Many requisite ingredients for a media feast accompanied the civil fraud charges commenced by the Securities and Exchange Commission (SEC) against Goldman Sachs & Co. and its employee Fabrice Tourre on April 16, 2010: The SEC was under criticism for the perceived weakness of its response to the credit crisis. The White House was stepping up pressure for financial sector reform. Goldman, a pre-eminent firm, had repaid its government loans and was reporting good results. The type of securities involved in the SEC charges — collateralized debt obligations (CDOs) and credit default swaps referenced to the residential mortgage market, including subprime loans — were blamed for contributing to the credit crisis. And to this stewing pot, Mr. Tourre, the 31-year-old French math whiz principally responsible for devising and marketing the ABACUS 2007-AC1, added the spice.
However, attention raised by interesting politics and personalities aside, this case also raised an interesting legal issue with potentially broad implications — that of "materiality."
The SEC's Case
Relying on its widely used "anti-fraud" provisions — Section 10(b) of the Securities Act and Section 17 of the Exchange Act — the SEC alleges that Goldman and Tourre:
- represented that the reference portfolio of residential mortgage-backed securities underlying ABACUS 2007 - AC1 was selected by ACA Management LLC, which was experienced in analyzing credit risk in these types of securities; and
- failed to disclose to investors that Paulson & Co. Inc., a large hedge fund with economic interests adverse to investors in ABACUS 2007-AC1, played a significant role in the portfolio selection process.
Thus, the key allegation is of an omission in disclosure to investors, as the following passage from the Complaint encapsulates:
"[Goldman] arranged a transaction at Paulson's request in which Paulson heavily influenced the selection of the portfolio to suit its economic interests, but failed to disclose to investors, as part of the description of the portfolio selection process contained in the marketing materials used to promote the transaction, Paulson's role in the portfolio selection process or its adverse interests."
Another significant allegation is that Tourre misled ACA into believing that Paulson had invested approximately $200 million in the equity of ABACUS 2007-AC1 and, accordingly, Paulson's interest in the selection of collateral was aligned with ACA's. In reality Paulson's interests were sharply conflicting because it was taking a significant short position. If ACA had known this, ACA likely would have refused to serve as portfolio selection agent, according to the SEC. ACA's parent invested in the vehicle.
The SEC alleges that the other investor, IKB Deutsche Industriebank AG, relied on the involvement of ACA, as an experienced and independent collateral manager, when assessing whether to invest in ABACUS 2007-AC1, especially since the market had started to show signs of distress. According to the SEC, IKB would not have invested had it known that Paulson had played a significant role in the collateral selection process while intending to take a short position. In the end, IKB lost $150 million.
Goldman issued a press release denying the SEC's allegations and identifying "four critical points that were missing from the SEC's complaint":
- While Goldman earned $15 million in fees, it lost $90 million on the transaction by being long on the portfolio.
- ACA's parent and IKB were among the most sophisticated investors in these types of transactions, and were provided with extensive information about the underlying mortgage securities.
- The portfolio was selected by ACA, whose discussions with Paulson were typical for such transactions. ACA had the obligation to select appropriate securities and the incentive to do so, given its large exposure to the transaction.
- As normal business practice, a market maker does not disclose the identities of a buyer to a seller, and vice versa. Therefore, according to Goldman, it cannot be faulted for not disclosing that Paulson was taking a short position. Furthermore, according to Goldman, it never represented to ACA that Paulson was going to be a long investor.
At this stage, only the SEC has pleaded, and we have not seen the evidentiary record that may support either side.
The anti-fraud statutes upon which the SEC relies upon are part of bedrock of US securities law.
The anti-fraud statutes prohibit, inter alia, (i) the making of any untrue statement of material fact, or (ii) the omission of any material fact necessary for a statement, in light of the circumstances in which it was made, to not be misleading.
Typically, material facts relate to the nature or quality of an investment. Here, the SEC's case focuses on the identity and incentive of a party that participated in creating the investment. There is no suggestion of a failure to disclose material facts about the investment itself. Detailed information about the underlying mortgage-backed assets was disclosed.
It is not uncommon for purchasers of securities not to know the identity of the seller. This is the case in a secondary market stock purchase, for instance. Major institutional investors regularly invested in CDOs, not knowing or caring about the identity of the party on the other side of the risk. So, does it matter that the other party assisted in selecting the assets, if all of the facts relating to the assets were disclosed?
The US Supreme Court has held that the materiality threshold requires a "substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the 'total mix' of information made available."1
Under Section 1 of Ontario's Securities Act, a "material fact" is defined as "a fact that would reasonably be expected to have a significant effect on the market price or value of the securities."2
The tests are similar. Obviously they are both directed to the goal of ensuring adequate disclosure for investment decisions. Arguably there is a subtle difference in that the American "total mix" is more general than the focus on "market price or value" under Section 1 of Ontario's Securities Act.
Two principles of materiality that find expression in both jurisdictions appear highly relevant in the context of the Goldman case.
First, the test of materiality is objective.3 It is not based on the subjective perspective of the particular investor involved, but rather on the perspective of a reasonable investor in the same circumstances.
Second, materiality is not determined retrospectively or with the benefit of hindsight.4
Applying these principles to the Goldman case, it must be borne in mind that at the time of the transaction, the housing market was not widely regarded as a bubble. And that Paulson was not the well-known billionaire he is today. Rather, he was a low-profile hedge fund manager with a view about a market that differed from others' views, including the ABACUS 2007-AC1 investors'.
McCarthy Tétrault Notes
It is interesting to note that if a similar case were brought before the Ontario Securities Commission (OSC), it might not necessarily turn on the issue of materiality. If the charge were strictly under Section 126.2 of Ontario's Securities Act, which is similar to the American anti-fraud statutes, materiality would be a necessary element. However, the OSC claims authority to impose sanctions for abuse of the capital market even if no particular breach of this Act is made out pursuant to "public interest jurisdiction" under Section 127 of the Act.5 This "public interest jurisdiction" affords OSC Staff great latitude in how they formulate and attempt to establish a case. They are not constrained by having to allege or prove a breach of a specific securities law.
The open-ended nature of "public interest jurisdiction" is vulnerable to criticism, particularly when it is invoked in a context where a specific securities law applies. Why should a respondent be sanctioned based on an ill-defined, after-the-fact notion of what is "the public interest," rather than judged based on a specific securities law that applied at the time? Shouldn't there be precision in the law that market participants are expected to follow? Isn't it unfair to prosecute based on an after-the-fact "gotcha"?
1. Basic, Inc. v. Levinson 485 US 224, 232 (1988).
2. See Securities Act, R.S.B.C. 1996, c. 418, s. 1(1); Securities Act, R.S.A. 2000, s. S-4, s. 1(gg); Securities Act, S.S. 1988-89, c. S-42.2, s. 2(1)(z); Securities Act, C.C.S.M. c.s50, s.108(1); Securities Act, R.S.Q. c.V-1.1, s. 5; Securities Act, S.N.B. 2004, c. S-5.5, s. 1(1); Securities Act, R.N.S. 1989, c. 418, s. 1(1); Securities Act, R.S.P.E.I. 1988, c.S-3.1, s.1(gg); Securities Act, R.S.N.L. 1990, c. S-13, s. 2(1)(x).
3. Re YBM Magnex International Inc., (2003), 26 O.S.C.B. 5285 at para.91; TSC Industries, Inc. v. Northway, Inc., 426 US 438, 445 (1976).
4. Core Mark International Inc. v. 162093 Canada Ltd. (8 June 1989), Toronto 1220/89 (Ont. H.C.) cited in Re YBM Magnex International Inc., (2003), 26 O.S.C.B. 5285 at para. 90; Value Line Fund, Inc. v. Marcus, 161 F. Supp. 533, 535 (Dist. Ct. N.Y.) cited in SEC v. Texas Gulf Sulphur Co. 258 F. Supp. 262, 283 (Dist. Ct. N.Y.), rev'd on other grounds, 401 F. 2d 833 (2d Cir. 1968).
5. In the matter of Mithras Management Ltd. et al. (1990), 13 O.S.C.B. 1600 at pp. 1610-1611; Re H.E.R.O. Industries Ltd., (1990), 13 O.S.C.B. 3775 at pp. 3794-3795.
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