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Helping Law Catch Up to Markets: Applying Broker-Dealer Law to Subprime Mortgages


Jonathan R. Macey


Yale Law School

Geoffrey P. Miller


New York University School of Law

Maureen O'Hara


Cornell University - Samuel Curtis Johnson Graduate School of Management

Gabriel D. Rosenberg


Davis Polk & Wardwell LLP

January 3, 2009

Journal of Corporation Law, Vol. 33, 2009
Yale Law & Economics Research Paper No. 359
Johnson School Research Paper Series No. #12-09

Abstract:     
Much of the blame for the current financial crisis is attributable to problems in the subprime mortgage market. In this Article we argue that changes in the nature of the mortgage contract make it both legally plausible and normatively desirable that subprime mortgages brokers be treated as securities broker-dealers for the purposes of the Securities Act of 1933 and the Securities and Exchange Act of 1934. Modern subprime mortgages are, in large part, investments that contain imbedded options, and are not subject to any alternative comprehensive regulatory regime. Thus, they should qualify as "notes" under the Securities Act definition and the Supreme Court's Reves test, and expose their brokers to Rule 10b-5 oversight. In the alternative, we argue that the emergence of securitization as the primary process by which mortgages are financed provides a second, independent analytical basis for our theory that subprime mortgage financings should be subject to securities law: Mortgage financings qualify for the protections of rules such as SEC Rule 10b-5 because they occur "in connection with the purchase or sale of a security," namely, the mortgage-backed security that is created and funded on the basis of the cash flows from the mortgagors' payments on their subprime mortgages.

Were the SEC to take control of subprime mortgages brokers, rules that forbid the sale of financial instruments to any person unless investing in those instruments is appropriate (suitable) to the investment needs and risk tolerance of that investor would come into play, oversight that would have avoided or greatly mitigated the current crisis. In describing what suitability would do for the mortgage market, we make a novel distinction between "product" and "transaction form" suitability in our analysis of the suitability rules. We argue that transaction form suitability is the appropriate legal theory to use when pursuing people who have unscrupulously sold subprime mortgages to unsophisticated investors. In closing, we discuss reasons why we believe the SEC has not tried to exert this authority to date, and address the likely result of a legal challenge in the event the SEC were to adopt our proposal by rule.

Number of Pages in PDF File: 55

Keywords: securities law, subprime, reves test, crisis, mortgage

JEL Classification: K22

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Date posted: November 23, 2008 ; Last revised: July 15, 2009

Suggested Citation

Macey, Jonathan R. and Miller, Geoffrey P. and O'Hara, Maureen and Rosenberg, Gabriel D., Helping Law Catch Up to Markets: Applying Broker-Dealer Law to Subprime Mortgages (January 3, 2009). Journal of Corporation Law, Vol. 33, 2009; Yale Law & Economics Research Paper No. 359; Johnson School Research Paper Series No. #12-09. Available at SSRN: http://ssrn.com/abstract=1304789

Contact Information

Jonathan R. Macey (Contact Author)
Yale Law School ( email )
P.O. Box 208215
New Haven, CT 06520-8215
United States
+203-432-7913 (Phone)
+203-4871 (Fax)
Geoffrey P. Miller
New York University School of Law ( email )
Center for the Study of Central Banks
40 Washington Square South
New York, NY 10012-1099
United States
212-998-6329 (Phone)
212-995-4590 (Fax)
Maureen O'Hara
Cornell University - Samuel Curtis Johnson Graduate School of Management ( email )
Ithaca, NY 14853
United States
607-255-3645 (Phone)
607-255-5993 (Fax)
Gabriel D. Rosenberg
Davis Polk & Wardwell LLP ( email )
450 Lexington Ave.
New York, NY 10017
United States
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