April 21: This post has been corrected.
In a conference call this morning, Goldman Sachs' co-general counsel Greg Palm said the firm was "somewhat surprised" by the SEC's civil suit last week, since "no one had told us in advance." Typically, when the SEC files a lawsuit, it gives companies advance notice, so they can either settle the case quickly or brace themselves for a PR hit. In this case, the SEC didn't give Goldman the courtesy.
But far from being completely blindsided, the firm has known about the potential for civil charges since July 2009, when the SEC first gave the bank a warning known as a Wells notice. While the investment bank felt the Wells notice warranted a 49-page defense and then 20 more pages of supplemental documents that it submitted to the SEC, Goldman Sachs made no mention to shareholders of the possibility of legal action against the firm.
Why not? First, because by the SEC's rules, they probably didn't have to--not unless the amount involved exceeded 10 percent of the firm's current assets. With about $849 billion in assets at the end of 2009, Goldman could reasonably expect that a lawsuit over a $2 billion CDO would never result in penalties nearing 10 percent of its assets.
Of course, nothing about the SEC rules forbade them from making the disclosure either.
So why didn't they? Once again, it goes back to the concept of "materiality." Was an investigation into possible fraud "material" information for shareholders making investment decisions?
Apparently not in Goldman's view. Bloomberg News reports that in Goldman's 2009 annual report filed last month, the company recycled language "used in the previous year’s report to describe regulatory probes involving securities linked to subprime mortgages." That language makes no mention of the Wells notice, makes no mention of the meeting that Goldman had with the SEC following the Wells notice, makes no mention of the almost 70 pages of documents Goldman's lawyers sent the SEC to defend the bank on the very issue it's now being sued over. Here's what the company disclosed in its 2009 annual report, unchanged from the year before:
"GS&Co. and certain of its affiliates, together with other financial services firms, have received requests for information from various governmental agencies and self-regulatory organizations relating to subprime mortgages, and securitizations, collateralized debt obligations and synthetic products related to subprime mortgages. GS&Co. and its affiliates are cooperating with the requests."
As we've pointed out, materiality is a cloudy subject. But what Goldman felt wasn't "material" was judged to be material by many other companies. Michelle Leder at Footnoted.org, a business blog run by the research company Morningstar, points out that many of Goldman's peers in the investment banking world had felt Wells notices were material, and had disclosed when they received them:
If Goldman’s argument was that the Wells Notice was not material, they may see some challenges from other very large companies that have disclosed Wells Notices in the past. A quick skim of Morningstar Document Research of companies over $50 billion in market cap that have disclosed the existence of Wells Notices in the past turns up General Electric, Bank of America, UBS and units of both Berkshire Hathaway and of JP Morgan Chase.
And of course, investors certainly seem to have thought the SEC's suit was important: Goldman's stocks slumped 13 percent, and its market value fell by more than $10 billion after the news.
As former SEC official Richard Sauer wrote in a 2007 issue of The Business Lawyer, "the most objective evidence of the materiality of information is the stock market's reaction to its disclosure. As one court stated, 'the concept of materiality translates into information that alters the price of the firm's stock. ...'"
Goldman has declined requests by both Bloomberg and Reuters for comment on its nondisclosure of the Wells notice. On the issue of allegedly misleading or incomplete disclosure that is now the subject of the SEC's lawsuit, Goldman said in a statement that investors "were provided extensive information about the underlying mortgage securities," and called the SEC lawsuit "unfounded in law and fact."