Loyola University Chicago School of Law, JD 2024
The 2008 financial collapse occurred when banks began substantially increasing access to debt. They offered adjustable-rate mortgages to borrowers who could afford the initial mortgage payments, but would end up defaulting on the loans when their adjustable interest rates kicked in. The banks then subsequently packaged these high-risk loans together and sold them as securities to mutual funds, investment banks, and pension funds. When most of these high-risk loans defaulted, the market crashed. The recession that followed cost the public thousands of jobs, homes, and retirement accounts.
Before the market crashed, some of the Wall Street banks that created the risky mortgage securities began to bet against these securities. When the market crashed, banks like Goldman Sachs saw huge profits from betting against securities that they had created. This practice represents an obvious conflict of interest. The Congressional investigation that followed labeled Goldman Sachs as a “case study of the recklessness and greed of Wall Street”. Goldman later settled with the Securities and Exchange Commission (SEC) for $550 million, which constitutes the largest penalty in SEC history.
The proposed rule
On January 25, 2023, SEC Chair Gary Gensler proposed a new rule that would address conflicts of interest related to transactions involving asset-backed securities. The rule would “prohibit securitization participants from engaging in certain transactions that could incentivize a securitization participant to structure an asset-backed security (ABS) in a way that would put the securitization participant’s interests ahead of those of ABS investors”. Essentially, the rule would prevent the sale of an ABS that is tainted by material conflicts of interest. If the rule is implemented, transactions involving material conflicts of interest would be categorized as “conflicted transactions”, and the underwriter, agent, intial purchaser, or sponsor of an ABS would be prohibited from engaging in those transactions for at least one year.
This constitutes the SEC’s second attempt to address this Wall Street practice since the 2008 market crash. The SEC initially attempted and failed to implement a similar rule back in 2011. The initial push to ban these types of conflicted transactions came as a response to section 621 of the Dodd-Frank Act. Congress passed the Dodd-Frank bill with an intention to ban these types of transactions. After pushback from market executives, the SEC did not ultimately implement the rule in 2011. After more than a decade since Congress passed the Dodd-Frank Act, the SEC has not been able to implement a rule that applies Section 621.
The SEC under Gensler
Gensler’s new attempt to apply Section 261 has been part of an ambitious rulemaking agenda. Gensler was appointed as SEC chair in April 2021 and since then has amassed more than 50 ongoing rulemaking projects. Gensler’s ambitious agenda has drawn criticism for the swiftness of the changes, and the costs that Wall Street firms will undergo to implement the changes. However, Gensler has said that this proposed rule is necessary because there are still opportunities for securities underwriters to place their interests before the interests of their purchasers.
Many disagree with Gensler’s assessment. Opponents to the proposed rule have argued that betting against a security is simply a form of insurance to mitigate risk. Critics of the proposed rule have analogized the practice to the purchase of auto insurance. A person purchases auto insurance as a “bet” against themselves. In the event that they do crash, then they have a form of financial protection. Opponents also argue that purchasers are mitigating risks when a firm sells a security and subsequently bets against the interest of security. Section 621 exempts from prohibition transactions that mitigate risk. However, the announcement from the SEC did not detail how the SEC will interpret mitigation of risk concerns.
The effectiveness of the new rule should be measured by how well it deters behaviors like those of Goldman Sachs immediately before the 2008 crash. The statement announcing the proposed rule does not do enough to adequately describe the behavior it seeks to prohibit. The essence of this proposed rule is to discourage the sale of securities that the seller knows will likely fail and subsequently profit from that failure. The language of the proposed rule may be overly broad, which opens the rule up to criticism. The SEC should re-frame their language around the proposed rule so that it is not prohibiting risk mitigation but rather discourage fraud.