Material Omissions

What you don’t say can hurt you

If it can happen to Goldman Sachs, AXA Rosenberg and Blackstone, it can also happen to you.

A material omission.

Goldman Sachs made its big blunder in 2007, when it sold $2 billion of a synthetic collateralized debt obligation (CDO) without telling its investors – all large institutions — that the subprime residential mortgage-backed bonds to which the CDO was indexed were being selected by John Paulson. At the time of sale, Goldman must have known that Paulson’s hedge fund was shorting the housing market and would therefore be betting against the very bonds it was selecting for the CDO, but Goldman only told its investors that the bonds linked to the CDO were being chosen by an independent entity called ACA Management. The SEC brought charges against Goldman in April 2010 for defrauding its CDO investors by not advising them of Paulson’s behind-the-scenes role in selecting the portfolio, and Goldman settled the case quickly for $550 million, the largest SEC settlement in history.

AXA Rosenberg, a highly-respected, quantitative hedge fund manager with over $21 billion under management, also had its come-uppance in 2007, when its programmers uncovered a significant error in the risk management component of its computer model. The snafu resulted in client losses of $217 million, which AXA deceptively ascribed to market volatility. Instead of fixing the error and disclosing it to clients immediately, certain AXA officials concealed it until 2009 when the firm learned of an upcoming, routine SEC examination. AXA then disclosed the computer error and investor losses to the SEC and, last year, settled the fraud charges against it for $240 million.

Also in 2011, The Blackstone Group – which manages over $166 billion in alternative assets — fell prey to a material omission, one that surprised even the securities bar. The U.S. Court of Appeals for the Second Circuit reversed a District Court decision in favor of Blackstone in connection with its failure to disclose in its 2007 public offering documents that certain segments of its business were experiencing problems that could be expected to depress the firm’s future revenues. The Second Circuit ruled that the potential negative impact of such problems on overall revenues could be regarded as material information by a reasonable investor (and therefore a required disclosure item) in spite of the fact that the particular business reversals Blackstone had suffered were already public knowledge. The case has been remanded to the District Court for retrial.

What these three cases show is that it doesn’t matter how sophisticated your clients are, whether an undisclosed fact is concealed from management or even if the omitted information is already public, you may be exposed to liability for securities fraud (and to serious reputational risk) if you omit a material piece of information from your discourse with investors. You should also consider that all three of these huge and successful defendants presumably had robust compliance policies and procedures in place when their material omissions occurred and, in two of the cases at least, their managements consciously miscalculated the potential adverse effects of the incomplete disclosures.

In the course of conducting your business, you will undoubtedly come across situations in which the law is not entirely clear as to whether a particular piece of information should be divulged to clients. It could be a personal credit matter, a system breakdown or trade error, an aggressive tax position or any one of countless conflicts of interest for which there is no specific disclosure rule.

The prickliest issues I’ve had to face in my career as a securities attorney involved disclosures that management ultimately chose not to make. When you are on the cusp of such a decision, then, you should think long and hard before you settle on silence.