The fraud charges leveled against Goldman Sachs on Friday are—or more accurately, could be—a pivotal moment as the United States continues its long, slow extrication from the financial crisis. The 22-page complaint filed by the Securities and Exchange Commission is almost too painful to read, filled with damning e-mail excerpts and fact patterns sure to make any legal department retch. The SEC has stabbed at the very heart of Wall Street, with an accusation that resonates from Main Street to Washington and all points in between. Compliance officers would do well to consider it carefully, because the mistakes Goldman stands accused of making carry lessons for you all.

The allegations are somewhat convoluted, but can be boiled down as follows. In early 2007, hedge fund manager John Paulson believed the U.S. housing market was in a bubble, and wanted to short the entire sector. Lacking any easy way to do this, he worked with Goldman Sachs trader Fabrice Tourre to draw up a list of mortgage-backed securities that looked like clunkers doomed to default. Tourre then shared that list of securities with a mortgage analysis outfit named ACA Management, and coaxed ACA into using that list to draw up collateralized debt obligations Goldman Sachs could sell to investors—CDOs whose value would depend on homeowners continuing to make their mortgage payments.

Tourre neglected to tell ACA or investors that Paulson had pre-selected those securities on the assumption that the homeowners funding them would not continue to make their payments. Paulson, meanwhile, also purchased credit default swaps on those CDOs, betting that they would default. When they did, the investors lost $1 billion. Paulson netted $1 billion. Goldman, like any good investment banker, acted as the middleman for this transaction and collected $15 million in fees.

These are all sins of disclosure. Had Tourre been forthcoming about Paulson’s role in this scheme, neither ACA nor any intelligent investor would have purchased the CDOs Goldman was selling. But a large, lucrative client wanted them sold, so Goldman omitted material facts about the nature of those CDOs to get them sold—that’s the underlying misconduct the SEC alleges.

The SEC accuses Goldman of violating three specific securities laws: Section 17(a) of the Securities Act, Section 10(b) of the Securities Exchange Act, and Exchange Act Rule 10b-5. All three essentially forbid anyone from using fraud or deceit, including the omission of material facts, to profit from a securities sale.

Compliance officers should marvel at the subtlety of Goldman’s problem. Nobody violated accounting rules, or circumvented IT controls, or fabricated fake receipts. The vast system of controls Corporate America has put in place to stop that sort of misconduct—misconduct the Sarbanes-Oxley Act was meant to prevent—would not have stopped a scheme like this. SOX was intended to prevent fraudulent financial reporting, and that wasn’t the problem here. Goldman never reported false financial data to cheat its investors. I don't even see how its external auditors would have spotted this.

Instead, Tourre and Goldman stand accused of simple, immoral, unethical behavior: withholding material data about products to cheat their customers. What sort of ethics and compliance program can you enforce to prevent that?

This isn’t a rhetorical question; at least some companies succeed at it sometimes, because Paulson approached Bear Stearns with his mortgage-shorting scheme, too, and Bear Stearns took a pass on it. Paulson’s mammoth bet against the housing sector is detailed in the book The Greatest Trade Ever, which quotes senior Bear executive Soctt Eichel pretty clearly: Paulson’s proposal “didn’t pass the ethics standards; it was a reputation issue, and it didn’t pass our moral compass.”

Quite right, Mr. Eichel. So why did Bear Stearns act ethically in this case, but Goldman apparently did not? That is the question compliance officers should ponder.

This might have been a problem of personnel. Tourre was only 28 as he and Paulson assembled this trade in early 2007. Did he have the maturity to understand the consequences of such a trade? Did he not understand whatever training Goldman gave him on ethics and compliance? Or was he simply morally bankrupt, and deliberately ignored the ethical implications?

This may have been a problem of systems. Did Goldman not monitor email Tourre was sending in early 2007 warning that the CDO business was about to collapse? Could it not see that the synethic CDOs were stacked with mortgage bonds of the highest possible risk? Might any analytical tools have connected these dots?

This might have been a problem of risk management. The SEC complaint says Goldman’s mortgage capital committee reviewed the Paulson trade and allowed it to proceed. If that is true, who failed to see the regulatory risks inherent in such a questionable deal? How were the people who approved this deal compensated? Did anyone have any incentive to veto trades that might not pass regulatory muster?

Finally, this might have been a problem of law. Goldman argues that at the time of the trade (early 2007), Paulson was just your standard-issue hedge fund manager, not a market svengali whose counter-intutive ideas might give risk managers pause. It also argues that the investors in the CDOs were not fools (a fair point), and should have known that for every buyer of a synethetic CDO, somebody else out there is shorting that position (which is how these deals work). Is that a valid interpretation of the applicable law? Is it a narrow, letter-of-the-law view that contradicts the clear spirit of the law? Which is the right way to view those rules? How would you want your employees to interpret the rules that apply to them?

Those are only some of the questions CCOs might want to ask as they watch the case against Goldman proceed. And we all should be watching the Goldman case, because it will not be the last time Wall Street goes through this. Many other banks and trading houses tried schemes similar to what Goldman stands accuesed of doing. More charges will be coming against more people, rest assured—because too few companies compelled their employees to act within common-sense ethical standards. Compliance officers of all stripes would do well to contemplate how Goldman found itself into this mess, and what sort of compliance program you would want in place to be sure your company doesn’t find itself there, too.

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