Burning Down the House or Simply Rolling the Dice: A Comment on Section 621 of the Dodd-Frank Act and Recommendation for Its Implementation

By Rosenthal, Joshua R. | Fordham Journal of Corporate & Financial Law, October 1, 2012 | Go to article overview

Burning Down the House or Simply Rolling the Dice: A Comment on Section 621 of the Dodd-Frank Act and Recommendation for Its Implementation


Rosenthal, Joshua R., Fordham Journal of Corporate & Financial Law


ABSTRACT

Section 621 of the Dodd-Frank Wall Street Reform and Consumer Protection Act modifies the Securities Act of 1933 to prohibit the underwriter, placement agent, initial purchaser, or sponsor, or any affiliate or subsidiary of any such entity of an asset-backed financial product from betting against that very product for one year after the product's initial sale. The rule prohibits anyone who structures or sells an asset-backed security or a product composed of asset-backed securities from going short, in the specified timeframe, on what they have sold, and labels such transactions as presenting material conflicts of interest. This Comment discusses traces this new law's development through the Financial Crisis by recounting the events involving alleged material conflicts of interest that gave rise to Section 621's drafting as well as statements of its drafters. The Comment then argues that adding a disclosure exemption to Section 621 via the corresponding SEC regulation implementing it would be preferable to an outright prohibition because a disclosure exemption would 1) be more consistent with the securities laws; 2) provide purchasers with sufficient protection while still allowing the markets to operate with limited restriction; and 3) allow buyers to price the risk of securities affected by material conflicts of interest.

INTRODUCTION

Section 621 ("Section 621") of the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank" or the "Dodd-Frank Act") modifies the Securities Act of 1933 to prohibit the underwriter, placement agent, initial purchaser, or sponsor, or any affiliate or subsidiary of any such entity of an asset-backed financial product from betting against that very product for one year after the product's initial sale.1 The rule prohibits anyone who structures or sells an asset-backed security ("ABS") or a product composed of asset-backed securities from going short, in the specified timeframe, on what they have sold.2 This runs counter to the established principles of the the federal securities laws, which focus primarily on disclosure and include few per se bans on transactions.3

In the midst of the Financial Crisis, the SEC and Congress launched investigations focused on alleged misdeeds by one of Wall Street's biggest players, Goldman, Sachs & Co ("Goldman").4 At the core of the government's interest in Goldman lay several structured financial products. Among those products was "ABACUS 2007- AC 1," a highly controversial offering because it referenced a portfolio of subprime residential mortgage backed securities chosen by a party that went short, or bet against, that same referenced portfolio.5 At the same time, Goldman structured and sold a series of similar products that the institution itself shorted.6 Alarmed, Senator Carl Levin of Michigan and Senator Jeffrey Merkley of Oregon labeled such deals as "Designed to Fail," and drafted Section 621 in response.7

From their understanding of Goldman's alleged misdeeds, Section 62 G s authors argue that assembling asset-backed securities and selling them should require heightened duties to one's clients because such assemblers have extraordinary "control over whether a security is intended to succeed or fail."8 Despite this potential for control, the securities laws already provide sufficient remedies for those damaged by such assemblers and thus, provide incentives against such misdeeds.9

By enacting Section 621, Congress, in essence, responded "No" to the following question: Would you allow someone to live in a house where the house's electrician had an insurance policy that rewarded him in the event the building were to burn down?10

Now, consider the following question: Is it illegal or unacceptable for a casino1 ' to set odds on the outcome of a sports game, take bets from gamblers and then profit from the spread of odds and the losses incurred by the gamblers? No, because it is expected that casinos will set odds in their favor (and no one forces the gambler to wager his money) and the gambler is privy to the same information that the casino has. …

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