Securities regulator Financial Industry Regulatory Authority (FINRA) has ordered Goldman Sachs Group Inc. (GS) to pay $20.6 million to settle claims with the creditors of a failed hedge fund. The creditors claimed that Goldman should have known about its clearing brokerage client, Bayou Hedge Funds’ fraudulent activities in connection with a Ponzi scheme.
The arbitration panel of FINRA held Goldman responsible for the dispute. However, this was the first time that a bank who has acted as the middleman has been accused of and fined for helping a fund that pulled off a Ponzi scheme.
A Ponzi scheme is an investment fraud that involves the payment of purported returns to existing investors from funds contributed by new investors. With little or no legitimate earnings, the schemes require a consistent flow of money from new investors to continue. Ponzi schemes tend to collapse when it becomes difficult to recruit new investors or when a large number of investors ask to cash out.
As a prime broker for the Bayou hedge fund, Goldman had handled all its trading activities between 1999 and 2005. However, the fund collapsed in 2005 when the company’s CEO and CFO admitted to making false statements about the company’s profits and deceiving investors of millions of dollars.
According to the complaint that was filed two years back, Goldman, which cleared the hedge fund’s trades and lent money, had access to both Bayou’s trading records that showed losses and the marketing materials that showed profits. Therefore, Goldman was – or should have been – well aware of the fraudulent activities of Bayou.
The $20.6 million award in fact represents the money that was deposited in Bayou’s accounts held at Goldman between March 2003 and June 2005. This amount is around 8% of the $250 million losses suffered by the investors in the Bayou fraud.
In response, Goldman has claimed that it was unaware of any fraudulent activities of Bayou and was under no obligation to investigate its accountholders as well.
Goldman has been subject to a number of litigations of late. Recently, the company and some of its top officers and directors have been charged with a securities fraud. Goldman has been charged with providing false and misleading facts regarding its business model and the reasons for its accomplishments during December 14, 2006 to June 9, 2010.
Goldman has also been charged by the SEC for misstating facts and selling bad quality subprime investments to its customers in 2006 without disclosing the risk factors including the vital role of Paulson & Co., a prime hedge fund, in the portfolio selection process.
Additionally, the SEC accused the investment bank of creating a collateral debt obligation (CDO) called Abacus 2007-AC1, which comprised mortgage-backed securities.
Following up on its civil fraud litigation against Goldman, the SEC is also planning to probe the investment practices of other industry giants such as Bank of America Corp. (BAC), Citigroup Inc. (C) and JPMorgan Chase & Co. (JPM).
While we believe that Goldman is well-positioned to reap the benefits of its strategic cost-balancing initiatives and attractive business mix, we think that such allegations and charges against the company somewhat dampen investors’ confidence in the stock. Additionally, such fines are not only a blow to the company’s reputation, but also a dent on its financials.
Read the full analyst report on “GS”
Read the full analyst report on “C”
Read the full analyst report on “JPM”
Read the full analyst report on “BAC”
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