Conflicted Deals and Stress Tests

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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TeslaCity.

If you are the ambitious founder, chief executive officer and largest shareholder of a big public company, it is not that hard to build your empire with minimal shareholder oversight. You want your company to buy another company? Just offer a big enough premium to convince the target's shareholders. (Don't worry about your own shareholders; unless the deal is for stock and more than 20 percent of your company, they don't get to vote.) You want your company to buy another company that you also control? Just have each company appoint a special committee of independent directors; if they're directors at your companies, presumably they're pre-disposed to like you. You can't just do whatever you want -- you, and your directors, have fiduciary duties to the public shareholders -- but if you are set on value-destructive self-aggrandizement, you can find a way.

People are calling Tesla's proposed acquisition of SolarCity mean names like a "shameful example of corporate governance at its worst," and you can see their point. It is not an obvious business fit, Elon Musk owns big chunks of both companies and has weird interrelated financing arrangements between them, Tesla just did a big equity offering a month ago without mentioning this deal, the stock price reaction was pretty negative, etc. Jim Chanos:

"The combined market drop in the value of both companies is more than the equity value of the deal itself — which means that Tesla shareholders think SolarCity shares are essentially worthless," Chanos said. "Finally, it is hard for me to believe that this deal was not being contemplated when Tesla, and Mr. (Elon) Musk himself, sold shares just a few weeks ago."

And Steven Davidoff Solomon points out that the companies have not quite followed the normal corporate-governance best practice of forming special committees of independent directors to handle the conflicts of interest. And yet Tesla is doing one very important shareholder-friendly thing that is not strictly required: It "said that any deal would be subject to approval by a majority of its disinterested shareholders."

Tesla is issuing shares, but it does not technically need shareholder approval for the issuance because buying SolarCity will not require it to issue more than 20 percent of its outstanding float, the point at which stock exchange rules require a vote.

Institutional shareholders, however, hold 63.57 percent of Tesla. It is hard to see them liking this deal. Tesla is also a darling of day traders. These short-term holders want the stock to go up, and voting no on the deal is a way to get the shares to rise.

So there are about three possibilities:

  1. Elon Musk persuades Tesla shareholders of the compelling logic of this deal, and they vote for it, which strikes me as a win for good governance.
  2. Musk fails to persuade Tesla shareholders about the deal, and they vote it down, which strikes me as also a win for governance, though also a weird distraction for the two companies for a while.
  3. Musk fails to persuade Tesla shareholders about the deal, and convinces Tesla's board to quietly forget about the shareholder approval requirement and do the deal anyway. Which strikes me as very bad governance, so bad that it would be almost impossible to actually do it. (You'd get so sued! "We will certainly abide by the shareholder vote," says Musk.)

So, like, sure, in the narrow sense, it's awkward for the guy who runs one company to try to use that company to buy out another, troubled company that he also runs. But he has voluntarily given shareholders the tools they need to stop him, which in a broader sense is actually pretty good corporate governance, as far as corporate governance goes.

In other TeslaCity news, I am actually becoming more convinced of the industrial logic of the combination? Tesla is a car company, but it is also in the business of, like, putting a big battery in your house, and surely SolarCity's solar-panel salespeople will be helpful at convincing homeowners to put big batteries in their houses? Also there is vertical integration. On the other hand, Craig Pirrong is very down on the deal. Morgan Stanley's Adam Jonas downgraded Tesla. The combination is "hardly a trillion-dollar formula." It is "mad science." It "pits Wall Street against Silicon Valley." It will be an absolute mess to value.

Happy Stress Test Day!

Today is the day that the Federal Reserve releases the results of the Dodd-Frank Act Stress Tests of the big banks, sort of the practice round for next week's more important release of the Comprehensive Capital Analysis and Review stress tests, which determine how much capital the banks can return to shareholders. Here is a Bloomberg View editorial on "Why the Fed's Stress Tests Aren't Credible," and I suppose they aren't:

The simulation is a far cry from what happens in a real crisis. It doesn't fully capture how contagion can afflict many of a bank's counterparties at once, magnifying losses many times over. It also assumes that a thin minimum layer of equity capital -- just $4 per $100 in assets -- would be enough to maintain the market's confidence in a bank's solvency.

The way I remain serene about the stress tests is by just thinking of them as another set of capital requirements. Banks have one set of capital requirements -- the leverage ratio -- that requires them to keep at least a minimum amount of capital calculated based on the size of their balance sheets. They have another set of capital requirements -- risk-based capital -- that requires them to keep a minimum amount of capital calculated based on the (assumed) riskiness of their balance sheets. They have a third set of capital requirements -- the stress test -- that requires them to keep a minimum amount of capital calculated based on what would happen to their balance sheets in some very stylized crisis. Any one requirement can be gamed: You can optimize risk-based capital by loading up on risky things that regulators think aren't risky; you can optimize the leverage ratio by just loading up on risky things period. But in combination they are harder to game, because optimizing under one regime will run afoul of another. (The stress tests are particularly hard to game because the Fed is cagey about how they actually work.) 

The stress tests are not a guarantee that every bank could survive every possible crisis, because any future crisis is in some way impossible to anticipate. ("We can survive any crisis because of our fortress-like holdings of super-safe AAA mortgage securities," a bank could have said in 2006.) The stress tests aren't the total solution, the perfect guarantee; they're just part of a patchwork of capital regulation that, in the aggregate, makes banks safer than any regulation standing alone.

Elsewhere: "Do You Pass the Financial Stress Test?"

Account intrusion!

The global financial system is just a bunch of computers that say how much money everyone has, and if you can control the computers, you can just make them give you more money. Or that is my dumb dream of financial hacking. Sometimes it comes true. The Bangladesh Swift hack was, basically, the hackers got on a computer and sent themselves $81 million. Good hack! But a lot of financial hacking is disappointingly indirect. People hack into bank systems and then just ... leave. Or they hack into bank systems and take e-mail addresses that they then spam with pump-and-dump pitches. Or, most impressively, they hack into service-provider systems, steal information, and then insider trade with it. But the banks' computers are where the money is; it seems like a waste to get into the computers and take only information

Anyway here is a Securities and Exchange Commission case against a guy accused of hacking into a bunch of people's brokerage accounts and hijacking those accounts to buy stocks that he owned, pushing up the price of those stocks so that he could sell them at a profit. Allegedly the "scheme made at least $68,000 profits for himself and caused losses in the victims’ accounts of at least $289,000." That's ... okay? I give him like a 6 out of 10. If I could magically control people's brokerage accounts, I'd have them just send their money to me, but I suppose there are additional safeguards against that.

Blockchains. 

The DAO hack seems to have done nothing to dissuade global banks from the view that the blockchain is the future of finance. So here we go:

A group of seven banks including Santander, CIBC and UniCredit is claiming a breakthrough, ranking among the first financial institutions in the world to move real money across borders using blockchain-based technology. 

Congrats to them, and to Ripple, the startup whose platform they used. "The banks convert funds to Ripple’s own digital currency, known as XRP, then complete an exchange almost instantly," instead of the three to five days that it might otherwise take. Remember: The global financial system is just a bunch of computers that say how much money everyone has, and a cross-border payment is just updating the computers to say that one bank has more money and another bank has less. That shouldn't take five days. The fact that it does makes it easy to understand why people are so excited for the blockchain, despite all the hacks.

Meanwhile in the DAO hack, an "anonymous collective" has (allegedly) "contacted the SEC (Securities Exchange Commission) to raise awareness of the developments in Ethereum and specifically concepts like the DAO," hoping to get more regulation of smart contracts up in here. You probably shouldn't take that too seriously -- I bet the SEC already knew about Ethereum! -- but one of the great pleasures of modern finance is watching cryptocurrency enthusiasts discover the need for regulation, so I pass it along. Also there is an extended Monty Python knockoff dialogue in the comments.

Panama Papers.

When the Panama Papers leak first came out, there was a lot of speculation that it would reveal massive tax evasion by Western elites and massive theft and corruption by non-Western elites. And there was some of that, but less than the hype suggested. My assumption is that the paradigmatic Panama Papers client is, like, a C-list celebrity who buys his Manhattan condo through a shell company so that nosy strangers can't find out where he lives. But here is Felix Salmon on Brightao, a British Virgin Islands shell company revealed by the Panama Papers leak, that was formed by some McKinsey-connected people to invest in Mingya, a Chinese insurance brokerage founded by a McKinsey alumna named Heidi Hu. The main purpose of forming the offshore entity was just that, under Chinese law, the McKinsey-connected people couldn't invest directly in a Chinese company, but could through a corporate shell. So they formed a clean shell in the British Virgin Islands.

Was it a tax evasion scheme? Not really, though of course Brightao doesn't pay U.S. taxes, so "as long as any profits remain offshore, they remain untaxed." "There are secrecy benefits, too." And perhaps the investment by all the McKinsey-connected people created conflicts of interest with other McKinsey clients. Or perhaps not. It is hard to tell.

But mostly this is like: Some rich people wanted to invest in a business abroad, and they structured that business in a sensible, legally required and tax-efficient (though not tax-evasive) way, and they didn't want anyone bothering them about it. That seems ... totally normal? The headline is "The Panama Papers reveal a secret McKinsey-linked investment scheme involving major financiers." A lot of what I have read about the Panama Papers has been this sort of strenuous but vague de-legitimization of standard business practices. Sometimes that is justified -- if the normal practice is to hide your income offshore so that tax authorities can't get it, that is bad, and its normality is no excuse -- but often it just feels like people are wishing for a scandal that isn't there.

The Trump Trade.

Donald Trump seems to be pretty serious about his plan to crash the U.S. economy and then default on the debt:

In an appearance Wednesday morning on CBS This Morning, the presumptive Republican nominee returned to an idea he floated back in May: that if the U.S. economy “crashed,” he would offer to pay U.S. creditors less than what they are owed. “You go back and say, hey guess what, the economy just crashed. I’m going to give you back half,” he told Norah O’Donnell.

Back in May I assumed that he just happened to be saying some words, and I struggled to interpret them in a clever, liquidity-enhancing, on-the-run/off-the-run sort of way. But, no, it just seems like he likes the idea of defaulting on Treasuries, which, while not entirely surprising, is a bit extreme. In other news, Michelle Celarier profiles the Wall Street people who are for (John Paulson, Anthony Scaramucci, Stephen Feinberg, Carl Icahn, Wilbur Ross, Steve Mnuchin) and against (Dan Loeb, Paul Singer, Cliff Asness, Ray Dalio, Whitney Tilson) Trump.

People are worried about unicorns.

But there is good unicorn news! Yesterday Twilio, a unicorn, found its way out of the Enchanted Forest and into the bright light of the U.S. public equity markets. And, so far, so good. Now perhaps it can show its unicorn friends the way:

Twilio Inc. raised more than it expected in its initial public offering, an optimistic sign for the dozens of other technology companies that have been valued at more than $1 billion in private fundraising.

Twilio's deal is the largest tech IPO so far this year, and it's an up round: "The I.P.O. price yields a market valuation of $1.2 billion, slightly higher than the $1.1 billion valuation Twilio received in a private funding round a year ago." So that is all good news for the unicorn herd, though it is not great news, just because Twilio is not really an alpha unicorn:

Jeff Clavier, a managing partner at SoftTech VC, said Silicon Valley will be watching Twilio’s trading activity this week and rooting for it, but “it is too small to be a huge bellwether for everyone.”

I feel like in common English usage "unicorn" means (a magical one-horned horse or, metaphorically) a thing that is so rare and wonderful that you can hardly believe it's true. When the name "unicorn" was first applied to billion-dollar private tech startups (in 2013!), it had a bit of that connotation as well, though the "one horn = one billion dollars" equation probably also influenced the coinage. But we've already reached such a level of unicorn saturation that everyone shrugs at a $1.2 billion unicorn.

People are worried about stock buybacks.

Here's "Why Record Buybacks Are a Troubling Signal." From Art Cashin:

It would not take a great philosophic leap to note that if corporate America was going to liquidate itself in front of a long-term stagnation, it would be following just the kind of policies that it seems to be following right now.

Yeah but there are like hundreds of unicorns. Maybe American business has given up on investing and is just liquidating itself. Or maybe the biggest public companies are less representative of American business than they used to be.

People are worried about bond market liquidity.

The Financial Stability Board is worried about bond market illiquidity's evil twin, mutual fund liquidity:

Mutual funds should have the ability to lock up investors’ funds or charge shareholders for withdrawals if they urgently need cash to ride out a crisis, according to a new set of policy recommendations from a panel of global regulators.

The FSB "also called on regulators in the U.S. and Europe to consider systemwide stress tests for asset managers, and for new rules restricting the ability of funds to hold harder-to-sell assets." I don't know how much I believe the theory that big asset managers are subject to run-like risks and need to be regulated to prevent a crisis. But I am sort of impressed that it is an object of regulatory focus. The stereotype is that financial regulation is mostly about fighting the last war, and most of the big regulatory initiatives of the last few years have been about addressing problems that were identified in recent crises. But the idea that mutual funds that own illiquid bonds but offer daily liquidity could cause a market meltdown seems to be a purely theoretical invention: People think it might be true, but it's never really happened. And regulators are doing something about it. Perhaps they're wrong, but they get points for initiative.

Things happen.

Barack Obama on business and finance. The 20 Most Generous Companies of the Fortune 500 (Wells Fargo is #3, Goldman Sachs #4, JPMorgan #7, Bank of America #8, Citigroup #10). Bank of America Nearing SEC Settlement in Client-Accounts Probe. Wall Street Splits With Smaller Firms Over Broker-Rule Lawsuit. Hulk Hogan Challenges Gawker Over Bankruptcy Sale. Bill Gross Jumps On Argentina Bandwagon. Court Puts Sumner Redstone’s Plan to Replace Directors on Hold. Peter Thiel Got More Facebook Shareholder Votes Than Mark Zuckerberg. VW Shareholders Vent: ‘They Have Been Rewarded for Failure.’ Lululemon Director Rhoda Pitcher Is 'Valued' -- but Still a Mystery. Cliff Asness on factor timing. Platinum Partners Said to Be Raided by FBI Amid Bribes Probe. New York’s top finance regulator is no ‘Clint Eastwood.’ Mac n' Cheeto. Rooftop bars are the absolute worst. Third-generation surfing pig makes debut in Hawaii.

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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