Shares of diversified financial services giant Goldman Sachs (GS) plunged on the news that the U.S. Securities and Exchange Commission (SEC) has filed civil fraud charges against the company.

The SEC complaint charges Goldman with ``making materially misleading statements and omissions in connection with a synthetic collateralized debt obligation [CDO] .|.|. marketed to investors.'' At issue is Goldman's failure to notify investors that a third party, which was also making bets against the portfolio, had a role in selecting bonds for the portfolio. The CDO in question, Abacus 2007-AC1, is one of 25 residential mortgage-backed securities (RMBS) created and sold by Goldman, with a value of about $10.9 billion. The SEC is seeking disgorgement of illegal profits in addition to civil fines, and has not ruled out future charges in relation to other CDOs marketed by the company.

Goldman's potential liability resulting from this case, from possible future charges that may be leveled by the SEC or the U.K.'s Financial Services Authority (FSA), and from possible civil suits from its investors, is considerable. Also, the potential damage to the company's reputation with investors, while difficult to quantify, may well hurt its business prospects. Goldman Sachs did very well last year, largely on the strength of an unusually strong showing in its Fixed Income division, which posted a record year in 2009 while accounting for 45% of the company's total revenues.

Nevertheless, the SEC is limited in the value of the penalties it can impose, and Goldman will undoubtedly mount a vigorous defense. Unless the scope of the SEC probe widens considerably, we do not expect the company's core franchise to be damaged materially.