Private placements and conflicts of interest: do consenting adults need more protection? – COLUMN
By Helen Parry, Thomson Reuters Accelus regulatory intelligence expert. The views expressed are her own.
LONDON, May 16 (Thomson Reuters Accelus) -
“The first private placement memorandum disclosed the possibility that new investors may help pay distributions to old investors but this was not a risk; it was a certainty.” (US Securities and Exchange Commission v Bravata 2011 WL 339458.)
“This disclosure indicates that GSI may invest in securities that are ‘adverse to’ the Hudson investments … Goldman had already determined to keep 100 per cent of the short side of the Hudson CDO.” U.S. Senate Investigations Subcommittee Levin-Coburn Report on the Financial Crisis.
The fact that investors in the Billionaire Boys Club property investment Ponzi scheme, the subject of the Bravata case quoted above, blithely handed over their hard-earned cash, despite the fact that the private placement memorandum disclosed that it may be just that, is a striking example of the dangers that may befall unwary investors who fail to check the small print.
Nevertheless, although disclosing the fact that one might be operating a Ponzi scheme or a conflicted interest may not suffice to protect one from potential liability for misrepresentation or fraud if one has already determined to engage in such a course of action, disclosing such matters when one is yet to make such a determination and the statement is, therefore, true, may do the trick, at least in the case of the collateralized debt obligation (CDO).
DODD-FRANK AND MIFID II
That statement may soon, however, no longer hold true when the U.S. Dodd-Frank Act and the EU review of its Markets in Financial Instruments Directive are finally implemented. Conflicts of interest in the broadest sense are a fact of life in the wholesale financial marketplace in general, and with complex CDO private placements in particular. Such conflicts have been aired and picked over in a plethora of private civil suits, enforcement actions, governmental inquiries and regulatory consultations as the post-crunch reckoning has ground grimly on.
Despite heavy lobbying by the banking community, the well-documented excesses of recent years have made it inevitable that the Dodd-Frank and MiFID legislative machines will eventually produce many technical measures to limit the laissez-faire freedoms currently enjoyed. The Dodd-Frank Act contains some conflicts-related prohibitions known as the Volcker Rule, as well as an explicit prohibition on particular conflicts in the asset-backed securities market.
The recently published U.S. Senate Subcommittee report “Wall Street and the Financial Crisis” went further in proposing prohibitions of the specific types of conflicts exposed in the Abacus case at the root of the recent U.S. Securities and Exchange Commission fraud case against Goldman Sachs. The report also made further suggestions regarding possible additional prohibitions against abusive practices and structured finance, together with restrictions on the use of particular types of structured finance products.
Similar proposals feature in MiFID II. Meanwhile, regulators in Europe have recently pointed out that the current MiFID conflict-of-interests provisions do apply to transactions undertaken within the eligible counterparties (ECP) regime and, furthermore, that it could be made clear in MiFID II that in dealings with ECPs, investment firms have to still have act honestly, fairly and professionally and communicate with ECPs in a way that is fair, clear and not misleading.
DOTCOM BUBBLE TO CREDIT CRUNCH
After the dotcom bubble burst in the early years of the 21st century, reverse mergers and private placements became the new IPOs. Notoriously, the archetypal dotcom bubble issue was an IPO of equity securities issued by a high-tech start up, underwritten by an investment bank, endorsed by high-profile analysts and pitched at wholesale and retail investors. The archetypal credit bubble issue, conversely, was a private placement of ABS-related debt securities, originated, structured, underwritten and placed by an investment bank, endorsed by credit ratings agencies and pitched at institutional investors.
Both markets were, however, prone to abusive practices based on inter-connected conflicts of interest. While spinning, flipping, laddering and kissing, among others, prevailed in the dotcom era and resulted in the Spitzer Global Settlement, the conflicts at play in the market for structured finance products were considerably more complex. The subcommittee report cited the following activities as giving rise to potential conflicts of interest in the case of Goldman Sachs:
- Shorting its own securities.
- Failing to disclose key information to investors.
- Misrepresenting the source of assets.
- Failing to disclose client involvement.
- Minimizing premiums.
- Selling securities designed to fail.
- Delaying liquidation.
- Misrepresenting assets.
- Taking immediate post-sale markdowns.
- Evading put obligations.
- Using poor quality loans in securitisations, and
- Concealing its net short position.
Some of these potential conflict situations are predicated on the assumption that long investors always expect or want the price of a security to go up. There may, however, be other motivations at play for taking a long position, for example:
- They plan to re-securitise them into CDOs for the structuring and marketing fees.
- Those CDSs may then be re-securitised into CDOs squared or cubed for more fees.
- They wish to access the income flow from a CDO equity tranche while the market is rising to finance the premiums due on credit default swaps purchased in anticipation of the imminent bursting of the bubble.
- They may plan to use them as collateral in the repo market, or
- They need losses to set off against tax.
COMPLEXITY UPON COMPLEXITY
The sheer level of complexity which appertains in these markets is such that any regulator seeking to draft effective measures to offset the potentially malign effect of such conflicts faces a truly daunting task.
In addition to the fact that the interests of the parties engaged in transacting in complex structured products may be less than transparent, merely teasing out the roles played by those engaged in such transactions can be equally challenging. For example, in one case which involved secured fixed/CMS-linked interest rate notes issued under a structured-note program, the roles included trustee, principal paying agent, paying agent, custodian, issue agent, calculation agent, determination agent, issuer in respect of the notes, collateral lending counterparty, call option counterparty, put option counterparty, swap counterparty and holders of the notes and coupons.
The documentation outlining the express contractual provision that applies in such complex transactions can reach truly surreal proportions. The possible conflicts of interest that might arise from such a transaction are potentially quite dazzling.
In the immediate aftermath of the subcommittee hearings, the possibility of imposing fiduciary duties on broker-dealers dealing with sophisticated investors was heavily canvassed but, after making a short-lived appearance in the bill emerging from the House-Senate Conference Committee, it was subsequently abandoned by Congress. The Volcker Rule survived, however. The rule provides that a banking entity shall not engage in proprietary trading or retain any equity partnership or other ownership interest in or sponsor a hedge fund or private equity fund.
It takes the form of s13 of the Bank Holding Company Act 1956 and works on three levels:
- A broad prohibition.
- Exceptions to the prohibition.
- Restrictions on the exceptions driven by overriding limits on conflicts of interest.
These include certain permitted activities:
- Market making.
- Risk-mitigating hedging activities.
- Transacting on behalf of customers.
- Trading in US government securities and government-sponsored entities such as Fannie Mae.
The exceptions to the rule prohibiting affiliations between banks, hedge funds and private equity funds relate to making “seed” or “de minimis” investments in the funds that they oversee for clients in a fiduciary capacity.
CONFLICT OF INTEREST BACKSTOP
All permitted activities are then subject to the proviso that no activity, transaction or class of transactions is permitted as an exception to the general prohibition if it would involve or result in a material conflict of interest between parties in arm’s length transactions.
The term “material conflict of interest” has yet to be defined in a rule and further regulations are required to add additional activities as exceptions to the general prohibitions and for further restrictions or limitations to the permitted activities in addition to those in the backstop.
CONFLICTS RELATING TO CERTAIN SECURITISATIONS
In addition to the Volcker Rule there is a specialist securitisation conflicts rule which is now to be found in s27 (B) of the Securities Act. This section was designed to address some of the conflicts issues raised, among others, in the SEC case against Goldman Sachs and further explored in the subcommittee report.
It prohibits an underwriter, placement agent, initial purchaser or sponsor, or any of its affiliates, of an asset-backed security including a synthetic ABS, from engaging in any transaction for one year after the first closing of the sale of the security that would result in any material conflict of interest with respect to an investor in a transaction arising out of such activity
PRIVATE PLACEMENT AND DISCLOSURE
Broader issues of managing or prohibiting conflicts of interest are frequently bound up with more specific rules covering disclosure requirements. The Abacus CDO involved a private placement of notes to institutional/professional investors; a method of issuance of securities which provides an opportunity for issuers and underwriters to avoid the heavier disclosure requirements concomitant with an IPO marketed to all investors including to the retail market.
The issue of the precise level of such disclosure that is mandated in the case of a CDO private placement is, however, less than entirely clear cut and was the subject of much disagreement between Goldman Sachs and the SEC concerning the marketing of the Abacus CDO. Goldman Sachs’ position initially was that market practice did not entail the disclosure of a short investor’s participation and that a duty of confidentiality was owed to one’s reverse inquiry client which precluded it.
MARKET PRACTICE AND PORTFOLIO SELECTION
They argued further in the in the supplemental submission that if it were market practice to disclose reverse inquiries and participation by entities with long or short positions in selecting the reference portfolio they would have expected to see many examples of that disclosure, because those activities were a regular feature of synthetic CDO transactions. Furthermore, they had confirmed with outside counsel who were experienced in the drafting of CDO offering materials that market participants were well aware that participants in CDO transactions routinely provided input on the selection of the portfolio securities, and that it was not market practice to disclose their involvement in the portfolio selection process.
SEC VS. GOLDMAN
The SEC case was that Goldman failed to disclose to investors the role that hedge fund Paulson & Co Inc played in the portfolio selection process, and the fact that Paulson had taken a short position against the CDO. In settlement papers Goldman acknowledged that the marketing materials for the CDO contained incomplete information. In particular they conceded that it was a mistake for the marketing materials to state that the reference portfolio was “selected by” ACA Management LLC without disclosing the role of Paulson & Co Inc. in the portfolio selection process, and that Paulson’s economic interests were adverse to the CDO investors. Goldman regretted that the marketing materials did not contain that disclosure and agreed to settle the SEC’s charges without admitting or denying the allegations by consenting to the entry of a final judgment that provided for a permanent injunction from violations of s 17(a) of the Securities Act of 1933.
The Abacus deal was one of dozens of synthetic (CDS-based) CDOs created in 2006-7. According to research published by the Wall Street Journal, in a few of the deals the banks told potential buyers that they may have been created with the input of market players with contrary interests, although the research failed to reveal a consistent approach to how these types of CDOs were assembled, or to what was disclosed about them. One expert in the field was quoted as implying that they were in untested waters and that the rules governing the field of private placements had never really been clear.
ALTERING THE MIX?
The issue of disclosure and conflicts of interests in synthetic CDO cases was addressed in some depth by the subcommittee, which concluded that:
– An issuer selling new securities to potential investors had an affirmative duty to disclose material information that a reasonable investor would want to know.
– A broker-dealer acting as an underwriter or placement agent was liable for any material misrepresentation or omission of material fact made in connection with a solicitation or sale of securities to an investor.
– A fact was material if there was 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.
The question of materiality was an objective one involving the significance of an omitted or misrepresented fact to a reasonable investor and depended on the significance the reasonable investor would place on the withheld or misrepresented information.
PLACEMENT AGENT, UNDERWRITER OR MARKET MAKER
During the course of the Senate hearings that led up to the publication of the report, executives from Goldman Sachs had argued that their role in the CDO market was primarily as a market maker; the disclosure requirements on market makers are significantly less onerous than those on underwriters, placement agents and broker-dealers.
Market making activity is also one of the exceptions to the Volcker Rule general prohibition. Market makers typically do not actively solicit clients or make investment recommendations to them, and their disclosure obligations are generally limited to providing fair and accurate information which relates to the execution of a particular trade. Such a position was, however, not maintained by the firm in its dealings with the SEC with regard to the Abacus CDO, where it described itself in effect as a placement agent.
(This article was first published by the Compliance Complete service of Thomson Reuters Accelus. Compliance Complete (http://accelus.thomsonreuters.com/solutions/regulatory-intelligence/compliance-complete/) provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 230 regulators and exchanges.)