Last week, a jury agreed with the Securities and Exchange Commission that Fabrice Tourre, a former Goldman trader, had committed securities fraud. Tourre's violation, which could earn him a permanent bar from the securities industry and a penalty, was a failure to make clear to sophisticated parties in a complex transaction that another sophisticated party was betting against the transaction. In bringing cases like this, the SEC is encouraging market players, even sophisticated ones, to adopt the extremely naïve view that everybody is on the same side of a deal.
In the securities markets, companies routinely and voluntarily enter into transactions based on their needs, knowledge, and expectations about the future. The deal that Tourre crafted was one of many such securities transactions. It was marketed to investors who wanted to benefit from a rise in the value of subprime residential mortgage-backed securities. Looking to benefit from a drop in the value of subprime mortgage-backed securities, Paulson & Co, a hedge fund manager, identified particular mortgage-backed securities that it wanted to bet against. Tourre and Goldman, with the help of a seasoned collateral manager that ratified Paulson's bond selections, put together a deal that allowed both sets of investors to take their desired positions.
As it turned out, Paulson made out better than the other investors. In the SEC's estimation, if the collateral manager and other investors had been aware that Paulson was investing against the securities rather than in them, they wouldn't have taken part in the transaction. Finding out that another investor was doing something different likely would neither have surprised nor deterred sophisticated investors intent on benefiting from the rising housing market. And merely knowing Paulson's position would have been of limited value without understanding whether Paulson was motivated by a negative view of the particular mortgage bonds at issue, a desire to hedge another position, a general discomfort about overvaluation in the housing market, or something else.
Could Tourre and Goldman have been more forthcoming? Certainly. Goldman, in its settlement with the SEC, professed that "it was a mistake for the Goldman marketing materials to state that the reference portfolio was 'selected by' ACA Management LLC without disclosing the role of Paulson & Co. Inc. in the portfolio selection process and that Paulson's economic interests were adverse to CDO investors." But should sophisticated investors really be shocked that another investor is going to take the opposite side of the transaction? And ACA shouldn't have put its name on the deal without doing its own due diligence on the mortgage-backed securities it was claiming credit for having selected.
Tourre's countryman, Alexis de Tocqueville, wrote in Democracy in America, that Americans "judge that the diffusion of knowledge must necessarily be advantageous and the consequences of ignorance fatal." The deal Tourre structured was designed to allow companies to transact based on their diffuse knowledge and different perspectives. As it happens, certain investors' ignorance of what the future would hold proved costly. These losses could have served as a valuable lesson were it not for the SEC's decision to blame Tourre for not preventing them. Thus, Tourre has become the unwitting bearer of a very different message than Tocqueville's -- in the securities markets, there is something unfair about diffuse knowledge, the advantages of those in possession of it should be stripped away, and steps should be taken to ensure that nobody bears the consequences of his own lack of knowledge.