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1 Off-Shore Short Sales after Morrison: Will the SEC be Emboldened or Constrained? Edward Pekarek, Esq. and Soufiane Cherkaoui.

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Presentation on theme: "1 Off-Shore Short Sales after Morrison: Will the SEC be Emboldened or Constrained? Edward Pekarek, Esq. and Soufiane Cherkaoui."— Presentation transcript:

1 1 Off-Shore Short Sales after Morrison: Will the SEC be Emboldened or Constrained? Edward Pekarek, Esq. and Soufiane Cherkaoui

2 2 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 Paulsons involvement in the deal present? What measures should Goldman have undertaken in anticipation of such problem(s)? 6. Summarize the SECs allegations against Goldman. What violations of the U.S. securities (if any) did Tourre commit?

3 Reading Questions (continued) 7. How might the Supreme Courts ruling in Morrison inure to Tourres 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

4 4 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.

5 5 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.

6 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

7 7 Short Selling ABACUS Paulson developed a strategy to sell short the RMBS referenced by ABACUS. It served as counterparty to ACAs 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.

8 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 Paulsons 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

9 9 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.

10 10 Conduct & Effects Test In Morrison, the United States Supreme Court fashioned the so- called 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.

11 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

12 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

13 13 Conclusion The chapter discusses recent developments concerning the extraterritorial application of the U.S. securities laws including: The Securities and Exchange Commissions pending litigation against Goldman executive Fabrice Tourre; The United States Supreme Courts recent decision in Morrison, articulating its so-called transactional test; and The United States Congress legislative efforts to buttress the Securities and Exchange Commissions enforcement powers.

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