SAN FRANCISCO (MarketWatch) -- The Securities and Exchange Commission on Friday charged Goldman Sachs Group Inc. and one of its vice presidents with defrauding investors by misstating and omitting key facts about a financial product related to subprime mortgages.

The SEC alleged in a civil lawsuit that Goldman GS, +2.12% structured and marketed a collateralized debt obligation that hinged on the performance of subprime residential-mortgage-backed securities, or RMBS. However, it failed to disclose the role that a major hedge fund, Paulson & Co., played in the portfolio selection process as well as the fact that the hedge fund had taken a short position against the CDO. See full story on Paulson & Co.'s role in the Goldman Sachs case.

"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," said Robert Khuzami, director of the SEC's division of enforcement, according to a statement. Read commentary about Goldman's 'faulty brakes' argument.

Goldman said the SEC's charges "are completely unfounded in law and fact."

"We will vigorously contest them and defend the firm and its reputation," the investment bank added in a statement.

Goldman shares were down 13% to $160.02 after the SEC unveiled its suit. See text of SEC complaint.

"Once upon a time, Wall Street firms protected clients," said Christopher Whalen, who heads the research firm Institutional Risk Analytics. "This litigation exposes the cynical, savage culture of Wall Street that allows a dealer to commit fraud on one customer to benefit another."

John Paulson of Paulson & Co. Reuters

The SEC's suit is aimed at the heart of one of the most profitable hedge-fund trades in history. Paulson, headed by John Paulson, generated billions of dollars in profit in 2007 from bets against CDOs. Other firms also made huge gains in similar trades as the housing market imploded, triggering a global financial crisis.

"The SEC continues to investigate the practices of investment banks and others involved in the securitization of complex financial products tied to the U.S. housing market as it was beginning to show signs of distress," Kenneth Lench, chief of the SEC's structured and new-products unit, said.

Still, Paulson & Co. wasn't charged by the SEC because the hedge fund firm wasn't obligated to tell investors about the CDO. Read about Paulson's involvement.

Paulson & Co. paid Goldman to structure a transaction in which the hedge-fund giant could take short positions against mortgage securities chosen by Paulson & Co. based on a belief that the securities would experience credit events, the SEC alleged.

Marketing materials for the CDO known as Abacus 2007-AC1 told investors that the portfolio of residential-mortgage-backed securities underlying the CDO was selected by ACA Management LLC, a third party with expertise in analyzing credit risk in these securities.

Goldman Sachs CEO Lloyd Blankfein testifies before a congressional panel in January. Reuters

The SEC alleged that, undisclosed in the marketing materials and unbeknownst to investors, Paulson & Co., which was poised to benefit if the RMBS defaulted, played a significant role in selecting which RMBS should make up the portfolio.

After participating in the portfolio selection, Paulson & Co. effectively shorted the RMBS portfolio it had helped select by entering into credit-default swaps with Goldman to buy protection on specific layers of the Abacus 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," the SEC said.

Goldman 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.

Investors in these securities, including German bank IKB (IKB) and Dutch financial-services company ABN Amro, now a unit of the Royal Bank of Scotland RBS, , lost more than $1 billion when the securities in the CDO turned toxic, the SEC said.

Paulson & Co. made a profit of roughly $1 billion on the trade, the regulator added.

Paulson & Co. said in a statement that it wasn't involved in selecting the collateral that went into the ABACUS CDO, in contrast to the SEC's allegations.

"ACA as collateral manager had sole authority over the selection of all collateral in the CDO," the hedge fund firm said. "While Paulson purchased credit protection from Goldman Sachs on securities issued under the ABACUS ABS CDO program, we were not involved in the marketing of any ABACUS products to any third parties."

"Paulson did not sponsor or initiate Goldman's ABACUS program, which involved at least 20 transactions other than that described in the SEC's complaint," the firm continued. "As the SEC said at its press conference, Paulson is not the subject of this complaint, made no misrepresentations and is not the subject of any charges."

The deal closed on April 26, 2007, and Paulson & Co. paid Goldman roughly $15 million for structuring and marketing Abacus.

By Oct. 24, 2007, 83% of the RMBS in the Abacus portfolio had been downgraded and 17% were on negative watch. By Jan. 29, 2008, 99% of the portfolio had been downgraded.