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A "Modest Proposal" for Capital Market Reform: Close Down Rule 144A

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This article was co-written by Stephen Diamond.

Years ago, it is unlikely deals like Goldman Sachs' now infamous Abacus would have been sold. The securities laws written in the 1930s demanded more accountability than we have today, not only for public offerings of stocks and bonds, but for private placements like Abacus. Such private placements had to go through a review process before the Securities and Exchange Commission and issuers were held to high standards of disclosure. No longer. Enter Rule 144A. In one simple step the Securities and Exchange Commission could remove a major cause of the recent credit crisis by shutting this rule down.

Issued in 1990, the rule was the SEC's attempt to make it easier for companies to sell securities in so-called "private placements." Private placements avoid advance SEC review of disclosure about an offering and, more importantly, exempt issuers, as well as their directors, officers, accountants and underwriters from the most effective liability provision in the federal securities laws, Section 11 of the Securities Act of 1933. Section 11 allows investors who are misled to sue those parties for damages. Issuers face "strict liability" under this provision while other parties who help prepare the disclosure escape liability only by following a rigorous due diligence process.

Under Rule 144A, an issuer of a mortgage backed security or a note linked to a collateralized debt obligation can be sold initially to an investment bank and then re-sold immediately to so-called "qualified institutional buyers" such as pension funds, banks, insurance companies and mutual funds. The "Abacus" CDO transaction at the heart of the SEC's charges against Goldman Sachs, for example, was completed using Rule 144A.

While appropriate in limited circumstances, such private securities sales have exploded in size and complexity. More than a trillion dollars of such offerings were made in 2006 alone, triple the amount in 2002. The significant losses experienced by even large financial institutions suggest that the original justification for Rule 144A -- that large institutions could, in the words of a leading Supreme Court case, "fend for themselves" -- no longer holds.

In fact, the SEC itself now admits "investors and other participants in the securitization market did not have the necessary tools to be able to fully understand the risk underlying those securities and did not value those securities properly or accurately." In response, the SEC recently proposed to tweak the disclosure requirements for asset backed securities. But their proposal does not go far enough.

The strict liability penalty of Section 11 and the mandatory SEC review process were at the heart of the original design of the securities laws in the New Deal era. They insure that investors in public markets are provided full disclosure of the risks associated with a securities transaction. In the words of Justice William O. Douglas, an SEC Chairman prior to his elevation to the Supreme Court, Section 11 was consciously intended to have an in terrorem effect so severe that those who prepared the offering would be hyper vigilant in disclosing risks to investors fully and clearly.

In addition, the review process conducted by the SEC's Division of Corporate Finance is intensive, rigorous and adversarial with the SEC acting, as Justice Douglas said it should, as "the investor's advocate." The Commission's staff asks tough questions and often pushes the issuer and the underwriters and their counsel to make significant changes to the disclosures in order to make sure these are complete and comprehensible to investors.

Now Rule 144A has given rise to a massive parallel private market largely outside of these protective measures. Thus, diligence and disclosure standards can weaken considerably. One academy study found that yields on bonds issued in 144A transactions are higher than those on registered public offerings due to the "lower liquidity, information uncertainty, and weaker legal protection for investors" found in these deals.

While some of the anti-fraud remedies of the securities laws still apply in 144A transactions, these have been watered down in recent years by Congressional action and judicial interpretation. In a series of opinions authored first by Justice Powell and then by Justice Kennedy, the Supreme Court has steadily scaled back the scope of the securities laws. Opinions by Justice Kennedy, in particular, limited the impact of anti-fraud protections as well as the ability of investors to sue gatekeepers who play a significant role in preparing offerings.

The combination of legislation, judicial opinions and SEC rule-making over the last thirty years laid the ground work for the crisis we are now experiencing. It is time to undo the damage. Putting an end to the unregulated world of Rule 144A offerings would be a great place to start.

Cross-posted from New Deal 2.0.