ON JULY 29, 2009, JIM Kidney left his townhouse in southwest Washington, DC, got onto the Metro train, and went to work at the SEC. In the summer heat, he felt grateful that he needed to be outside only for about a block during his commute. The agency’s new building, built a few years earlier, was standard General Services Administration: new, clean, and unremarkable. The government had tucked it into a side street, attached like a barnacle to the backside of Union Station.
Kidney went to his orderly office and stood at his custom-made mahogany desk, a gift from his wife. When the agency had moved in, his office overlooked a parking lot. He checked on the progress of the new building now going up there. It wasn’t improving his view. Kidney, a grizzled and experienced trial lawyer, was a good soldier at the SEC. As a litigator, he received cases that the staff developed, then came up with a compelling narrative to present to a jury of laymen unfamiliar with the intricacies of finance. He delivered his arguments in a raspy voice, cutting through jargon and distilling complicated concepts. Epigrammatic phrases spilled out of him. His soft eyes and carefully groomed gray hair gave him the air of a good-natured grandfather, belying his ornery and stubborn disposition.
Then a nineteen-year vet at the agency, Kidney took pride in the SEC, but in recent years, he’d become worried about what was happening at his shop. The regulator had suffered under Chairman Christopher Cox in the late Bush years and was still struggling to recover its reputation. Today he looked at his in-box. His boss asked him to take on a case. Kidney took a look at it and thought, “This could be it.”
After a few months of investigation, the SEC was preparing to take action against Goldman Sachs for wrongdoing in the lead-up to the financial crisis. A top team of SEC staffers, charged with investigating Wall Street fraud, had warned Goldman that it was contemplating charges and preparing memos to put in front of the five-person commission that runs the SEC. The commission must okay every enforcement action. Kidney read the staff’s Wells notice, the legal document the SEC sends to people and entities that it is considering charging with securities violations.
The charges stunned him. Throughout late 2006 and early 2007, Goldman had arranged a complex mortgage deal called Abacus 2007-AC1 for Paulson & Co., the hedge fund run by John Paulson that made about a billion dollars when US housing prices fell. Paulson placed “the big short”—the bet—made famous by the Michael Lewis book of the same name, that the real estate market was an epic bubble that would soon collapse.
Abacus was a collateralized debt obligation made up of derivatives, or side bets, on mortgage securities. Paulson shorted the $1 billion deal, betting that the bonds would crater in value. Paulson’s point man, Paolo Pellegrini, had also essentially picked the bonds that would underpin Abacus. The hedge fund was not only betting on which horses would lose the race but also getting to pick the lame and infirm ones.
Abacus would pay off big if people began defaulting on their mortgages. Goldman was responsible for selling the deal to investors. It marketed the investment to a bank in Germany willing to take the opposite side of the bet—that housing prices would rise or remain stable. Cautious, the bank, Industriekreditbank, or IKB, asked that Goldman hire an independent manager to assemble the deal and look out for the interests of the investors.
Goldman did not tell IKB anything about Paulson’s role in picking the assets. To assuage IKB’s concerns, Goldman chose ACA Financial Guaranty Corp. to act as the independent “portfolio selection agent” for the assets that undergirded the deal. But the financial firm was anything but independent, effectively outsourcing its choices to Paulson & Co. What’s more, the SEC discovered that Goldman had misled ACA about key aspects of the deal.
The day after he was given the case, on July 30, 2009, Kidney emailed Reid Muoio, the SEC official heading up the investigative team, expressing his enthusiasm. “I have been reading online stuff about Paulson,” he wrote. “They are really big fish. If they rigged the cards against Abacus and ACA by picking the portfolio and then betting against it with Goldman’s help, this is a really great case.”1
In scrutinizing Goldman only months after the peak of the 2008 financial crisis, the SEC outpaced all the other regulators. The firm still retained its glittering reputation. Goldman almost certainly would have gone under had the government not bailed out the financial system and injected capital into the investment bank. Its short on the market would not have saved it, though Goldman Sachs would contend otherwise. Goldman was still nicknamed Government Sachs for its ability to stock regulatory agencies and presidential cabinets with its former executives. The US Senate had not yet put executives through embarrassing hearings. Rolling Stone magazine’s Matt Taibbi had not yet written one of the most memorable phrases to emerge from the financial crisis: that Goldman was “a great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money.”2
As excited as he was, Kidney also read the Abacus memos with concern.The agency contemplated charging only Goldman Sachs itself and no individuals. That charge: Goldman omitted material information when selling Abacus. Pretty weak for the allegations, he thought. More worrisome, the investigation seemed incomplete. The SEC staff had not taken testimony from any top executives in Goldman’s mortgage businesses or any top Goldman officials. It had not interviewed the German bank, the supposed victim. More bizarre still, the SEC hadn’t even taken John Paulson’s testimony. The SEC could not know if it was charging the right people with the right securities law violations, Kidney felt. The agency conducted much more extensive investigations in small-time insider trading cases. Recently, he had tried a case where the last guy charged was a fifth-level “tippee”—that is, the guy who got a tip from a guy who got a tip from a guy who got a tip from a guy who got a tip from the guy with the information. The whole lot of them had reaped only $1 million in ill-gotten gains, yet the agency brought out the B-52 bombers.
Here was one of its first and biggest investigations of the financial crisis, and it was against the marquee bank on Wall Street. Over the next nine months, Kidney would wage a battle within the SEC, making the same accusations internally that wouldn’t emerge in public until much later. Kidney came to believe that the big banks had captured his beloved regulator—that it went after only minor actors and was cautious to the point of cowardice.
On August 14, a little more than two weeks after having started on the Goldman case, Kidney sent a memo to lead investigator Muoio’s team. His group was readying an enforcement action memorandum to send to the commissioners, who vote on every enforcement action. Action memos lay out the staff’s case to the commission: what the SEC’s findings are, who the agency is prepared to sue, and sometimes why it is not suing others. Within the bureaucracy of the agency, they assume elevated importance. Sometimes the staff writes forty or fifty drafts of such memos. Often the commission sends them back with comments. The staff toils on its replies and returns them. Then the commission votes.
Kidney tried to get Muoio’s team to hold back on sending the action memo until it had done more on the probe. He suggested charges for individuals, including the Paulson & Co. executive who spearheaded the deal, Paolo Pellegrini, and a low-level Goldman banker named Fabrice Tourre. He called for more investigation of other Goldman bankers. He said the SEC should allege “scheme liability” for the fraudulent conduct and aiding and abetting. Charging them with scheme liability was a bold idea. Kidney thought the agency should argue that Paulson and Goldman had entered into an illegal “scheme”: a conspiracy to build a product to fail, which had then been sold to unwitting buyers. Instead, the SEC picked the narrowest charge it could find: that Goldman had omitted material information. Kidney thought the charge was not only weak but also didn’t depict what had happened. To him, it felt false.
Kidney had been thinking for a while that the SEC neglected to go after big targets. Here it was happening again. During his career, Kidney had never lost a trial. In 1989 he’d handled the agency’s first trial of an insider trader that went before a jury. He’d won a case against KPMG accountants who had enabled Xerox to violate accounting rules. His bosses had framed some cheesy news clippings from his various victories. He’d put them up on the walls of his office. In 2001 he won the agency’s Irving M. Pollack Award, named after the first head of enforcement at the agency and Stanley Sporkin’s mentor, for his dedication to public service. He shrugged off his record, however, as the SEC didn’t bring that many cases to trial. “I don’t want to make too much of that because you settle a lot and have to know when to fold ’em,” he says.
A native Washingtonian, born on the same day as Hillary Clinton, Kidney joined the SEC in 1986. He was already thirty-nine. He’d started out as a reporter. His father had also been a reporter. He had worked for the United Press International wire service, where he covered the Supreme Court. Kidney joked that he became a lawyer because the hard-drinking life of a reporter might lead to an early death. In reality, he thought it would make him a better legal reporter. And he wanted to take advantage of the GI Bill. His draft number had come up early—007—and he enlisted in December 1969, at the height of the Vietnam War. He served—“heroically,” he’d say—in Kansas City, Missouri, at the Army Hometown News Service, mostly writing captions for photographs.
Once, Kidney left for a nongovernment job, but after four years, he returned to the agency. Kidney’s mother had instilled in him a pride in civil service. She had been a pioneer who had risen to become a commissioner at the US Bureau of Labor Statistics at a time when few women had such prominent roles. Public service was worth the inevitable financial sacrifices, she taught him. When Kidney arrived at the SEC in the mid-1980s, the “steam was elevated” at the place, he says. Young lawyers were told to go after impressive cases, and they did in those early years: junk bond king Michael Milken, insider trader Ivan Boesky, investment banker Martin Siegel. But the place changed over the decades, as the SEC recruited more lawyers from big firms such as WilmerHale and from Wall Street banks.
The unspeakable marked James Kidney. More than a decade before the Abacus case had begun, he and his wife suspected that their young son was suffering from depression. But they could not get the attention of the multiple professionals they approached about him. One night in late October 2000, their son hung himself. He was twelve years old. Kidney wrote later that their faith in those professionals was “horribly misplaced.”
Kidney went to work only days after the tragedy but remained in a fog that did not lift for months. Later, he started a website for parents of depressed children, where he posted a quote from Philip Roth’s novel American Pastoral. It held terrible resonance:
He had learned the worst lesson that life can teach—that it makes no sense. And when that happens the happiness is never spontaneous again. It is artificial and, even then, bought at the price of an obstinate estrangement from oneself and one’s history . . . Stoically he suppresses his horror. He learns to live behind a mask. A lifetime experiment in endurance. A performance over a ruin.
Though scarring, the event did not, Kidney felt, change his approach to work. Kidney never wanted a promotion. He liked being a litigation jockey. Perhaps it amplified his central professional trait: a kind of reverse ambition. He did not need approval from his bosses. He did not put his trust in their judgment. He did not yearn for prestige. He wanted to remain able to say what he thought. And he wanted to do his job.
• • •
After getting the Abacus case, Kidney pressed the team to take what he thought were obvious investigative steps. A staff attorney in the group informed him that Muoio had vetoed the idea of calling John Paulson to testify. They hadn’t even subpoenaed his emails yet. What could they be thinking? The SEC should interview him and the head of the group that Tourre was in, Jonathan Egol, yesterday. How could they know what happened, and who knew what and when? It turned out that the SEC was making little use of its subpoena power for the investigation—a sign of how gingerly the agency treated major investigative targets.
Muoio did not agree with Kidney. He wrote in an email, “I continue to have serious reservations about charging Paulson on our facts. And I worry that doing so could severely undermine and delay our solid case against Goldman. That said, I am committed to reconsidering the issue.” Muoio was a low-key but bright SEC veteran who was serving as the deputy chief of the structured products unit. He’d been at the agency about a decade, having worked in private practice and graduated from Yale Law School.
Another attorney in the group, however, came to Kidney’s defense: “Our theory of the case, as I understand it, is that Paulson and Goldman conspired to structure a transaction that was meant to rip off their ultimate counterparties, in this case [German bank] IKB. In other words, the case is more about stealing than about lying,” underlining the words for emphasis. He went on: “It would be more than a little odd for the complaint not to name the primary architect and beneficiary of the scam. Not only odd, but it would undermine our case before the jury . . . And if we are going to argue that the case is about stealing, the jury is going to wonder why the hell Paulson isn’t there.”
Pleased to find an ally, Kidney seconded him: “If this is not scheme liability, I don’t know what might be in a securities context. In any event, we should bring cases like this that challenge status quo thinking. We should do it on very strong facts. We have all that here, though I don’t think it is much of a stretch legally.”
The following week, Kidney emailed his boss Lou Mejia to voice his concerns in the event that the Goldman case came up while he was on vacation. “I am getting the sense that there is a desire to fast track a complaint against Goldman, presumably to show we are after these deals with synthetic swaps, CDOs, and other crap,” he wrote. “This appears to be an unbelievable fraud. I don’t think we should bring it without naming all those we believe to be liable.”
As the weeks went by, Kidney and the staff traded damning bits of evidence and debated expanding the investigation and the charges. On September 14, 2009, a staff attorney referred to a 2007 Goldman email that circulated to the entire mortgage desk, in which a Goldman mortgage securities executive praised Paulson’s work: “I would also note that paulson [sic] did a great job with the names they selected.” Williams understood that Paulson & Co. had expertly picked dogs that made the hedge fund money. Abacus had been completed and sold to investors in early 2007. Less than a year later, the ratings agencies were downgrading the underlying bonds, turning Paulson’s investment into a winner. The email confirmed further that Paulson, and not the selection agent, ACA, had driven the choices of what went into Abacus and that many Goldman executives knew what was going on. Kidney wanted to know: How many people at Goldman understood how Abacus had worked? The SEC had no idea.
The commission decided at last to charge an individual in the Abacus matter: Fabrice Tourre. They had a cornucopia of imprudent material from Tourre, a French citizen who lived in London and who was in his late twenties when the deal was created. Tourre had joked about selling the doomed deal to “widows and orphans.” On January 23, 2007, he sent what would become an infamous email:
More and more leverage in the system, the entire system is about to crumble any moment . . . the only potential survivor the fabulous Fab . . . standing in the middle of all these complex, highly levered, exotic trades he created without necessarily understanding all the implications of those monstruosities !!! [sic]
Tourre had not been in charge. 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.
On September 16, 2009, Kidney sent an email to the group with the subject line “splainin to do”: “I think we will need to explain to the Commission why we are or are not recommending an action against” other Goldman executives.
An SEC staff lawyer responded: “Egol and Lehman were there, but not actively pushing the deal, from my perspective.”
Kidney replied: Tourre “could not do it without their approval, however. It’s always the lowest guy’s deal when it comes to litigation.”
Muoio, the investigation’s leader, was implacable. On the morning of Saturday, September 19, 2009, Muoio sent a congratulatory email about the investigation, but with a note of caution. He had reviewed their work to make sure they had gotten the right guy:
Ten years into this, I have 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.
The email agitated Kidney. How did Muoio know they had done only one bad thing? Could he look into their souls to know whether they were decent folk or not? He stewed. Kidney waited out the weekend. He went to work on Monday and managed to hold off for hours before responding. Then, trying to keep a measured tone, he wrote:
I think we should talk about a couple of the others. 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. But I’m not at all convinced that Tourre alone is sufficient here.
Then Kidney sent an alarmed email to his boss: “This is sort of the problem in a nutshell.” Was this the right mind-set for a regulator? Street criminals were hardly afforded such assumptions about their character. Since the agency was in the middle of a bunch of investigations of the CDO business and multiple Goldman deals, maybe this incident wasn’t just one bad occurrence but something much worse: systemic fraud on Wall Street.
Mejia backed his subordinate and encouraged him. “If you want me to escalate, let me know. Commission is going to have a lot of questions if this goes up without individuals,” he wrote to Kidney on September 25.
In a meeting with the group to discuss taking the testimony of Tourre’s superior Jonathan Egol, Muoio said, “We know what he is going to say: he was too busy to pay attention.” Kidney went ballistic: “That’s a cardinal sin in an investigation! You can’t assume what somebody will say!”
The staff sought direct evidence, as it had against Tourre. The SEC wanted something incriminating that John Paulson, Paolo Pellegrini, or Goldman Sachs executives had written down somewhere—and embarrassing emails such as “Fab”’s would be a bonus. But high-level Goldman executives were savvy about communications. When topics broached sensitive territory in emails, they would often write “LDL”: let’s discuss live.
Kidney emailed Mejia with resignation:
There is no way that the staff will go along with suing Paulson or anyone at Paulson & Co. unless his emails [contain] admissions about scheming to defraud which are wholly unrealistice [sic] to expect. Theis [sic] staff wants an extraordinary amount of direct evidence before bringing any claim against anyone, and are very satisfied to just sue Goldman.
The lack of direct evidence did not bother Kidney. The SEC could rely on inferences the buyers made. In its defense, Goldman was going to argue that sophisticated investors stood on the other side of Paulson. Kidney explained the SEC could flip that argument to its advantage. Because of its relative sophistication, ACA assumed Paulson was investing in the deal, not against it. IKB assumed ACA would act in its interest. Yes, IKB could see the portfolio of bonds that made up Abacus, but the bank didn’t know anything about the origin or the construction process. The SEC uncovered evidence that IKB discussed needing a selection agent like ACA on the deal to act in its interest. The German bank told Goldman it would decline to invest in the deal otherwise. Had it understood that Paulson and Goldman had suborned ACA, as it did later, it would not have put in the money. In other words, the information was material.
Kidney continued to believe Goldman and the hedge fund had entered into a conspiracy. On October 21 his boss emailed him, “I back the theory” of scheme liability and wrote that he “share[d your] concerns” about the lack of charges for more individuals. But Kidney’s argument to bring a scheme liability charge was getting nowhere. Muoio cited bad legal precedent. The major setback to scheme liability law had come in the Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc. case in 2008. The Supreme Court ruled that private investors could not sue a secondary participant in a fraud scheme, unless that participant had made misleading statements directly to the plaintiff.
Stoneridge was the most important securities fraud ruling in years. The case involved two large companies: the cable giant Charter Communications and Motorola. Charter, worried about meeting its earnings estimates, came up with a way to inflate revenue and earnings. The company bought cable set-top boxes from Scientific-Atlanta for a low price—say, $25 a box. The cable company went to its vendors and told them it would be willing now to pay, say, $50 a box. In exchange, the vendors would pay $25 back to Charter in advertising revenue. Charter could increase its advertising revenue but had no corresponding cost. Eventually the market realized what had happened, and the stock crashed.
A hedge fund investor in Scientific-Atlanta, called Stoneridge Investment Partners, sued the company, saying it had entered into a scheme with Charter to defraud the public. (When the companies came up with this transaction, Charter backdated documents to make it appear as if these were two unrelated transactions, for the purchase of set-top boxes and a separate advertising buy, to avoid detection by the auditors.) A majority of Supreme Court justices took the position that Scientific-Atlantic and other vendors were not responsible for what Charter told its investors.
Through the 2000s and into the 2010s, as courts ruled against the Justice Department and the SEC in corporate and securities fraud cases, the government responded inadequately. The government did not retry Kathy Ruemmler’s Enron case against Merrill bankers. Lanny Breuer and the Obama Justice Department did not seek to restore the honest-services charge. Remarkably, the Justice Department and former SEC commissioners went one step further in the Stoneridge case. They helped the Supreme Court reach its conclusion. The Justice Department and fourteen commissioners of the SEC wrote briefs in support of Charter. Both briefs argued against allowing private actors to hold parties such as the vendors in the case liable. The Bush-era Justice Department, reflecting the conservative hostility to such lawsuits, wrote in its brief: “[P]rivate securities actions can be abused in ways that impose substantial costs on companies that have fully complied with the applicable laws.”
The Supreme Court did not prevent the SEC or the Department of Justice from bringing such suits. But the ruling hurt the enforcers nonetheless. By 2009, as the SEC considered bringing charges against Goldman over Abacus, the Supreme Court ruling, which the agency helped nudge to fruition, now constrained the enforcement lawyers. They worried they could not win a scheme liability case.
Muoio, by now, appeared exasperated. He found Kidney unsophisticated and wasn’t impressed with his record. Undefeated at trial? Sure, but that was for chickenfeed matters. Muoio didn’t display his emotions, but he’d put up his record against Kidney’s any day. Muoio specialized in what the agency considered the big blockbuster cases against the major banks and he thought his judgment had proven spot on. That they were settlements—no-admit, no-deny ones, at that—didn’t matter. Muoio counted them as wins nonetheless.
Debating Abacus, Muoio would explain to Kidney, “It’s just a trade!” The general Wall Street attitude about transactions such as Abacus was that there were buyers and sellers, making a trade. Buyers didn’t know why sellers were offloading, and neither had any obligation to explain their reasoning. Nor did the investment bank facilitating the transactions. Muoio told Kidney he was concerned about “being laughed at” on Wall Street if the SEC charged Paulson, because it would look naïve about trading.
But Abacus was nothing like buying or selling stock. Goldman arranged the deal, acting more like an underwriter. The entire transaction was predicated on keeping Paulson’s role and aims quiet. If the buyer had known the true circumstances, it would not have bought the CDO. Kidney felt that Goldman executives didn’t need to say these sentiments out loud or write them in an email. It was all understood. Goldman and Paulson had teamed up to make something designed to fail. Kidney posted a slogan at his desk, to help him simplify and encapsulate the deal: “Satisfy the long and sell to the short is legal. . . . Satisfy the short and sell to the long is fraud.”
For its part, Paulson & Co. and Goldman said there was never any “scheme.” And they said Abacus was never “designed to fail.” Paulson & Co. maintained throughout the investigation and afterward that ACA was free to reject its suggestions and said that it never misled anyone in the deal. The hedge fund did not instruct Goldman what to disclose to investors and said it did not know what the bank was telling investors. The investment bank argued that the precipitous collapse in the value of Abacus resulted from the broad decline in the housing market that afflicted all securities related to real estate, not because of flaws in the product.
On October 21 Kidney circulated a long memo arguing that the SEC should consider charging Paulson & Co.; John Paulson himself; the employee responsible for the deal, Pellegrini; and Goldman’s Egol:
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. An important part of the scheme was, of course, not to inform investors the product was designed to fail and, further, to lull them into confidence about the offering by promoting the participation of a supposed independent entity to select the underlying assets which dictated the performance of the offering. This was intentionally done to disguise the participation and veto authority of Paulson & Co. in selecting the assets. In other words, the current and possibly additional evidence suggests they should be sued for securities fraud because they are liable for securities fraud.
Kidney argued to the SEC that under Section 10(b) of the Exchange Act, it is unlawful “to employ any device, scheme, or artifice to defraud” and “to engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person.” Kidney premised the case on a simple notion: “Paulson and Goldman created and offered a deceptive product. It was in connection with the purchase and sale of a security. Nothing more is required to find them liable for a deceptive scheme.”
If the SEC pressed the case and won, the agency could widen the securities law in its favor. The current SEC case fell, Kidney conceded, “within accepted legal maxims,” he wrote. But he argued for ambition.
By the fall of 2009, Kidney was furious with the staff, and the staff seemed fairly well fed up with him. After Kidney wrote an insulting email about Muoio—and then inadvertently fired it off to Muoio himself—he apologized and tried to explain why he was so passionate: he loved the SEC and worried about the institution where he’d spent his career, referring, as SEC lawyers do, to the commission as their “client.”
“The damage to the reputation of the client in the last few years and the decline of the institution are very troubling to me,” he told Muoio.
Kidney saw the chance to rehabilitate that reputation slipping away. He started to get aggressive. No one could mistake Kidney for having bureaucratic acumen. On November 6 he did something audacious: he sent an email to Robert Khuzami, the director of enforcement at the SEC. Before taking this role, Khuzami had been the general counsel of the American division of Deutsche Bank, the major German bank. Deutsche Bank had a vast structured finance business and had been neck-deep in the CDO business. Since Paulson had shopped his idea to Deutsche Bank as well as to Goldman, Kidney suggested that Khuzami think about recusing himself. He conceded that his boss had warned him off making this entreaty, writing that Mejia had told him “it should be not mentioned and that you would know whether to recuse yourself.”
But Kidney explained, “There may be debate” after the SEC charges Goldman about whether the charge was right and sufficient. “Given all our recent problems,” he wrote, the SEC doesn’t want critics claiming it had a conflict of interest, especially since it wasn’t going to sue Paulson.
Khuzami was politely dismissive. He said he would forward the concern to the proper channels but replied, “Can’t say I see a basis for recusal under the recusal principles as I know them.” The ethics czars at the agency agreed. Khuzami stayed involved with the case.
• • •
Frustrated by the overarching theory of the case, Kidney pressed another issue: charging more individuals. He argued the SEC should charge Jonathan Egol, Tourre’s superior. “He was on most of the most incriminating emails, was Tourre’s boss, and is more prominent in structured finance circles than Tourre,” Kidney wrote. Tourre was just a piker, he explained. A small-time gambler.
Kidney laid out the evidence: Egol created the first Abacus structure and had been one of two lead Goldman representatives on two earlier Abacus trades involving a hedge fund called Magnetar Capital and Deutsche Bank as the shorts. Egol knew Paulson was investing in Abacus and that Paulson was shorting the market. Egol reviewed all of the materials that had been prepared to create and sell the deal, including the three key documents the SEC was relying on to make its false-statement-and-misrepresentation case.
When he couldn’t persuade Muoio and his team, Kidney tried to take himself off the case. He emailed a deputy to chairwoman Mary Schapiro, explaining that he had withdrawn as litigation counsel. “Maybe I have lost professional distance somehow (though in my heart, I don’t think so),” he despaired. “In good conscience, I cannot put my name on the current draft being circulated.” The complaint “is woefully inadequate. My fear is that the Commission will lose the chance to show it is a tough regulator worthy of public trust and instead look like chumps.”
Mejia told Kidney that Khuzami wanted him to stay on the case. So he relented. He had prevailed on the Egol interview, so the staff postponed its meeting with the commissioners to get their approval for the enforcement action until after it had the Goldman executive’s testimony. The SEC still hadn’t interviewed the primary victim: the German bank Industriekreditbank. A top official forced a reluctant Muoio to fly to Germany to interview IKB officials. They ended up saying they had no idea how the deal had come about or the extent of Paulson’s involvement. But for reasons that were never clear to the SEC, the German bank refused to send someone to the States to testify. That hurt the case.
As 2009 ended, Muoio not only resisted Kidney’s view but almost seemed like he was making Wall Street’s case rather than the SEC’s. On December 30 he wrote another congratulatory email to his team: “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.”
Muoio’s note echoed bankers’ favored explanation of the crisis. Wall Street had captured Kidney’s agency. Enforcement officials are not required to figure out causes of crises. They are responsible for enforcing against fraudulent activity. If Muoio meant his message just for Kidney, well, Kidney wasn’t making a sweeping argument about the losses from the financial crisis. He was making a narrower point: on a deal the SEC did believe was fraudulent, more than the lowest drudge at Goldman might be guilty. Kidney emailed a warning to a top SEC official: “We must be on guard against any risk that we adopt the thinking of . . . Wall Street Elders.”
Kidney and Muoio dueled into January 2010. One SEC staffer wrote that they had testimony but little documentary evidence that Egol reviewed the Abacus documents. “The law surely imposes liability on others besides the literal scrivenor [sic], or we are in big trouble. How did we get Mike Milken?” Kidney lamented 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?”
Muoio fired back,
I am sure you are not suggesting we charge Egol because of his position within the company, as we have previously discussed with you our concerns with that approach to our charging decisions. 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.
The staff interviewed Egol later in January. Muoio would eventually tell the SEC inspector general, “We didn’t lay a glove on him.” But Kidney felt differently: Egol had confirmed he had reviewed all the documents that the SEC contended were misleading. That made Egol responsible, he believed.
The SEC readied its complaint against Goldman and Tourre. Kidney found it constipated and filled with financial arcana. Wall Street used complexity as a cover, and the SEC had fallen victim. He tried to offer edits. “Unless the complaint is intended for an audience of CDO brokers, I think the opening is way too full of jargon and will be incomprehensible to most people. This is more than a cosmetic or publicity issue. Goldman’s defense will rely heavily on making this sound like a really complex deal. This complaint plays right into that,” he wrote.
Finally, Kidney got help. A top official in the SEC’s litigation department wrote a memo enumerating the evidence against Egol and explaining the state of the law. The official concluded, “Given Egol’s participation in the preparation of the offering materials, outlined above, it might behoove us to consider whether we should recommend a charge of primary liability and allege aiding and abetting in the alternative.”
On January 29, 2010, after months of investigation and debate, the SEC sent a Wells notice to Jonathan Egol. His attorneys started their negotiations by attacking the long delay, asking for more time. On February 2 the lawyer responded, “This investigation began in the late summer of 2008, and the formal order was issued in February 2009. Mr. Egol’s involvement . . . was perfectly obvious from the beginning, yet the staff did not even ask for his testimony until November 2009, over a year after the beginning of the investigation. After Mr. Egol testified on January 4, 2010, it took the staff three weeks, until January 28, to decide that it was considering an action against him, and until January 29 to provide us with a Wells call.”
Muoio took a tough line at first. Three days later, Egol’s lawyer took his complaints to senior SEC officials. Two weeks after that, on February 19, a sheepish Muoio backed down. The agency agreed to extend the deadline. When Egol’s lawyers did respond, they disputed everything the SEC contended: the deal was not fraudulent, and, at any rate, Egol had little responsibility for it. The attorneys argued that the offering hadn’t been misleading in the first place; that Egol himself did not make any misleading statements to anyone; and—in what they thought was a killing blow—that not only had Goldman not shorted Abacus, but also it had kept a piece and lost money on the deal. The last point did not persuade the SEC. Goldman never had plans to buy a piece of Abacus. It simply wasn’t able to unload all of it.
The Egol response underscored to Kidney the error of the SEC’s narrow approach. The agency could avoid battling over the minutiae of Egol’s specific role if it charged them all with a scheme.
Reid Muoio hadn’t seen the point in interviewing Egol in the first place, and now he believed that Egol’s lawyers had the better argument. On March 8 he made the case against charging Egol. He wrote that Egol did not know that Tourre misled ACA, did not communicate directly with the buyers or ACA, and had only one conversation with Paulson. He contended that Egol did not “approve” the transaction. That was done by Goldman’s Mortgage Capital Committee. The marketing materials had been approved not by Egol but by the legal and compliance departments. Egol was not even Tourre’s supervisor, nor did he suggest to anyone that Paulson’s role in the transaction be concealed. Muoio wrote: “I put our chances of surviving a motion to dismiss at 25 percent. Odds of winning at trial drop to 10 percent for a variety of reasons, including, among other things, the quality and experience of defense counsel and my expectation that Egol will strike most jurors as a nice, likable, down-to-earth family man.”
If the Mortgage Committee had approved it, maybe the SEC needed to be charging more than Egol, Kidney thought. Here was Chickenshit Club thinking. Stubborn and pissed off, Kidney forwarded on a sardonic reply to a colleague: “I guess Reid is relying on his deep experience as a staff attorney and gofer at a big NY law firm for his estimate of surviving a motion to dismiss. I will forbear from crystal ball gazing.”
On March 22 the team assembled in Khuzami’s office for an afternoon meeting. Kidney and two others, including the deputy director of enforcement, voted in favor of suing Egol. Muoio remained 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, but in the end, the record does not for me reflect the necessary level of comfort that he knowingly provided substantial assistance in this violation to warrant proceeding against him. I am not substituting my judgment for that of judge or jury, but applying my view of our obligations as an enforcement authority as to what we need to see before we should file a case. The lack of consensus among our group is itself, for me, confirmation of this conclusion. There are lots of other secondary considerations, some for and some against, but in the end, the fundamental principle has to be whether in my heart of heats [sic], he meets this standard. For me, he does not.
The case against Tourre and Goldman is a good case and an important one to bring. The decision on Egol does not change that.
Kidney had lost. The top officials offered him the job of handling the experts during the trial but he knew what that meant. He’d been demoted. He declined.
On Friday, April 16, 2010, the SEC stunned the markets by suing Goldman Sachs, charging the firm with omitting information that would have been crucial to investors in Abacus. The agency brought a charge against Tourre as well. They were the first against firms that capitalized on the housing bubble and its collapse. Goldman’s stock dropped 13 percent that day, erasing $10 billion from its market capitalization.3
For the SEC, the tactic was tough. It rarely sued and mostly settled. But it wasn’t tough enough for Kidney. As he had feared, the public reception to the suit was mixed, at best. The tabloid New York Post accurately headlined its story about Tourre “Goldman Fall Guy.”4
“Sadly, it will not suffice to offer up Fabrice Tourre as a ritual sacrifice,” Michael Lewis, the author of The Big Short and a columnist for Bloomberg, wrote several days after the SEC announced its complaint. “No one is going to accept a then twenty-seven-year-old Frenchman, whose job was apparently to keep sweet the patsies on the other end of your trades, as the world’s authority on your trading positions. His name isn’t even on the top of the list of Goldman traders on the $2 billion Abacus deal for which you are being sued. The name on top of that document is ‘Jonathan Egol.’ ” Lewis concluded, “The public eventually will ask: Who is Jonathan Egol and what exactly was his game?”5
Kidney had been right.
• • •
On April 27, 2010, Senator Carl Levin’s Permanent Subcommittee on Investigations (PSI) held hearings on the role that investment banks played in the financial crisis. One of its reports examined Goldman’s CDO business and found that the bank had deceived and taken advantage of its customers. Relieved that the firm had managed to offload it to some credulous buyers, a top Goldman executive referred to a CDO as “one shitty deal.” On one occasion, Goldman had marked, or recorded, slices of a CDO at one low price and sold those same slices the same day for much higher prices. Lloyd Blankfein, Goldman’s CEO, testified before the PSI. Levin and the investigators believed that he had misled Congress. The committee referred its report to the Department of Justice for criminal investigation into Goldman’s CDO business and its representations to Congress.
Blankfein hired star defense attorney Reid Weingarten. One of Eric Holder’s close friends, Weingarten thought the case was bullshit and going nowhere. When Goldman’s board of directors wondered if it should cut Blankfein loose, Weingarten argued that it should not. He guaranteed that the CEO would not be indicted. The board did not need much convincing to heed Weingarten’s advice. The Department of Justice didn’t seem active. The Southern District of New York had done a cursory investigation of some Goldman CDOs. The investigation didn’t seem hot at all.
Now the head of Main Justice’s criminal division, Lanny Breuer, reopened the matter. He did not give the investigation to the fraud section. Instead, Breuer assigned one of his staffers, Dan Suleiman, to review the evidence. Suleiman was a member of the Breu Crew, who, like the others, had been a young associate at Covington. And, like several of the others, Suleiman had no prosecutorial experience. Weingarten and Lanny Breuer were acquaintances. Both had children at Georgetown Day School, a posh private school in the capital. Weingarten had a series of conversations with Breuer about the case. He would call up periodically to wheedle and bellow, “Close this fucking case, will ya?”
The Justice Department found nothing criminal in Goldman’s actions. In July 2013 Suleiman rejoined Covington. Lanny Breuer’s staffers had boosted their résumés with government experience and now revolved back into the private sector. On August 9, 2012, the department put out an unusual statement, clearing Goldman in the Abacus case.
Abacus was a fulcrum point. Had the government taken a different tack, enforcement following the financial crisis might have looked different. If Kidney had prevailed, the SEC would have brought fraud charges against numerous individuals as well as Goldman and Paulson & Co. With the major regulator bringing such fraud charges, the Department of Justice might have found it easier to make a criminal case in Abacus. The Abacus case might have provided a framework for other SEC civil charges against individuals and Justice Department criminal cases.
Instead, the SEC stumbled. The Abacus case illustrates how debilitated the government’s investigative skills had become by 2009. Like Gresham’s law, where copper coins drive more valuable gold coins out of circulation, the agency’s focus on corporate accountability (an obsession shared by the Justice Department) drove out the good investigations of individuals. The two kinds of investigations should have aided each other but didn’t. The investigators who were skilled and motivated to go after the human beings behind corporate bad actions suffered. To the SEC staff’s mind, bringing charges against Goldman and Goldman alone was fine.
Publicly, Goldman expressed outrage and innocence about the PSI’s and the SEC’s allegations. But the pressure forced the firm to the negotiating table. Three days after the SEC sued, on April 19, Khuzami sent around a note: “Settlement possibilities have been raised; pls come prepared to think about terms. RK.” There would be no trial. A couple of months later, on July 15, 2010, the SEC settled with Goldman for what appeared to be a sizable fine of $550 million. Goldman Sachs did not admit any wrongdoing. The SEC wrung an apology out of the bank, which it perceived as a victory. Critics perceived it as comically inadequate. The bank issued a statement:
Goldman acknowledges that the marketing materials for the Abacus 2007-AC1 transaction contained incomplete information. In particular, it was a mistake for the Goldman marketing materials to state that the reference portfolio was “selected by” ACA Management LLC without disclosing the role of Paulson & Co. Inc. in the portfolio selection process and that Paulson’s economic interests were adverse to CDO investors. Goldman regrets that the marketing materials did not contain that disclosure.6
Where had the SEC gone wrong? The staff was blinkered. It failed to understand Goldman’s overall mortgage and CDOs business. Senator Levin’s committee, by contrast, did take a sweeping view. It uncovered the entirety of the bank’s mortgage views and business. The PSI found that in late 2006, Goldman’s top executives worried that the American housing market and mortgage securities, including CDOs, would crash. The firm pivoted to short the market, selling as much as it could. The PSI found numerous dodgy deals, but the SEC did not fully grasp this context as it analyzed the Abacus deal. The SEC staff hadn’t interviewed enough people at the bank. The staff, except for Kidney, was staring too hard at the Abacus documents.
Not only did the Abacus investigation suffer, but so did the other SEC investigations into Goldman CDOs. Goldman understood that if it settled Abacus, the SEC wouldn’t bring any more cases. The SEC appears to have wrapped up all of the settlements into one. The SEC never brought any other charges against the firm over CDOs. A $550 million payout for one CDO was a lot, dwarfing the bank’s fees on the deal. But if it implicitly covered all of its mortgage securities transgressions, the fine was much smaller as a percentage of its overall revenue and profits that the business had generated during the bubble.
Kidney, meanwhile, was disillusioned. In late 2013 his wife went into the hospital for routine hip replacement surgery. Having suffered continuous health problems since their son’s suicide, she acquired an infection and spent six weeks on life support before dying. She was two months shy of her sixty-ninth birthday. Six months later, Kidney decided he didn’t need to struggle with the bureaucracy anymore. He retired. At his retirement, in 2014, he gave an impassioned going-away speech: “It is no surprise that we lose our best and brightest as they see no place to go in the agency and eventually decide they are just going to get their own ticket to a law firm or corporate job punched. They see an agency that polices the broken windows on the street level and rarely goes to the penthouse floors,” he said. “For the powerful, we are at most a tollbooth on the bankster turnpike. We are a cost, not a serious expense.”
The speech leaked, and Kidney had a moment of media attention. He went on National Public Radio and Bloomberg Television. Then nothing happened.
After he left, he toyed with going public with his story but felt torn out of loyalty to the SEC. He penned a long, anonymous letter to the New York Times and sent it. No one seemed to receive it. (He’d sent it to an old address.) He wondered if anyone cared anymore. Kidney reflected on what had gone wrong at the SEC and with securities law enforcement. The oft-cited explanations—campaign contributions and the allure of private sector jobs to low-paid government lawyers—played a role. But to Kidney, the driving force was something subtler. Over the course of three decades, the public and the civil servants working in the agency lost belief in the good that comes from enforcement and regulation. Regulatory capture was a psychological process. Officials become timorous in the face of criticism from their bosses, Congress, and the industry the agency is supposed to oversee. Regulators don’t pursue leads. Prosecutors don’t open cases. The enforcers never make Wall Street executives explain their actions.
In 2013 the SEC took Tourre to trial and won.7 By that point, the view that the government had gone soft on financial crisis crimes had crystallized, and the victory did nothing to dispel it. Tourre was found liable and ordered to pay more than $850,000. He went on to become a PhD candidate at the University of Chicago. In early 2016 the Justice Department settled a case with Goldman, charging that the bank had misrepresented mortgage-backed securities (investments that differed from CDOs). The bank had to pay a headline figure of $5 billion, though various sweeteners in the settlement meant that Goldman would pay far less. The Justice Department did not charge any individuals.
“I was a believer in the SEC. A subpoena from the SEC meant something when I started,” Kidney says. “I still believed [in] it until I saw how this case and the subsequent cases were handled.” But, he adds, “The answers to unasked questions are now lost to history as well as to law enforcement. It is a shame.”