September 23, 2006
Nocera on Hedge Funds
Joe Nocera as a piece in today's NY Times on hedge funds, "Curiosity Has Its merits and Its Profits." Maybe Joe is waking up. The piece describes how hedge funds find corporate misbehavior, invest, disclose the companies problems, and reap profits. Nocera, who is distrustful of hedge funds does not know what to make of this. Is it good or bad? He plays both sides, which for Nocera, is an improvement. The hedge funds are not .... public spirited... they are doing it for...profit. He quotes company spoke persons (with sympathy??) saying they are exploiting a "technicality" for a "quick buck" "to the detriment of shareholders." But the companies they have outed for problems.... such as stock backdating...smell. In the end, Nocera grits his teeth "The punishment ... may be harsh...but it's hardly undeserved."
He equivocation on legal hedge fund activity is comical. Hedge funds are bringing a new version of accountability to the market. Shareholders are better off with it and without. Hedge funds that act illegally can be a problem; but hedge funds that act legally...they are not.
Amaranth : Lessons on Hedge Fund Failures
The difficulty of Amaranth has three notable features. First, there was no market panic. It caused barely a ripple. Those who believe a hedge fund failure could take down our financial system are... well... silly. Second, investors are learning and getting education on the effects of lock ins. Those investors who are trying to leave Amaranth with what is left are finding their redemptions penalized in the fine print of their investment contracts. With many funds, it costs .24 to 2% to get out before a two year lock up period expires. If too many ask to redeem the fund can stagger repayments and so. Moreover, investors are discovering that some negotiated for better redemption terms than others (called "side agreements"). The problems with Amaranth redemptions will not be lost on a very intelligent group of investors; risk assessments will factor in redemption terms. Third, investors are a bit surprised by Amaranth's COO's appearance at two "beauty shows" hawking his funds, claiming a 25% return, during the two days when the fund was starting to lose big. Investors have hired lawyers and are looking into lawsuits based on misrepresentation. Hedge Funds, who often use the law to attack management, are going to find that their investors know how to do this too.
September 22, 2006
Naked Shorting and the SEC
The SEC is worried about the increase in naked shorting (SEC rules do not seem to have reduced the practice to the levels the SEC prefers) and is now listening to panels of economists on what to do about it. Naking shorting occurs when a person sells stock that she does not own and has not borrowed, intending to either cover and deliver (buy the stock before the three day settlement period expires) or to default on delivery. A trader covers if the stock price falls in the three day period and defaults if the stock price rises (in an amount that exceeds the penalties for a default). Managers hate the practice; they believe it puts unfair downward pressure on their stock price and that the practice is, to some extent, self-contained. Naked shorting itself will depress price, allowing those who do it to cover at the lower price making money on the trading practice itself and not on outside market factors. The SEC does not like; the agency has declared it illegal in most contexts (there are some exceptions for market makers.) But some traders do it anyway.
What to do? The SEC has in place a complex pattern of disclosure rules, soon to get more complex, that require firms be put on a "watch list" for high number trade defaults; those who trade stock of watch list firms have tighter trading rules. The rules work only marginally well. The pure market solutions is to allow other traders, who see naked shorts in a stock, to "squeeze" the shorts by buying stock, forcing the shorts to default. But the squeeze seems to be as much an artifical a price move as the naked short (the SEC does not want pure trading plays to move the market price). The economists want naked traders to pay fees for naked trading equal to the fees paid by those who borrow stock to sell it (short stock). The problem with their proposal is its implementation; how does someone collect the fees??? Indeed, when one looks at implementation one sees that the SEC and the economists are overlooking the obvious.
Naked shorting only works is the penalty for default, failure to cover, is small. If penalties are significant, the naked short seller will cover and deliver not only if the stock price falls but also if the price rises and the rise is less than the penalty he must pay on default. This is a very different bet than a pure negative play. [Indeed, it approximates the play on a legal short; the stock borrower can, after all, refuse to return the stock borrowed.] What is the penalty? Too often in today's markets it is close to zero. The counterparty who does not get the stock promised absorbs the loss (losing the price rise gain), complains, and walks. Simple contract principles give the counterparty damages equal to the full price rise (the counterparty can cover immediately, buying the stock and charge the defaulting party the price of the newly purchased cover net of the price of the original sale, if paid). Damages would also include repayment of the trading costs of the second transactions (a second set of commissions, for example) or a liquidated damage amount included in the trading contract (this could be set at the price to cover plus the price of a short, the price to borrow; the economist's solution). If counterparties that routinely do this, it would solve the naked shorting problem. Naked shorting would become extremely risky (much more than it is) and those left who do it may have information we want in the market price.
Why do some many counterparties walk and not collect damages?? This is where the SEC needs to work. I suggest a simple solution. Require counterparties in defaults to cover immediately (buy the stock not delivered on the date of the default) if the stock sale that fails has been previously publicly disclosed on the ticker (or its trade reporting equivalent) ; disable the counterparties walking away from such deals. Jilted counterparts will be more likely to collect damages from the naked shorts (or refuse to deal with them at all) and the increased buying pressure on the stock (to cover) will reduce the effect of the naked shorting on the stock price. Those counterparties that fail to cover lose their broker/dealer license.
September 20, 2006
"I shouldn't have asked..."
A Hewlett-Packard lawyer asked whether the company's investigation of it own board was on the up and up and was told -- "It is on the edge." (See Damon Darlin & Matt Richtel, "Some at HP Knew Early of Tactics," NYT today). His response, "I shouldn't have asked." I assume he asked for no further details. The lesson, apparently, is that by asking, the lawyer may have lost his ability for a "plausible denial" of knowledge of the illegal techniques used in the investigation. He still can argue that he thought "on the edge" meant legal, I suppose, but the plausibility of his denial is now suspect. He knew that he put a plausible denial a risk.
He needed better training in the use of the technique, I guess. I need to suggest to the Dean that we teach a course in the techniques of "plausible denial" for our law students; the skill seems to be very important nowadays. Get just enough facts to offer a valid legal opinion (or other advise or services) with qualifiers and disclaimers, charge a nice fee, avoid investigating any red flags and put aside any suspicions, and then tell everyone after a scheme blows up that you were hook winked too and assumed that the limited facts as given in your opinion were the entire story. Yup, that's the ticket.
September 19, 2006
Deferred Prosecution Agreement
At least 16 publicly traded companies have agreed to deferred prosecution agreements to protect the themselves from criminal indictment. Many of the agreements put a court-approved overseer in place to monitor the company's compliance with the agreement's requirements. This is not a harmless move. The overseer at Bristol-Myers Squibb, a former federal district court judge Frederick B. Lacey, was apparently instrumental in the firing of the company's CEO. The rub is that the CEO did not violate any provisions in the deferred prosecution agreement; the CEO, according to the New York Times (Stephanie Saul, "A Corporate Nanny Turns Assertive" (great piece Stephanie!)), was responsible for a poor "corporate culture" of "secrecy and poor internal communications." In essence, a retired federal district court judge fires the CEO for screwing up a patent dispute negotiation because the CEO did not run the details of the negotiation by the board. The second guessing was easy; had the CEO run the negotiations by the board the board would have helped him put together a successful deal. No business judgment rule here. The lesson is also easy for CEOs: turn a former federal district court judge free in your company and you had better be perfect in your business decisions as well as your legal compliance.
A big hedge fund, Amaranth Advisors, is reported to have lost over $3 billion in the natural gas market. The healthy part of the story is how quickly Amaranth investors discovered the loss. Several investors investigated personally Amaranth's books to determine the extent of their exposure. The quick action of investors is very healthy and a signal that the hedge fund market is working, not that it is failing.
September 18, 2006
HP's Pretexting and Lawyers
The secret investigation of directors at Hewlett Packard necessarily involves lawyers. One lawyer, Sonsini, was on the board and asked for assurances from the companies Chief Legal Officer, Baskins that the investigation was on the up and up. Baskins assured him that it was. She, we now know, was wrong and may have had a heavy hand in supervising the program. Another lawyer in Boston,Kiernan, wrote an opinion letter for HP advising that the methods of the outside investigator were legal; he was mistaken and conflicted. These kinds of assurances from lawyers are routinely requested by managers and without affirmative responses managers do not go ahead with their planned activities. Lawyers then are often integral to any scheme of managerial misbehavior. As participants, lawyers should be held accountable, both in criminal and civil prosecutions and in bar investigations. Once a few lawyers are sanctioned, opinions and assurances on what turn out to be questionable actions will be harder to secure.
September 17, 2006
New Glass Lewis Study on Executive Compensation
The new Glass Lewis study on executive compensation is a devastating rebuttal to those who support the current levels of compensation. Among other conclusions, the twenty-five companies with the worst record of excessive pay for poor performance, the compensation average $16.7 million in 2005 and the companies income dropped an average of 25 percent (the stock value dropped an average of 14 percent). The executives of such companies drained 6.4 percent of the losing companies' total net income in compensation payments! This is just institutional theft. The top twenty-five companies paid an average of $4.4 million, only .2 percent of the companies total net income. There is no longer any doubt that executive compensation systems are not working in significant number of American corporations.
Corporate Criminal Liability
John Hasnas has an editorial in the Wall Street Journal ("Do Nothing") summarizing his position on corporation criminal liability. His view is that absolute corporate liability for a misbehaving senior officer or director should be rejected in favor of a standard of corporate criminal liability based on institutional culpability (was there a corporate policy that facilitated the criminal misconduct?). Corporate criminal liability is in the spotlight because it has proven so devastating to financial companies, whose reputation for honesty is critical to their business. Criminal liability of an accounting firm or a bank or a brokerage operation can cause investors and customers to run and kill the business. Hasans is correct no the merits; I would favor a defense, however, based on a blame free corporate culture and explicit instructions and training to behave rather than a redefining of the offense. I would also have no defense if the senior officers in charge of the company are the wrongdoers; they are the company.
The litigation in New York over the compensation of ex-NYSE chief Grasso is a classic example of what money-is-no-object defense lawyers can do to the litigation process. The defense lawyers are paid to explore every defense, make every motion, take every edge in the litigation. It puts very, very heavy pressure on the state court judge hearing the case (who, buy the way, having decided a few motions against Grasso now finds himself the subject of the motions for recusal.) Those who are interested in the litigation process, and the effect of wealth on the process, should be following this case, blow by blow. It will be an education.