Structured Products and CDO Fraud: The Short Seller Helped Choose the Portfolio

Fraud in structured products and CDOs can hide who chose an investment’s reference portfolio and who profits when it fails. Investors hear that an independent manager selected the mortgage securities. Inside the deal, someone sees a short seller proposing bonds, rejecting replacements and buying protection against the portfolio’s losses. The selection emails and the sales presentation can tell very different stories.

This page follows synthetic CDO offerings through portfolio selection, counterparties and disclosures. Our broader page on false statements used to sell investments follows the pitch and the money across other kinds of offerings.

What Is a Synthetic CDO?

A synthetic CDO is a collateralized debt obligation that takes exposure to a reference portfolio through credit default swaps. The Securities and Exchange Commission’s ABACUS complaint explains the distinction: a cash structure holds debt obligations that support payments to noteholders, while a synthetic structure references assets through swap contracts. The synthetic structure can also hold separate collateral to meet its payment obligations. Goldman’s structured product correlation trading desk structured and marketed the ABACUS series of synthetic CDOs, according to the complaint.

A credit default swap transfers credit risk between a protection buyer and a protection seller. The buyer makes periodic premium payments. The seller owes a contingent payment if the referenced obligation experiences a credit event. A participant buying protection can therefore profit from deterioration in the securities another investor expects to perform.

Tranches divide the exposure into layers. The equity tranche takes losses first, making an equity investor’s position very different from a short seller’s. In the ABACUS allegations, whether a participant held equity or bought protection mattered because it told the portfolio manager which outcome that participant wanted. For someone working on the transaction, the swap terms and the description of the participant’s role belong side by side.

Who Selected the ABACUS Reference Portfolio?

The Securities and Exchange Commission alleged that Goldman Sachs presented ACA Management as the portfolio selector while leaving out the influence of hedge fund Paulson & Co. Inc. Goldman structured and marketed ABACUS 2007-AC1, whose performance depended on subprime residential mortgage-backed securities. According to the complaint, Paulson & Co. wanted to buy protection against securities it expected to deteriorate and helped choose the reference portfolio.

The complaint describes a selection process with lists, revisions and meetings. It alleges that ACA proposed a revised portfolio after reviewing the hedge fund’s initial list, and that the hedge fund later deleted eight securities ACA had recommended. An insider who saw those revisions could connect the final list to the participants who shaped it.

Goldman’s internal messages, as quoted in the complaint, explain why ACA’s name mattered to the sale. A Goldman vice president wrote:

The Commission alleged that the sales presentation described ACA’s expertise and told investors the selector’s economic interests aligned with theirs, while omitting the hedge fund’s role and adverse interest. We see a convenient version of independence in the Commission’s account. ACA supplied the name; the short seller helped supply the portfolio.

The Counterparty’s Position Changed the Story

The Commission alleged that Goldman also led ACA to believe the hedge fund would invest in the equity tranche. ACA’s own committee approval described a hedge fund equity investor, while Goldman’s internal approval memorandum described an order to buy protection. Those documents assigned opposite economic interests to the same participant.

The counterparty chain extended beyond the note investors. According to the complaint, ACA Capital sold protection on the super-senior tranche in exchange for premiums, and ABN AMRO stood between ACA Capital and Goldman through a series of swaps. ABN AMRO assumed the credit risk if ACA Capital could not pay. The identities on those contracts mattered as much as the name on the sales deck.

The complaint alleged that the hedge fund paid Goldman approximately $15 million to structure and market the transaction. It also alleged that investors lost over $1 billion, while the hedge fund’s opposite swap positions produced approximately $1 billion in profit.

What Did Goldman Sachs Acknowledge in the Settlement?

Goldman acknowledged that its ABACUS marketing materials contained incomplete information. In the Securities and Exchange Commission’s July 2010 settlement announcement, the company said it was a mistake to describe the portfolio as selected by ACA without disclosing the hedge fund’s selection role and adverse economic interests.

Goldman agreed to pay $550 million to settle the Commission’s charges. The announced allocation designated $250 million for harmed investors through a Fair Fund distribution and $300 million for the U.S. Treasury. The agreement also required changes to the review and approval of certain mortgage-securities offerings, including review of written marketing materials by legal and compliance personnel. The Securities and Exchange Commission’s Enforcement Division investigated the conduct through its Structured and New Products Unit.

What Records Can Reveal CDO Offering Fraud?

CDO offering evidence connects what investors were told to how the portfolio was assembled and how the participants stood to be paid. The records behind an offering become useful together: the final presentation shows the promise, while earlier communications can explain who changed the deal and who knew about the change.

• The term sheet, sales presentation and offering memorandum show how the selector, reference assets and economic interests were described. Versions and recipient emails connect those statements to what a particular investor received.
• Portfolio lists and selection emails show proposed assets, rejected substitutions and the people approving the final selection. In ABACUS, the Commission used those exchanges to describe the hedge fund’s influence.
• Swap terms and payment records show who bought protection, who sold it, and which counterparty carried the obligation to pay. They connect a participant’s stated role to its financial position.
• Committee memoranda and internal communications show what decision-makers understood. The ABACUS complaint placed ACA’s belief in an equity investment beside Goldman’s internal description of a protection purchase.

The Significance of Whistleblowing as an Anti-Fraud Measure, published in the Journal of Forensic & Investigative Accounting in 2018, attributed 35.9% of detections in its occupational-fraud sample to whistleblowing, compared with 21.4% to internal controls. In a CDO offering, the contribution we look for is concrete: someone who can explain why the final disclosure leaves out a decision they witnessed.

When the Rating Method Differs From the Published Method

A rating carries a methodology and assumptions behind it, and the rating file can expose a different account from the published explanation. The Securities and Exchange Commission’s 2015 proceedings against Standard & Poor’s provide a parallel involving commercial mortgage-backed securities. The agency described public disclosures that claimed one methodology while the firm used another to rate transactions.

The same announcement described a separate order concerning internal controls in residential mortgage-backed securities ratings surveillance. According to the Commission, S&P changed an assumption to make ratings less conservative and used workarounds that were not fully disclosed to investors. For a ratings or modeling insider, the useful comparison is the published criteria against the assumptions actually used and the record of their approval.

Which Whistleblower Program Fits a CDO Offering?

The Securities and Exchange Commission’s whistleblower program rewards qualifying information that contributes to successful securities enforcement. Eligible SEC whistleblower awards range from 10% to 30% of qualifying monetary sanctions collected, where the qualifying action produces sanctions exceeding $1 million. The Commission brings the enforcement action, and its Office of the Whistleblower administers the award program.

A whistleblower case under the False Claims Act can pay 15% to 30% of what the government recovers. That is a separate program concerning fraud against the government. We work through the fit between your information, the transaction and the relevant whistleblower program with you.

You Know Who Shaped the Deal

If you worked on portfolio selection, structuring, sales or compliance and saw a different transaction from the one investors were shown, speak with our whistleblower experts about that difference. We connect your knowledge to the selection decisions, disclosures and counterparty positions that can make a CDO whistleblower case specific and persuasive. We bring in securities fraud whistleblower lawyers who understand structured offerings, and we stay beside you through the whole case.