Fraud, Bonuses and Accredited Investors

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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How's Martin Shkreli doing?

I appreciate that Martin Shkreli, the pharmaceuticals-and-hedge-fund guy arrested last week for securities fraud, took time out of his busy schedule of making weird YouTube livestreams to sit down with the Wall Street Journal and criticize the grandstanding of the prosecutors who arrested him: 

“You know, the press conference they put on was unacceptable,” Mr. Shkreli said Sunday. “They used the term ‘Ponzi,’ or ‘Ponzi-like,’ which is nowhere near reality. The indictment doesn’t use that word.”

Who's to say what is or isn't Ponzi-like, really? Really you want to lead with the argument that what you did wasn't fraud, not that it wasn't "Ponzi-like" fraud. Also this stops somewhere short of saying that the indictment is wrong:

“The indictment itself is lacking rigor. I think it doesn’t tell my side of the story at all,” said Mr. Shkreli. 

Yeah that is pretty much how indictments work though.

Last week I wrote about how impressive it is that Shkreli, after apparently losing all of his investors' money at least twice in hedge funds, managed to battle his way back and leave his investors, in aggregate, richer than when they started. That's pretty unusual for an accused securities fraudster. The bulk of Shkreli's gains came from Retrophin, the public drug company that he started, and I confess that it is something of a mystery to me how much of Retrophin's success is about actual drug development, how much is about manipulation of the health care pricing system, and how much is about good old stock manipulation. From Bethany McLean's profile of Shkreli in Vanity Fair, I gather it was a bit of all three:

At least some of the investors wanted in based on the promise that Retrophin was going to develop new drugs for rare diseases, but the company started to buy existing drugs—including Thiola, which helps prevent a rare form of kidney stone—and hike the prices. One person close to events says that both Hassan and Saunders sold their stakes when they began to feel Retrophin was moving away from developing its own drugs.

In the spring of 2014, Shkreli began posting bullish messages online about the company’s prospects, as Retrophin’s stock was soaring, from around $3 a share in early 2013 to almost $20. On May 29, he tweeted, without explanation, that “this is one of the best days of my life!” The next day he sold almost $4.5 million worth of his own stock in the company. This infuriated investors who believed he was cashing out.

There are many other delights in the profile, including Shkreli's claim that he founded Retrophin because there "wasn't enough  money in hedge funds." If you believe the indictment against him, there sure wasn't enough money in his hedge funds!

In other rough news for Shkreli:

Investor accreditation.

Under U.S. law, some financial products, like hedge funds and private-company shares, are generally available only to "accredited investors." There's no actual accreditation -- there's no test -- it's just that if you have enough money you're "accredited." The theory is partly that if you have a lot of money you can afford to lose some of it on dumb private investments, and partly that if you have a lot of money then probably you know things about money and won't make dumb private investments. Both of these are terrible theories: If you have a lot of money, you still can't afford to lose all of it in dumb private investments, and there are plenty of rich dentists who don't know much about investing. The result is that it is both too easy to be an accredited investor, in that unsophisticated investors can be accredited, and too hard, in that fancy investing products are available only to the rich. (Rich-ish: The threshold is basically $200,000 in annual income or $1 million in assets.)

Anyway here is a fun new staff report from the Securities and Exchange Commission recommending some changes to the accredited investor rules. Given the essential silliness of the rules, there is lots of low-hanging fruit. So for instance the SEC staff recommends keeping the current thresholds but making them "subject to investment limitations," so that if you're a wealthy dentist you can invest some but not all of your savings in dumb schemes. (The staff would add higher thresholds, e.g. $500,000 in income or $2.5 million in net worth, without investment limitations.) There is also some consideration of accreditation by test rather than by wealth:

Expanding the accredited investor definition to include persons holding certain professional credentials would recognize an objective indication of sophistication. The Commission could consider adding a new category to the accredited investor definition that, for example, includes individuals who have passed the Series 7 examination, Series 65 examination or Series 82 examination. Those credentials may provide demonstrable evidence of relevant investor sophistication because of the subject matter their examinations cover

I have to say that passing the Series 7 represents an absolute minimum of investing competence, but probably still more than making $200,000 a year, so why not.

Banker bonuses.

The European Banking Authority caps banker bonuses at no more than twice fixed pay. The argument for the cap is that big bonuses incentivize risky behavior. The argument against is that banker pay is set by the market; if variable pay is limited, fixed pay will have to go up, and having a larger cost base is risky for banks too. The banks sort of thought they'd solved this conundrum with something called "allowances," in which senior bankers get paid something that looks sort of like salary (it is fixed in advance, paid over the course of the year) but that can be revised each year. The EBA is displeased:

The regulator’s stance on cash allowances, which depend on seniority and are also known as role-based pay, is detailed in the final guidelines. The regulator leaves little room for interpretation, or for banks to use allowances to bolster total compensation above the cap.

“Remuneration is either fixed or variable; there is no third category,” the EBA said. Moreover, “the effectiveness of risk alignment would be significantly weakened if institutions made excessive use of allowances.” Institutions need to be able to justify the use of any variable remuneration element, including allowances, retention bonuses, guaranteed variable remuneration and severance payments, the EBA said.

Here is the EBA's announcement of its final remuneration guidelines; here are the guidelines. You get the sense that there's a right answer here, some way to cut down on risky incentives while still giving banks some flexibility on fixed costs, but that no one wants to find it because the process has become so adversarial. The banks' goal is to replicate the old bonus system as closely as possible, the EBA's goal is to force as much as possible into fixed salary, and neither extreme is all that desirable. 

Some fraud.

Here is a Financial Industry Regulatory Authority enforcement action with the headline "FINRA Sanctions Fidelity Brokerage Services LLC $1 Million for Supervisory Failures." Fidelity failed to properly supervise a woman named Lisa Lewis, who stole "more than $1 million from nine of its customers, eight of whom were senior citizens." That is bad, of course, but you might feel a little bit of sympathy for Fidelity if only because Lewis didn't work there. She was just an impostor, pretending to work for Fidelity. The lesson might be that, if you are a big brokerage firm, you have to properly supervise both your employees and anyone pretending to be your employee. Elsewhere: "Banks Battle Staffers' Vulnerability to Hacks."

Buy gold!

CNBC has Peter Schiff on a lot to talk about how the Fed will destroy the dollar and you should buy gold, and someone at CNBC thought it would be a good idea to check on how those predictions are working out, and the result is as hilarious as you'd expect:

In a long series of emails with CNBC, Schiff maintained that his $5,000 gold call has not yet been proven incorrect.

"I never specified that gold would hit 5000 in two years," Schiff wrote. "You can say that Schiff thought gold would make a big more in two years. He was right, but the move was in the opposite direction."

Oh man. A fun fact is that the English language actually has a word to express the concept of "right, but in the opposite direction." That word is "wrong."

People are worried about unicorns.

I have to say that I don't understand the public relations strategy of Theranos, the Blood Unicorn. There was a Bloomberg Businessweek cover story this month, and this weekend there was another big article in the New York Times, and Theranos seems to have cooperated with both of them, and its chief executive officer Elizabeth Holmes was interviewed for both of them. Obviously if you are Elizabeth Holmes you have to know that the only questions anyone wants to ask you are to the effect of: Is your company legit? Can you actually do the blood tests that you've claimed you can do? And obviously you need to have answers for those questions. But she never does. It's a lot of this:

Ms. Holmes insists, however, that the company can still rely on some of its technology, which she won’t specify.

And this:

Ms. Holmes argues that the company’s focus over time simply shifted away from the pharmaceutical industry, but it was able to successfully use its technology. “We can show you the programs we’ve done,” she said in the interview. But when pressed for examples, the company did not provide details. 

No no no no no, that is bad PR, obviously the details are what people want. The time for "trying to take back control of the Theranos story" is after your tests work. Then these interviews are easy: People ask you if your tests work, and you say yes, and you point to the FDA approval or peer review or whatever, and everyone is convinced, and the story is about how Theranos has been unfairly maligned. Without that, the story is still about how Theranos still won't answer direct questions about its tests. Also:

She claims her mother dressed her and her brother in black turtlenecks when they were young and now she finds them comfortable. Moreover, she wanted to deflect attention from what she might be wearing. But now she admits she is frustrated about how to handle the media fascination they seem to have created.

When times were good, every story was about the black turtlenecks; now every story is about how she doesn't like all the stories about the black turtlenecks. It is turtlenecks all the way down. The way to change the story is to have better facts: The media is actually fascinated with Theranos's product, right now, but Theranos doesn't have much to say about it. So, turtlenecks.

Meanwhile in the Wall Street Journal, "U.S. Probes Theranos Complaints." And elsewhere in unicorns, high private valuations mean that private tech company employee stock options aren't as exciting as they used to be.

People are worried about bond market liquidity.

Let's have a soothing day on the bond-market-liquidity front. Here James Stewart makes I think a pretty convincing case that the run on the Third Avenue Focused Credit Fund was idiosyncratic, non-systemic, and not worth getting too worried about:

“The Third Avenue situation is unique,” said Gary Cohn, president of Goldman Sachs, who has been in frequent contact with clients throughout the week. “They owned really low-credit-rated products compared to the typical high-yield fund. The long-term impact of rising rates remains a big question mark. But no one thinks that the collapse of Third Avenue is going to contaminate the world.”

Elsewhere, Cullen Roche argues that "the recent widening in spreads looks to be contained specifically in the very lowest quality corporate bonds," without any real contagion to better credits. 

Me Friday.

I wrote about JPMorgan's fine for steering clients to its own mutual funds. Or I mean, the fine wasn't for steering clients to its own mutual funds; JPMorgan will continue to do that. The fine was for not explicitly disclosing that JPMorgan steers its clients to its own mutual funds. Disclosure fixes everything. 

Things happen.

Inside the Billion-Dollar Battle for Puerto Rico’s Future. Behind Frank Quattrone’s Comeback in New Tech Era. Crude oil plumbs new post-crisis depths. After ‘The Big Short,’ Hedge Funders Lose Cultural Capital. The Woes of the Asset Managers. Do Mutual Fund Investors Get What They Pay For? The Legal Consequences of Closet Index Funds. How Yahoo!’s Identity Crisis Infected Tumblr. Some Axel Springer executives "roomed together in a rented house in Palo Alto, with marching orders to network with Silicon Valley executives and study the habits and mores of American start-up culture." FIFA Bans Blatter and Platini From Soccer for Eight Years. Credit Risk, Liquidity and Lies. The Miss Universe contest messed up. Democracy is doomed. Babysitters are surge pricing for New Year’s Eve.

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This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

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

To contact the editor responsible for this story:
Zara Kessler at zkessler@bloomberg.net