Corporate Governance

SEC v. Goldman: The Failure of the Market and the Need for Substantive Reform

By J Robert Brown Jr.

By now, everyone not otherwise comatose has heard about the case brought by the SEC against Goldman Sachs.  Certainly the market heard, dropping on the fear that the case makes financial reform harder to ward off.  See Obama pushes bank reform, lashes out at GOP, Reuters, April 17, 2010 ("Bank shares and the broader stock market fell on fears the civil lawsuit could make it more difficult for the financial industry to ward off reform."). 

In many ways, the case against Goldman involves something approaching garden variety securities fraud.   According to the complaint, Goldman sold securities without disclosing that the relative portfolio underlying the synthetic CDOs had been influenced by a hedge fund that was also shorting the same investment.  There are some interesting issues that we will explore in later posts.  The case is not a slam dunk.  The Commission has to deal with sophisticated investors (ABN-Amro and IKB, a German bank) who knew that they were going long and that someone had to be going short.  Its not, therefore, about the existence of short selling but about the role of the particular short seller in assisting in the creation of the portfolio and the failure to disclose that role.

The case, however, demonstrates something much broader than disclosure problems.  It shows the consequences of an almost entirely unregulated market and the inability, in these circumstances, of large investors (ABN-Amro and IKB, a German Bank) to protect themselves.  The action all but makes the case for regulation of the derivatives market.  Moreover, it suggests that the form of regulation ought to go beyond disclosure and encompass substantive regulation as well. 

The complaint is posted at the DU Corporate Governance web site.

Full post as published by The Race to the Bottom on April 19, 2010 (boomark / email).