'Materiality' Requirement in Credit Derivatives Fraud Litigations: The Hidden Role of the 'Short-Party'

Since early 2006 until late 2007 when the U.S. housing market began show signs of distress, certain hedge funds and investment banks started to develop complex short-selling strategies based on sophisticated credit derivatives instruments, which enabled them to express a bearish view of systematic spread widening in the U.S. housing market and place unlimited side bets on it. When the U.S. housing market bubble burst, investment banks and hedge funds realized enormous positive returns whilst other investors collectively failed and saw the value of their investments literally vanished away. During the last twelve months, complex synthetic short selling transactions have come under severe scrutiny by the U.S. Securities Exchange Commission (“SEC”). According to the SEC, in the context of such transactions, investment banks made material misrepresentations and omissions to investors, guarantors and portfolio agents by hiding the role and involvement in the asset pool selection process of the “short” party, with economic interest adverse those of long investors. The assessment of the liability of investment banks and certain of their top executive managers responsible for structuring and marketing the synthetic derivative products critically relies on the resolution of the issue of materiality: was the involvement of the short-party in the selection process and its adverse economic interest material? How would a reasonable investor have viewed this information if properly and timely revealed in the context of all facts and circumstances of the case? Would a reasonable investor have acted differently with the benefit of this information under the circumstances of the case? This essay will attempt to answer the aforesaid questions, as follows. Part I will analyze different types of credit derivative products and discuss latest innovations in credit derivatives market. Part II will examine the SEC antifraud enforcement theories and the concept of “materiality” in the context of antifraud provisions. Part III will, then, discuss the materiality of the hidden role of the short-party in the context of three credit derivatives fraud litigations recently brought by the SEC against, respectively, Goldman, Sachs & Co, J.P. Morgan Securities LLC, and Citigroup Global Markets Inc. Lastly, Part IV will address in details potential legal defenses and factual rebuttal on the issue of materiality.