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.
muni bonds are exempt, as are US govt securities.
What is good for the goose ....
how would these markets be larger that makes no sense, why would any investor knowingly invest in an item that has less safety rules, and less openness when it comes to seeing what is its made of its like having a mcdonalds company that refuses to allow safety inspectors in, and they refuse to list their ingredients or caloric info, and than you have a burger king that does the opposite, they have extra safety checks and allow anyone to inspect their kitchen yet the majority of hungry people eat at the less safe joint, just boggles the mind
Mr. Madrick correctly states that Rule 144A is "... appropriate in limited circumstances ...", but the world of capital formation is in a constant, frantic rush and even the most sophisticated and disciplined people behave differently (often unscrupulously) in such circumstances.
Because Rule 144A is a privileged fast track around the "in terrorem" qualities of '33 Act Section 11 ... in cases where Rule 144A is used, perhaps there should be UNLIMITED PERSONAL LIABILITY, with mandatory jail terms where personal assets are sheltered. And, here's the key ... STRICT ENFORCEMENT, because, for the past ten years anyway, SEC enforcement has been a JOKE.
In the recent cases, lifetime industry bans, jail time and forfeiture of all personal assets should result. People like those at Goldman should be ferreted out, impoverished and shunned for the remainder of their lives if not jailed for that period. And, they should probably feel lucky that they haven't already been personally attacked by angry public mobs or lone wolf victims of their misdeeds.
Our politicians are paid off by banks, and our regulators are told what to do by former bankers.
We aren't going to be able to fix the industry until we render the industry politically powerless.
If shutting rule 144a down would do the same as eliminating the "holder in due course" provision for consumer transactions under article 3 it would be good. Article 3 eliminates the shielding a seller gets by selling a negotiable bond to a holder in due course and makes it possible for a consumer to sue seller for defective product. If this proposal makes it possible for people who buy bad bundled mortgages to sue those who originally sold them to them rather than being bailed out with taxpayer money then it's a good thing.
Also, after reading the Dodd will, which has a lot of exemptions, it seems clear that the loopholes will be retained, which will allow more fraud being commited.
Smoke and mirrors.
2008 A Bush in the WH, financial meltdown
coinky dink? I think not!
2000 - A Dem in the WH - Dot com bubble burst (NASDAQ still 50% of value at peak of irrational exuberance)
Who used nuclear weapons on women and children? a Democrat.
Who got us into Vietnam? Democrats.
It goes on and on.
Thanks for the timely article. The confluence of de-regulation, judicial opinions, and intimidate law-makers can no longer be considered circumstantial. It turns out that 1990 was another very bad year and it appears that we must go further and further back in the history of our financial business in order to illuminate our way to a safe future.
Please prepare the next article addressing what transpired in the eighties. We may as well get it over with as soon as possible.
What could possibly go wrong with a rule like that?