Fraud Creates the Market

In his latest post about Goldman Sachs, Matt Taibbi points out that the investment bank has developed a record now of recommending that its clients buy various financial products at the same time that Goldman Sachs – coincidentally – is selling those products from out of its own accounts.  Inevitably, Goldman Sachs’s turns out to have been wrong and those financial products tank . . . but Goldman Sachs makes out like a bandit by moving those assets off of its own books before they tank.

Taibbi’s post reminded me of something I’ve been meaning to write about for a while now, something that occurred to me when Goldman Sachs and the rest of the Big Money Boyz showed up a year or so ago to testify before Congress as to why their selling mortgage backed securities that they knew to be “shitty” wasn’t unethical.  To a one, they all pointed out (i) that the people they were dealing with were “sophisticated investors” who “knew what they were doing,” (i) that these were “arm’s length transactions,” and therefore (iii) they had no responsibility to advise their customers that they personally considered these instruments to be “shitty.”

It always seemed to me that this defense rested on the investment banks’ fundamental unwillingness to acknowledge the real role they played as the creators of those mortgage-backed instruments:  the role of the “market gatekeeper.”

There is a somewhat obscure area of law – developed mostly by the Fifth and Eleventh Circuit Courts of Appeal – known as “fraud creates the market” that comes up sometimes in class action securities fraud cases.  In order to understand how it works, you’ve got to know a bit of legal background.

Essentially, when a bunch of investors feel they’ve been ripped off because they were misled into purchasing a shitty financial product like a stock or a bond, they can bring a class action against the seller for fraud.  However, class actions can only be maintained if there is sufficient “commonality” between the individual cases such that it makes sense to try them all as essentially one case; if the material facts of each case are fundamentally different, then each case needs to be tried separately and a class action cannot stand.  When securities fraud class actions are brought, the defendant Bank usually begins by opposing class certification on the grounds that the claims are too dissimilar to be tried as one case. 

Historically, the easiest way to do this was to assert that proving “fraud” means proving (i) a material misstatement or omission, (ii) upon which the purchaser of the security actually relied in purchasing the stock or bond.  Banks would argue that each individual investor would have had different concerns or interests and would therefore have relied on different statements about the security to justify their individual investment decisions; because the reliance of each investor would always differ, banks argues, there would always be insufficient commonality between claims to justify any securities fraud class action.

In response, the courts articulated the concept of “fraud on the market” under which reliance could be presumed.  For example, if the prospectus issued with a financial product contains a misstatement or omits certain information – and if the misstatement or the omission is objectively material to correctly evaluating the worth of the product – then under such circumstances the Bank is deemed to have committed a fraud on the entire market; in such a case, the courts will simply presume that any individual investor relied on that fraud when he or she chose to purchase the financial product.  The burden is then on the Bank to demonstrate that in any particular instance there was no such reliance – for example, if the investor in question had never had an opportunity to review the prospectus before purchasing the stock or bond.

However, in certain limited circumstances the courts also have held that not even that will save the banks, because sometimes the fraud alleged is so endemic that only through fraud could a market for the financial product have been created in the first place.  This is the “fraud creates the market” doctrine.

Now, it should be noted that this doctrine is of extremely limited application.  For reasons too involved to get into here, it applies only to bonds purchased directly from the bond issuer (the bank) which are supposed to be redeemed from revenues generated by the specific project the bonds were issued to finance. 

The basic idea is that if a bond issuer is selling bonds to raise money to finance a project like, say, a private nursing home and the bond issuer knows for a fact that there is not the slightest chance that the nursing home is going to generate sufficient revenue to ever pay the bonds back, then the bond issuer is engaging in fraud merely by offering the bonds for sale regardless of whether the underlying financial information in the bonds’ prospectus is sufficient to allow an investor independently to determine the bonds were worthless.

The reason for the doctrine is that the courts consider investment banks to be “market gatekeepers” – that is, they have an obligation not to issue worthless financial products.  If I sell you a bond at a price of $1,000 and I know the revenue generated from the project financed by that bond will never be able to pay back more than $800, then I am selling you essentially a worthless security.  And the courts have determined that – as market gatekeepers – investment banks have an obligation not to do that . . . not even if a reasonably prudent investor could discover the bond is worthless.  Customers, even sophisticated customers, are entitled to rely upon the assumption that investment banks are not peddling worthless dross.

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Like I said, it is an obscure area of securities law but it seems to me an interesting avenue to explore in pursuing claims against the Big Money Banks.  Despite their protestations that their sale of mortgage-backed bonds were arms-length transactions involving sophisticated buyers, if someone could satisfy the (extremely high) burden of proof of demonstrating that the banks knew the bonds would never pay back their initial investment then the banks would be liable for failing to meet their duty as market gatekeepers.

Moreover,  even if this burden of proof could not be satisfied I personally think it is time to re-inject the idea of banks as market gatekeepers back into our understanding of their role in the financial industry.  Their customers trust them not to sell, metaphorically, a car without an engine; the banks should be reminded that even in the World of Wall Street there are still restrictions on the idea of caveat emptor.