Everything is securities something

Let’s say you’re a real estate company. Say you own apartment buildings and make money by renting out the apartments. Some of your apartment buildings might be in desirable ocean-front locations and command premium rents. If sea levels rise dramatically, those buildings will be in significantly less desirable underwater locations, and command no rents. This will be bad for business. 

What should you do about that? I don’t know, I am not in the real estate business. Since we are talking about it, I suppose I would say things like:

• You should consider and attempt to quantify this risk.
• You should consult scientific studies, and perhaps even hire climate scientists, to try to understand the likelihood and impact of the risk.
• You should reserve some money against the possibility of it coming true.
• You should consider divesting some of your desirable but risky ocean-front properties as a defensive move to minimize the risk.
• You should consider buying some somewhat-less-desirable a-few-blocks-from-the-ocean properties as an offensive move to take advantage of the risk, hoping that when sea levels rise they will become ocean-front properties and command premium rents.

Those are just some guesses. They seem reasonable to me but again I am not in the real estate business, or the climate science business for that matter. The world is complicated and there is a lot going on, and it is not impossible that some people who are actually in the real estate business would do a quick meta-analysis of the timing, likelihood, and expected impact of this risk and decide that it’s not worth thinking about at the moment, that there are other more pressing things to worry about. This sounds wrong, to me, perhaps also to you, when I say it after the whole setup about the buildings ending up underwater, but I can’t say for certain that it’s actually wrong for actual companies. 

Another thing you might do, if you are a public company, is disclose this risk to your shareholders. The rules for U.S. public companies require disclosure of material risk factors in annual reports, and if you consider this risk and decide it’s material then you’d better disclose it. And so some companies do. Here’s a real one 1 :

To the extent that significant changes in the climate occur in areas where our communities are located, we may experience extreme weather and changes in precipitation and temperature, all of which may result in physical damage to or a decrease in demand for properties located in these areas or affected by these conditions. Should the impact of climate change be material in nature, including significant property damage to or destruction of our communities, or occur for lengthy periods of time, our financial condition or results of operations may be adversely affected. 

This is much more general than “our buildings might end up underwater,” which makes sense, since the actual risk is pretty general and open-ended. A lot of bad stuff could happen, to the buildings, because of climate change. Good stuff could happen too—maybe their buildings in cold states, or a few blocks from the ocean, will become more desirable—but you don’t put good stuff in the risk factors.

Notice what else is not in the risk factor. There is no effort to quantify the risk, to say “by 2025 we expect these changes to reduce our net income by $X million per year” or whatever. This is hardly worth mentioning as an omission. The other risk factors aren’t quantified either. The point is that they are highly uncertain, that they’re risks for investors to think about rather than specific detailed projections of costs. That doesn’t necessarily mean that the company hasn’t done some specific projections—or at least what-if scenarios—for its own internal planning purposes, but then companies don’t typically disclose their long-term plans and projections, never mind their what-if scenarios, in annual reports.

Here is a proposal from Senator (and presidential candidate) Elizabeth Warren to change that:

Publicly traded companies have an obligation to share important information about their business. But right now, these companies don’t share much about how climate change might affect their business, their customers, and their investors. 

That’s a problem in two ways. First, there are a lot of companies that could be badly hurt by the likely environmental effects of climate change. … Second, global efforts to combat climate change will have an enormous impact on certain types of companies, particularly those in the energy sector. ...

My Climate Risk Disclosure plan addresses these problems by requiring companies to publicly disclose both of these types of climate-related risks. It directs the Securities and Exchange Commission to issue rules that make every public company disclose detailed information, including the likely effect on the company if climate change continues at its current pace and the likely effect on the company if the world successfully restricts greenhouse gas emissions to meet the targets of the Paris Agreement. …

This plan will have an immediate effect on our efforts to combat change. Some investors are already divesting from fossil fuel companies, and a leading American insurance company recently announced that it would no longer insure or invest in coal. My plan will push more investors to move their money out of the fossil fuel industry, accelerating the transition to clean energy. It will also demonstrate to investors that — if nothing else — climate change represents a serious risk to their money and they need to demand global action to address it. And it will make clear that climate change represents not just an existential environmental threat to the planet, but a serious threat to our financial system — one that we need to head off now before it costs people their homes, jobs, and savings like the 2008 crisis.

It might be worth thinking about this proposal in a couple of different ways. Imagine if, instead of a regulatory proposal from a presidential candidate, this was a thing that a management guru wrote in a book. The book would say “companies should make serious efforts to understand the potential effects of climate change on their business, make detailed projections of the financial impact of those effects, have plans to mitigate them, and disclose all of this to shareholders to help them understand the long-term prospects of the business.” This would, I think, be a little hard to argue with. 2  You could ignore it, sure. But a message of “think about all of the important risks facing your company and take steps to prepare for them” is pretty unobjectionable, and an infinitely conscientious manager with infinite time certainly would do that. Quite possibly even a reasonably conscientious manager with limited time would do it, too, because the risks of climate change really are material and imminent. All of this stuff could well be good management advice that companies ought to follow.

Now imagine if, instead of a piece of management advice from a professor, this was a letter to corporate boards from a major institutional shareholder, say Larry Fink of BlackRock Inc. This is not hard to imagine; Fink has written letters like that, some of them touching on “environmental risks and opportunities.” Here, again, the message seems unobjectionable—major shareholder wants to hold boards accountable for thinking about the risks facing their companies, etc.—though, again, ignorable. (What is he gonna do, dump energy companies from his index funds?) It fits with the popular institutional-investor messaging about “long-termism.” The idea is that corporate managers are too focused on the short term, thinking about next quarter’s profits rather than whether their buildings will be underwater in a decade. Diversified institutional investors with a long time horizon have to pressure managers to take the longer view of broad problems. Fine.

Now imagine it’s Warren’s plan, but leave off the last paragraph I quoted. And instead of the actual title—“Accelerating the Transition to Clean Energy”—give it some bland title like “Improving Shareholder Disclosure of Long-Term Climate Risks.” Unlike the management guru or Larry Fink, this plan calls for regulators to mandate the extra disclosure. And not just extra disclosure. It’s not like every company has detailed projections of the likely effect of climate change on its business, and just has to make them public. Lots of companies presumably don’t have those projections, and would have to go make them. And they’d need to hire climate scientists or specialized consultants to help them project the likely physical effects of climate change before they could model the financial effects. The SEC would be meddling, in a fairly intrusive way, in the actual managerial decisions of companies, telling managers how to run their businesses rather than just regulating their communications with shareholders.

Maybe that’s bad. It’s a little weird, and certainly a big expansion of regulation. But if you liked the management-guru and Larry-Fink versions of the proposal, then maybe this version is fine too. Sure it takes an expansive view of the SEC’s mission, giving the SEC power to intervene directly to shape management decisions, but that’s not exactly unheard-of in modern securities regulation. And if this is really good management practice, and if there are systemic biases or blind spots (short-termism, etc.) that prevent managements from implementing it on their own, maybe it makes sense for the SEC to mandate it. 

So there are lots of business-y reasons to support this plan, or something like it. (The details are quite vague at this point.) There are business-y reasons to oppose it, too, but the point is that you can have a business-y conversation about its merits and faults. And in its broadest form, “companies need to consider and plan for big material risks and disclose them to shareholders” seems like pretty good corporate governance.

But now let’s consider Warren’s actual plan. It is not a plan to improve shareholder disclosure, or I guess it is, but that’s not the headline. It’s a plan for “Accelerating the Transition to Clean Energy.” It “will have an immediate effect on our efforts to combat [climate] change.” It will “push more investors to move their money out of the fossil fuel industry, accelerating the transition to clean energy.” It will focus investors on climate risk and make them “demand global action to address it.”

In other words, the real goal of this proposal is not to improve shareholder returns or corporate governance or stock-market transparency. Nor is it to improve the overall quality of corporate management and planning. The real goal is to address the substantive issue, to reduce the world’s use of fossil fuels, to solve climate change through the mechanism of corporate disclosure.

That’s quite plausibly a better goal than shareholder value! Obviously! If human-caused climate change is going to make the planet uninhabitable in the near future then that’s a way more important thing to worry about than shareholder empowerment! If you take climate change seriously then you can’t take it all that seriously as a matter of shareholder value; if it is serious then it is just more important than that. But as a practical matter you might rationally, as Warren does, try to enlist shareholder value as a tool to achieve your real goals.

It is a strange way to achieve them, though. Requiring every company to estimate the financial effect of climate change on its business means requiring every company to estimate the physical effect of climate change, to figure out how the climate will change and how sea levels will rise and so forth. It is strange to think that the best way to inform the public about the risks of climate change might be by getting not just every oil company but also every real estate company, every social-media company, every ride-sharing company, every pet-food company, every company of any sort to do its own evaluation of those risks. What makes them the experts? 3

There are more obvious centers of expertise. The U.S. federal government, for instance, employs a lot of scientists who think about climate change. It has meteorological agencies, even an Environmental Protection Agency. Perhaps those agencies could take the lead on estimating the physical and human impacts of climate change, and even on responding to them—by regulating climate-impacting activities, for instance. If climate change is a genuinely serious issue that attracts the attention of senators and presidential candidates, perhaps the government should tell its citizens about the stakes, and then make democratic decisions about what to do about it. Instead of leaving it to hundreds of companies to tell their shareholders about the stakes, and then leaving it to large institutional shareholders to decide, company by company, what to do about it.

This is why I am skeptical of regulating everything through securities law. The deep message of this proposal is that the democratic process is incapable of responding to serious substantive issues, that the U.S. government is not suited to solving collective problems that affect its citizens, so our best hope is to turn them into corporate governance issues and solve them through the securities laws. That might be right! It’s a sad thing to think, though.

Custody

If you buy a share of stock in a company, you don’t get your own tiny fractional share of all of the company’s assets delivered in a bag to your door. With rare exceptions, you don’t even get a paper stock certificate. Instead you get an entry in the computer of your broker reflecting that some of the shares that the broker holds are actually held for your account. But the broker doesn’t have a bag, or a paper certificate, either. The broker has an entry in the computer of some other intermediary—in the U.S., generally, the Depository Trust Company—saying that some of the shares that DTC holds are actually held for your broker’s account. DTC may have a paper certificate, though often it just has an entry in the computer of the company’s transfer agent reflecting that many of the company’s shares are owned by DTC.

I guess if any of these computers crashed then that would be bad? For you? Presumably they keep backups. This system actually works really well; there are occasional weird glitches in which the technical details of stock ownership can get confused, but there are not really cases of people losing their shares because their broker or DTC or the transfer agent forgot where it put them.

This is not an accident: Reliably keeping track of security ownership is a really really really important feature of the financial system, and so the financial industry works together to maintain a functioning system, and it is all heavily regulated to make sure that it works. This system is conventionally called “custody,” which is sort of a historical metaphor suggesting that you own paper stock certificates and your broker is keeping them safe in a box for you. But, in almost every case, that’s not actually happening; that’s just a metaphor. Really “custody”—the methods that your broker, and the financial system generally, use to keep your securities safe for you—occurs entirely on computers, and is basically an agreed and regulated set of legal and technological conventions for making sure that everyone knows who owns what stocks.

Cryptocurrency has different conventions. Basically there’s a blockchain recording who owns what, and an enormous set of possible numbered accounts each with, in effect, a password (a private key) entitling its owner to use the cryptocurrency in the account. There is (generally) no centralized intermediary holding everything for everybody; distributed technology and cryptography are what keep your coins safe. There is a lot to like about this—it is not vulnerable to single points of failure, it is not captured by powerful incumbents, etc.—and crypto enthusiasts quite vocally like it. There is also, to be fair, a lot to dislike. You can lose your password, or someone else, absurdly, can guess it. Maintaining your password yourself might be a pain so you might rely on someone else to keep custody of your coins, and they might lose them. In fact there is a comically long history of people losing their cryptocurrency because they or their broker or their exchange forgot where they put them. The actual experience really is much worse than in the securities industry.

So far. You could imagine better conventions for just, like, how your broker should write down the password or whatever. Getting to institutional-grade custody of cryptocurrency is not an unsolvable problem; it is just a matter of finding some good legal and technical conventions, and getting the industry, and the regulators, to buy into them. It is a hard problem mostly in that the industry, and the regulators, are used to the conventions that work for regular securities, and it is hard at this late date to get them all to agree on a new set of conventions for a new sort of asset.

Anyway here is a joint statement from the SEC and the Financial Industry Regulatory Authority on “Broker-Dealer Custody of Digital Asset Securities”:

In particular, a broker-dealer may face challenges in determining that it, or its third-party custodian, maintains custody of digital asset securities.  If, for example, the broker-dealer holds a private key, it may be able to transfer such securities reflected on the blockchain or distributed ledger.  However, the fact that a broker-dealer (or its third party custodian) maintains the private key may not be sufficient evidence by itself that the broker-dealer has exclusive control of the digital asset security (e.g., it may not be able to demonstrate that no other party has a copy of the private key and could transfer the digital asset security without the broker-dealer’s consent).  In addition, the fact that the broker-dealer (or custodian) holds the private key may not be sufficient to allow it to reverse or cancel mistaken or unauthorized transactions.  These risks could cause securities customers to suffer losses, with corresponding liabilities for the broker-dealer, imperiling the firm, its customers, and other creditors.

These are not problems that are so different from the problems of keeping a list of securities at DTC; it’s just that those problems are familiar and the crypto ones are new.

Insider trading

I spend a lot of time around here telling you what not to do when you’re insider trading. Don’t insider trade at all, really, and certainly don’t do it using short-dated out-of-the-money options, that sort of thing. I tend not to praise insider traders much, though that might just be due to sampling bias: I only really write about insider traders who get caught, which by definition means that they messed something up. Often a lot of things.

Still every so often I can appreciate even the failed insider traders. There was that guy who ate the Post-It notes containing the illegal stock tips; I am not sure that this is a great idea from either a nutritional or a tradecraft perspective, but I like the effort.

And then there is the insider trading case that the SEC and the Justice Department brought yesterday against Donald Blakstad, accusing him of making more than $6 million by trading on insider tips from Martha Bustos, who was then an accountant at Illumina Inc. (and who has pleaded guilty). Blakstad is 60 years old; Bustos is 31, and “traveled, socialized, and had a close friendship with Blakstad.” From 2016 through 2018, Bustos allegedly gave Blakstad advance notice of Illumina’s quarterly results, and Blakstad allegedly used other people’s accounts to trade short-dated options. (Bad!) Those trades made about $6.2 million, most of which allegedly went to Blakstad, though the people who traded for him allegedly got a cut. What about Bustos?

In return for the tips, Blakstad rewarded Bustos lavishly. For example, following one successful tip, Blakstad treated Bustos and several of her friends to an all-expense paid trip to New York, spending nearly $35,000 for first-class airfare, hotels, and meals for every member of the traveling party, including a $7,500 meal at New York’s upscale restaurant Per Se.

Look it’s not good, I don’t endorse it, you shouldn’t pay for insider trading tips with first-class plane tickets and group dinners at Per Se. I’m not even sure it’s better than the traditional method, handing over a sack of cash in a parking lot. And yet there is something appealing about it. You get your tips from a much younger in-house accountant, but rather than rewarding her as a criminal conspirator—sacks of cash in parking lots—you welcome her into a world of glamor and luxury. The implicit message, to her, is not “hey thanks for doing crimes with me” but rather “this is how rich people operate, this is normal, this is the right way to live.” So much of the real business of high finance is about making financial transactions feel less transactional, more like the natural outgrowth of deep relationships, and you can apply those lessons to illegal finance too.

Obviously not legal advice!

An airdrop

I don’t know, do you like the airdrop joke? There are “quantitive easing” or “helicopter money” or “finally the Fed is listening to Trump” sort of jokes available. Anyway this happened:

On Tuesday before sunset it was a fluttering swirl of cash — and a lot of it — blowing through the air that brought traffic to a halt and people into the street when a side door of an armored Garda truck suddenly opened on a highway.

About $175,000 in bills spilled out and were carried away by the wind over a section of Interstate 285, which encircles Atlanta, the police said. The bills scattered to the shoulder of the six-lane westbound section of the highway. Some floated across the divider into eastbound lanes. Bills blew into the woods or sank into storm drains.

More than a dozen commuters screeched to a halt or veered off to the shoulder of the highway near the Dunwoody Road exits, the police said. They scooped up bills from the pavement and returned to their vehicles with fistfuls, and sometimes armloads, of cash.

The police want people to return the money! Seems unsporting; dollars are bearer instruments and, you know, finders keepers. I hope this will lead to a fork in the dollar, where some dollar users live in a world in which people return the money and others live in a world (Dollar Classic) in which they keep it. 

Elsewhere in newsletters

My Bloomberg Opinion colleague Brooke Sutherland has a new weekly newsletter called “Industrial Strength,” covering industrial topics including aerospace, machinery, logistics and more. You can sign up for it here. 

Things happen

Jeffrey Epstein’s ‘Infinite Means’ May Be a Mirage. U.S. Investigating Deutsche Bank’s Dealings With Malaysian Fund 1MDB. Deutsche Bank Draws on Two-Week-Old Rule in $8.3 Billion Revamp. SEC Clears Blockstack to Hold First Regulated Token Offering. PG&E Knew for Years Its Lines Could Spark Wildfires, and Didn’t Fix Them. Chevron Is Playing a Long Game in Venezuela’s Oil Fields. “Ben Hamm used machine-learning software to train a system to recognise when his cat Metric was approaching with a rodent or bird in its mouth.” “Naturally, you shouldn’t swim there, but for the length of an hourlong photo shoot, you won’t grow a third hand.” 

If you'd like to get Money Stuff in handy email form, right in your inbox, please subscribe at this link. Or you can subscribe to Money Stuff and other great Bloomberg newsletters here. Thanks!

1. It’s from the 10-K of AvalonBay Communities Inc., a big apartment real estate investment trust. I don’t mean to pick on them, though, or suggest that they’re particularly vulnerable to this risk. It’s just some sample disclosure.

2. Well, I suppose you could object “actually climate change is a myth so there’s no reason for managers to worry about it.” (Or “climate change is totally random and there are no predictable impacts,” etc.). But even if you think that, it’s not really an argumentagainstthe proposal. You can accept the proposal, spend five minutes confirming your priors that climate change is a myth, and then write your trivially easy projections (no impact) and plans (do nothing). The essential form of the proposal is “managers should think about material risks and prepare for them”; the objection “I do not think that this particular risk is material to my business” does not really undermine the proposal.

3. Requiring every company to estimate the financial effect of future climate-change *regulation* on its business is even weirder, since it requires every company topredict the future course of climate-change regulation. What makes them the experts? Why aren’t the *regulators* the experts? Why shouldn’t the regulators just *implement* those future regulations now?

To contact the author of this story:
Matt Levine at mlevine51@bloomberg.net

To contact the editor responsible for this story:
James Greiff at jgreiff@bloomberg.net