Appeals Court Hears Fraud Claim Against Goldman, TCW Over CDOs

By | April 2, 2012

A U.S. appeals court was asked on Friday to decide whether Goldman Sachs Group Inc. and TCW Asset Management Co. should have foreseen the housing market implosion that caused a $37 million loss for German state-owned Landesbank Baden-Wurttemberg.

A three-judge panel on Friday did not make an immediate ruling on a trial judge’s decision last September to dismiss the German bank’s lawsuit claiming fraud against Goldman and TCW, an investment advisor.

The lawsuit was brought over a collateralized debt obligation (CDO) named Davis Square Funding VI, which was managed and marketed by Goldman and TCW at the height of the housing bubble when profits were potentially lucrative. The lawsuit was filed in October 2010, about four years after Davis Square closed.

It is one of the few cases to reach the appellate court level in which a sophisticated investor has accused a bank of profiting unjustly by being negligent in marketing and selling the product. Landesbank also accused Goldman of betting against its own derivative product that was riddled with risky residential mortgage-backed securities.

In dismissing the case, U.S. District Judge William Pauley in New York had said the allegations against Goldman and TCW were “sparse and lack particulars” and speculated on events occurring long after Davis Square closed.

Judges on the 2nd U.S. Circuit Court of Appeals also zeroed in on whether Landesbank should have more carefully scrutinized what it was buying.

“What does the record show about your client’s diligence in the housing market during this period?” Judge Susan Carney asked Landesbank lawyer Arthur Miller.

Miller responded that there was “no way of having equal information to Goldman,” describing the investment bank as the “emperor” of financial institutions.

Miller told the panel that Goldman knew what information the ratings agencies and the top market regulator, the U.S. Securities and Exchange Commission, had about the quality of the underlying mortgages in the investment pool.

The CDO’s underlying portfolio comprised about 95 percent RMBS, which went on to lose value as the housing market crashed in 2007 and 2008, contributing to a global economic crisis. The German bank’s lawsuit said it lost its investment of $37 million.

“They know that representing them as triple-A securities is false,” Miller said, referring to the highest debt rating for a security.

The judges also queried Goldman’s lawyer about what it knew at the time about the securities and the risks to its client.

Goldman lawyer Theodore Edelman told the panel that the firm’s disclosures were “extremely clear and specific” and that the SEC website had timely information on loan delinquencies.

“All of this is available by a click of the mouse,” Edelman said.

In court papers, Goldman said Landesbank relied on a late 2007 report by Clayton Holdings, a provider of due diligence services to the mortgage industry. The report referred to loans that Clayton examined in 2006 and 2007, but the loans backing Davis Square were originated primarily in 2004 and 2005.

Landesbank accused Goldman of profiting unjustly from Davis Square by charging an excessively high purchase price and fees. It said Goldman also bet against the product by buying billions of dollars in credit default swaps that insured Goldman against the collapse of the mortgage securities collateral it sold to Landesbank.

In 2010, the SEC sued Goldman and a vice president of the firm over another CDO, called Abacus 2007-AC1, accusing them of failing to tell investors the Paulson & Co hedge fund helped choose and bet against the subprime RMBS underlying Abacus.

Goldman settled with the SEC for $550 million without admitting wrongdoing. The case against the executive, Fabrice Tourre, is ongoing.

The case is Landesbank Baden-Wurttemberg vs. Goldman Sachs and TCW Asset Management Co., 2nd Circuit U.S. Court of Appeals in New York No. 11-4443.

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