THE BLOG
06/22/2010 05:12 am ET | Updated May 25, 2011

John Paulson: Man Behind the Curtain

Allow me to add to the overabundance of analogies contrived to explain the SEC's lawsuit against Goldman Sachs: John Paulson, the hedge fund manager who made a billion dollars from transaction in the suit, is the man behind the curtain at the end of "The Wizard of Oz."

He pulled the levers to set up the allegedly fraudulent Abacus CDO, which Goldman duped their clients into buying. Had the investors, like the German bank IKB, known that the mortgage-backed securities in Abacus were selected by Paulson to crash, so that he could bet against them and cash out when they lost value, they would not have bought that CDO. Now, Goldman Sachs is taking the fall for their prized client, even though Paulson aided and abetted the alleged fraud and profited handsomely at everyone's expense. The SEC left Paulson out of the suit, probably because they have decided on a litigation strategy that focuses on the principal fraudsters first.

A little-noticed bill that is currently before the Senate Judiciary committee, that could be included in the financial regulatory reform percolating in Washington, will allow people who lost money to go behind the curtain and take their money back. Right now, investors who lost money as a result of Paulson's scheme can not sue him for the fraud he orchestrated with Goldman.

Thanks to two recent Supreme Court cases, Central Bank of Denver v. First Interstate Bank of Denver and Stoneridge Investment Partners v. Scientific-Atlanta, victims of fraud cannot hold aiders and abetters of securities fraud liable in court. Only the SEC can go after aiders and abetters, but they have decided not to in this case.

To prove a fraud, investors have to show that the seller of the security--in this case Goldman Sachs--lied, omitted material information, or misled them about a security they bought. Investors have the right to sue issuers of a security to make the issuers responsible for providing accurate information about the products they sell. Think Bernie Madoff, claiming he was investing money, when he was really paying off old investors with new investors' money.

Because Paulson did not market or sell Abacus (in fact he and Goldman obscured his involvement even though he selected most of the securities in the CDO) he cannot be sued by investors to recoup their losses, even though he was the only party to make money from the scheme. To prove the fraud, The SEC will have to show that Goldman misled investors by hiding John Paulson's involvement and intentions in selecting which securities went into Abacus. If they can prove that the investors who bought Abacus would not have bought it had they known how it was created and by whom, they should win the case. Common sense suggests that if IKB knew that Abacus was designed to collapse to enrich a hedge fund manager who had professed his bearish predictions for the housing market, the bank would not have purchased it.

Luckily for future victims of fraud, Sen. Arlen Specter introduced the "Liability for Aiding and Abetting Securities Violations Act of 2009" to make individuals and corporations think twice before helping other companies commit fraud. If aiders and abetters will be on the hook when fraud is discovered, they are much less likely to participate in it, making fraud less common, less harmful, and allowing victims to recoup their losses. Think Bernie Madoff's accountant or the "feeder funds" who either knew of his Ponzi scheme or were willfully blind to it, but still directed clients' money into it.

The third party who helps the fraudster commit the fraud often reaps great rewards for its involvement, and are in a better position to repay defrauded investors, but they are currently beyond the reach of the private civil justice system. In extreme cases, such as Stoneridge, the fraudster will go bankrupt when the fraud is discovered, and investors who lost money are left with no recourse.

The SEC has compelling reasons to limit its lawsuit to the named defendants, such as the appealing storyline of American People vs. Greedy Investment Bank and "Fabulous Fab." While I appreciate the SEC's newfound aggressiveness, the truth remains that they do not do an adequate job enforcing the rights of investors who lose money to corporate fraud. Only defrauded investors have the financial incentive to pursue well-funded fraudsters. When the dust settles and it is time for Abacus investors to recoup their losses, they will be without legal recourse. The man behind the curtain will sit comfortably, and unpunished, free to continue pulling the levers that wrecked the economy. Sen. Specter's amendment should be a timely and necessary addition to deter future frauds and ensure that all schemers must repay what they stole.