Teaching Note: Did Goldman Sachs Commit Fraud?

In the mid-2000s, hedge fund manager John Paulson approached Goldman Sachs after speculating bubble
in housing, fueled by cheap money from banks. During the early 2000s, mortgage originators had started
bonds known as collateralized debt obligations, or CDOs. Many of these bonds were given favorable
ratings from Moody’s and Standard & Poor’s, suggesting that they were safe investments. Paulson
believed that these ratings were wrong and that many CDOs were far more risky than investors thought.
He believed that when people started to default on their mortgage payments, the price of these CDOs
would collapse.

Goldman Sachs decided to offer bonds for sale to institutional investors as synthetic CDOs. Goldman
Sachs asked Paulson to identify the CDOs that he thought were very risky and grouped them together into
synthetic CDOs. Paulson then took a short position in these synthetic CDOs. Paulson was effectively
betting against the synthetic CDOs, a fact that Goldman knew, while he was actively marketing these
bonds to institutions. Shortly thereafter, people started to default on their housing payments, the price of
houses did fall, and the value of CDOs and the synthetic CDOs that Goldman had created plunged.

Paulson made an estimated $3.7 billion in 2007 alone from the event. Goldman Sachs, too, made over $1
billion by betting against the very same bonds that it had been selling. In April 2010, the SEC formally
charged Goldman Sachs with civil fraud, arguing that the company had knowingly mislead investors
about the risk and value of the synthetic CDOs, and failed to inform them of John Paulson’s involvement
in selecting the underlying CDOs. Goldman argued that a market maker like Goldman Sachs owes no
fiduciary duty to clients and offers no warranties—it is up to clients to make their own assessment of the
value of a security. However, faced with a barrage of negative publicity, Goldman opted to settle the case
out of court and pay a $550 million fine. In doing so, Goldman admitted no legal wrongdoing, but did say
that the company had made a “mistake” in not disclosing Paulson’s role, and vowed to raise its standards
for the future.

0Teaching Note:

The alleged fraud committed by Goldman Sachs is an excellent example of the themes in this chapter.
How were their actions not in the best interests of the investors? What governance mechanisms were
lacking to allow Goldman Sachs to conspire against their personal clients? Was the fine of $550 million
which Goldman Sachs paid anticipating negative publicity fair for their behavior? What motivated their
unethical behavior and what measures could have been taken to curtail such behavior at an early stage?

Answers to Case Discussion Questions

1. 0Did Goldman Sachs break the law by not telling investors that Paulson had created the synthetic
CDOs and was betting against them? Was it unethical for Goldman Sachs to market the CDOs?

Student answers will vary. In April 2010, Goldman Sachs was formally charged by the SEC with
civil fraud. However, it argued that a market maker like Goldman Sachs owes no fiduciary duty to
clients and offers no warranties—it is up to clients to make their own assessment of the value of a
 security. Goldman Sachs did pay a fine of $550 million to avoid negative publicity. In doing so,
Goldman admitted no legal wrongdoing, but did say that the company had made a “mistake” in not
disclosing Paulson’s role, and vowed to raise its standards for the future. They may not have broken
the law. However, they did violate the ethical code towards their investors.

Ethically, as individuals we are taught that it is wrong to lie and cheat and that it is right to behave
with integrity and honor and to stand up for what we believe to be right and true. Goldman Sachs
argued that it owes no fiduciary duty to clients and offers no warranties even though it kept
information from its clients regarding the involvement of Paulson in creating the synthetic CDOs.
This was unethical. It also bet against the very same bonds that it had been selling. This speaks
volumes of its unethical behavior.

2. 0Would your answer to the question above change if Goldman had not made billions from selling
the CDOs? Would your answer to the question above change if Paulson had been wrong, and the
CDOs had increased in value?

Student answers will vary. Some of them will not change their answer to the question above. If
Paulson had been wrong, and the CDOs had increased in value, the answer to the above question
would still be the same. They would emphasize that the ethical code should be followed in every
aspect of life whether one incurs gain or loss.

3. 0If opinions vary about the quality or riskiness of an investment, does a firm like Goldman Sachs
owe a fiduciary duty to its clients to try to represent all of those opinions?

Student answers will vary. Some of them may say that a market maker like Goldman Sachs owes
no fiduciary duty to clients and offers no warranties—it is up to clients to make their own
assessment of the value of a security. However, if the firm knowingly misleads investors about the
risk and value of an investment it can be formally charged with civil fraud.

4. 0Is it unethical for a company like Goldman to permit its managers to trade on the company’s
account (i.e., invest on the company’s behalf rather than an external client’s behalf)? If not, how
should compensation policies be designed to prevent conflicts of interest from arising between
trades on behalf of the firm and trades on behalf of clients?

Student answers will vary. Some of them may say that it is not unethical for a company like Goldman
to permit its managers to trade on the company’s account. Companies can adopt pay-for-performance
systems as compensation policies for managers. Giving managers stock options has been the most
common pay-for-performance system. Ideally, stock options will motivate managers to adopt
strategies that increase the share price of the company, in doing so managers will also increase the
value of their own stock options. Performance based system can also prevent conflicts of interest
from arising between trades on behalf of the firm and trades on behalf of clients.