* Settlement talks between Basis fund and Goldman heat up
* Basis claims it was misled on Timberwolf CDO
* Basis invested in deal in June 2007 (Attention language in paragraphs 19-20 that may offend some readers)
NEW YORK, May 18 (Reuters) - An Australian hedge fund's former independent director has been complaining to U.S. regulators for more than two years about how Goldman Sachs Group contributed to the fund's collapse by selling it a toxic mortgage-linked security.
Now, in the wake of a recent U.S. Senate hearing on Goldman's role in the U.S. mortgage mess, during which the security -- called Timberwolf -- was repeatedly singled out by lawmakers as a particularly egregious transaction, David Mapley said he's finally getting a measure of satisfaction.
But Mapley, a former independent director for the Basis Yield Alpha Fund, said what he really wants is for Goldman to give back the $100 million the Basis Capital fund and its investors sank into the Timberwolf collateralized debt obligation.
There are signs the persistence of Mapley and others connected to the defunct Australian hedge fund may be about to pay off.
A Washington, D.C., law firm that represents the Basis fund is negotiating with Goldman over a possible settlement to the hedge fund's $100 million claim, people familiar with the situation said.
The fund's representatives initially hired Washington's Baach Robinson & Lewis more than a year ago to look into suing Goldman over the Timberwolf deal. The law firm did work on a draft complaint, but a lawsuit was never filed for reasons that remain unclear.
'BEYOND THE NORM'
Mapley, who resides in Switzerland but also has homes in the Cayman Islands and the United States, said he met with lawyers from Baach Robinson when he was still serving as one of the fund's independent directors and urged them to sue Goldman.
He stepped down from the fund's board last summer and hasn't been involved in any settlement talks with the investment bank.
"We found this aggressive behavior by Goldman," said Mapley, who still serves an independent director for a number of other offshore hedge funds. "We started uncovering certain practices that were beyond the norm."
The Basis fund's main contention is that the fund's managers were misled by Goldman when it purchased two $50 million tranches of Timberwolf, a $1 billion CDO that Goldman took to market in March 2007, according to Mapley and other people familiar with the situation.
The Basis fund sank money into Timberwolf in June 2007, after the one-time $500 million fund claims it got assurances from Goldman's mortgage trading desk that the market for CDOs had stabilized after falling sharply.
In fact, the hedge fund initially passed up an opportunity to invest in Timberwolf in April 2007 because Basis' managers were concerned about the health of the CDO market.
Mapley said he has been told Goldman sold the Timberwolf securities to the hedge fund at a significantly higher price than what similar mortgage-linked securities were selling for at the time. Basis' managers were not aware that Goldman's mortgage trading desk was actively shorting CDOs and other subprime mortgage-linked securities at the time of the Timberwolf deal, he said.
Michael Duvally, a Goldman spokesman, said, "Basis advertised itself as a highly experienced, professional CDO manager and investor." He added that the hedge fund "had access to the same information regarding the underlying portfolio as Goldman Sachs."
Mapley, however, said he found Goldman's conduct in marketing and selling Timberwolf so disturbing that he contacted the U.S. Securities and Exchange Commission about the deal in December 2007. He subsequently sat down with SEC lawyers several times in early 2008 to discuss the transaction, which he said securities regulators were already looking into.
In light of the SEC's early interest in Timberwolf, Mapley said he was surprised the commission's civil fraud claim against Goldman focused on another CDO -- Abacus 2007.
"When I saw the SEC action against Goldman I thought it was going to be Timberwolf," he said.
An SEC spokesman declined to comment on whether its lawyer met with Mapley and if regulators are looking into the Timberwolf transaction.
However, the Timberwolf deal drew considerable notoriety during last month's hearing by the Senate Permanent Subcommittee on Investigation when lawmakers revealed that a former Goldman executive had described the transaction as "one shitty deal" in an internal Goldman email.
Former Goldman mortgage executive Thomas Montag, who now works for Bank of America, penned that "shitty deal" email on June 22, 2007. A week earlier, Basis invested in the Timberwolf deal by plunking down about $11 million in cash and financing the rest of the transaction with a margin loan from Goldman.
The Timberwolf deal, which referenced a pool of other subprime-backed CDOs, quickly soured. By the end of August, the deal had lost 80 percent of its value and the CDO was liquidated in June 2008.
In buying Timberwolf on margin, Basis agreed to let Goldman re-price the value of the securities as it saw fit. And within weeks of closing the transaction, Goldman began marking down the securities and demanding cash collateral from Basis.
In August 2007, the hedge fund told its investors it was planning to liquidate. Basis contends the liquidation was prompted in part by the demands for collateral payments by Goldman, said people familiar with the hedge fund and information reviewed by Reuters.
TOKIO MARINE ROLE
Basis was not the only hedge fund that purchased Timberwolf securities and went belly-up in summer 2007.
The single biggest buyer of Timberwolf securities was the once giant Bear Stearns group of hedge funds, which invested $300 million in the CDO. The Bear funds, which once controlled nearly $30 billion of CDOs and other subprime mortgage-linked securities, imploded in June 2007 after the funds could not meet a series of margin calls from a dozen Wall Street lenders, including Goldman.
Another buyer of Timberwolf securities was a division of Tokio Marine Holding Inc, one of Japan's largest property and casualty insurers, said people familiar with the Timberwolf deal. The insurer did not return phone calls seeking comment.Basis for claim?
The rather ambitious attempt by Australian hedge fund Basis Yield Alpha Fund to win more than $US1 billion in damages from Goldman Sachs over the $US56 million it lost investing in a portfolio of 'toxic' sub-prime mortgage securities promoted by the bank will, if it fully runs its course through the courts, help provide a better understanding of the limitations of the caveat emptor principle.
Basis, described by Goldman as one of the world’s most experienced investors in collateralised debt obligations, was forced into insolvency in 2007 after failing to meet a series of margin calls made by Goldman.
Two and a half weeks before that happened, Basis had invested in the now notorious Timberwolf CDO product – securities described famously by a senior Goldman executive involved at the time as "one shitty deal." At the time Goldman was promoting Timberwolf, its house view was that the sub-prime market was likely to become distressed and it held a net short position against that market.
The Basis case appears to have grown out of the Securities and Exchange Commission’s civil action against Goldman, in relation to a similar transaction in which it sold a synthetic CDO developed in conjunction with hedge fund Paulson & Co to a German bank without telling the CDO manager or the bank that Paulson – which was on the "short" side if the transaction – had a role in choosing the underlying securities in the portfolio. Goldman and the SEC have been in negotiations for a settlement of that action.
Both cases raise the issue of the extent to which sophisticated institutional investors are responsible for their own investment decisions and the due diligence associated with them. The corollary to that question is the extent to which promoters of a product offered to a sophisticated investor have a duty to fully explain the nature of the risks involved and express their own opinion of the product and the securities and market conditions underlying it.
In its statement of claim, filed in the US courts, Basis says it would never have invested in Timberwolf had it know Goldman played a significant role in the collateral selection process. It says Goldman’s knowledge of the market and price for Timberwolf was superior to its own and, because Timberwolf and similar CDOs were not publicly traded and were illiquid, it had little ability to obtain information about prevailing prices in the sector and, in particular, the pricing of the securities in Timberwolf.
It says that, at the time, it was reluctant to purchase an interest in Timberwolf because of its concerns about the CDO market, but sought assurance from Goldman that the price being offered (it bought securities with a face value of $US100 million for $US80 million) was good in the existing market and that the market for that type of security was stable. It is self-evident that it relied upon those assurances, to its detriment.
Goldman itself says that, in entering the transaction, Basis specifically stated that it would place no reliance on Goldman – and signed off on that statement.
If Basis were a "mum and dad" retail investor, Goldman would no doubt be in strife. But it wasn’t. It was an experienced hedge fund managed by very experienced market professionals.
In its own product disclosure statements, Basis described its investment process to prospective clients. Its first step was to identify miss-priced securities. The second was to research the opportunity and analyse perceived up-side and the potential down-side. The third was for the investment team to review the risk/reward attributes.
The disclosure went on to say that the Basis process started with a search for "compelling" opportunities, using "detailed models" maintained by the group to look at each security based on macro and micro factors considered relevant to making an informed investment decision, drawing heavily on the "extensive experience" of the investment team.
With all its sophistication, experience, process and technology – and its own reservations about the sub-prime market and its understanding of what was occurring within it – Basis, a leveraged investor, invested in a leveraged product exposed to that market… because Goldman said it was a good idea!
One wonders how Basis' own investors would feel about that insight into the level of due diligence taken before investing their funds.
If Goldman had an obligation (as much of the US discussion of the bank’s dealings would suggest) to disclose more information about the products it was offering and its own dealings in those and similar products to substantial and supposedly sophisticated professional investment institutions – institutions charging their own clients for their expertise – what obligations did the buyers of the products have to properly inform themselves of the nature and value of what they were buying?
If the case lasts the distance, we may find out where the balance of obligations lies and whether the caveat emptor principle still applies to deals between sophisticated consenting adults.