Return of the Jedi

Two SEC actions since April 7th answer the long-asked question of whether the Commission will be succumbing to "the Perfect Storm" version of events between 2008 and 2010.  In a pair of cases centering on mortgage-related products, the SEC made clear that cries of complexity and unforeseeable risk shall not further cloud the assignment of blame for questionable sales practices in recent years.

In the Morgan Keegan case, the firm is alleged to have "masked from investors the true impact of the subprime mortgage meltdown" on five affiliated funds by preventing market quotes from lowering the daily net asset values.  Among other things, the case counters remarks by regulators made early in the Crisis seemingly acquiescing to the industry's proffered difficulty in pricing exotic investments.

Separately, in the well noted charging of Goldman Sachs last week, the Commission alleged that the firm and one of its employees made misstatements in offering a synthetic CDO whose reference portfolio was influenced by a hedge fund "with economic interests directly adverse to investors."  The ensuing downturn is said to have cost institutional investors over $1 billion while generating a profit of approximately the same for the hedge fund.  See the civil complaint at http://www.sec.gov/litigation/complaints/2010/comp21489.pdf. 

The Goldman Sachs case at once demonstrates the conflicting interplay of credit default swaps and CDOs and the dangers of blandly accepting the notion that downturns (and market victors) are inevitable.  It also serves as an eery reminder of the "tainted research" case brought by New York years ago where it relies on internal e-mails colorfully disclosing a lack of faith in marketed products (e.g., "the cdo biz is dead, we don't have a lot of time left"; February 2007).        

Collectively, the cases will, of course, test new legal theory and may encounter difficulties in the form of 1) procuring expert testimony, which is more accustomed to supporting Wall Street's valuations, and 2) re-evaluating the role of hedges, which, by definition evidence contrary actions by brokerage firms.  But both actions make good on the SEC's longstanding promise to undertake "sweeping enforcement measures" against frauds contributing to the subprime crisis.  See http://www.sec.gov/news/press/sec-actions.htm (January 2009).  We can only hope that Congress evidences such loyalty to its Crisis-related reforms, which have languished in committees for the past 18 months; in that regard, it bears noting that federal remedies speaking to consolidating regulators, limiting net capital, regulating credit derivatives and adding consumer protection from predatory loans have still largely been neutralized by lobbyists/political forces.  

---JSC, 4/19/10