Download Explaining Cross-Sectional Differences in Credit Default

Off-Shore Short Sales after
Morrison: Will the SEC be
Emboldened or Constrained?
Edward Pekarek, Esq. and Soufiane Cherkaoui
1
Reading Questions
1.
Describe the intricate structuring of the ABACUS transaction.
2.
Define a credit default swap (CDS) and identify the parties executing
the transaction.
3.
What risk(s) did each party in the ABACUS transaction bear when
entering the CDS?
4.
What role did Paulson play in the structuring of ABACUS?
5.
What problem(s) (if any) did Paulson’s involvement in the deal
present? What measures should Goldman have undertaken in
anticipation of such problem(s)?
6.
Summarize the SEC’s allegations against Goldman. What violations
of the U.S. securities (if any) did Tourre commit?
2
Reading Questions (continued)
7.
How might the Supreme Court’s ruling in Morrison inure to Tourre’s
benefit?
8.
What decades-long test did the so-called Morrison “transactional
test” supplant? What policies are served/not served by this
jurisprudential change?
9.
Discuss Congressional directives concerning the extraterritorial
application of the U.S. securities laws. Can these be reconciled
with Morrison?
10.
In light of Morrison and Dodd-Frank, what are the implications for
private actions (as opposed to SEC enforcement actions) brought
by shareholder litigants?
3
A Closer Look at the ABACUS
Transaction

Goldman issued Class A-1 and Class A-2 notes to IKB Deutsche
Industriebank AG (IKB), a foreign commercial bank.

Payment on the notes was derived from revenue generated by the
underlying assets – i.e., residential mortgage-backed securities (RMBS).

Goldman subsequently executed a Credit Default Swap (CDS) with ACA
Management, LLC (ACA) for the most senior CDO tranche.

This CDO tranche referenced a portfolio of RMBS, largely backed by
domestic subprime mortgages.
4
Credit Default Swap

A CDS is a contractual obligation between the seller and buyer, with the
latter obtaining a right for future compensation conditioned on the
happening of a credit event at a later date.

With the funds earned from note sales to IKB, Goldman entered into a CDS
agreement with ACA Management, LLC (ACA). Goldman made payments
of approximately 50 basis per year.

As a CDS seller, ACA earned a regular income stream of premium
payments. Its exposure totaled $909 million and represented the risk
associated with RMBS default rates in a distressed housing market.
5
Paulson Credit Opportunity
Funds

Paulson handpicked RMBS bearing strikingly similar characteristics.
For example, the hedge fund heavily favored those mortgages
carrying so-called “teaser” rates for homebuyers with low FICO
scores.

Paulson also favored RMBS that included a high concentration of
mortgages in states like Arizona, California, Florida, and Nevada.
These states had recently witnessed appreciation in home prices.

Paulson had initially selected and submitted a list of 123 sub-prime
RMBS to be included in ABACUS, none of which enjoyed a credit
rating greater than Baa2. Of the original Paulson submissions, 55
were accepted.
6
Short Selling ABACUS

Paulson developed a strategy to sell short the RMBS referenced by
ABACUS. It served as counterparty to ACA’s long position.

Paulson partook in the structuring of ABACUS selecting RMBS
reference assets likely to experience full or partial default.

Paulson, a Goldman client, was synthetically short-selling ABACUS.
Its interest was materially adverse to that of ACA.

Goldman should have made the requisite disclosures (including any
conflict of interest issues) to the investing public.
7
SEC Complaint

The SEC alleged that Goldman and Tourre (its employee) violated
U.S. securities laws — in particular, § 17(a) of the 1933 Securities
Act and § 10(b) of the 1934 Securities Exchange Act.

Specifically, the SEC alleged that the defendants misrepresented
Paulson’s economic interest in ABACUS as being aligned with that
of ACA, the collateral manager.

Goldman led ACA was to believe that Paulson had invested in the
equity tranche of the synthetically structured CDO, the first to
experience losses in the event the underlying RMBS declined in
value.
8
Extraterritorial Application of
Securities Laws under Morrison

In Morrison, the United States Supreme Court held that private
causes of action under Section 10(b) of the Exchange Act may not
be based (1) on the purchase or sale of securities listed on foreign
exchanges, or (2) on securities transactions otherwise occurring
outside the United States.

Tourre contended that the ABACUS notes were not listed on a
domestic exchange. The SEC, he maintained, could not
satisfactorily prove any violation of the federal securities laws. The
relevant transactions took place outside the United States.
9
“Conduct & Effects” Test

In Morrison, the United States Supreme Court fashioned the socalled “transactional” test, a departure from decades of precedent in
the federal courts. Until then, the courts had resolved disputes under
the “conduct and effects” test.

In so doing, the Court made it abundantly clear that the United
States would not entertain securities fraud cases imported from
overseas securities exchanges, irrespective of whether or not U.S.
actors (or U.S.-based activities) were involved.

Although it provides for seeming consistency in its application, the
“transactional” test may conflict with the overarching policy of the
U.S. securities laws – i.e., the protection of American retail
investors.
10
Dodd-Frank Act

The Dodd-Frank Act extended the application of the antifraud
provisions of the U.S. securities laws to instances where there is:
(1) conduct within the United States that constitutes significant
steps in furtherance of the violation, even if the securities
transaction occurs outside the United States and involves only
foreign investors; or
(2) conduct occurring outside the United States that has a
foreseeable substantial effect with in the United States.

The Dodd-Frank Act appears to have codified the former “conduct &
effects” test, rejecting the Morrison ruling.
11
Private Actions

The United States Supreme Court in Morrison held that private
litigants could not state a claim for extraterritorial application of the
U.S. securities laws.

Under the Dodd-Frank Act, however, Congress has directed the
SEC to report (18 months after enactment) on the extent to which
private rights of action should be extended.
12
Conclusion

The chapter discusses recent developments concerning the
extraterritorial application of the U.S. securities laws including:

The Securities and Exchange Commission’s pending litigation
against Goldman executive Fabrice Tourre;

The United States Supreme Court’s recent decision in Morrison,
articulating its so-called “transactional” test; and

The United States Congress’ legislative efforts to buttress the
Securities and Exchange Commission’s enforcement powers.
13