Corporate Governance

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

By J Robert Brown Jr.

What does this tell us about the market for derivatives?  Regulation is necessary.

First, it is a myth to think that sophisticated investors can operate without some layer of regulatory protection, whether substantive or disclosure oriented.   Mere knowledge of the reference securities is not enough.  ABN-Amro and IKB may be sophisticated but they do not have the same depth or expertise as Paulson in assessing risk.    

Second, disclosure is not enough, at least in some cases.  Even had Paulson's identity been revealed in connection with the selection of the reference securities, sophisticated investors still would have been left at a serious disadvantage.  They would know that Paulson would have an incentive to make sure the portfolio included the securities with the greatest risk of failure (and providing the short with the greatest likelihood of positive return). 

But this is not enough.  Investors would need to either be told far more about the portfolio (the precise criteria used to selection the reference securities, the precise role played by Paulson, given that ACA had some input and perhaps veto over the selected securities) or would need to duplicate Paulson's analysis.  The former is difficult; the latter is inefficient and wasteful.

Third, these types of circumstances create a possible conflict of interest.  The creator of the synthetic CDO has one set of clients that wants to make money from going long and another that wants to make money from going short.  In these types of circumstances, there is always the risk that the transaction will be skewed in favor of one side or the other.  As a result, disclosure will not be enough. 

One possibility would be to prohibit this type of arrangement.  One way would be to impose on those creating a synthetic CDO a fiduciary obligation in favor of the investors purchasing the notes in the special purpose vehicle.  Fiduciary obligations would require banks to act in the best interests of the investors.  This would no doubt require additional disclosure by the bank to investors and preclude some types of interaction with short sellers that had contrary investment motives. 

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