Small Fish's Bond-Buying Trick Went Poorly
Here are some stylized facts about the corporate bond market.
- Corporate bond liquidity is worrying, and it is hard to trade bonds.
- The best way to get liquidity is in new issues: When a company issues new bonds, there are a lot of new bonds to buy. So a lot of people want to buy them. So you can buy bonds directly from the issuer, and then sell them at a quick profit to other people who also want to buy them. This is better than trading in seasoned issues, which you can neither buy nor sell.
- So buying new corporate bonds is the thing to do.
- This gives a lot of power to the people who allocate new issues. Those people are mostly investment banks, though at least in theory issuers have some input in the allocation process.
- Those people have their own incentives. Issuers and bankers both want to please big investors, since those investors can be critical to getting big bond deals done, and since those investors provide a lot of the banks' earnings in the form of trading commissions and so forth.
- So Pimco and BlackRock tend to get big allocations in hot deals, and pipsqueak investors tend to get zeroed.
We talked about these facts a year ago, when the news broke that the Securities and Exchange Commission was looking into these allocation practices because it was worried about abuses. As a former capital-markets banker myself, I was inclined to sympathize with the banks. From the outside, this sort of favor-trading -- giving big investors big allocations that they can then flip at a profit -- looks sort of shady and nefarious, but really the business of investment banking is a business of favor-trading. Issuers hire banks to help them issue bonds because the banks have relationships with investors and because the banks do favors for investors on hot deals in exchange for the right to call in favors on weak deals. By going to a bank, the issuer gives up some upside if its deal goes well, in exchange for some protection if its deal goes poorly.
This is not always an entirely convincing defense, as it happens. Like, it's hard to justify this on repeat-player favor-trading grounds:
A former syndicate banker at a large US bank described being goaded by a sales manager to alter the pricing of a bond offering to satisfy a powerful buyside client: “Then I have to basically lie to the issuer and tell them they can’t get a better deal. One time, I even had to modify the limits in an order book that they requested to make it look like a tighter deal wasn’t in the cards.”
Yes, that does seem worth investigating? And so the SEC has been investigating bond allocation practices for at least a year. And today it brought a case! Against ... hmm, against "Nearly Two Dozen Unregistered Broker-Dealers." Here's the problem:
An SEC investigation found that Global Fixed Income LLC, which was primarily in the business of purchasing investment grade corporate bonds, entered into agreements with third parties that acted as unregistered broker-dealers on its behalf and bought billions of dollars’ worth of newly issued bonds causing Global Fixed Income’s allocation in the bond offerings to increase. Because the offerings were often oversubscribed, Global Fixed Income was generally able to sell or “flip” the bonds within a few days for a small profit compared to the dollar value of the trade, and it split profits with the third-party participants.
As you probably guessed from the generically grandiose name, Global Fixed Income LLC is not, you know, Pimco. According to the SEC order, it had five employees, one of whom was "sole owner, president and primary decision maker" Charles Perlitz Kempf. But it did buy new-issue investment-grade bonds. Billions of dollars worth of them, in fact.
Starting in 2008, Kempf decided to try to "further increase GFI's profitability" by finding other small investors to team up to buy new-issue bonds. The idea seems to have been that other investors would put in orders to buy new bond issues, and while each of them individually was a relative minnow, if they all put in orders some of them would get partially filled. GFI would put up the money, and would then flip the bonds and give its partners 15 to 50 percent of the profits. The SEC says that over the course of three years -- July 2009 through June 2012 -- 10 of GFI's partners combined to buy $2.5 billion of new-issue bonds in 1,683 transactions, a relatively tiny average of less than $2 million per deal. (For scale, Pimco once bought $8 billion of a single bond issue.) They also teamed up to do $2.3 billion worth of secondary bond trades. The partners got paid a total of $9.7 million for their help -- basically, for calling up underwriters and placing orders from 10 different phone numbers instead of one. Ten times the chances to win the new issue lottery!
And now they are in trouble. GFI, its friends and their various principals settled with the SEC for disgorgement of amounts ranging from $94,000 to $2.4 million, and additional monetary penalties of $5,000 to $500,000 each. They are in trouble for acting as unregistered brokers for GFI. (And, in the case of GFI, causing or aiding and abetting those violations.) The idea is that you can buy a bond for yourself without being a registered broker-dealer, but if you buy a bond for someone else, on a more-or-less commission basis, then you need to be a registered and regulated broker-dealer. And these guys were pretty clearly buying their bonds for GFI. They had signed agreements with names like "Profit Splitting Agreement" and "Guarantee of Payment." You're not supposed to broker without being a broker, and they brokered, and then they were caught. Fair enough.
But, I don't know, aren't they pretty sympathetic? They didn't hurt anyone. Everyone seems to have gotten paid on time, and it doesn't seem like any of GFI's fellow investors were, like, holding themselves out as brokers for unsuspecting third parties. They were just teaming up to get better allocations in bond issues, so that they could compete in a process that even the SEC thinks is rigged against small investors. They were the little guys, trying to look out for one another in an unfair world. And they're the ones who got in trouble.
Exercise for the reader: Draw the supply and demand curves implied by these sentences.
Kempf marketed these deals using PowerPoint, of course:
Generally, GFI located Participants through word of mouth or through Participants that were compensating others as “finders.” Kempf provided some of the Participants with a PowerPoint presentation to market GFI. This presentation described GFI’s history, business, investment strategy and profitability. If interested, the Participant met with Kempf to discuss a formal business relationship with GFI. Once the Participant agreed to act as GFI’s agent, the Participant created a corporation, if one did not already exist, and all but one entered into a written agreement with GFI (a “Participant Agreement” or “Profit Splitting Agreement”) to purchase securities on GFI’s behalf. The Participant Agreement or Profit Splitting Agreement (depending on which was used) was signed by Kempf and the Participant’s control person. Among other things, the Participant Agreement set forth: (1) the Participant’s compensation, generally a splitting of the monthly trading profits with GFI ranging between 10% and 50%; (2) that GFI provided all of the capital for the Participant’s trading; and (3) that GFI generally assumed all trading losses. In addition, many of the Participants executed an additional agreement (a “Guaranty of Payment”) in which GFI: (1) agreed to pay for all securities; and (2) represented that the Participant did not have to register as a broker or dealer.
By the way, a representation that the law does not require you to do X does not necessarily mean that the law does not require you to do X! It's just some words that someone wrote.
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