JOSEPH I. LIEBERMAN, CONNECTICUT, CHAIRMAN 

CARl lEVIN, MICHIGAN 

DANIEl K. AKAI(A, HAWAII 

THOMAS R. C'.ARPER, DELAWARE 

MARK L PRYOR, ARKANSAS 

MARY L LANDRIEU. LOUISIANA 

CLAIRE McCASKill. MISSOURI 

JON TESTER, MONTANA 

MARK BEGICH, ALASKA 

SUSAN M. COLLINS, MAINE 

TOM COBURN, OKLAHOMA 

SCOTT P. BROWN. MASSACHUSETTS 

JOHN McCAIN, ARIZONA 

RON JOHNSON, WISCONSIN 

ROB PORTMAN, OHIO 

RAND PAUL, KENTUCKY 

JERRY MORAN, KANSAS 

CJ.anitnl ~tatrs ~rnatr COMMITIEE ON MICHAEL L ALEXANDER, STAFF DIRECTOR 

NICHOLAS A. R0$$1, MINORITY STAFF DIRECTOR HOMELAND SECURITY AND GOVERNMENTAL AFFAIRS 

WASHINGTON, DC 20510-6250 

August 29, 2011 

Filed via email at rule-comments@sec.gov 

Elizabeth M. Murphy 

Secretary 

Securities and Exchange Commission 

1 00 F Street, NE 

Washington, DC 20549-1090 

RE: File Number S7-25-11; Business Conduct Standards for Security-Based 

Swap Dealers and Major Security-Based Swap Participants 

Dear Ms. Murphy: 

The purpose of this letter is to express support for and suggest enhancements to the 

proposed rule, 

1 issued pursuant to Section 7 64 of the Dodd-Frank Wall Street Reform and 

Consumer Protection Act (Dodd-Frank Act), outlining minimum business conduct standards for 

security-based swap dealers and major security-based swap participants, known collectively as 

"SBS entities." Strong business conduct standards, including in particular those related to 

suitable recommendations and fair and balanced communications, are essential to restore 

integrity and confidence in U.S. financial markets, especially after the widespread abusive 

conduct that contributed to the recent financial crisis. 

The efforts of the Securities and Exchange Commission (SEC) to impose business 

conduct standards on SBS entities are parallel to, and should be closely coordinated with, the 

efforts of the Commodity Futures Trading Commission (CFTC) to impose analogous standards 

for the swap dealers and major swap participants overseen by that agency? As a general matter, 

the SEC's proposed rule should be modified to more closely align with those ofthe CFTC.3 

Similar rules will substantively enhance investor and market protections, as well as reduce 

redundancies, regulatory burdens, and costs for market participants. 

More specifically, among other measures, it is respectfully recommended that the SEC 

enhance the proposed rule by: 

1 76 Fed. Reg. 42396 (Jul. 18, 201 1 ). 2 Dodd-Frank Act§ 731. 

3 See, e.g.,75 Fed. Reg. 7 1397 (Nov. 23, 2010), 75 Fed. Reg. 81519 (Dec. 28, 2010), and 76 Fed. Reg. 6715 (Feb. 8, 

2011); Dodd-Frank Act§ 712. 

1 
1) strengthening the disclosures related to material risks and characteristics by requiring 

SBS entities to disclose any material risk related to the source of a security-based swap's 

assets and any negative view by the SBS entity itself of the assets' riskiness; 

2) ensuring that disclosures related to material incentives and conflicts of interest are 

coordinated with Sections 619 and 621 of the Dodd-Frank Act prohibiting certain 

conflicts of interest, and include in the disclosures to investors of any otherwise hidden 

profits or returns that the SBS entity expects to make from a security-based swap, related 

agreement or arrangement, or related hedging or trading activity; 

3) improving the disclosure provisions related to daily marks for uncleared swaps by 

requiring the use of third party quotations whenever possible, allowing use of the 

midpoint between an SBS entity's bid and offer prices as the daily mark only when the 

SBS entity's internal book value falls within the same price range, and requiring 

disclosure to investors upon request the data sources, methodology, and assumptions used 

to prepare the daily marks; and 

4) using its broad authority under Section 15F(h)(3)(D) ofthe Exchange Act to promote 

transparency and minimize risk by requiring periodic portfolio reconciliation and 

portfolio comprcssion.4 

Enhancements to Disclosure Requirements 

Pursuant to the express language of the statute, the SEC has proposed requiring 

disclosures by SBS entities ofthe material risks and characteristics of a security-based swap, 

material incentives or conflicts of interest in connection with a security-based swap, and the 

daily marks assigned to security-based swaps. 5 

Material Risks and Characteristics. The first set of disclosures involves material risks 

and characteristics of security-based swaps being marketed to investors. The proposed rule 

should be strengthened by requiring SBS entities to disclose material risks and characteristics of, 

not just of the security-based swap itself, but also with respect to any reference securities, 

indices, or other assets. This disclosure is especially important when the SI3S references unique 

pools of assets arranged by the SBS entity, as opposed to functioning as a "plain-vanilla" swap. 

Over the past two years, the Permanent Subcommittee on Investigations, which I chair, 

has conducted an extensive investigation into key causes of the financial crisis. One 

Subcommittee case study examined the role of investment banks in the financial crisis, exploring 

how Goldman Sachs and Deutsch Bank structured, marketed, and sold high risk, poor quality 

mortgage products to investors. The Subcommittee's investigation identified several specific 

instances in which Goldman failed to disclose material risks and characteristics of its financial 

products to investors, failures that are addressed only in part by the proposed rulemaking. 

4 See 75 Fed. Reg. 81519 (Dec. 28, 20 I 0). 5 Securities Exchange Act of 1934, § 15F (h)(3)(B). 

2 
For example, in the fall of2006, Goldman assembled Hudson Mezzanine 2006-1 

("Hudson"), a $2 billion synthetic CDO that referenced subprime residential mortgage backed 

securities (RMBS). At the time, senior Goldman executives felt that declines in the ABX index, 

an index of subprime mortgages securities, were eminent. Rather than trade away its tmwanted 

ABX assets using index swaps, Goldman decided the most efficient method to reduce its 

exposure to the ABX index was to assemble the Hudson CDO. The assets Goldman selected for 

Hudson consisted of $1.2 billion in ABX assets from its own balance sheet, and another $800 

million in outright shorts of subprime RMBS. These assets were placed on the balance sheet of 

an offshore shell corporation via a credit default swap (CDS), and then marketed to investors. 

Although Goldman provided vague and generalized risk factors, it failed to inform investors that 

the CDO was specifically designed to remove risky underlying assets from Goldman's balance 

sheet and to produce profits for the firm from shorting the referenced RMBS assets. Goldman's 

clients ended up losing nearly $1.7 billion from their investments in Hudson. 

In another example in 2007, Goldman assembled Anderson Mezzanine Funding 2007-1 

("Anderson"), a $500 million synthetic CDO constructed using CDS contracts referencing 

subprime RMBS. The majority of the referenced assets in Anderson had been issued by 

subprime lenders which were known to Goldman for issuing poor quality loans. The largest 

single issuer was New Century, which at that time was being scrutinized by Goldman for its poor 

quality loans. During the period in which Goldman assembled and sold the Anderson securities, 

Goldman had a strongly negative view of the mortgage market and was working intensively to 

remove mortgage-related assets from its balance sheet, including from New Century. A senior 

Goldman executive had considered liquidating the Anderson CDO due to the falling value of its 

assets, but instead decided to market the Anderson CDO to investors. In summary, at the time 

Anderson was issued, Goldman had a negative outlook of the entire mortgage market, a negative 

view of Anderson's largest issuer, New Century, and a negative view of the specific assets in 

Anderson. None of these risks was disclosed to investors. In fact, when an investor raised 

concerns about the New Century loans referenced in the CDO, Goldman worked affirmatively to 

dispel those concerns. Ultimately, Anderson investors lost virtually their entire investments. 

To ensure that SBS entities provide material information to investors, the proposed rule 

should specifically require them to disclose all material risks and characteristics of not only the 

security-based swap, but also of any assets referenced by that swap. Requiring disclosures 

related to the underlying assets is particularly critical for security-based swaps in which the 

underlying assets have been selected and pooled by the SBS entity, as was the case in Hudson. 

Thedisclosures should include material risk information related to the source of the swap's assets 

and any negative view by the SBS entity itself of the assets' riskiness - thus preventing situations 

like Hudson and Anderson wherein Goldman bet against its own clients and hid its own negative 

view of the market from investors. 

The required risk disclosures should be made to all counterparties, and opting out should 

not be permitted. In particular, in instances such as Hudson and Anderson, where the swaps took 

place between the SBS entity and a Cayman Islands shell corporation, risk disclosures should be 

made by both the SBS entity and the shell corporation to all investors. Furthermore, SBS entities 

should not be allowed to avoid providing material risk disclosures to a "qualified institutional 

3 
buyer," since even sophisticated investors were misled during the financial crisis about the nature 

of the securities they purchased. 

Material Incentives and Conflicts of Interest. Pursuant to the express language of the 

statute, the proposed rule also requires SBS entities to disclose material incentives or conflicts of 

interest in connection with a security-based swap. The proposed rule defines "incentives" as 

"any other financial arrangements pursuant to which an SBS entity may have an incentive to 

encourage the counterparty to enter into the transaction." It excludes from the definition, 

however, "any profit or return that the SBS entity would expect to earn from the security-based 

swap itself, or from any related hedging or trading activities of the SBS entity." This exclusion 

is ill advised and could enable SBS entities to hide important information from investors, 

including potential profits or loss avoidance gained because of a hidden adverse interest, that a 

reasonable investor would want to know prior to making an investment decision. 

The Subcommittee's case study into the role of investment banks in the financial crisis 

illustrates a number of financial arrangements involving hidden profits or returns for an SBS 

entity about which a reasonable investor would want to be informed. 

In September 2006, for example, Goldman executives realized that the firm had 

significant long exposure to mortgage-related securities. To reduce the firm's exposure, its 

traders began to sell or transfer to others the risk of loss from its mortgage-related positions, 

including by using security-based swaps to create and sell interests in synthetic CDOs designed 

or expected to produce profits for the firm when the CDOs declined in value. 

The Hudson CDO, mentioned.above, was one of those synthetic CDOs. Goldman 

structured the CDO itself, transferring $1.2 billion of its own risk to investors while telling 

potential investors that I Iudson was "not a balance sheet CDO" and was "sourced from the 

Street." Goldman held 100 percent of the short side of the CDO, meaning that in the event of 

widespread default on the referenced assets, the Hudson shell corporation set up by Goldman as 

the legal issuer of the securities would stop making payments to investors and start making 

payments to Goldman using investors' funds. The CDO represented a zero-sum transaction: 

either Goldman or the investors made money, but not both. Thus, Goldman's position was 

diametrically opposed to that of its own clients. 

Goldman then marketed and sold this CDO to potential investors, telling them that it had 

"aligned" its interests with investors and mentioning that it held a $6 million equity share while 

simultaneously failing to disclose that it was shorting all $2 billion of Hudson's assets. The 

marketing materials contained a section entitled "Certain Conflicts of Interest" that stated that 

"GSI [the Goldman affiliate involved in Hudson] and/or any of its affiliates may invest and/or 

deal" in securities or other interests in the assets underlying Hudson, and "may invest and/or 

deal" in CDS contracts that are "linked to" the Hudson investments. By the time these materials 

were circulated, however, Goldman had already decided to keep 100 percent of Hudson's short 

side. Thus, the marketing material misrepresented Goldman's investment plans, and the extent 

of Goldman's adverse interests in Hudson was not known to the investors that it solicited. 

Ultimately, the Hudson CDO enabled Goldman to earn a gross profit of $1.7 billion at the direct 

expense of its clients. 

4 
Similarly, Goldman retained 40 percent of the short side of the Anderson CDO, a COO 

that Goldman expected to perform poorly. Anderson produced a $131 million gain for Goldman 

at the direct expense of the investors to whom it had sold the Anderson securities. It also held 36 

percent of the short side ofTimberwolfi COO ("Timberwolf'), which produced about $330 

million in revenues for the fum at the direct expense of the clients who invested in that CDO. In 

neither case did Goldman disclose its short position to investors, nor did Goldman ever disclose 

to any of its investors that it had built a large net short position betting that RMBS securities 

similar to the ones referenced in Hudson, Anderson, and Timberwolf would lose value. 

Goldman's short positions on its COOs encouraged other self-dealing actions on the part 

of Goldman. For example, the firm exploited a conflict of interest resulting from serving as the 

"liquidation agent" in the Hudson COO. As liquidation agent, Goldman promised to liquidate on 

a nondiscretionary basis any Hudson asset determined to be a "credit risk." . Instead, despite 

urgent requests from Hudson investors, Goldman delayed liquidating the assets for months, 

while maximi:.-::ing its profits from its short position. In the Timberwolf CDO, Goldman used its 

role as the collateral security agent to protect its own short interests, to the detriment of investors. 

Still another conflict of interest is demonstrated in the case of the Abacus 2007-ACl 

COO ("Abacus"). Goldman created Abacus in partnership with a hedge fund, Paulson & Co., 

which Goldman knew held strong negative views of the residential mortgage market, and the 

CDO was structured to enable Paulson to short multiple RMBS securities. As part of the 

arrangement, Paulson agreed to pay Goldman a higher fee if Goldman could provide Paulson 

with CDS contracts requiring premium payments below a certain level. Lower premiums for 

Paulson translated into lower premium payments to the CDO, directly reducing the amount of 

cash available to long investors. In marketing and selling Abacus to long investors, Goldman not 

only failed to disclose the key role that the hedge ftmd played in the asset selection process to the 

detriment of potential investors, it also failed to disclose how its own economic interest was 

aligned with Paulson - and against the investors to whom it was selling the securities- through 

the side arrangement for lower premium payments. 

The Subcommittee's investigation demonstrates that problematic conflicts of interest 

arise not only from "financial arrangements pursuant to which an SBS entity may have an 

incentive to encourage the counterparty to enter into the transaction," as was the case in Abacus. 

Problematic conflicts of interest also arise from hidden profits that an SBS entity has arranged to 

earn from the swap itself, including profits from related management, hedging, or trading 

activities of the SBS entity, as was the case in Hudson, Anderson, and Timberwolf. Thus, the 

SEC should expand the definition of "incentives" to include profits or returns that the SBS entity 

expects to make from any undisclosed adverse interest in the swap, a related agreement or 

arrangement, or a related hedging or trading activity. 

In addition, the proposed material incentives and conflicts of interest disclosure 

requirements need to be coordinated and work in conjunction with the conflict of interest 

prohibitions in Section 621 ofthe Dodd-Frank Act related to asset-backed securitizations, as well 

5 
as the limitations on permitted activities outlined in Section 619.6 It is critical that the proposed 

rule make it clear that the conflict of interest prohibitions in those sections cannot be circumvented or 

somehow nullified through application of the disclosure requirements in the business conduct standards 

adopted pursuant to Section 764. 

Daily Marks. The Dodd-Frank Act also amends the Exchange Act to direct the SEC to 

require SBS entities to disclose the daily marks assigned to security-based swaps. 7 The SEC has 

interpreted the statute to require the disclosure of the end-of-day settlement price from the 

appropriate clearing organization for cleared security-based swaps, and the midpoint between the 

bid and offer prices, or the calculated equivalent thereof, for uncleared swaps. While using the 

settlement price of an appropriate clearing organization as the daily mark for cleared swaps may 

be a sensible approach, using an SBS entity's own bid and offer prices to determine the daily 

marks for uncleared swaps could, without further restrictions, invite abuses. 

The Subcommittee's case study found ample evidence of marking abuses by Goldman in 

connection with security-based swaps it fashioned and sold to investors. Those abuses included 

pricing the swaps higher than its internal valuations, refusing to provide investors with its pricing 

methodology and scenarios, and presenting investors with bid-offer spreads that had little 

relation to the firm's own internal valuations. 

The TimberwolfCDO, discussed above, provides a prime example of these problems. 

Goldman sold Timberwolf security-based swaps to clients at a much higher price than Goldman 

knew they were worth, marked the value down substantially days or weeks after the sale, and 

refused to proyide its pricing methodologies or scenarios to investors who requested them. 

Timberwolf was issued in March 2007, when concerns about declining mortgage assets 

caused Goldman to rush Timberwolfto market. By May 2007, Goldman believed the value of 

the assets referenced in Timberwolfhad fallen significantly and conducted an extensive 

revaluation of that and other CDOs. The results of this valuation project indicated that the 

Timberwolf prices should be dramatically lower. However, Goldman did not provide notice to 

clients, either directly or through the Timberwolf shell corporation, that the SBS underlying . 

Timberwolfhad lost significant value. Rather, Goldman continued to market at inflated prices. 

For example, on May 25,2007, Goldman internally marked down the value of AAA- rated 

Timberwolf A2 securities to 80. However, Goldman sold Timberwolf to clients at prices of 87 

on May 24, 83.90 on May 30, and 84.50 on June 11. 

Goldman's sale ofTimberwolfsecurity-based swaps at inflated prices also created the 

potential for rapid markdowns after an SBS was sold. For example, on June 13, 2007, Goldman 

sold a client, Basis Capital, !\A-rated Timberwolf securities via CDS at a price of77.3, despite 

an internal mark of 65. It also sold Basis Capital AAA-rated Timberwolf securities via CDS at a 

6 Section 621 prohibits firms that issue asset-backed securities from engaging "in any transaction that would involve 

or result in any material conflict of interest with respect to any investor in a transaction arising out of such activity." 

Section 619 generally restricts proprietary trading and relationships with certain types of funds, subject to certain 

enumerated exceptions, but also disallows covered firms from engaging in activities that would " involve or result in 

a material conflict of interest ... between the [firm] and its clients, customers, or counterparties." 7 Exchange Act § 15F(h)(3)(B)(iii). 

6 
mark of 84.3 despite an internal mark of 80. One month later, on July 12, Goldman marked 

down the value of both the Timberwolf AAA and AA securities to 65 and 60, respectively. On 

July 16, Goldman marked them down further to 55 and 45, numbers that matched Goldman's 

internal valuations from July 12. By the end of July, Basis Capital liquidated its assets, and 

Goldman bought back its Timberwolf holdings at prices of 30 and 25. 

Although Goldman executives have suggested that the reason for the differences between 

the selling prices and internal valuations of their CDO securities was the bid-offer spread, there 

appears to have been little to no relationship b~tween the securities' internal valuations and the 

bid and offer prices quoted to clients. For example, at the end of June 2007, Goldman provided 

Timberwolf investor Moneygram with an offer price of 86 for Timberwolf A2 securities and a 

bid price of83. Goldman's internal valuation ofthe same securities was 75. Furthermore, 

Goldman executives defended their marks by noting they stood willing to buy or sell SBS at their 

marks. While the mortgage markets were in turmoil in the summer of2007, however, Goldman 

lowered the size of its actionable bid to $1 million, a size far too small to ensure accurate 

marking. 

Throughout the period in which it sold Timberwolf, Goldman consistently refused to 

provide investors with its pricing methodology, data scenarios, or specific marks for the 

securities it marketed. An internal Goldman email from management instructed its sales 

personnel as follows: 

[U]ndcr no circumstances are we going to be able to provide 

materials specific to Timberwolf ... or even use the word 'mark' in 

written materials .... Everything will be described in general terms, 

and if what we provide is too vague or general, the medium for 

further clarification must be oral, not written. 

Investors often asked for pricing and valuing information, seeking additional information 

to understand the daily marks assigned to their swap holdings. An email from a Basis Capital 

investor, for example, asked: "How many times do we have to request data points and scenarios 

by email. . . . I am getting weary of continually hearing about transparency and yet an obvious 

avoidance of 'putting things to paper."' Another Timberwolf investor, Hungkuk Life, received 

asset reports from Goldman with the pricing and valuing information removed. Additionally, 

Goldman did not inform its investors when its pricing methodology changed, as it did in during 

its CDO valuation project in May 2007. 

One key measure to protect against abusive marks would be to require SBS entities to 

disclose to any investor upon request the data sources, methodology, and assumptions used to 

prepare daily marks. Those data sources, methodology, and assumptions should constitute a 

"complete and independently verifiable methodology for valuing each [security-based] swap 

entered into between the parties".8 To the extent that those sources, methodology, or 

assumptions change in a material way, become unreliable, or become unavailable, SBS entities 

should be required to disclose those developments and any resulting changes to the valuations. 

8 See 76 Fed. Reg. 6715,6719 (Feb. 8, 2011). 

7 
The Subcommittee's research also suggests that using the midpoint of the bid-offer 

spread may be an appropriate daily mark for uncleared swaps only so long as the relevant SBS 

entity's internal book value also falls within that range. The rules should be strengthened to 

impose that requirement on SBS entities producing daily marks. To further protect against 

abusive pricing, the SEC should require SBS entities to use third-party market quotations when 

calculating an uncleared swap's midmarket value, whenever possible. In addition, the SEC 

should consider requiring the SBS entity to provide clients with actionable quotes or prices at 

which the SBS entity would terminate the swap or allow the client to buy more. Furthermore, 

the SEC should consider requiring SBS entities to provide actionable quotes at a significant size 

as a means to ensure accuracy. 

Portfolio Reconciliation and Compression 

To further strengthen the rule and bring it into closer alignment with the approach taken 

by the CFTC, the SEC should use its broad authority under Section 15F(h)(3)(D) to require SBS 

entities to engage in portfolio reconciliation and compression, which would increase 

transparency, promote market integrity, reduce risk, and promote regulatory consistency across 

related products.9 

As the CFTC noted in its analogous proposed rules: 

Through portfolio reconciliation, counterparties are able to resolve 

any discrepancies or disputes as early as possible and arrive at an 

understanding of their overall risk exposure to one another. 

Portfolio compression allows for a reduction in outstanding trade 

count and outstanding gross notional value by replacing redw1dant 

trades with a smaller number of trades and reduced gross notional 

value. This process reduces operational risk and increases 

operational efficiency because there are fewer trades to maintain, 

and results in a more accurate expression of market size. 10 

Portfolio reconciliation, which could be performed on a bilateral basis or by a qualified 

third party, should be performed on a regular basis, with the frequency determined in large part 

by the materiality and size of the SBS entity's security-based swap portfolio. Collectively, 

portfolio reconciliation and compression would improve both counterparties' abilities to 

indentify and manage their security-based swap-related risk exposures, and should be adopted. 

Duty to Make Suitable Recommendations 

Pursuant to the statutory text in Section 764 of the Dodd-Frank Act, the proposed rule 

would also impose a duty on SBS entities to make suitable recommendations when marketing 

SBS to clients. The proposed rule would require an SBS dealer to "have a reasonable basis to 

believe: (i) Based on reasonable diligence, that the recommended security-based swap or trading 

9 See 75 Fed. Reg. at 81520. 

10 &~ 

8 
strategy involving a security-based swap is suitable for at least some counterparties; and (ii) that 

a recommended security-based swap or trading strategy involving a security-based swap is 

suitable for the counterparty." 11 

To establish a reasonable basis for a recommendation, an SBS dealer would need to have 

or obtain relevant information regarding the counterpmty, including the counterparty's 

investment profile, trading objectives, and its ability to absorb potential losses associated with 

the recommended security-based swap or trading strategy. In addition, under the proposed rule, 

an SBS dealer that makes a "recommendation" to a counterparty must have a reasonable basis 

for believing that the recommended security-based swap or trading strategy involving securitybased swaps is suitable for at least some counterparties. It could no longer recommend securitybased swaps that the SBS dealer expected to lose value for the investors who purchased them. 

The need for this suitability requirement is strongly supported by the Subcommittee's 

work, which uncovered significant evidence of unsuitable recommendations made by investment 

banks, essentially urging investors to buy security-based swaps that the investment bank 

expected or knew were designed to lose value. 

Goldman, for example, consistently constructed, marketed, and sold security-based swaps 

referencing pools of subprime RMBS that Goldman knew were of poor quality, including RMBS 

containing loans issued by lenders known to Goldman for issuing poorly performing mortgages. 

Additionally, Goldman specifically marketed via CDS arrangements Timberwolf securities 

which it knew were falling sharply in value to non-traditional buyers and clients outside of the 

United States. In the case of Basis Capital, Goldman actively pushed sales to a hedge fund that it 

had good reason to believe could not absorb the expected losses. Goldman also knew Basis 

Capital was traditionally an equity investor, and had little experience with the synthetic CDOs 

being marketed to the fund. Less than two months after entering into a $100 million swap 

involving Timberwolf securities with Goldman, Basis Capital was forced to liquidate its hedge 

fimd holdings, due to the losses it suffered from that purchase. 

Goldman also sold securities to investors that the bank itself was betting would fail. For 

example, Goldman held 100 percent of the short side in the Hudson CDO via CDS, and had 

structured the transaction specifically to remove unwanted risk from its balance sheet. Goldman 

held 40 percent of the short side of the Anderson CDO, the largest short position of m1y party to 

that transaction. In the Abacus transaction, Goldman had allowed the referenced assets to be 

influenced by the Paulson hedge fund, which had a known, negative view of the residential 

mortgage market, held 100 percent of the short side of the CDO, and had a side arrangement 

with Goldman to obtain lower premium payments. In all three cases, Goldman sold the securitybased swaps to its clients with the expectation that the long side of the swaps would lose value. 

An SBS dea~er should not only understand the swap or trading strategy that it is 

recommending to investors, it should also have reason to believe that the recommendation is 

suitable for a specific investor, that the swap is not designed or expected to lose value to the 

detriment of that investor, and that the investor is able to bear potential losses. The proposed 

11 76 Fed. Reg. at 42440. 

9 
rule may want to state plainly that, under its provisions, SBS dealers cannot recommend to 

investors financial products that the dealers believe will fail. Additionally, the proposed rule 

should consider requiring that an SBS dealer making recommendations regarding a certain 

product or type of product have background in understanding that product. 

The proposed rule currently allows SBS dealers to fulfill their suitability requirement 

with respect to any specific counterparty if they: "( 1) reasonably determine that the counterparty 

(or its agent) is capable of independently evaluating the investment risks related to the securitybased swap or trading strategy; (2) the counterparty (or its agent) affirmatively represents that it 

is exercising its independent judgment in evaluating the recommendation; and (3) the SBS 

Dealer discloses to the cotmterparty that it is acting in its capacity as a counterparty and is not 

undertaking to assess the suitability of the security-based swap or trading strategy." 12 The · 

proposed rule requires such institutional-specific suitability determinations to be supported by 

representations documented in writing.

13 

The SEC should be wary of these institutional-level suitability determinations which 

could quickly become outdated, or simply ignored, boiler-plate language that is inappropriate for 

the counterparty to which it is directed. The SEC should consider requiring firms to conduct 

routine audits to ensure that these institutional-level suitability determinations are not overutilized, that they are appropriate for the particular counterparties involved, and that the 

appropriate written documentation was provided and signed in applicable transactions. As part 

of that audit process, and to prevent inaccurate determinations, firms should be required to test, 

perhaps on an annual basis, whether the counterparties continue to have the personnel and 

expertise needed to conduct independent evaluations of the SBS products being marketed. 

Without these basic investor protections, to safeguard against the marketing by SBS 

dealers of unsuitable SBS products that are expected or designed to fail, investor confidence in 

U.S. financial markets as fair, open, and efficient will not be restored. 

Duty to Communicate in a Fair and Balanced Manner 

Consistent with the express text of the statute/ 4 the proposed rule would require SBS 

entities to communicate with their counterparties in a fair and balanced manner based upon 

principles of fair dealing and good faith. 15 This provision, which tracks longstanding principles 

of exchanges and other self-regulatory organizations, is also strongly supported by the 

Subcommittee's work, which found many instances of misleading and inaccurate 

communications by SBS dealers to investors. 

The marketing materials associated with the Hudson CDO, for example, stated that 

Hudson was "not a balance sheet CDO" and was "sourced from the Street," even though 

Goldman itself had structured and priced the COO, using it to transfer $1.2 billion of risk from 

12 76 Fed. Reg. at 42440. 13 76 Fed. Reg. at 42440. 

14 Section 15F(h)(3)(C) of the Securities Exchange Act of 1934. 15 76 Fed. Reg. at 42440. 

10 
its own books to investors. The marketing materials also contained a section entitled "Certain 

Conflicts oflnterest" that stated that "GSI [Goldman Sachs] and/or any of its affiliates may 

invest and/or deal" in securities or other interests in the assets underlying Hudson, and ''may 

invest and/or deal" in CDS contracts that are "linked to" the Hudson investments. However, by 

the time those materials were circulated, Goldman had already decided to keep 100 percent of 

Hudson's short side. Thus, the marketing materials misrepresented Goldman's investment plans. 

Additionally, Goldman told Hudson investors that it had "aligned" its interests with them 

and held a $6 million equity share of the CDO, without also disclosing that it was shorting all $2 

billion of Hudson's assets. Similarly, when marketing the Anderson CDO, Goldman informed 

investors that it would be holding up to 50% of the CDO's equity tranche - worth about $21 

million - without mentioning that it would also be holding 40% of the short side of Anderson -

worth about$ 1 35 million. Goldman also sold Timberwolf securities via CDS arrangements to 

investors at inflated values, withholding its internal analysis that the Timberwolf securities were 

dropping sharply in value. In addition, Goldman deliberately avoided specificity in its written 

materials, instructing its Timberwolf sales personnel that "[ e ]verything will be described in 

general terms, and if what we provide is too vague or general, the medium for further 

clarification must be oral, not written." 

In order to be fair and balanced, communications from an SBS entity must inform 

investors of both the potential rewards and risks of their investments, and the entity's own 

involvement and interests in the investments, in specific terms. All material adverse interests 

must be disclosed and communicated. The proposed rules should also make it clear that it is not 

enough to inform a customer that the SBS entity "may" have an adverse interest if that adverse 

interest already cxists. 16 

Thank you for the opportunity to comment on the proposed rule. 

Carl Levin 

Chairman 

Permanent Subcommittee on Investigations 

16 SEC v. Czuczko, Case No. CV06-4792 (USDC CD Calif.), Order Granting Plaintiffs Unopposed Motion for 

Summary Judgment (Dec. 5, 2007) (finding defendant made a material misstatement to potential investors when he 

disclosed that officers, directors, employees and members of their famii'ies "may" trade in the stocks recommended 

on his website, without disclosing that he, his father, and business partner were trading in those stocks and had an 

interest in them). 

11