In the late summer of 2009, lawyers at the Securities and Exchange Commission were preparing to bring charges in what they expected would be their first big crackdown coming out of the financial crisis. The investigators had been looking into Goldman Sachs’ mortgage-securities business, and were preparing to take on the bank over a complex deal, known as Abacus, that it had arranged with a hedge fund. They believed that Goldman had committed securities violations in developing Abacus, and were ready to charge the firm.
James Kidney, a longtime SEC lawyer, was assigned to take the completed investigation and bring the case to trial. Right away, something seemed amiss. He thought that the staff had assembled enough evidence to support charging individuals. At the very least, he felt, the agency should continue to investigate more senior executives at Goldman and John Paulson & Co., the hedge fund run by John Paulson that made about a billion dollars from the Abacus deal. In his view, the SEC staff was more worried about the effect the case would have on Wall Street executives, a fear that deepened when he read an email from Reid Muoio, the head of the SEC’s team looking into complex mortgage securities. Muoio, who had worked at the agency for years, told colleagues that he had seen the “devasting [sic] impact our little ol’ civil actions reap on real people more often than I care to remember. It is the least favorite part of the job. Most of our civil defendants are good people who have done one bad thing.” This attitude agitated Kidney, and he felt that it held his agency back from pursuing the people who made the decisions that led to the financial collapse.
While the SEC, as well as federal prosecutors, eventually wrenched billions of dollars from the big banks, a vexing question remains: Why did no top bankers go to prison? Some have pointed out that statutes weren’t strong enough in some areas and resources were scarce, and while there is truth in those arguments, subtler reasons were also at play. During a year spent researching for a book on this subject, I’ve come across case after case in which regulators were reluctant to use the laws and resources available to them. Members of the public don’t have a full sense of the issue because they rarely get to see how such decisions are made inside government agencies.
Kidney was on the inside at a crucial moment. Now retired after decades of service to the SEC, Kidney recently provided me with a cache of internal documents and emails about the Abacus investigation. The agency holds the case up as a success, and in some ways it was: Goldman had to pay a $550 million fine, and a low-ranking trader was found liable for violating securities laws. But the documents provided by Kidney show that SEC officials considered and rejected a much broader case against Goldman and John Paulson & Co.
Kidney has criticized the SEC publicly in the past, and the agency’s handling of the Abacus case has been previously described, most thoroughly in a piece by Susan Beck, in The American Lawyer, but the documents provided by Kidney offer new details about how the SEC handled its case against Goldman. The SEC declined to comment on the emails or the Abacus investigation, citing its policies not to comment on individual probes. In a recent interview with me, Muoio stood by the agency’s investigation and its case. “Results matter. It was a clear win against a company and culpable individual. We put it to a jury and won,” he said.
Kidney, for his part, came to believe that the big banks had “captured” his agency — that is, that the SEC, which is charged with keeping financial institutions in line, had become overly cautious to the point of cowardice.
The Abacus investigation traces to a moment in late 2006 when the hedge fund Paulson & Co. asked Goldman to create an investment that would pay off if U.S. housing prices fell. Paulson was hoping to place a bet on what we now know as “the big short”: the notion that the real-estate market was inflated by an epic bubble and would soon collapse. To facilitate Paulson’s short position, Goldman created Abacus, an investment composed of what amounted to side bets on mortgage bonds. Abacus would pay off big if people began defaulting on their mortgages. Goldman marketed the investment to a bank in Germany that was willing to take the opposite side of the bet — that housing prices would remain stable. The bank, IKB, was cautious enough to ask that Goldman hire an independent manager to assemble the deal and look out for its interests.
This is where things got dodgy. Unbeknownst to IKB, the hedge fund Paulson & Co. improved its odds of success by inducing the manager, a company called ACA Capital, to include the diciest possible housing bonds in the deal. Paulson wasn’t just betting on the horse race. The fund was secretly slipping Quaaludes to the favorite. ACA did not understand that Paulson was betting against the security. Goldman knew, but didn’t give either ACA or IKB the full picture. (For its part, Paulson & Co. contended that ACA was free to reject its suggestions and said that it never misled anyone in the deal.)
When SEC officials discovered this in 2009, they decided that Goldman Sachs had misled both the German bank and ACA by making false statements and omitting what the law terms “material details” — and that these actions constituted a violation of securities law. (The SEC oversees civil enforcement of U.S. securities law and can charge both companies and individuals with violations. Its work can often be a precursor to criminal cases, which are handled by prosecutors at the Justice Department.)
Kidney was a trial attorney with two decades of experience at the SEC, and had won his share of courtroom battles. But the stakes in this case were particularly high. Politically, it was a delicate moment. The global financial system was only just recovering, millions of Americans had lost their jobs, and there was growing public anger about the bailout of the banks and car companies in Detroit. When Kidney looked at the work that had been done on the case, he found what he saw as serious shortcomings. For one, SEC investigators had not interviewed enough executives. For another, the staff decided to charge only the lowest man on the totem pole, a midlevel Goldman trader named Fabrice Tourre, a French citizen who lived in London, and who was in his late twenties when the deal came together. Tourre had joked about selling the doomed deal to “widows and orphans,” and had referred to himself as “Fabulous Fab,’’ a sobriquet that probably would not endear him to a jury. He was an easy target, but charging him was not likely to send a signal that Washington was serious about cracking down on Wall Street’s excesses.
Kidney could not understand why SEC staffers were reluctant to investigate Tourre’s bosses at Goldman or anyone at Paulson & Co. Charging only Goldman, he said, would send exactly the wrong message to Wall Street. “This appears to be an unbelievable fraud,” he wrote to his boss, Luis Mejia. “I don’t think we should bring it without naming all those we believe to be liable.”
Kidney came to work at the SEC in 1986. He was thirty-nine at the time, having first worked a stint as a journalist. The “steam was elevated” at the agency when he started there, he said. Young lawyers were expected to go after the big names, and they did: the junk-bond king Michael Milken, the insider trader Ivan Boesky, the investment banker Martin A. Siegel.
As a trial lawyer, Kidney’s job was to develop a compelling narrative that could be presented to a jury of laymen unfamiliar with the intricacies of finance. “Jim was a great attorney. A lawyer’s lawyer. Sound legal mind, excellent writer, and a true trial lawyer,” said Terence Healy, the vice-chair of securities enforcement practice at Hughes Hubbard and a former colleague of Kidney’s at the SEC. But Kidney also exasperated some staffers who thought he wasn’t detail-oriented and didn’t grasp nuances.
Soon after he joined the case, Kidney believed that the evidence the SEC staff had assembled justified charges against more people and he argued for, at the very least, an investigation of higher-level executives. The SEC team had not interviewed Tourre’s direct superior, Jonathan Egol. Nor had they questioned top bankers in Goldman’s mortgage businesses or any of the bank’s senior executives. Even more surprising to Kidney, the agency had not taken testimony from John Paulson, the key figure at his eponymous hedge fund. It seemed to Kidney, as he reviewed the case materials, that the agency had spent more time and effort investigating much smaller insider-trading cases. Just two weeks after he joined the case, on August 14th, Kidney urged the team to broaden its investigation and issue key participants in the Abacus deal what are known as Wells notices — official notification that the SEC is considering charges.
Kidney’s view of the case put him at odds with Muoio, who was widely respected at the agency for his analytical abilities. Kidney said that he was aghast when, in an email sent a month later congratulating his team on their work investigating Tourre, Muoio described potential targets of SEC charges as “good people who had done one bad thing,’’ and he did little to hide his irritation.
“I am in full agreement that when we sue it can be devastating, and that we have sued little guys way too often on flimsy charges or when they have been punished enough,’’ he wrote back. “But I’m not at all convinced that Tourre alone is sufficient here.”
Kidney later explained to Muoio that he was pushing for a more assertive approach because he believed that the SEC had grown too passive in its oversight of Wall Street. “The damage to the reputation of the [SEC] in the last few years and the decline of the institution are very troubling to me,” he wrote.
Kidney and Muoio battled for months. Kidney felt that the agency was overly dependent on the kind of direct evidence it had against Tourre. Part of the problem was that high-level Goldman executives had been savvier in how they communicated: when topics broached sensitive territory in emails, they would often write “LDL” — let’s discuss live.
Kidney pressed the team to take what he thought were obvious investigative steps. He had been told by a staff attorney in the group that Muoio had vetoed the idea of calling Paulson to testify, and the agency hadn’t subpoenaed Paulson’s emails initially, relying mainly on the voluntary disclosure of documents. “We didn’t get subpoena power until late in the investigation,” a staff attorney acknowledged to Kidney in an email sent late in August of 2009.
As the year ended, Muoio remained opposed to bringing charges against anyone but Tourre. In a December 30th email, sent to the entire group investigating the deal, Muoio offered an explanation for what had happened during the bubble years: “Now that we are gearing up to bring a handful of cases in this area, I suggest that we keep in mind that the vast majority of the losses suffered had nothing to do with fraud and the like and are more fairly attributable to lesser human failings of greed, arrogance and stupidity of which we are all guilty from time to time.”
Several days later, Kidney sent an email to Lorin Reisner, the SEC’s deputy director of enforcement, in which he warned, “We must be on guard against any risk that we adopt the thinking of those sponsoring these structures and join the Wall Street Elders, if you will.”
Kidney also continued to push the agency to bring charges against Egol, Tourre’s superior at Goldman, arguing that the SEC should at least interview him. According to Kidney, Muoio dismissed the idea, saying that the agency knew what Egol would say.
“That’s a cardinal sin in an investigation,’’ Kidney said that he told Muoio. “You can’t assume what somebody will say.”
One reason for the reluctance from Muoio and others at the SEC was that they wanted to make the case about misleading statements and they didn’t have that sort of evidence from Paulson & Co. employees or high-level Goldman executives.
Kidney told me that he thought the SEC could avail itself of a broader interpretation of securities law. He argued that the agency should file civil actions against top players at both the bank and the hedge fund under a concept called “scheme liability” — a doctrine of securities law that makes it illegal to sell financial products whose main purpose is to deceive investors.
In late October of 2009, Kidney circulated a long memo arguing that the SEC should consider charging Paulson & Co., John Paulson himself, and Paolo Pellegrini, who was the hedge fund executive who worked on the Abacus deal.
“Each of them knowingly participated, as did Goldman and Tourre, in a scheme to sell a product which, in blunt but accurate terms, was designed to fail,” Kidney’s memo said. “In other words, the current pre-discovery evidence suggests they should be sued for securities fraud because they are liable for securities fraud.”
John Paulson and Pellegrini declined to comment for this article. Paulson & Co. and Goldman dispute that the deal was fraudulent. A spokesman for the Paulson hedge fund said that “there was no ‘scheme’ nor was Abacus ‘designed to fail’” and that the hedge fund neither told Goldman what to disclose to investors nor knew anything about what the bank was telling investors. A Goldman spokesman said that the bank never created mortgage-related products that were designed to fail. He said the precipitous collapse in the value of Abacus, which fell to zero several months after it had been created, resulted from the broad decline in the housing market that afflicted all securities related to real estate, not because of flaws in the product.
Some of Kidney’s colleagues initially supported his idea to pursue scheme liability, but Muoio seemed to think that doing so would hurt the agency’s solid but narrower case against Goldman. “I continue to have serious reservations about charging Paulson on our facts,’’ Muoio wrote. “And I worry that doing so could severely undermine and delay our solid case against Goldman.” Muoio’s viewpoint, again, prevailed.
Muoio, in a recent interview with me, dismissed Kidney’s complaints. “I cannot imagine any basis for claiming ‘regulatory capture,’ given that I have never worked in industry or finance and given the cases I have made, including very significant cases against banks, auditing firms, companies and senior executives," he said.
Even after he lost the debate over scheme liability, Kidney continued to argue for charging Jonathan Egol with securities-law violations. One staffer wrote that the SEC had testimony, but little documentary evidence, proving that Egol had reviewed the Abacus documents. “The law surely imposes liability on others besides the literal scrivenor [sic], or we are in big trouble,” Kidney shot back in an email. “Why are we working so hard to defend a guy who is now a managing director at Goldman so we can limit the case to the French guy in London?”
“I am sure you are not suggesting we charge Egol because of his position within the company,” Muoio replied. “Nationality is also clearly irrelevant and I hope that’s the last we hear from you on that subject. Tourre admits he was principally responsible for the problematic disclosures.”
Members of the SEC staff finally interviewed Egol in January. Muoio would later tell the SEC inspector general: “We didn’t lay a glove on him.” But Kidney felt differently. As he saw it, Egol had acknowledged reviewing all the documents that the SEC had deemed misleading.
On January 29, 2010, after months of investigation and debate, the SEC provided a Wells notice to Jonathan Egol. Neither Egol nor his lawyers responded to repeated calls and emails seeking comment.
Things dragged on. In March, Muoio wrote an email arguing against charging Egol, saying that, among other reaons, he “will strike most jurors as nice, likable, down-to-earth family man.” On the afternoon of March 22nd, the team gathered in the office of Robert Khuzami, the SEC’s director of enforcement, for a meeting. Kidney, Lorin Reisner, and one other lawyer present were in favor of suing Egol; Muoio remained implacably against, as did others. Most of the lower-level staffers stayed quiet.
The following day, Khuzami emailed the group with his decision: “I am a no on Egol. An extremely difficult call,” he wrote. “The lack of consensus among our group is itself, for me, confirmation of this conclusion.” Khuzami did not respond to a request for comment for this article.
Kidney had lost. He was offered the job of handling the expert witnesses for the trial but knew what that meant — that he was getting demoted. He declined.
On Friday, April 16, 2010, the SEC stunned the markets, suing Goldman Sachs and charging the firm with omitting information that would have been crucial to investors in Abacus. The agency brought a charge against Tourre, as well. Goldman’s stock dropped thirteen per cent that day, erasing $10 billion of its market capitalization.
A couple of months later, on July 15, 2010, the SEC settled with Goldman for $550 million. Goldman Sachs did not admit any wrongdoing. The SEC wrung an apology out of the bank, which the agency perceived as scoring a victory that critics called inadequate.
It would be the only SEC action brought against the bank for its actions in this corner of the mortgage securities markets just before the meltdown, although a Senate investigation uncovered questionable behavior related to other Goldman mortgage securities. The Justice Department recently settled a case with Goldman that charged that the bank had misrepresented mortgage-backed securities. The bank had to pay on the order of $5 billion. The Justice Department did not charge any individuals.
In 2013, Fabrice Tourre was found liable in a civil trial and ordered to pay more than $850,000. He is now a Ph.D. candidate at the University of Chicago.
Kidney became disillusioned. Upon retiring, in 2014, he gave an impassioned going-away speech, in which he called the SEC “an agency that polices the broken windows on the street level and rarely goes to the penthouse floors.”
In our conversations, Kidney reflected on why that might be. The oft-cited explanations — campaign contributions and the allure of private-sector jobs to low-paid government lawyers — have certainly played a role. But to Kidney, the driving force was something subtler. Over the course of three decades, the concept of the government as an active player had been tarnished in the minds of the public and the civil servants inside working inside the agency. In his view, regulatory capture is a psychological process in which officials become increasingly gun shy in the face of criticism from their bosses, Congress, and the industry the agency is supposed to oversee. Leads aren’t pursued. Cases are never opened. Wall Street executives are not forced to explain their actions.
Kidney still rues the Goldman case as a missed chance to learn the lessons of the financial crisis. “The answers to unasked questions are now lost to history as well as to law enforcement,“ he said. ”It is a shame.”