Massey Energy and Walmart made headlines last week for different reasons. Massey had the worst mining disaster in 40 years, killing 29 employees and entered into a nonprescution agreement with the Department of Justice. The DOJ has stated in the past that these agreements balance the interests of penalizing offending companies, compensating victims and stopping criminal conduct “without the loss of jobs, the loss of pensions, and other significant negative consequences to innocent parties who played no role in the criminal conduct, were unaware of it, or were unable to prevent it.”

Massey’s new owner Alpha Natural Resources, has agreed to pay $210 million dollars in fines to the government, compensation to the families of the deceased miners and for safety improvements (the latter may be tax-deductible). The government’s 972-page report concluded that the root cause was Massey’s “systematic, intentional and aggressive efforts” to conceal life threatening safety violations. The company maintained a doctored set of safety records for investigators, intimidated workers who complained of safety issues, warned miners when inspectors were coming (a crime), and had 370 violations. The mine had been shut down 48 times in the previous year and reopened once violations were fixed.  112 miners had had no basic safety training at all.  Only one executive has been convicted of destroying documents and obstruction, and investigations on other executives are pending. However, the company itself has escaped prosecution for violations of the Mine Safety and Health Act, conspiracy or obstruction of justice. Perhaps new ownership swayed prosecutors and if Massey had its same owners, things would be different. But is this really justice? The miner’s families receiving the settlement certainly don’t think so.

Walmart announced in its 10-Q that based upon a compliance review and other sources (Dodd-Frank whistleblowers maybe?), it had informed both the SEC and DOJ that it was conducting a worldwide review of its practices to ensure that there were no violations of the Foreign Corrupt Practices Act (“FCPA”).  Although no facts have come out in the Walmart case and I have no personal knowledge of the circumstances, let’s assume for the sake of this post that Walmart has a robust compliance program, which takes a risk based approach to training its two million employees in what they need to know (the greeter in Tulsa may not need in-depth training on bribery and corruption but the warehouse manager and office workers in Brazil and China do). Let’s also assume that Walmart can hire the best attorneys, investigators and consultants around, and based on their advice, chose to disclose to the government that they were conducting an internal investigation.  Let’s further assume that the incidents are not widespread and may involve a few rogue managers around the world, who have chosen to ignore the training and the policies and a strong tone at the top.

As is common today, let’s also assume that depending on what they find, the company will do what every good “corporate citizen” does to avoid indictment --disclose all factual findings and underlying information of its internal investigation, waive the attorney client privilege and work product protection, fire employees, replace management, possibly cut off payment of legal fees for those under investigation, and actively participate in any government investigations of employees, competitors, agents and vendors.

Should this idealized version of Walmart be treated the same as Massey Energy? (For a great compilation of essays on the potential conflicts between the company and its employees, read Prosecutors in the Boardroom: Using Criminal Law to Regulate Corporate Conduct, edited by Anthony and Rachel Barkow).  Should they both be charged and face trial or should they get deferred or nonprosecution agreements for cooperation? Do these NPAs and DPAs erode our sense of justice or should there be an additional alternative for companies that have done the right thing -- an affirmative defense?

A discussion of the history of corporate criminal liability would be too detailed for this post, but in its most simplistic form, ever since the 1909 case of New York Central & Hudson River Railroad Co v. United States, companies have endured strict liability for the criminal acts of employees who were acting within the scope of their employment and who were motivated in part by an intent to benefit the corporation.  As case law has evolved, companies face this liability even if the employee flouted clear rules and mandates and the company has a state of the art compliance program and corporate culture.  In reality, no matter how much money, time or effort a company spends to train and inculcate values into its employees, agents and vendors, there is no guarantee that their employees will neither intentionally nor unintentionally violate the law.

The DOJ has reiterated this 1909 standard in its policy documents. And because so few corporations go to trial and instead enter into DPAs or NPAs, we don’t know whether the compliance programs in place would have led to either the potential 400% increase or 95% decrease in fines and penalties under the Federal Sentencing Guidelines because judges aren’t making those determinations. The DPAs are now providing more information about corporate compliance reporting provisions, but again, even if a company already had all of those practices in place, and a rogue group of employees ignored them, the company faces the criminal liability. The Ethical Resource Center is preparing a report in celebration of the 20^th Anniversary of the Sentencing Guidelines with recommendations for the U.S. Sentencing Commission, members of Congress, the DOJ and other enforcement agencies. They are excellent and timely, but they do not go far enough.

A Massey Energy should not receive the same treatment as my idealized model corporate citizen Walmart. Instead, I agree with Larry Thompson, formerly of the DOJ and now a general counsel and others who propose an affirmative defense for an effective compliance program- not simply as possible reduction in a fine or a DPA or NPA.

While the ideal standard would require prosecutors to prove that upper management was willfully blind or negligent regarding the conduct, this proposed standard may presume corporate involvement or condonation of wrongful conduct but allow the company to rebut this presumption with a defense.

In the past decade, companies drastically changed their antiharassment programs after the Supreme Court cases of Fargher and Ellerth allowed for an affirmative defense. The UK Bribery Act also allows for an affirmative defense for implementing “adequate procedures” with six principles of bribery prevention. Interestingly, they too are looking at instituting DPAs.

I would limit a proposed affirmative defense to when nonpolicymaking employees have committed misconduct contrary to law, policy or management instructions. If the company adopted or ratified the conduct and/or did not correct it, it could not avail itself of the defense. The company would have to prove by a preponderance of the evidence that: it has implemented a state of the art program approved and overseen by the board or a designated committee; clearly communicated the corporation’s intent to comply with the law and announced employee penalties for prohibited acts; met or exceeded industry standards and norms; is periodically audited and benchmarked by a third party and has made modifications if necessary; has financial incentives for lawful and penalties unlawful behavior; elevated the compliance officer to report directly to the board or a designated committee (a suggestion rejected in the 2010 amendments to the Sentencing Guidelines); has consistently applied anti-retaliation policies for whistleblowers; voluntarily reported wrongdoing to authorities when appropriate; and of course taken into account what the DOJ has required of offending companies and which is now becoming the standard. The court should have to rule on the defense pre-trial.

Instead of serving as vicarious or deputized prosecutors, under this proposed standard, a corporation’s cooperation with prosecutors will be based on factors more within the corporation's control,rather than the catch-22 they currently face where if employees are guilty, there is no defense. And if the employees are guilty, this would not preclude the government from prosecuting them, as they should.

Responsible corporations now spend significant sums on compliance programs and the reward is simply a reduction in a fine for conduct for which it is vicariously liable and which its policies strictly prohibited. A defense will promote earlier detection and remedying of the wrongdoing, reduce government expenditures, provide more assurance to investors and regulators, allow the government to focus on companies that don’t have effective compliance program, and most important provide incentives for companies to invest in more state of the art programs rather than a cosmetic, check the box initiative because the standard would be higher than what is currently Sentencing Guidelines.

Perhaps only a small number of companies may be able to prevail with this defense.  Frankly, corporations won’t want to bear the risk of a trial, but they will at least have a better negotiating position with prosecutors. Moreover, companies that try in good faith to do the right thing won’t be lumped into the same categories as those who invest in the least expensive programs that may pass muster or worse, engage in clearly intentional criminal behavior.  If companies have the certainty that there is a chance to use a defense, that will invariably lead to stronger programs that can truly detect and prevent criminal behavior.

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I must admit I have been a bit surprised (though happily so) by the seeming strength of the endorsement and support for Breast Cancer Awareness Month by some sports programs.  I have seen this support not only at the professional level, but also with respect to college and even high school sports.  Certainly the NFL has done a lot in this regard, from coaches and players' hats, players' cleats, and arm bands to pink symbols on the football field and padding on goal posts.  The NFL has provided visible signs of its support and endorsement of the fight against breast cancer.  The NFL also has a website pinpointing critical issues related to breast cancer, indicating ways in which people can support the fight, and highlighting  personal stories from NFL players and others connected to the NFL.  Given the impact and influence of sports in this country, this kind of partnership sends a strong message (with some equally strong resources behind it).  Recently, as I was riding in a cab, I noticed a pink cab, and my cab driver told me that the owner of the cab dedicated her all of her fares to the fight against breast cancer.  Intrigued, I decided to dig a bit deeper.  While I did not find information about that particular pink cab, I did discover that many cab companies across the nation had agreed to paint at least one of their cabs pink and engage in a variety of endeavors aimed at support the fight against breast cancer from donating a portion of their cab fares, to providing free cab rides to those in need of transportation for breast cancer treatment.  Like the companies here and here.  I think one of the key goals of the CSR movement should be to promote partnerships between the nonprofit and for-profit sectors pursuant to which the for-profit entity helps raise awareness regarding important issues and responsibly uses its particular business resources, expertise, and influence to address those issues.  Pink cabs appear to reflect this goal, which is why I found myself trying to hail one when I next needed a cab ride. . .

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Another college football scandal, another round of calls for the NCAA to get tough on schools.

Why can’t we just admit that the NCAA is doomed to perpetual failure? Enforcing amateurism in big revenue sports is just a price control on the labor of college-age athletes. Price controls succeed mainly in creating black markets. Although, if they are effectively enforced, price controls can reduce supply.

But does the NCAA really want to reduce supply? Does it really want to enforce its rules? Miami won’t be treated like SMU and have its football program shut down because that would hurt television revenue.

There are really three explanations for why the NCAA seeks to enforce price controls:

1. It sincerely believes that doing so will encourage schools to provide the students who are generating the billions of dollars in revenue to NCAA schools with an education. (This focuses only on the supply side of education and ignores the demand side.  It also is only lightly tethered to reality.).

2. It wants to prevent rising labor prices for student athletes from eating into the revenue to schools.

3. It needs to protect the “amateur” brand that it thinks creates such strong demand for its product.

If this last assumption is true, it leads to a perverse result: demand for amateurism threatens to undermine that amateurism. As a result, the NCAA would have to do just enough enforcement to maintain a perception of amateurism.

Likely some combination of all three of the above explanations accounts for the continuing NCAA game: being “shocked, shocked” to find that college athletes are getting paid under the table and then imposing some penalties on schools, but not enough to actually hurt the egg-laying goose.

So let’s be frank. Division 1 football and basketball is about gobs and gobs of money. If universities would like to engage in a little less hypocrisy and actually serve the interests of its money-generating athletes, isn’t it time to actually test the premise of reason number three above? Is amateurism really essential to rabid demand for college football and basketball? Let’s pay college athletes a market rate for bringing in revenue to their schools. Better yet, let’s have schools sponsor professional athletic teams.

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Marketplace ran a story on Friday about Walmart's banking operations in Mexico. Glom friend Anna Gelpern has written about the Walmart bank, and she was interviewed for the Marketplace story. I blogged about Walmart's prospects as a U.S. bank here, inspired by my now-colleague Mehrsa Baradaran. The U.S. Walmart bank that Mehrsa and I were imagining bears only a slight resemblance to the Mexican version, which "does not offer car loans or mortgages, but ... offer[s] a credit card so customers can buy Wal-Mart merchandise." By the way, the annual interest rate on the credit card is 60 percent. Still, Anna is sanguine about the development for Mexico, where most of the population does not use a bank:

Whatever the pros and cons of a Wal-Mart bank might be in the United States, they look quite different in an environment where, despite recent growth, there is little credit, no competition, and a fresh history of political, economic, and legal instability. Wal-Mart is among the few actors capable of dislodging the dysfunctional status quo.

Banco Walmart "presents a transnational regulatory dilemma," Anna tells us, and that is the subject of her paper. But Walmart is quickly getting on the map for bank regulators. Earlier this summer, the company opened banking operations in Canada, and Sam's Club has started making small business loans. It looks to me like Walmart is developing institutional competence in banking that will serve it well when it moves on a bigger scale into the U.S.

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I love to read "Corner Office" in the Sunday NYT Business section, which presents micro-interviews with interesting executives.  On Sunday, Corner Office featured Aaron Levie, who is 25 years old and a co-founder of Box.net.  Box.net is a successful venture capital-funded start-up that provides a web-based platform for companies to store and share documents.

I like to read the answers to question about what the executive looks for in hiring, particularly if there are any nuggest of wisdom we can use in the law firm hiring world.  Two things stood out here.

One, Levie says that he looks for are "energy and persistence. . . in addition to just having a clean résumé where there's nothing crazy going on.  In a business like ours, we have to be super, super competitive."  What does that mean?  I'm not sure.  The "clean résumé" says to me that he looks for a very linear, driven personality.  Someone that goes from high school to college to grad school to being CEO in one swoop without any veering off path.  The résumé that doesn't show you switching colleges or jobs multiple times.  Most people tend to look for people who remind them of themselves, and he is an energetic, persistent person who followed a pretty straight course. 

Unfortunately, I think a lot of folks hiring, even in the law school world, look for the "clean résumé."  Why do I think this is unfortunate?  Because you can't fix a muddy résumé once it's muddy.  You can try to make the most recent part as clean as possible, and maybe over time early stuff can fall off the résumé, but it's tough.  Is the clean résumé a good proxy for energetic and persistent?  Maybe, but one can also grow in energy and persistence over time.

Second, Levie values curiosity as a proxy for "who's going to be energetic and have the right attitude."  He wants to interview people who are curious about his business.  This reminds me of the dreaded law firm interview question "So, do you have any questions for us?"  (Also related to the dreaded law school interview question.)  Yes, great questions would show curiosity.  But, a few obstacles.  One, most law firms have the same business model, so coming up with an authentic question here is difficult.  Second, law firm life is fairly conservative and hierarchical, and there may be a fine line between curious and intermeddling.  Levie may be looking for someone who'll come in and think outside to improve the business model.  Most law firms are not.  And maybe that's a problem.

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My efforts to prepay my summer rent in Berlin have been a fascinating tour of modern payment systems and foreign currency risk. Here’s the scoop: my rent is due in full June 1st. My landlord would like the money early and agreed to pay the transfer fees if I could prepay. One additional complication, I need to use my University’s credit card.

I first tried Paypal – but the transaction got dinged based on a paypal algorithm that tries to detect fraud. Setting up a wire transfer takes time (and further navigating the University bureaucracy) not to mention higher fees than Paypal. I then ran across this alternative for foreign currency transfers: xoom. It worked like a charm, although having taught payment systems once I did carefully read the terms of use to figure out what my recourse would be should the money go into the wrong German account, or should there be no apartment when I arrive in Berlin.

Xoom is just one of a bevy of new payment systems that have emerged in the last several years. Glompetitor Tim Zinnecker has already pointed out the great article in Wired magazine two months ago on the future of payment systems. When I agreed to prepay, I thought the fees I saved would more than offset the time value of money. What I didn’t anticipate was that little ‘ole me would also be subject to foreign currency risk; I guess I need to read Kim Krawiec’s posts over at the Glompetition on the Greek debt crisis on a more regular basis.  In all seriousness, I do feel blessed though that my personal stakes in the foreign currency swings are so trivial (so far) compared to what many in Europe are going through.

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My first reaction to the SEC's Goldman case was skeptical, and it now appears that there are plenty of commentators who agree. I've since had a chance to look more closely at the complaint, and, while as complaints go, it is a model of brevity and clarity, I'm still unconvinced by the case.

• Much has been made of the fact that Paulson helped pick the securities in the instrument that he wanted to short.  I'm not sure that we'd want to start policing real estate brokers for getting tips on properties to sell from people interested in selling, and that doesn't seem too different to me than this.  Someone had to pick the assets referenced by the CDO, and requiring them to be a mirror of the state of the residential market is both silly and impossible.  And as the complaint itself notes, ACA (the manager of the debt obligation at issue in the case) was getting emails entitled "Paulson Portfolio" during their involvement in selecting collateral.
• Fraud of omission is always a troubling claim to make, but that's what the SEC's complaint relies on in large part.  Paulson's role "was not mentioned" to purchasers of the upside of the CDO.  Again, Paulson was hardly known for his brilliance when the transaction was designed, so I doubt it would have made a difference.  As for the number of things that could have been mentioned, but were not, when some big banks made long bets in favor of US residential mortgage market (and see John Carney on this), the imagination runs riot.
• Most compelling, to me at least, is the fact that ACA may not have known that Paulson was short, when Goldman knew it.  This is because ACA kind of asked Goldman what Paulson was doing.  On P46 of the complaint, they sent an email to Goldman after meeting with Paulson saying "we didn't know exactly how they [Paulson] want to participate in the space.  Can you give us some feedback?"  That feedback is not, potentially, fraud by omission, it's fraud by commission.  Still, ACA knew Paulson's fingerprints were all over the deal. 
• And, of course, a fundamental problem for the SEC is the sophisticated nature of every party to the transaction.  The SEC often describes its mission as one of consumer protection.  But the consumers in this case didn't need to be protected.  They weren't even consumers, as you or I often think of that term.  They were traders.
• A final note on relief.  The prayer for relief is standard, but most banks can overcome fines and disgorgement - Goldman certainly can.  That prayer for a judgment "Permanently restraining and enjoining GS&Co and Tourre from violating section 17(a) of the Securities Act....Section 10(b) of the Exchange Act....and Exchange Act Rule 10b-5" is a bit like the yellow card of securities enforcement. Violate it again, and you could get red carded from the securities industry, let alone exposed to contempt of court orders, which are no laughing matter.

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While we are on the subject of pure bets, when will there be a prediction market on the outcome of this case?  When will you be able to place your bets?

I am not ready to take an official position - "Goldman is liable" or the "SEC will lose."  What law professor would given that we are only at the beginning of learning the facts?

But that doesn't stop you from making educated guesses and bets.  There is of course an active arbitrage market on Wall Street betting on the outcome of things like high profile litigation and whether a regulator will allow a merger to go through.

When there is a Goldman prediction market, prices will change as new facts come up.

Is there any social value to this type of bet? -- you can probably predict what I will say if you read a previous post -- depends if any party to a bet has a pre-existing risk.

And there is entertainment value.

Would there be any intellectual value to a prediction market beyond giving me something to blog about?  Remember Oliver Wendell Holmes' old adage that law is just a prediction of what a court will do.

Does that mean a prediction market is the law?   

Addendum:  I wouldn't be at all shocked if lawyers -- even law professors -- will be hired by arbitrageurs to evaluate bets on the case.  There may be a lot less professional risk if you are placing a bet without putting your name in writing or on a blog. 

Here is a more gossipy question: if you were hiring a lawyer or law professor to help you place a bet on the outcome of the case, who would you pick? 

Here is a half serious legal question: could there be market manipulation if a professor then writes statements to influence the price without disclosing her interest?

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In a previous post, I noted that the SEC's case that Goldman failed to disclose the Paulson & Co hedge fund's role in selecting the collateral might be weakened, because the investors themselves likely were told which assets went into the CDO.  To rehash my metaphor, it isn't as critical to know who selected the deck when you know the cards in the deck.  Evidently, I was not alone in this conclusion -- see some of the reactions of other law professors in the NY Times. 

Offline, a reader pointed me to a paper that convinced me that I might be completely wrong about this.  The paper's conclusions may turn out to have pretty significant implications for this case.

Here's the insight, an October 2009 paper by a team of computer scientists and an economist at Princeton argues that the parties that structure a CDO may be able to hide lemons -- that is assets that they know are subpar -- in the collateral of a CDO through carefully structuring the CDO.  The investors in the CDO may find it impossible to detect these lemons even when the collateral is fully disclosed and the investors are sophisticated and have significant computing resources.

Why? The paper (Arora et al., "Computational Complexity and Information Asymmetry in Financial Products") argues that the complex structuring of derivatives can create "computational intractability."  In layperson terms, finding the "lemons" can become an inordinately difficult mathematical problem.  Unless an investor has unlimited computational power, it may not be able to "solve" the problem and detect the lemons.  It's the same problem that occurs with trying to decode computer messages protected with a certain level of encryption.  The structuring of the deal functions as a kind of encryption to camoflauge the bad assets.

This means that the party that both selects the collateral and structures a complex derivative (like a synthetic CDO)  has a potentially insurmountable information advantage over its counterparties. One blog commentary on the paper likened this advantage of the structurer to being able to hide a booby trap in plain sight.  (In an amusing twist, the paper argues that "even Goldman Sachs" wouldn't be able to detect the lemons).

What could this mean for the Goldman case?  Many things.  First, we shouldn't assume that even when the investors (or ACA, the collateral manager for that matter) knew what the collateral was that they could easily detect any lemons.  Arguments that the investors and ACA were sophisticated and should have been able to fend for themselves should be given less weight.  Conversely, arguments that investors need to rely on the proper incentives (or at least the disclosure) of both the party that selected the collateral and the party that structured the deal gain a lot more weight.

Second, how the deal was structured (not just how the collateral was selected) may prove to be crucial.  From the SEC Complaint, it looks like Goldman structured the deal and that ACA was mainly involved in the collateral selection.  It is unclear if Paulson played a role in structuring the deal.  Did Goldman structure the deal to "hide" the Paulson-selected assets?  Unfortunately, based on the conclusions of the Princeton paper, detecting this hiding is subject to the same intractibility problem.  Unless there is some "smoking gun" evidence -- e.g. loose-lipped e-mail correspondence, testimony from Goldman employees.  Even the absence of a smoking gun doesn't detract from the first point -- that the investors wouldn't be able to detect lemons even if the collateral was fully disclosed to them.

Third, this insight means that an already complex case may require even more expert witnesses -- let's see if the Princeton team gets a call.

On a personal level, I need to think more about what this means for my own research on using technology to improve securities disclosure and address "complexity."

(I would like to thank the reader (who'd like to remain anonymous) who prompted this post and pointed me to the Princeton paper.)

Addendum 4/21:  Several readers have noted that the Princeton study that a seller of assets can hide "lemons" in a CDO through structuring is premised on the fact that the seller enjoys an advantage of asymetric information.  We don't know if Paulson had nonpublic information about the assets it wanted in the CDO.  If ACA and the CDO investors had access to all the information Paulson did about the assets Paulson requested go into the portfolio.  Drawing a bright line between public and nonpublic information is not as easy at it may sound.  We could always say that an investor should have done more homework on a particular asset-backed security -- even, to use the Princeton example, inquiring whether there were "liar's loans" backing certain collateral a seller is putting into a CDO.  This goes back to a recurring point in my posts -- that how much homework the ACA/investors would do on Paulson-requested collateral and how toughly they would negotiate with Paulson depends on whether they thought he was betting with them or against them.   

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As I posted yesterday, the legal case against Goldman boils down to disclosure, particularly to this question:

“Did Goldman have to disclose to investors in the ABACUS CDO that the Paulson hedge fund, who was shorting the CDO, was involved in selecting the collateral?”

Listening to the radio last night, I heard a number of commentators talk about how investors should have known that there were investors – including Paulson -- out there that would buy credit default swaps and bet against their CDO investments. When you gamble, you should assume someone will bet against you. The question in this case is whether you should be told that that this gambler betting against you selected the cards in the deck.

Would a reasonable investor want to know who picked the cards in the deck?

My guess is that a reasonable investor would indeed want to know that Paulson was involved in selecting the deck. What’s the support for this beyond the SEC’s Complaint? Look at the “flipbook” for the transaction provided to investors by Goldman (posted on the NY Times). It goes on at length of why ACA is a good collateral manager for the CDO. On p. 27, it includes a bullet point “Alignment of Economic Interest.” The SEC complaint zooms in on this little nugget (see Complaint Para. 38). (Note to law students: bullet points in “powerpoint” style are not only bad devices to communicate ideas, they have some itty bitty securities law problems when used to market securities. If you can’t formulate something in a complete sentence, try again.) Nowhere does the flipbook mention that the Paulson hedge fund was involved in selecting the collateral for the CDO.

Hurdles for the SEC

Does this mean the SEC has a slam dunk case? No; they have plenty of other legal hurdles. [More after the break]

For starters, even though Paulson’s role in selecting the deck wasn’t disclosed to investors, the deck itself likely was. In other words, investors probably were told of the assets put into the CDO (I can’t say for sure, since I have not seen the prospectus given to investors, but would be shocked if it didn’t disclose in some detail the “reference assets”). This disclosure might lessen the importance of disclosing Paulson’s role in selecting the assets.

ACA’s role

A large chunk of the SEC Complaint focuses on the fact that ACA was duped into thinking that Paulson had invested in the CDO and was not betting against it. This section of the complaint highlights that the SEC needs to downplay the ACA’s ultimate responsibility for the collateral. The SEC’s argument goes like this:

1. ACA did not know Paulson was betting against the CDO. It thought Paulson was investing in the CDO.

2. If ACA had known that Paulson was betting against the CDO, it would not have acted as collateral manager (largely because its reputation would suffer because it would be seen as picking cards that would hurt the CDO investors).

3. If ACA had not acted as collateral manager, investors (like the German bank IKB) would not have bought the securities.

Goldman will likely try to saw away at each of the links in this chain. I am assuming that the SEC is not making these statements out of thin air, but has the cooperation of ACA and IKB. How well will these allies do in depositions? Did ACA really not know (or should it have known) that Paulson was not investing in, but betting against the CDO? Other commentators have noted that Paulson was becoming famous on Wall Street for betting against mortgage backed securities. The assertion that ACA didn’t know of Paulson’s bet may be a weak spot in the SEC case.

Causation and damages after Freefall

In a 10b-5 case, my Business Associations 2 students can tell you that the SEC still has to prove various other elements beyond whether the disclosure was materially misleading. Causation and damages might prove particularly tricky. The SEC focuses in the complaint on the number of the ABACUS CDO bonds that were downgraded. Downgrades don’t give us a sense of monetary damages. True – the complaint later mentions that the IKB lost most of its $150 million investment.

This looks a little grim for GS, but one big question is about “the baseline.” In other words, “shouldn’t we subtract market-wide losses from damages?” As the SEC Complaint notes, the ABACUS CDOs lost in value in the midst of market-wide losses in asset-backed securities tied to mortgages. Analyzing elements like causation and damages is extremely tricky during market-wide crashes. But not impossible – (see Lev & de Villiers, Stock Price Crashes and 10b-5 Damages: A Legal, Economic, and Policy Analysis, 47 Stan. L. Rev. 7 (1994) for an one, older treatment of this question.) Analyzing causation and damages would be greatly complicated if the market for a given class of security is frozen – with very few buyers.

What should investors be charged with knowing about the risk?

Many commentators asked whether the investors in the ABACUS should have known that the securities they were buying were extremely risky. Again, lots of mortgage-backed securities plummeted in value. This case is noteworthy for how late the ABACUS deal closed – April 2007, when the subprime real estate, mortgage-backed security, and ABS markets were already wobbling hard. That was pretty late in the game of musical chairs to be starting another dance.

Goldman will likely use this particular argument – investors should have known the general risks in these securities -- in multiple doctrinal places in the litigation – not just causation and damages.

Usha’s post reminded me of the 2003 opinion by Lewis Pollack in In re Merrill Lynch, in which Judge Pollack (known as a securities law expert) dismissed claims against Merrill Lynch, Henry Blodgett and others in one of the internet stock analyst cases because the collapse of the internet bubble was an intervening cause of the plaintiff’s losses. [My name is Erik. I’ve been addicted to studying bubbles and financial regulation for 8 years.]

Pollack’s particular ruling may not apply to this case, but it underscores that courts are not always sympathetic to investors investing in risky securities during boom times. The countervailing position is that issuers, underwriters, and others should bear responsibility for hidden practices that made the securities more risky. Claiming that a bubble occurred doesn’t necessarily mean that investors should bear losses because they were Tulipmaniacs; issuers and bankers often play a big role in blowing up a bubble.

Facts not overly general normative assertions should govern. Nevertheless, it is hard to escape normative judgments in the messy allocation of losses between investors and market players in the aftermath of a boom and crash. It is far easier to ask who is the “cheapest cost avoider” than to come up with a value-neutral answer. Answers usually have much to do with gut reactions and where you fall on an ideological spectrum.

A close look at the "investors"

Enough generalities, let’s go back to the Complaint – particularly the discussion of the Investors. IKB seems like a solid witness for the SEC. ACA, as mentioned above, less so. The Complaint details not only ACA’s role as collateral manager, but its parent, ACA Capital, as an investor that lost money. But ACA Capital is not your usual investor that lost money. It lost money when it issued a financial guaranty to some of the ABACUS investors. Essentially, ACA Capital wrote an “insurance policy” and would not have done so had it known that Paulson was betting against not investing in the CDO. But how did they not know? The timing in paragraph 62 of the complaint is odd. ACA Capital issued the guaranty in May 2007 – a month after the CDO closed. They didn’t have access to the list of investors in the CDO? They didn’t check that Paulson & Co wasn’t included? Did some firewall between the collateral manager ACA and the parent prevent them from putting two and two together? Did ACA Capital think Paulson invested in the CDO?

ABN Amro is also listed as an “investor,” because they entered into a series of credit default swaps under which they basically guaranteed ACA Capital’s guaranty. I buy a little more that ABN Amro had no reason to know of Paulson’s involvement.

Paragraph 66 is interesting too. What it looks like is that when Goldman sold the credit default swaps to Paulson (in which Paulson was betting against the CDO), Goldman hedged itself with the credit default swaps with ABN. Goldman sold the swaps to Paulson, but may not have taken any risk itself. According to the Complaint, ABN’s payment on the swaps mostly went to Paulson. Framing IKB as an “investor” is straight forward. ABN is not: it will be interesting to see how 10b-5 and 17(a) antifraud protections apply in this case when the “investor” is an OTC derivative counterparty, not a purchaser of the securities. (For example, 10b5 claims must involve the "purchase or sale" of securities).

Bigger picture questions

This last point raises some bigger picture issues for legal scholars. Securities law and the SEC has come a long way from the image of protecting mom & pop investors from sharp practices. As financial markets have been institutionalized and institutional investors have assumed a larger role (see Langevoort), how will the SEC’s role change? How should it?

You can make a strong case that protecting institutional investors benefits not only their beneficiaries (like pensioners), but also the small fry retail investors. But protecting institutional investors does not always translate into protecting mom & pop. Moreover, when you are protecting “big kids” in the playground, when do we let them fight for themselves and make their own mistakes?

The outcome of this case will also have much to say about the viability of Goldman’s business model (and the model of other conglomerates) to have their fingers in many different pots – and to play many different angles in the same transaction. But if the potential for conflicts of interest is a chief concern, let’s not think of litigation as anything other than a very poor substitute for regulation.

On another note, I often relish finding ways in which market players could get caught up in conflicting arguments. Here is one to watch for: many Wall Street executives have claimed “we could not have foreseen this.” Will this come back to haunt them in litigation when the lawyers claim that investors should have been on notice about risky securities? These mixed messages may create more political than legal problems. But then again, many commentators, like Larry Ribstein, have contended that the Goldman suit may be more about firing a salvo in the financial regulatory war – and putting Wall Street on the defensive as regulatory reform heats up -- than just the facts of this case.

The Question you’ll get asked at a party: Why didn’t the SEC go after Paulson & Co.?

The short answer is that – maybe it could have, but that would have made the case much harder to win. This case is about disclosure and Paulson didn’t say anything to the CDO investors and didn’t owe them any fiduciary duty to disclose. Perhaps the SEC could have brought a 10b-5 claim against Paulson on a “scheme” theory, but they may not have the evidence to do so. The Complaint doesn’t say Paulson intended to deceive the ABACUS investors. The hedge fund would likely take the position - “We were looking for an investment, so were the CDO investors. We didn’t create a “scheme” to defraud anyone and it was Goldman or the issuer’s job to disclose to investors.”

Perhaps the hedge fund employees were also smarter in what they put in e-mails than the 31 year old Goldman employee defendant. The SEC may also want to enlist Paulson in the case. Here is something else that may sound semi-smart to say at the party:

“Goldman may have more pressure to settle given that they have more of a reputational stake to lose with clients in their various businesses, they are much more heavily regulated than Paulson, and they may be even more regulated if financial reform gets any traction.”

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Those Supreme Court watchers out there may remember that Massey Coal, the company at the center of last week’s mine tragedy in West Virginia, was also at the center of last year’s Supreme court decision in Caperton v. Massey (129 S. Ct. 2252).

In that case, the Supreme Court faced the issue of whether a West Virginia Supreme Court justice should have been forced to recuse himself in a case involving Massey Coal. The company had spent $3 million to support the judge’s reelection to the state Supreme Court – roughly 60% of the total spent in support of the judge’s campaign.

Justice Kennedy wrote a 5-4 opinion for the Court ruling that the justice should have recused himself because of the “risk of actual bias” from these campaign contributions. The dissent argued that this imposed a new recusal standard that would greatly unsettle the law.

If there is state litigation in the wake of the mine collapse, how many judges would have to recuse themselves?

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If Saab does meet its demise (I hope it doesn't) and now that Volvo seems to be thinking outside the box (wink) and marketing itself to Republicans, what will academics drive?  Here are some of the candidates with a thumbnail analysis of implications for parking one in the faculty lot:

1.  Volkswagen: verboten.

2.  Prius: Check plus on assauging social guilt, check minus on panache. 

3.  Subaru: A strong candidate except doesn't exactly scream "I'm a European Social Democrat stuck in the U.S."

4.  Jaguar: Screams "I'm a Tory, and you don't even know what that means."

5.  Land Rover: The toxic connotation combination of yuppiedom and colonialism.

6.  Mercedes/BMW: makes it hard for the driver to make social justice arguments in faculty meetings on the parking situation.

7.  Mazda/Honda and everything else: a little too lower case "d" democratic.

I guess that leaves us with ... Audi. Just don't check its corporate structure or you'll be back at square 1.

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I would really like to read some good reporting on why GM is unwilling to sell Saab.  At first blush, it seems odd; wouldn't G.M. be better off selling at any price than incurring the costs of shutting Saab down?  What is it about GM's diligence on the Russian-backed Spyker that cause the deal to fall apart?  Concern about protecting GM intellectual property?  It is pretty unusual for a seller's diligence on a buyer to scuttle a deal. 

Other possible explanations -- buyers are looking for GM to finance the acquisition or assume various Saab liabilities.  Or are tax implications playing a role?

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Just on Sunday, I wondered when Google would take on Lexis and Westlaw in the legal research field as Bloomberg has already done.

Google scholar now includes features where you can search for cases (legal opinions and journals) and patents in addition to articles:

http://scholar.google.com/

I couldn't resist searching for my name.  One of the top results: a European patent for "Apparat for Avvanning Av Slam" translated as "Apparatus for Draining of Sludge."  I didn't know I had Dutch relatives working in financial markets.

I still am curious when Google will move into Bloomberg's home turf of financial data, analytics, and content.

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Now that the kids are asleep, I finished the Sunday Times.  A few questions based on the profile of Bloomberg's expansion:

1. When will Google take on Bloomberg?

2.  When will either take on Lexis and Westlaw?

There was a one sentence hint in the article that Bloomberg is beta testing some web-based product for law firms.  Anybody know what that product looks like?

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