The U.S. Securities and Exchange Commission unveiled charges against Wall Street scion Goldman, Sachs & Co. on Friday, alleging that it failed to disclose that a hedge fund had a big hand in structuring a collateralized debt obligation that was then sold to investors, while the fund bet against the underlying securities.

The SEC brought charges against Goldman and one of its vice presidents, “for defrauding investors by misstating and omitting key facts about a financial product tied to subprime mortgages as the U.S. housing market was beginning to falter,” it said.

In particular, the regulator alleges that in structuring and marketing a CDO that was based on the performance of subprime residential mortgage-backed securities, Goldman Sachs failed to disclose to investors “the role that a major hedge fund played in the portfolio selection process, and the fact that the fund had taken a short position against the CDO.”

The SEC claims that one of the world’s largest hedge funds, Paulson & Co., paid Goldman to structure a transaction in which the fund could take short positions against mortgage securities chosen by the fund based on a belief that the securities would experience credit events.

The complaint says that the marketing materials for the CDO indicated that the underlying portfolio was selected by ACA Management LLC, a third party with expertise in analyzing credit risk in RMBS. But the SEC alleges that the marketing materials didn’t reveal that the hedge fund, which was poised to benefit if the underlying securities defaulted, played a significant role in selecting which securities should make up the portfolio.

The SEC’s complaint further alleges that after participating in the portfolio selection, Paulson & Co. effectively shorted the RMBS portfolio it helped select by entering into credit default swaps with Goldman Sachs to buy protection on specific layers of the CDO’s capital structure.

“Given that financial short interest, Paulson & Co. had an economic incentive to select RMBS that it expected to experience credit events in the near future. Goldman Sachs did not disclose Paulson & Co.’s short position or its role in the collateral selection process in the term sheet, flip book, offering memorandum, or other marketing materials provided to investors,” the SEC said.

The allegations have not been proven.

“The product was new and complex but the deception and conflicts are old and simple,” said Robert Khuzami, director of the Division of Enforcement. “Goldman wrongly permitted a client that was betting against the mortgage market to heavily influence which mortgage securities to include in an investment portfolio, while telling other investors that the securities were selected by an independent, objective third party.”

Investors in the liabilities of the CDO are alleged to have lost more than $1 billion. The SEC is seeking injunctive relief, disgorgement of profits, prejudgment interest, and financial penalties.

In response to the allegations handed down by the SEC today, Goldman Sachs issued a statement protesting its innocence. “The SEC’s charges are completely unfounded in law and fact and we will vigorously contest them and defend the firm and its reputation,” the firm said.

IE