Goldman Sachs Hit With Suit Over Student-Loan Auction Securities

Two institutional investors have sued Goldman Sachs Group Inc. for allegedly convincing them to continue buying auction rate securities when the Wall Street firm knew the market for them was collapsing.

Bankruptcy Management Solutions Inc. and Ocwen Financial Corp. claim that Goldman hid a drop in third-party demand for the securities in August 2007 and even began secretly increasing purchases for its own accounts to create and maintain "the illusion of continuing liquidity in the market."

Auction rate securities are long-term interest-bearing instruments that are traded at periodic auctions in which their interest rates are reset and investors can easily liquidate their investments.

According to the complaint, filed in the U.S. District Court for the Southern District of New York, Goldman earned substantial fees as a leading underwriter of auction rate securities backed by government-guaranteed student loans.

The plaintiffs say they bought nearly $3.6 billion in student loan auction rate securities, or SLARS, from Goldman between July 2006 and August 2007. The firm allegedly advised them that SLARS were appropriate securities for their investment portfolios.

In addition Goldman told the plaintiffs that in the event that there were insufficient third-party purchasers for the SLARS, the firm would buy those securities at "par value" for its own account and thereby ensure the liquidity of the investments.

Third-party demand for the SLARS "evaporated" by August 2007, leaving an excess of supply of the securities being offered for sale, the complaint says.

Because SLARS always had been marketed for their purported safety and liquidity, Goldman knew that any disruption in liquidity for the securities "could kill what had been a lucrative market for nearly two decades," the plaintiffs allege.

As a result, they say, Goldman "chose to take action to conceal from investors such as BMS and Ocwen the rapid loss of liquidity from the market by increasing purchases."

Goldman also compounded the problem in October 2007 when it misrepresented to the plaintiffs that SLARS remained AAA-rated and "were as safe as ever," according to the complaint.

"The truth was the exact opposite," the plaintiffs say. "Liquidity was disappearing for the securities, [and] the high interest rates SLARS were paying were caused by Goldman's and other brokers' efforts to artificially inflate returns to induce investors to buy those instruments."

The plaintiffs were able to liquidate a majority of their SLARs over the next several months, but by June 2008 they were still stuck with a combined $236 million in Goldman-brokered SLARS, the suit says.

Going back on its word, Goldman refused to buy any of the SLARS it had sold to BMS and Ocwen unless they agreed to accept a significant discount for the securities, according to the complaint.

Having little choice, the plaintiffs gave in to the new terms and handed Goldman a 5.5 percent discount to par value on nearly $26 million of the SLARS the firm had sold to them.

Because of Goldman's false statements, the plaintiffs also are left holding nearly $210 million in illiquid SLARS that can be sold only at a material discount, according to the suit.

The plaintiffs are seeking unspecified compensatory and punitive damages.

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Eric J. Wallach, Michael M. Fay and Charles M. Miller of Kasowitz, Benson, Torres & Friedman in New York represent the plaintiffs.