Proposed SEC Rule Addresses Conflicts of Interest in Securities Transactions

Securities fraud and broker misconduct arbitration claims and lawsuits often are based on actions by individuals and investment firms who have violated their fiduciary duties to investors. Allegations of recommending unsuitable investments, churning, unauthorized trading, misrepresentations, and other wrongdoing can lead to liability for brokerage firms and stockbrokers.

The legal basis for such actions is often found in rules generated by the U.S. Securities and Exchange Commission (SEC). The SEC, born out of the Great Crash of 1929, was created to provide protection for investors by maintaining fair and orderly financial markets while facilitating capital markets.

In a unanimous vote, the SEC recently proposed a new rule intended to address material conflicts of interest between bundlers and sellers of asset-backed securities (ABS) on one side, and those who invest in them, on the other. The new regulation represents implementation of a section of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

“This proposed rule is designed to ensure that those who create and sell asset-backed securities cannot profit by betting against those same securities at the expense of those who buy them,” insists SEC Chairperson Mary Schapiro.

Regulating Banks and Other Sponsors of Asset-Backed Securities

A 2010 SEC securities fraud action involving Goldman Sachs & Co. illustrates the problems inherent in allowing financial firms to sell short (bet against) investments that they simultaneously offer to investors. In that case, the SEC alleged that Goldman Sachs defrauded investors by misstating and omitting key information about a financial product connected to subprime mortgages just as the American housing market was faltering.

The SEC charged that Goldman Sachs left an important key fact out of the prospectus: the hedge fund Paulson & Co., which had played an important part in the asset selection process for the investment product that Goldman Sachs was putting together, also had taken a short position against the very financial product that Goldman Sachs was creating. In other words, Paulson & Co. helped pick the mortgage that would be part of the investment product and simultaneously placed a bet that the investment product would perform poorly. Clearly, Paulson & Co. had an incentive to select poor quality mortgages for the investment product that Goldman then would sell to investors. Goldman Sachs settled the lawsuit for more than half a billion dollars.

The new SEC rule prohibits Wall Street firms from shorting securities that they package in the first year after offering the investment. It also prohibits other securitization participants, including underwriters, initial purchasers, placement agents and sponsors from engaging in short sales of a relevant ABS if their activity would create a material conflict of interest.

The rule defines “material conflict of interest” as meeting two separate criteria:

  • The securitization participant would benefit from adverse performance, loss of principal, monetary default or decline in value of the underlying assets.
  • The circumstances reveal “a substantial likelihood that a reasonable investor would consider the conflict important to his or her investment decision.”

The proposed rule is subject to public comment for 90 days, then must be reconsidered by the SEC before it is given legal effect.

Investors Must Be Able to Trust That Brokers Believe in the Investments They Promote

The SEC’s new conflict-of-interest rule goes to the heart of the confidence and honesty required when individuals decide to entrust their money to brokerage firms. Investors who lose a large share of their retirement savings or other funds because of stockbroker misconduct or unethical practices condoned by a brokerage firm must have legal recourse to maintain public faith in the securities markets.

Individual claims are one option for investors who suffer significant investment losses due to securities fraud. In contrast, class actions are a particularly powerful tool to allow plaintiffs to aggregate smaller claims. Either way, U.S. securities laws define appropriate broker practices, including duties regarding asset allocation, margin account claims, misrepresentations and omissions, and other misconduct that can serve as the basis for a securities fraud lawsuit or arbitration claim.

From asset-backed securities to credit derivatives, collateralized debt obligations (CDOs), variable annuities, and other structured products, financial advisors must not casually recommend investments without understanding the investor’s goals and appetite for risk. Brokers also must disclose all material information about the securities to investors. Whether the proper forum for resolving an investment fraud dispute is a federal district court or an arbitration claim before the Financial Industry Regulatory Authority (FINRA), a securities fraud attorney can advise defrauded investors about the latest legal developments and explain strategies for holding brokers and investment firms accountable.