The law that was broken in the mortgage scandal

By Felix Salmon
October 14, 2010
post yesterday on the mortgage bond scandal, a lot of commenters said that it looked like a violation of Rule 10b5-1 of the Exchange Act -- the bit that prohibits trading on material nonpublic information. Well, it may or may not be a violation of 10b5-1. But that might be beside the point, because this looks like an absolutely textbook violation of Section 15E(s)(4)(A).

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Update: Thanks to Economics of Contempt. This turns out not to be the cut-and-dried breaking of the law that it looks like. Because it turns out that Section 15E(s)(4)(A) of the Exchange Act is very new: it was only inserted into the Act by Dodd-Frank (page 1,376, if you’re following along at home). So it wasn’t in force when these bonds were issued. You couldn’t do this kind of thing any more — it would be illegal. But Section 15E(s)(4)(A) isn’t enforceable retroactively.

After my post yesterday on the mortgage bond scandal, a lot of commenters said that it looked like a violation of Rule 10b5-1 of the Exchange Act — the bit that prohibits trading on material nonpublic information. Well, it may or may not be a violation of 10b5-1. But that might be beside the point, because this looks like an absolutely textbook violation of Section 15E(s)(4)(A).

This rule is not dense legalese at all. In fact Section 15E(s)(4)(A) is written in very plain English. Here it is in full (see page 231 of the PDF):

The issuer or underwriter of any asset-backed security shall make publicly available the findings and conclusions of any third-party due diligence report obtained by the issuer or underwriter.

I can’t for the life of me work out how every single mortgage bond that Clayton taste-tested didn’t violate this rule.

And in fact, the SEC has now proposed its own additional rule, which would mandate this kind of due diligence, and would also mandate that the issuer disclose the nature, findings and conclusions of any such taste test.

Up until now, underwriters have not been obliged to do this kind of due diligence. But the fact is that they did it, and that Clayton, in particular, made good money from performing such due diligence for just about every major investment bank in the world. As far as I know, not a single one of those banks disclosed Clayton’s results when they sold their bonds. And that looks to me like a blatant violation of Section 15E(s)(4)(A).

Or is there something I’m missing here? (Obviously, yes, there was.)

Update 2: If Section 15E(s)(4)(A) doesn’t do the job, what are we left with? Well, there’s still 10b5-1, of course. That prohibits the sale of any security on the basis of material nonpublic information. And there’s also Section 17 of the Securities Act:

It shall be unlawful for any person in the offer or sale of any securities… to obtain money… by means of any untrue statement of a material fact or any omission to state a material fact.

Which still does the job, I think.

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