At the heart of the SEC's civil suit against Goldman Sachs -- and at the center of our story detailing many similar deals -- is a legal standard that is quite cloudy. Here is the first line of the SEC's complaint (emphasis mine):
The Commission brings this securities fraud action against Goldman, Sachs & Co. (“GS&Co”) and a GS&Co employee, Fabrice Tourre (“Tourre”), for making materially misleading statements and omissions in connection with a synthetic collateralized debt obligation (“CDO”) GS&Co structured and marketed to investors.
Financial firms selling securities are required to disclose all the information about their products that is "material" to an investor's decision to invest.
"The legal concept of materiality provides the dividing line between what information companies must disclose -- and disclose correctly -- and everything else," explained former SEC official Richard Sauer in a 2007 issue of The Business Lawyer. "Materiality, however, is a highly judgmental standard, often colored by a variety of factual presumptions." It's also "inherently situational," according to Sauer.
So what exactly is considered material information? I talked to several experts and got several answers. The only thing they seemed to agree on was this: It's "legally complex." It "depends on the situation." It's "not a clear line."
Generally, if a bank sold the complex investments known as CDOs while presenting investors with information that it knew was false or incomplete, investors could have grounds for legal action. Under securities law, both affirmative misrepresentation and sins of omission can be illegal. You can't say a CDO is risk-free if you know the underlying assets are on fire, and you also "can't make misleadingly partial disclosures," according to Sauer.
If that sounds fairly simple, consider this: Standards of materiality also depend on the type of investor. It's generally understood that banks have fewer disclosure obligations when customers are so-called "sophisticated investors." That's why in a statement on Friday, Goldman Sachs argued that the investors in that particular deal "were among the most sophisticated mortgage investors in the world" -- the bank was appealing to a distinction in securities law. From Bloomberg:
“Materiality is a lot like a continuum,” said Jacob Frenkel, a former SEC lawyer now in private practice at Shulman Rogers Gandal Pordy & Ecker in Potomac, Md. “The amount of information that needs to be disclosed to institutional investors at the highest level, where they’re doing their own research and analysis, is less. Their criteria for the investment decisions tend to be far more sophisticated than the individual investor’s.”
The law doesn't specifically spell out the type of information that is material, but the outcome of the SEC's lawsuit against Goldman could set a legal precedent.
"This is all new territory," said Tom Hazen, professor of law at the University of North Carolina at Chapel Hill. The problem is that short of having more sophisticated rules governing CDO and derivative transactions, "the question is how many of these non-disclosures can fit into just traditional, fraud-based rules? That's why all the answers you're getting are 'Well, it could be,' or 'That's a good question."
It comes down to this: When financial innovation spurs the industry to make new products, and those products are so complex even lawyers are left scratching their heads, what you find is that rules for determining legal liability are also riddled with gray areas.
"Regulatory rules are pretty basic as to making pretty clear distinctions as to what can and cannot be done with many types of routine transactions," explained Hazen. "It's when financial innovation comes around that regulators have to decide, how are we going to adapt our regulations? Are we going to create new ones or not? And here they decided not to."
The gray areas in securities law and banks' disclosure responsibilities have posed significant challenges for individual investors trying to sue their banks for misrepresenting a product's risk.
"These are difficult cases to bring," said James Cox, a professor of securities law at Duke University. Because disclosure requirements are so situational, "CDOs and swaps, those markets do not lend themselves to class certification," even for investors in the same CDO. Goldman made 25 Abacus deals, but the SEC lawsuit tackles only one.
The current financial regulation bill in the Senate proposes a one-year study to consider expanding fiduciary duty to apply to more investment situations. Making that a requirement would mean banks would in effect have higher disclosure requirements since it would make more information material for more investors. It would also chip away at the "sophisticated investor" defense. The Senate bill originally had such language expanding banks' responsibilities. But the bill has since been revised to require only that the matter be studied.
This means that for the time being, what we're left with is an indeterminate level of obligation to investors and a murky legal standard so complex that it has rendered legal recourse mostly unsuccessful -- at least so far.