SEC to Prohibit Firms From Betting Against Products Sold to Investors

The U.S. Securities and Exchange Commission (SEC) has issued SEC Release 2011-185, which will prohibit material conflicts of interest between those who package and sell asset backed securities (ABS) and those who invest in them. The bottom line is that firms would no longer be allowed to bet against the very complex products that they have created and sold to investors. This would eliminate firms being able to package an ABS, sell it to investors and then short the ABS to make a profit when it fails and the investor losses money.

Firms who package asset backed securities (ABS) would be prohibited from engaging in transactions that would result in a conflict of interest for a set time period. The new law will restrict underwriters, placement agents, initial purchasers, or sponsors of any asset backed security (ABS) from shorting the assets in the pool, creating a conflict of interest, for a one year period. The new SEC proposal be an added provision in the Dodd-Frank Act.

The move is to prevent another Goldman/Paulson situation, where another firm helped pick the underlying assets in order to allow them to profit when the investment failed. In that deal Goldman was accused of packaging and selling a collateralized debt obligation (CDO) which was named ABACUS 2007-AC1. Paulson & Company, a hedge fund company, helped to pick the underlying securities and was betting that investment would fail. Goldman Sachs cut a deal with the SEC to settle all charges of misrepresentation and non-disclosure for a record $550 million.

Luis Aguilar, SEC Commissioner, said, “In the aftermath of the financial crisis, it became clear that firms were creating financial products, selling those same products to their customers and then turning around and making bets against those same products they just sold.” “The proposal under consideration is an important step forward to prohibit this practice and to protect investors from being persuaded to invest in products designed to fail.”

The SEC has asked for public comment on the proposal in hopes of industry consideration of it in conjunction with the Volcker rule, which would serve to restrict proprietary trading at banks and affiliates. It too has some hedging exemptions, just as does the SEC proposal.

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