By: Thomas E. Holber
The United States Securities and Exchange Commission (the “SEC”) has issued Proposed Rule 127B, implementing Section 621 of the Dodd-Frank Act, which amended Section 27B of the Securities Act of 1933 (the “Securities Act”), barring material conflicts of interest in securitization transactions. Rule 127B would ban hedge funds and banks from assembling risky securities, marketing them to investors and then immediately betting against their own creations, reaping profits when they fail. The rule would also ban firms from setting up risky securities for the benefit of an undisclosed third party.
The prohibition against short-selling would last one year and apply to affiliates and subsidiaries. The language in the proposed Rule tracks the amended section of the Securities Act and the accompanying release provides examples of the Rule’s operation.
This Rule and explanatory release reflect the policies resulted in three SEC settlements with investment banks in the last eighteen months. In each circumstance, the investment bank structured a CDO (collateralized debt obligation) intending to immediately bet against it or allow a third party to do so.
In the first case, JPMorgan reached a $153m settlement with the SEC on July 19, 2011. The settlement related to a $1b synthetic CDO. The amount included a $19m disgorgement, $2m interest and $133m in fines. JPMorgan’s synthetic CDO promised investors cash payments associated with credit default swaps on underlying assets. If the underlying assets default, the security holders are obligated to pay the credit default swap counterparty. JPMorgan represented that a third party collateral manager had selected the reference entities when, in fact, the Hedge Fund Magnetar had selected those securities intending to take a $600m short position synthetically created by the CDO. Magnetar also held a long equity position in the CDO, entitling it to excess proceeds after all security holders were paid. Institutional Investors purchasing $150m of CDO notes were returned $126m.
In the second and most notable case, on July 15, 2010, Goldman Sachs reached a $550m settlement with the SEC related to a CDO. The settlement represented a $15m disgorgement and $535m in fines. Goldman represented that a third party collateral manager had selected the CDO assets when, in fact, Paulson & Co. (of “The Greatest Trade Ever” fame) had selected those securities intending to take a short position against the CDO. Investors purchasing CDO notes were returned $250m.
Lastly, on October 19, 2011, Citigroup reached a $285m settlement with the SEC related to a $1b CDO. The amount included a $160m disgorgement, $30m interest and $35m in fines. The SEC alleged that Citigroup represented that a third party collateral manager selected $500m in CDO assets when, in fact, Citigroup selected the assets intending to take a short position. The bankrupt bond insurer Ambac, Inc. wrote credit default swaps guaranteeing those assets.
In these cases, the SEC enforcement actions resulted in permanent injunctions from violating Section 17(a)(2)-(3) of the Securities Act, an anti-fraud provision, which states:
It shall be unlawful for any person in the offer or sale of any securities or any security-based swap agreement (as defined in section 206B of the Gramm-Leach-Bliley Act) by the use of any means or instruments of transportation or communication in interstate commerce or by use of the mails, directly or indirectly—
(1) to employ any device, scheme, or artifice to defraud, or
(2) to obtain money or property by means of any untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading; or
(3) to engage in any transaction, practice, or course of business which operates or would operate as a fraud or deceit upon the purchaser.
While Section 17(a)(2)-(3) require only proof of negligence, Section 17(a)(1) requires proof of scienter. The SEC initially brought charges against Goldman Sachs under Section 10b-5 of the Securities and Exchange Act of 1934 (the “Exchange Act”), which also requires scienter. Willful violations of either the Securities Act or the Exchange Act are felonies and can lead to significant jail time and large fines, with much larger penalties available for Exchange Act violations.
Thus, a willful violation of Section 127B would also constitute a felony and permit large fines, but remedies will be less robust than the consequences for violating the Exchange Act. Presumably the SEC will also contend that a violation of Proposed Rule 127B can be shown through proof of negligence, as under Section 17(a)(2)-(3).
The SEC’s three previous CDO settlements generated very large fines and disgorgement awards, which largely offset investor losses. In light of these actions, Proposed Rule 127B seems to add little to the current regulatory framework. The SEC has also noted that this Rule will be brought into alignment with rule-making under the so-called Volcker Rule, prohibiting certain banking conflicts of interest. Legal commentators have noted that since the proposed rule’s application is explained in a release rather than a rule, future actions will require case-by-case analysis and legal certainty will be slow to develop. Given the SEC’s recent successes in bringing actions under the Securities Act, it will be interesting to see whether Proposed Rule 127B has much impact on the size and scope of penalty awards and on the SEC’s ability to pursue enforcement actions.