Douglas A. McIntyre