LendingClub and Hedge-Fund Pay

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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LendingClub.

I confess that I don't understand the LendingClub scandal. LendingClub sold $22 million worth of "near-prime loans" to one investor (Jefferies) "in contravention of the investor's express instructions as to a non-credit and non-pricing element"; it noticed the problem "with the discovery of a change in the application dates for $3.0 million of the loans." So:

  • What was the "non-credit and non-pricing element"? Were the loans all incorrectly dated? (It doesn't seem like it.) Or were Jefferies's instructions not about the application date but about something else? "The discrepancy was fairly minor," apparently, but what was it?  
  • LendingClub fixed the problem, not with an apology and a promise to do better next time, but by buying the loans back at par. Is it not a little weird that Jefferies would sell? Obviously Jefferies had a reason for only wanting loans that met its requirements, and not other loans, but it is not at all clear to me what that reason was. (Perhaps it had to do with securitization?)
  • LendingClub "subsequently resold them at par to another investor," I guess confirming its view that whatever flaws there were in the loans didn't affect value. Did the other investor know that Jefferies had rejected them? Would you be sad if you bought loans at par that Jefferies had bought and then sold back in disgust? Or would you be, like, "hmm, Jefferies sure has weird idiosyncratic standards for its near-prime loans."

It is just a strange sequence of events. Obviously it is bad -- you shouldn't change the application dates on loans, and you shouldn't sell investors loans that don't meet their requirements -- but it is still, to me, a pretty complete mystery what actually happened.

Anyway Chief Executive Officer Renaud Laplanche, the face of LendingClub and to some extent of the whole "marketplace lending" industry, has resigned, three senior managers involved in this deal have also left, the stock closed down almost 35 percent yesterday, and there is an amount of soul-searching in the marketplace lending business that does not seem entirely proportional to some minor documentation problems with a few loans that were caught internally and promptly corrected with no harm done. I feel like, if 2008-era bankers did what LendingClub did, we'd give them a medal. But marketplace lending was supposed to have higher standards. Todd Baker:

LendingClub built its entire business model on the idea of complete loan data transparency. As Laplanche said last year, "Transparency in the industry is very differentiated from more traditional banks. Our ability to embrace transparency of data, track records, performance as an industry is really important." By altering loan data to make a loan sale work, LendingClub has undermined investor confidence in loan data industrywide.

There's another part of the scandal: Laplanche owned a stake in a fund called Cirrix Capital, and didn't disclose that stake to the board's risk committee when LendingClub was considering investing in Cirrix. That's bad! But John Mack, a board member, also owned a (bigger) stake in Cirrix, and also didn't disclose it to the board. Which was apparently fine because, I guess, no one asked him? (He "didn't know the company was weighing an investment in Cirrix.") Anyway LendingClub ended up putting $10 million into Cirrix, which people also find weird. Kadhim Shubber:

Such an investment contradicts the core proposition of Lending Club, as per Laplanche’s comments in January. The business is supposed to be a pure marketplace, which takes no risk on to its balance sheet and merely sells loans through to retail and institutional buyers. We now discover that the business does indeed have direct exposure to some of the loans that it makes.

It all leaves me a little cold, but then, it would. Of course LendingClub both runs a market and takes positions in that market (and its executives also take positions). Of course sometimes it fudges loan documentation and then corrects problems in quiet ad-hoc ways. That's how banks work. Of course LendingClub is not a bank, and was supposed to be better than the banks. But here we are. I recently said, about marketplace lenders generally and SoFi in particular:

You can witness ontogeny recapitulating phylogeny. A social club for regular people to lend money to other regular people becomes a securitization platform with its own in-house hedge fund while you watch. The whole history of modern finance recurs, sped up, right before your eyes. It is kind of beautiful.

I suppose I am relatively unsurprised to see LendingClub misbehaving in bank-like ways, and relatively surprised to see everyone else's shock and disappointment.

Hedge funds.

Oh look, Institutional Investor's Alpha's 2016 Rich List is out. Ken Griffin of Citadel and James Simons of Renaissance are tied at the top, with $1.7 billion each in hedge-fund income in 2015; Ray Dalio of Bridgewater, David Tepper of Appaloosa and Izzy Englander of Millennium round out the top five. Two co-founders of Two Sigma, John Overdeck and David Siegel, made the top 10 for the first time, along with Joseph Edelman of Perceptive Advisors. Last week I mentioned that every  year the coverage of the Rich List hits the same themes, and this year fits the pattern. DealBook 2016:

The 25 best-paid hedge fund managers took home a collective $12.94 billion in income last year, according to an annual ranking published on Tuesday by Institutional Investor’s Alpha magazine.

Those riches came during a year of tremendous market volatility that was so bad for some Wall Street investors that the billionaire manager Daniel S. Loeb called it a “hedge fund killing field.”

Remember, these guys are the guys who did well! The guys who were killed on the killing field mostly aren't making the big bucks, though there are exceptions. ("Among 2015’s top hedge fund earners are five men who actually lost money for some investors last year but still made handsome profits because their firms are so big.") Also, remember that the Rich List numbers count not just "compensation" (management and incentive fees) but also gains on the managers' own investments. And Griffin, for one, is down in that category so far in 2016.

Elsewhere: "Midas touch gone, hedge fund industry's influence may be waning." And the Securities and Exchange Commission is looking skeptically at hedge funds that mark up the value of their illiquid investments without market prices.

Should mutual funds be illegal?

We have talked several times before about the somewhat fringe theory that ownership of multiple companies in a single industry by diversified mutual funds reduces competition and might be a violation of U.S. antitrust law. What a kooky theory! It is not like the big diversified mutual funds who collectively control most of America's public companies are holding secret meetings where they strategize about how a whole industry can keep its prices up:

A group of major U.S. investors, spooked by the recent slump in biotech shares amid political bashing of drug prices, met with a lobbying group and executives last month to urge them to do a better job in defending their industry and take control of the conversation before lawmakers try to regulate prices.

Representatives from Fidelity Investments, T. Rowe Price Group Inc. and Wellington Management Co. -- which all invest about a fifth or more of their U.S. stock holdings in health care -- were among those at the meeting.

Huh, weird. To be fair, the pharmaceutical industry -- with its insurer-negotiated prices and patent-based monopolies -- is not exactly a normal venue for capitalist competition, but still. 

Elsewhere in antitrust: "German Retailers Fined $103 Million for Fixing Beer Prices." And elsewhere in diversified mutual funds: "Research: Index Funds Are Improving Corporate Governance."

Valeant and Ackman.

Speaking of investors telling drug companies how to keep their prices up, the Senate Special Committee on Aging has released the exhibits for its recent Valeant hearing, and they are full of pleasures. Like the time Bill Ackman tried to set up a meeting with Warren Buffett to convince Charlie Munger to take back the mean things he'd said about Valeant:

Buffett demurred. “I don’t want to get into the picture myself on this,” according to an e-mail sent from the account of a Buffett assistant. “Charlie always makes up his own mind, as I’m sure you’ve noticed. It won’t be easy to change. Best, Warren.”

A good life rule is, "don't say anything in e-mail that you wouldn't want to see released in a Senate investigation," and for the most part Valeant and Ackman did a good job of this; there is nothing exactly scandalous in any of the correspondence released by the Senate. Ackman did, however, get visibly frustrated with Valeant's response to the controversies over its pricing and accounting. Don't miss his Oct. 27, 2015 e-mail urging Valeant to adopt an Ackman-esque public relations approach:

If you want to save the company, I strongly recommend you immediately hold a conference call to address every remaining question from shareholders, short sellers, and the media. The call should be of unlimited duration. There should be no PowerPoint. Management and the board should open the line and answer every question asked by anyone until there are no further questions. You should answer the questions honestly no matter how embarrassing the answers are and no matter what the legal implications are. Just tell the truth. The truth will set you free.

It goes on in that vein ("the torpedoes are in the water and the sharks are circling"; "The only people that need scripts and limited questions are crooks"; "We are on the bring of a catastrophe that will dramatically affect the lives of everyone involved in a negative way"; etc.). And Ackman sometimes gets a little antsy:

Remind me never to be the CEO of Valeant.

Elsewhere in Bill Ackman and pharmaceuticals, Pershing Square is selling about $800 million worth of Zoetis stock.

Insider trading.

The U.K. just finished a big insider trading trial in which two people (a corporate broker at Deutsche Bank and an accountant to whom he passed tips about deals) were convicted of insider dealing, while three others (a broker and two day traders who allegedly traded on the tips) were acquitted. 

Anderson and Parvizi, the two day traders, also argued the whole stock market operated on rumors, most of which were false, and they had no reason to think they were getting inside information.

It's a marked contrast to the Newman/Chiasson cases in the U.S., where a jury convicted hedge fund managers who traded on fourth-hand inside information, while the corporate insiders who actually provided that information were never even charged with a crime. (Newman's and Chiasson's convictions were reversed on appeal.) You can see the attraction of punishing the traders rather than the leakers; after all, the trading is how you make the money. But it's a bit harsh to criminalize trading on inside information in total ignorance that it is inside information.

Cynk, etc.

Elsewhere in criminal trading, the guy who did the Cynk pump-and-dump pled guilty to running a bunch of pump-and-dump schemes, and will be giving up his jet:

Gregg R. Mulholland, a dual U.S. and Canadian citizen and secret owner of Legacy Global Markets S.A. (Legacy), an offshore broker-dealer and investment management company based in Panama City, Panama, and Belize City, Belize, pleaded guilty to money laundering conspiracy for fraudulently manipulating the stocks of more than 40 U.S. publicly-traded companies and then laundering more than $250 million in profits through at least five offshore law firms.  Pursuant to his plea agreement with the government, Mulholland has agreed to forfeit, among other things, a Dassault-Breguet Falcon 50 aircraft, a Range Rover Defender vehicle, two real estate properties in British Columbia, and funds and securities on deposit at more than a dozen bank and brokerage accounts.  

We have talked before about Cynk, which in addition to being a beautiful short-squeezy market manipulation was also not a completely terrible idea for a real company. It is almost a letdown to be shown the workings of the man behind the curtain:

For example, this structure enabled the Mulholland Group to manipulate the stock of Cynk Technology Corp, which traded on the U.S. OTC markets under the ticker symbol CYNK.  Using aliases such as “Stamps” and “Charlie Wolf,” Mulholland was intercepted on a court-authorized wiretap on May 15, 2014, admitting to his ownership of “all the free trading” or unrestricted shares of CYNK.  Prior to this conversation between Mulholland and his trader at Legacy, there had been no trading in CYNK stock for 24 trading days.  Over the next two months, the stock of CYNK rose from $0.06 per share to $13.90 per share, a more than $4 billion stock market valuation for a company that had no revenue and no assets.    

Meh, Charlie Wolf, whatever.

And in yet more crime, Andrew Caspersen, who was arrested a while back for defrauding investors, also allegedly stole $8.9 million from PJT Partners clients "making payments on fees due to the firm for legitimate transactions":

He used false invoices to misdirect client payments to himself rather than the firm, according to PJT. Caspersen covered up that theft by paying the firm with funds that “most likely came from the proceeds of the fraudulent investments,” Taubman said on the conference call.

I don't get it! Why not just take the $8.9 million from the fraudulent investments directly, instead of shortstopping fees due to your employer? Crime seems difficult, but also, the people who do it seem to overcomplicate things. 

Blockchains.

Izabella Kaminska:

The capacity to share ledgers has always been there. The reason it was never a ‘thing’ is because getting a whole bunch of competing companies to agree on anything so significant is about as difficult as achieving consensus in the European Parliament. Rule by Bolshevik majority simply does not work out so well for those with minority interests. And bowing down to a central executive order just to get things done has, well, major competition implications.

Meanwhile, here is a baffling story about how "some education facilities" are "using blockchain, which was developed alongside the digital cryptocurrency bitcoin, to record their students' achievements in a cheap, secure and public way." Educational transcripts would seem to be a particularly good use case for a centralized database considering that only the school can award grades; there are no transactions, and no need for anyone but the school to be able to enter new data into the transcript. But, you know, blockchains are cool. And here is Adrian Chen on Satoshi Nakamoto, or whatever his name is.

Robin Hood.

The Robin Hood Foundation benefit dinner was last night. It raised $61 million. "As Katie Couric gave her opening remarks, she welcomed a crowd she called 'Bernie Sanders’s worst nightmare.'" And "comedian Jim Gaffigan warmed up the crowd by mocking how people complain about the cold." I suppose you had to be there. 

People are worried about unicorns.

Here is the story of Valiant Capital Management, which seems to be more optimistic about the value of some of its unicorn holdings than other public unicorn investors are. I mentioned above that the SEC is looking critically at hedge fund mark-to-market practices in markets without market prices; being out of line with consensus on valuation might now be a legal risk. On the other hand, it's not like anyone else knows what unicorns are worth either.

Elsewhere, here is Bloomberg Businessweek on Zenefits, the human resources unicorn that "self-disrupted." And William Alden reports that Zenefits co-founder Parker Conrad "sold $10 million of stock months before the public learned of compliance failures that led to his resignation." 

People are worried about stock buybacks.

Yesterday, like an idiot, I said:

If you have a company that is 100 percent owned by dispersed public shareholders, the company itself cannot buy 100 percent of the stock and then persist as a self-owned autonomous entity. It doesn't work that way.

I'm sure that someone will e-mail me a counterexample, and I am looking forward to it.

A number of people sent me examples of cases where companies bought a lot of stock until a large majority of their ownership was concentrated in one or a few shareholders. In some cases -- e.g. Uralkali -- the buybacks were enough that the company could delist from a public stock exchange and go along as a private company with concentrated ownership. But that doesn't count; I said that was possible -- that "as a matter of like, math, or philosophy, nothing stands in the way of that trade" -- and asked for examples, not of a company buying back enough shares to gift control to one shareholder, but of a company buying itself.

Examples of that are harder to find. Aaron Brown pointed me to what might be the closest analogy: A company enters bankruptcy proceedings, wipes out shareholders as part of the liquidation plan, and then turns out to be able to pay off creditors at 100 percent of their claims, leaving the company (or at least, its bankruptcy estate) with a surplus of assets and no claimants. The leading case seems to be In re Xpedior Inc. The bankruptcy court distributed the surplus to charity. It is not quite a company persisting indefinitely as a self-owned autonomous entity.

Ross Levin points me to the case of Belmond Ltd., a Bermuda company with high-vote Class B shares that are 100 percent owned by its own subsidiary. Under Bermuda law the company can vote those shares, making the company in effect its own majority shareholder. So that's weird. It still has outside shareholders though. Victor Fleischer points out that family businesses sometimes give their shares to charitable foundations, particularly in Europe; again, that can leave you with a company that runs itself, but it does not strike me as a case of a company buying itself. Obviously, in the limit case, a nonprofit corporation has no shareholders, but I don't think there are examples of regular public companies buying up all their shares and becoming nonprofits.

A few people sent me clever theoretical approaches that could get you to a company with (1) assets and (2) no shares outstanding, but these were too silly to trouble you with. Sometimes they were along the lines of "what if the directors just stole all the shares?" (I am interpreting a bit.) The problem is that this is not just a math problem; it is also a legal problem. If the directors came up with some tricky way to buy back all the shares in a company at a below-fair-value price, then the shareholders would sue, and a court would stop them. You can perhaps solve the math problem with trickery, but it doesn't get you anywhere legally.

Elsewhere, Bloomberg Gadfly's Shira Ovide points out that, at Google/Alphabet, "spending on research and development has crept up to record levels." 

People are worried about bond market liquidity.

Oh man, the Treasury market. There are lots of trading venues, and "that fragmentation is creating a sense of disorder beneath the surface." "The primacy of the dealers has been eroded" by high-frequency trading firms, and "if a market swing or technology malfunction leaves one of those high-speed firms with too much exposure to Treasuries, the losses may end up being absorbed by members of the central clearing platform." I sometimes feel like I have made a mistake in lumping Treasury market structure under "People are worried about bond market liquidity." They're not; Treasury liquidity is great, excessive even. People are worried about evil high-frequency traders, and their worries about HFT in the Treasury market are more or less identical to their worries about HFT in the equity markets, just with a time lag.

On the other hand, people still have good old-fashioned worries about liquidity in the corporate bond markets. Here is Bloomberg Gadfly's Lisa Abramowicz on the fact that new corporate bonds do most of their trading in the first few days after being issued.

Things happen.

Credit Suisse Posts Loss as CEO Signals Cost-Cuts Progress. (Announcement, financial report, shareholder letter, presentation.) The World's Most Extreme Speculative Mania Unravels in China. U.S. investigates market-making operations of Citadel, KCG. Eurozone Asked to Consider More Concessions on Greece’s Debt. Treasury Secretary Jacob Lew Puts a Face on Puerto Rico Debt Crisis. How Four Private-Equity Firms Cleaned Up on MultiPlan. Dodd-Frank has basically worked. Herbalife’s Endgame. "That’s why short selling alpha is so prized in the marketplace when you can find it, because it enables you to be more long." Redacting Proprietary Information and IPOs. Big Oil Abandons $2.5 Billion in U.S. Arctic Drilling Rights. Flexit. Sports betting mutual fundsNorth Korea isn't so bad. ESPN mathletics. Budweiser Considers Relabeling Itself ‘America’ Just Because It Can.

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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:
James Greiff at jgreiff@bloomberg.net