Sunday, April 18, 2010

Playing Liar's Dice with the financial system

OK, this is going to be so simple a statement as to perhaps be stupid, but that has never stopped Guambat before.

The point he wants to make here is that there are 2 general themes in US securities laws. One is disclosure and the other is fraud.

Disclosure requirements are mainly evolved from the 1933 Securities Act. This was the first main post-Great Depression securities law passed. Crudely, it was passed to keep the common man out of the clutches of the pandering stock salesmen by requiring securities to be registered. The registration process was fraught with disclosure requirements aimed at mitigating the caveat emptor rules of the ancient bazaars.

Fraud, on the other hand, is mainly based in the 1934 Securities Exchange Act. Crudely, it raises what would have been traditionally a state action (fraud was at that time thought to be a criminal act and the federal laws should stir clear of state prerogatives) into a federal crime.

The notion of disclosure includes the qualification that you don't need to disclose things that are obvious on their face. Of course, what is obvious to one person is beyond the perception, let alone ken, of another. Out of this observation rose the idea that certain risky elements of stocks didn't need to be explained to seasoned investors. Such investors didn't need to be held by federal hands.

And so exceptions were made to the registration/disclosure requirements when stocks were to be circulated only to seasoned investors. In defense of a charge of failure to disclose, the defendant would paint the plaintiff as a seasoned investor.

Plaintiffs, of course, are seasoned at times, like when they're bragging and telling war stories, and are orphans and widows at other times, like when they're claiming disclosure duties. They don't mind being labeled as unseasoned when it suits.

But claiming a seasoned investor is ever unsophisticated just goes too much to character for most investors to swallow. So the defense became, "Mr. investor, I assume you are a sophisticated person and investor, aren't you?"

Can't image many people, under oath, swearing they were unsophisticated. How would that play when the wife next appeared at the ladies' lunch?

While "sophisticated" is the connotative word preferred colloquially, "accredited" is the more neutral word used in the legal sense. Either way, hubris being what it is, people seem to clamor for glamor and want to be thought of as sophisticated or accredited, when it suits them of course.

Guambat reckons if you have to claim to be sophisticated, that should be one factor in proving you're not, but Guambat digresses.

This sophisticated investor became the poster child for defense lawyers, and they tend to apply that "defense" to both disclosure and fraud claims alike.

Thus, Goldman Sachs most recently per this Business Week article:

In their annual letter to shareholders last week, Blankfein and Goldman Sachs President Gary Cohn said most of the firm’s business is aimed at serving sophisticated clients capable of making their own decisions. “The investors who transacted with Goldman Sachs in CDOs in 2007, as in prior years, were primarily large, global financial institutions, insurance companies and hedge funds,” the letter said.
But bear in mind that the sophisticated investor notion is only really applicable to disclosure requirements. Fraud is a different matter, and only in the outlying elements of fraud, like reliance where there is no proof of intentional fraud, would the sophistication of the alleged fraud victim ever even be deemed relevant.

It is generally no defense to a claim of fraud that it is OK to defraud a sophisticated person. (See, e.g., THE SOPHISTICATED INVESTOR DEFENSE.)

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