Securities Fraud Attorney Blog

Below is a New York Times Piece about Bayou v. Goldman Sachs

Goldman Must Pay Some Bayou Losses
By LOUISE STORY and GRETCHEN MORGENSON
Goldman Sachs has been ordered to pay $20.58 million to creditors of a failed hedge fund to settle claims that the bank helped the fund perpetrate a Ponzi scheme.
The award represents the first time that a bank has been held accountable for a Ponzi scheme because of its role as a middleman.
Goldman cleared trades and lent money to the Bayou Group, a Connecticut hedge fund that collapsed in 2005, when state and federal investigators said the firm defrauded investors of hundreds of millions of dollars.
The Bayou fraud resurfaced in 2008 when its founder, Samuel Israel III, faked his own suicide after being sentenced to 20 years in prison for fraud. He later turned himself in and is now serving 22 years.
Bayou’s creditors filed a complaint against Goldman two years ago, saying the bank either knew or should have known of Bayou’s fraud. Goldman, the complaint said, had access to Bayou’s trading records, which showed losses, as well as its marketing materials, which showed profits.
The award, in a decision by an arbitration panel of the Financial Industry Regulatory Authority issued on Thursday, may put other banks on notice to better scrutinize their hedge fund clients’ activities.
“This case shows that you can’t just stick your head in the sand when a fraud is going on in your shop,” said Ross B. Intelisano, a lawyer at Rich & Intelisano, who brought the arbitration against Goldman. The bank “argued that you could, and the panel disagreed.”
A Goldman spokesman pointed to the bank’s filing in the case, which questioned whether the creditors could use bankruptcy laws to hold Goldman accountable for the $20.58 million of investor money that Bayou transferred among its Goldman accounts. The money was never actually conveyed to Goldman, the bank said, so it should not be considered a fraudulent transfer.
The arbitration panel does not determine whether wrongdoing occurred, but merely decides on compensation.
“We are disappointed with the award and are considering our options,” said Ed Canaday, a spokesman for Goldman.
Goldman has limited grounds for vacating an arbitration award, however.
The award to Bayou’s creditors is yet another legal woe for Goldman. The bank is also the target of a Securities and Exchange Commission investigation of its mortgage operations before and during the financial crisis, and Goldman is fighting an S.E.C. complaint and private lawsuits about mortgage securities it created. Goldman has defended its actions in the mortgage market and said the parties that purchased its mortgage deals should have known what they were dealing with.
Although the Bayou case dates long before the financial crisis and has nothing to do with mortgage bonds, Goldman made similar claims in its reply. The bank, for instance, said the creditors of Bayou were “highly sophisticated investors.” Goldman also said it had no duty to monitor the “honesty and the finances” of its account holders.
Goldman served as Bayou’s main prime broker from 1999 to 2005, meaning that the bank had a wide view of the hedge fund’s activities, according to the creditors’ complaint. In that role, Goldman was the custodian of Bayou’s assets and a lender to the fund. Goldman also prepared Bayou’s account statements, the creditors said.
The award represents the amount of money that was put into the Bayou funds held at Goldman between March 2003 and June 2005. It accounts for just over 8 percent of the $250 million in losses that Bayou investors incurred in the fraud. If this award is included in the total recovered by Bayou investors, it will rise to more than half of their losses.
Bayou began losing money long before it went bust, for more than $88 million in losses during its association with Goldman. At the same time, Bayou told prospective investors that it had positive returns. During those years, Bayou marketed its relationship with Goldman as a mark of legitimacy, the creditors said.
Goldman was aware that Bayou was losing money, the creditors said. In 2004, Goldman’s risk managers created a list of the top 10 money losers among its clients. The No. 1 loser was a Bayou fund, and two other Bayou funds were ranker lower. The list, the complaint said, was circulated among Goldman executives.
A month after that list was circulated, Goldman requested and received a copy of Bayou’s marketing materials, which falsely claimed positive returns. Goldman also was warned about Bayou by an outside firm in 2002, the complaint said.
Goldman’s employees, the complaint said, “have repeatedly claimed that they had no obligation to concern themselves with what had occurred at the Bayou Hedge Fund at anytime.”

Below is the Wall Street Journal piece regarding Bayou v. Goldman Sachs.

JUNE 26, 2010
Goldman Told to Pay Bayou Fund Creditors
By SUSANNE CRAIG
Goldman Sachs Group Inc. was ordered to pay $20.6 million, the largest arbitration award levied against the securities firm, to unsecured creditors of Bayou Group LLC who accused Goldman of ignoring signs of fraud at the hedge-fund firm.
Bayou collapsed in 2005, and the firm's former chief executive, Samuel Israel III, is serving a 20-year prison term for fraud. He pleaded guilty to misrepresenting the value of Bayou's funds and defrauding clients out of more than $400 million.
Goldman cleared trades for the Connecticut hedge-fund firm before it collapsed. In 2008, Bayou's unsecured creditors' committee filed an arbitration claim against two Goldman units.
"Through either gross negligence or a willful choice to ignore the signs of fraud, [Goldman] failed to diligently investigate the red flags it was made aware of, to contact Bayou's auditors to request additional information, or to alert the appropriate authorities of what it had learned," lawyers for the committee alleged in the claim.
A three-person Financial Industry Regulatory Authority arbitration panel didn't provide an explanation for its ruling, issued Thursday. A Goldman spokesman said the panel didn't conclude that the firm committed any wrongdoing or violated any rules.
In its response to the initial arbitration filing, Goldman said the $20.5 million represents money that was fraudulently transferred among Bayou accounts and was never in Goldman's possession. Clearing operations typically maintain client records and send out trade confirmations, often earning big fees in return.
The Goldman spokesman said the New York company is "disappointed with the award and is exploring its options." Unlike court decisions, it is extremely hard to overturn arbitration awards because courts can't review the facts in an arbitration case. Courts are allowed to reverse such awards only for exceptional reasons, such as finding that an arbitrator acted improperly.
"This is a big victory for the victims," said Ross Intelisano, a partner at New York law firm Rich & Intelisano LLP who represented the Bayou creditors.
The largest previous arbitration award against Goldman was $2.8 million in 1994, according to Securities Arbitration Commentator, a Maplewood, N.J., newsletter that tracks arbitration cases. The Bayou ruling also is the sixth-largest arbitration award to any customer of a Wall Street firm, the newsletter said.
Winning damages from clearing firms is especially difficult because firms are required to spell out their duties in advance, often limiting their liability to only those functions. In its response to the arbitration filing, Goldman said the law "does not require clearing firms or prime brokers to monitor the suitability of the transactions they process or to investigate their account holders." Imposing such a standard "would slow commerce, raise costs and imperil financial markets," the firm said.
Separately, the Financial Crisis Inquiry Commission said Goldman President and Chief Operating Officer Gary D. Cohn and Chief Financial Officer David Viniar will testify at a hearing next week to examine the role of derivatives in the financial crisis.

Investors who lost $1 billion in the Goldman Sachs structured ABACAS CDO were handed a strategic road map by the SEC when it filed the civil fraud complaint against Goldman on Friday. The alleged misrepresentation to ACA by Goldman that Paulson was long the equity tranches of ABACUS and the omission to disclose to ABACUS investors in writing and orally that Paulson handpicked securities in ABACUS while it was simultaneously shorting the same securities are the crux of a potential claim by ABACUS’ investors against Goldman. But what path should investors forge to recover their losses? Court or arbitration? The recent RaceTrac v. Bear Stearns arbitration award shows that a large investor can win a private arbitration against a significant brokerage firm related to misrepresentations and omissions of CDO’s regardless of the risk disclosure language contained in the prospectus.

Since the subprime market meltdown, only one multi billion dollar investor has received a legal award or judgment against brokerage firm for misrepresenting and materially omitting to disclose facts related to CDOs. RaceTrac Petroleum, an Atlanta-based chain of more than 525 retail gasoline convenience stores in the southeast U.S., won a $3.4 million award against Bear Stearns in December 2009. The FINRA arbitration panel ruled that Bear Stearns was liable for misrepresentation and material omission, negligence and failure to supervise related to the Bear Stearns High Grade Funds, a CDO packed hedge fund which caused $1.6 billion in losses in 2007.

The issues in the Goldman ABACUS case are very similar to the Bear Stearns High Grade case. Did Goldman misrepresent or omit disclosing a material fact to the ABACUS investors? Instead of filing a lengthy, costly, public civil lawsuit against Bear Stearns, RaceTrac filed an arbitration claim at FINRA in December 2007 seeking $5 million in damages. Federal prosecutors filed criminal charges against the funds’ portfolio managers, Ralph Cioffi and Matthew Tannin. In March 2009, on the eve of the arbitration hearings in Atlanta, the U.S. Attorneys’ Office in New York ran into federal court in Brooklyn to try to stop RaceTrac from going forward with the arbitration until the criminal trials of Cioffi and Tannin were completed. Judge Block shut the government down and allowed RaceTrac to proceed. A jury then acquitted Cioffi and Tannin of all criminal charges November 2009. However, after 16 days of private arbitration hearings, the FINRA arbitration panel ruled that Bear Stearns was liable and awarded damages of almost 70% of RaceTrac’s investment.

The RaceTrac case took only two years and was won irrespective of the criminal acquittals. There are pending SEC actions against Cioffi and Tannin. The award shows that a large investor may want to choose a quiet, less expensive venue in which equity plays a role as opposed to a civil fraud complaint in court which is exposed to motions to dismiss and will be a three ring circus.

The investment world is buzzing about the SEC’s fraud allegations against Goldman Sachs for misrepresenting and omitting to disclose Paulson’s role in choosing RMBS securities for the ABACUS CDO and then shorting the same individual RMBS through CDS transactions with Goldman. According to the SEC, “investors in the liabilities of ABACUS are alleged to have lost more than $1 billion.” It is hard to tell whether direct investors in ABACUS lost $1 billion or whether that includes companies which had CDS risk exposure to it. Either way, what are the money losers going to do about it?

According to the SEC complaint, IKB, the German commercial bank, bought $150 million of Class A-1 and Class A-2 Notes which seem to look like the AAA-rated upper tranches of ABACUS. But there is no other disclosure of who else bought ABACUS from Goldman. I presume that IKB was very cooperative with the SEC and allowed its name to be used in the complaint as opposed to being dubbed “Investor #1". IKB has likely been negotiating with Goldman behind the scenes. I expect to see a civil complaint filed by IKB against Goldman in federal court in New York shortly. However, they are probably better off arbitrating the dispute for numerous reasons (privacy, low cost, limited dispositive motion practice, etc.).

The SEC complaint also explains how a division of ACA, the monoline insurance company, served as the “Portfolio Selection Agent” for ABACUS, and another division of ACA (ACA Capital) also sold protection on $909 million of the super senior tranche of ABACUS through credit default swaps as well. ABN AMRO, the European bank, then assumed that same exposure through CDS deals with Goldman and ACA. The complaint alleges Goldman defrauded IKB, ACA and ABN AMRO. ABN AMRO was bought by the Royal Bank of Scotland and after ABACUS went to almost zero, RBS paid Goldman $841 million, most of which was then paid by Goldman to Paulson due to Paulson’s short bets on the underlying tranches. Got that?

So, RBS is holding the potential claims against Goldman (and Paulson?) for $841 million. Very interesting to see if RBS sues either of them.

But what about the rest of the ABACUS investors? According to the Flip Book available on Reuters’ website, ABACUS was a $2 billion synthetic CDO. Who else bought it besides IKB? And what are these investors going to do once they’ve read the SEC complaint? I have a guess or two.

By the way, Goldman netted $15-20 million for structuring and marketing ABACUS. Amazingly, Paulson paid Goldman $15 million to allow it to help pick the RMBS for ABACUS. This is a killer fact for the SEC.

The SEC charged Goldman Sachs with defrauding investors of ABACUS 2007-AC1, a synthetic CDO created and sold by Goldman in early 2007 when the subprime world was reeling. Investors in ABACUS ultimately lost $1 billion.

The SEC's civil fraud complaint alleges that Goldman allowed the multi billion dollar hedge fund Paulson & Co. to help select RMBS (residential mortgage backed securities) for the Abacus CDO, knew that Paulson was concurrently shorting specific tranches of the CDO but did not disclose anything about Paulson to investors in the CDO offering documents or marketing materials.

This is a huge development in that it shows SEC has the fortitude to file actions against the biggest firm of all related to its failure to disclose material information to investors. Goldman will likely be the brunt of civil lawsuits or arbitrations related to the ABACUS CDO. The next question is whether the SEC will file claims against Paulson as well.

CDOs and synthetic CDOs are extremely complex investments which are at the heart of the Bear Stearns High Grade Funds cases our firm is handling.