The March 2012 New York Times editorial by former Goldman Sachs executive Greg Smith accused the firm's culture and practices of being centered around "ripping their clients off." Smith followed-up on his editoral yesterday by publishing a full-length book on his time at Goldman and an editorial criticizing much of the financial services industry.
While the soundness of Smith's criticisms leave much to be desired, last week the New York State Supreme Court refused to dismiss an October 2011 lawsuit against Goldman that, much like Smith, faulted Goldman for "putting profits above integrity...to the detriment of its own clients." The case is Basis Yield Alpha Fund (Master) v. Goldman Sachs Group Inc et al., New York State Supreme Court, New York County, No. 652996/2011.
The suit was brought by a hedge fund claiming that Goldman sought to reduce its exposure to subprime mortgages by selling mortgage-related securities to the fund as sound investments without disclosing Goldman's negative view of the securities or its economic interest in their failure.
The court refused to dismiss the fraud claims because it found that the fund laid out in sufficient detail specific misrepresentations by Goldman.*
But the court went further. It held that the fund's fraud claim was also supported by Goldman's overly optimistic opinions about the value of the transactions allegedly made to the fund. These opinions included statements that the transaction was "attractive" and "rock solid."
Goldman argued in a motion that, even if the opinions were actually stated, they don't lay the basis for a fraud claim because they were merely sales talk and puffery--as distinct from misrepresentations of actual fact. A general principle of business and securities law is that opinions cannot serve as the basis for a fraud claim. Moreover, Goldman argued, any statements of opinion are irrelevant in light of the specific disclaimers that were made about the risks of the transactions.
But the court didn't buy Goldman's arguments.
Relying on prior cases finding that it is fraudulent for a seller to state an opinion that's unreasonable or that the seller does not genuinely believe, the court found as sufficient the fund's allegations that Goldman believed the securities it sold were toxic and that Goldman was motivated to remove the securities from its balance sheet. Likewise, the court found the disclaimers in the transaction's offering documents insufficient to dispose of the fund's fraud claim. This is because of other allegedly fraudulent statements Goldman made outside of the offering documents--in emails to, and calls with, the fund.
A primary lesson from the case thus far is that, to avoid civil liability, firms that use securitization vehicles to transfer risk should not opine as to the quality of securities they are issuing. They should also give the buyer a breakdown of the transactions directly related to the securitization that they are involved in, as well as their relationship with third parties that help structure the vehicle.
A major problem with the opinion is that it allows sophisticated parties like hedge funds to bring suits on the basis of having relied upon opinions, albeit insincere ones. In doing so, it undermines the incentive for sophisticated buyers to do their own research and negotiate for more disclosures and favorable deal terms.
A primary cause of the subprime mortgage crisis was investors' failure to perform their own research or hire independent parties, and the court's decision does not alleviate that problem. To the contrary, it gives implicit approval to buyers to rely on the opinions of sellers when they probably should be ignoring them altogether.
*Those allegations relate to Goldman's internal valuation of the securities, the independence of the underlying asset selection process, and whether Goldman's interests were really aligned with the fund's.