WASHINGTON (Reuters) - Financial firms would be restricted from betting against the bundled financial products they create and sell to investors, under a proposal issued by U.S. securities regulators on Monday.
The proposal from the Securities and Exchange Commission addresses issues raised by U.S. Senate investigators in a report earlier this year that accused Goldman Sachs of positioning itself to profit from clients’ losses on complex securities that it packaged and sold.
The proposal would also prohibit the kinds of conflicts seen in the SEC’s 2010 civil case against Goldman by banning third parties from helping assemble an asset-backed pool that would let them profit from investors’ losses.
In the Goldman case, the SEC accused the bank of creating and marketing a collateralized debt obligation known as ABACUS 2007-AC1 without telling investors that hedge fund Paulson & Co helped choose the underlying securities and was betting against them. Goldman later settled the case for $550 million.
Goldman declined to comment on the SEC proposal.
“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,” said SEC Commissioner Luis Aguilar, a Democrat.
“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’s proposal, which was put out for public comment in a 4-0 vote on Monday, would implement a provision in last year’s Dodd-Frank Wall Street oversight law.
The law requires the SEC to impose a one-year ban restricting underwriters, placement agents, initial purchasers, or sponsors of an asset-backed security from shorting the assets in the pool and creating a material conflict for investors.
The restrictions would not apply in certain cases, such as when a firm is hedging its risk or acting as a market-maker.
Under those exemptions, for instance, an underwriter who retains a piece of the security would be allowed to hedge that risk. The underwriter could not, however, take a directional bet that exceeds the value of the position.
Commissioner Troy Paredes, a Republican, said he was voting reluctantly to seek comments on the plan.
“I am concerned the prohibition will prove to be over inclusive,” he said, noting that he fears the plan could “unduly stifle the free flow of capital.”
The securities industry will likely pay close attention to how the SEC fleshes out the details of the proposed exemptions.
If the SEC is too restrictive in the kinds of permitted activities, some industry executives have warned it could impede the recovery of the securitization market.
Tom Deutsch, the executive director of the American Securitization Forum, said his group supports the idea of eliminating incentives to design doomed asset-backed securities, but has lingering concerns about how the SEC will execute it.
“We hope that the rules proposed by the SEC are crafted to eliminate these incentives without unintentionally prohibiting appropriate hedging, market-making and other legitimate transactions, and causing unnecessary adverse impacts on the markets for asset-backed securities,” he said.
In asking the public for comments on the proposed exemptions, the SEC is also hoping for the industry to examine it closely alongside the upcoming “Volcker rule.”
The Volcker rule, which would restrict proprietary trading at banks and other affiliates, also contains some hedging exemptions. The SEC wants the industry to comment on the interplay between the two rules.
SEC Chairman Mary Schapiro said on Monday that financial regulators jointly drafting the Volcker rule expect to release the plan “in the near future.”
Reporting by Sarah N. Lynch; editing by John Wallace, Lisa Von Ahn and Tim Dobbyn