Fake Checkups and Tax Opinions

Also index funds, arbitrage and spelling.

Fake fake accounts!

You remember the Wells Fargo scandal, right? Wells Fargo & Co. had a big cross-selling push, where bankers were supposed to sell lots of products all the time. The quotas were high, the pressure was intense, and the bankers were miserable. So they would just sign customers up for products they hadn't asked for, to get their bosses off their backs. Often this was harmless box-checking: If you had a checking account, and a banker signed you up for online banking without asking you, she got credit for a product and you weren't affected one way or another. Sometimes customers were harmed, though: If a banker signed you up for a credit card without asking you, that could affect your credit score, plus the card might have a fee. Eventually regulators figured this out, and Wells Fargo paid some fines, and it became a big embarrassing scandal.

Citizens Financial Group Inc. also has a big cross-selling push, where it "invites customers into branches for what the bank calls a financial checkup." "Financial checkup" appears to be a banking euphemism for "sales pitch": You go to the checkup and the banker says "your credit-card levels seem to be a little low, I would like to inject you with some more credit." If that sounds unappealing to you, you are not alone, and some Citizens bankers had trouble finding people to come to the meetings. But there was a solution, reports Rachel Louise Ensign:

Eleven current and former Citizens branch employees in five states claim that information about some meetings was fabricated by those employees or others as they struggled to meet goals set by the bank.

“For a week or so, I had my bankers [try to make] real appointments. No one was picking up the phone,” said a former branch manager in Massachusetts, recalling when the “Citizens Checkup” program was introduced in February 2016. “So we put random people’s names down and said, ‘We have an appointment.’”

I think this is my new favorite bank scandal. (It's a pretty low-grade scandal so far, but I have high hopes for it.) It takes the essence of the Wells Fargo scandal -- bankers lying to their bosses in order to get out of miserable impossible work -- but strips out all the harm to consumers. It's like if instead of signing people up for fake accounts, the Wells Fargo bankers had just told their bosses that they had signed people up for fake accounts. Nothing happened. No one was hurt.

Oh yes fine, fine, fine, the bank was hurt. The financial checkups were supposed to sell new banking products, and the fake ones didn't, so the bankers weren't really doing their jobs with the level of commitment that was expected of them. And, absurdly, Citizens talked about this program -- this program of calling up customers and asking them to schlep into the bank so someone could pitch them on credit cards -- to shareholders. Its head of consumer banking once "told investors at a conference that the initiative was 'near the top of the things that we’re most excited about.'" If you strain heroically, you can find a scandal here:

“Investors are potentially hurt if executives go out and talk to the Street about basically phantom appointments that don’t exist,” said Clifford Rossi, a professor at University of Maryland’s business school and a former bank-risk management executive.

Look, sure, it is possible that some shareholders were buying Citizens stock based on a price-to-appointments ratio, and overpaid because the denominator of that ratio was wrong. I don't really buy it, though: The point of a cross-selling program is to sell products, and bragging about appointments that don't lead to sales seems like a mixed bag. ("The bank told The Wall Street Journal that figures on the program presented to investors weren’t overstated and that those metrics were 'not a key financial measure.'") 

It is just so pure, the purest banking scandal. The story here is: A lot of people at a bank lied. Not to customers, or in a way that harmed customers. Just in the abstract. There was a bank, and there was lying, and that's it. That's the whole scandal. It's like reading that Goldman Sachs Group Inc. employees lied to each other about what they had for breakfast. I am so excited to see how much this ends up costing Citizens in settlements. 

Tax opinions.

We have talked a little bit before about the Energy Transfer/Williams merger-tax-opinion controversy, but the Delaware Supreme Court came out with an opinion about it last week, and the opinion is such a delight to read that I cannot resist summarizing it for you. The story is that Energy Transfer Equity, L.P. agreed to buy The Williams Companies, Inc., in a part-cash-part-stock merger involving a tax-free partnership exchange under Section 721(a) of the Internal Revenue Code. But then:

After the parties entered into the Agreement, the energy market suffered a severe decline which caused a significant loss in the value of assets of the type held by Williams and ETE. This caused the transaction to become financially undesirable to ETE. It also led to ETE raising an issue as to whether the IRS might view a portion of the $6.05 billion not as payment only for the ETC stock, but as payment in part for the Williams assets, thus rendering the second step of the merger taxable. 

Energy Transfer raised the issue with its tax lawyers at Latham & Watkins LLP, and Latham eventually concluded: Yup, that's an issue, the merger might end up being taxable. This was convenient for Energy Transfer, because it no longer wanted to close the deal, and one of the conditions to its obligation to close the merger was that Latham had to give it a tax opinion saying that the merger would be tax-free. After some discussions, Latham told Energy Transfer that it couldn't give it that opinion, and so it backed out of the deal. Williams sued saying, in essence: Come on, you can't get out of the deal by hinting to your tax lawyers that it would be helpful if they could make it go away.

Williams lost, but you can see their point! Latham had no problem with the tax treatment when the deal was signed, or for six months afterwards. Energy Transfer had no problem either, until its tax director had a sudden epiphany about how the price for the merger was calculated and contacted Latham about it. And then Latham, which hadn't even noticed this issue, went and looked at it and came back and said: You're right, you can't do the deal. You can view that as really good client service from Latham (which of course knew that its client didn't want to close the deal), but you can also view it as really bad tax advising:

The Court of Chancery realized that Latham had competing interests with regard to its issuance of the 721 opinion: while Latham’s client, ETE, would benefit substantially from its refusal to issue the 721 opinion, Latham also had an interest in maintaining its reputation by delivering an opinion that was consistent with its preliminary assessment from the time that the parties entered into the Agreement. The Court concluded that Latham’s ultimate refusal to issue the 721 opinion went against its reputational interests. 

The Delaware courts basically looked at poor Latham's position and said: Yes, well, this is so embarrassing that they wouldn't have refused to give the opinion unless they really, in the heart of their tax-lawyery hearts, believed that the deal would be taxable. (Some other tax lawyers, incidentally, disagreed.) And getting the tax opinion was a condition to closing. So Energy Transfer could get out of the deal.

Chief Justice Leo Strine dissented, saying: Look, sure, Latham may have genuinely thought there was a tax problem. But Energy Transfer had committed to use "commercially reasonable efforts" to get the opinion, and to use "reasonable best efforts" to close the deal. And whatever Latham thought, this wasn't that:

The Court of Chancery, applying an understandable reluctance to call the Latham Tax Lawyer dishonest or a bad man, accepted his testimony, that he just could not get to the point where he could give the opinion. That was so even in a context where Latham had indicated at the time the Merger Agreement was signed— indeed for the six months up until the moment ETE contacted it—that it was ready, based on what it knew, to give the required 721 opinion. ...  As the Majority and the Court of Chancery acknowledge, ETE itself also represented and warranted that it knew of nothing that would prevent Latham from issuing the 721 opinion. Fairly read, this means that ETE had no reason to believe that the structure of the deal’s exchange provisions would give rise to a challenge to its tax-free treatment. So, if, as ultimately happened, the Latham Tax Lawyer was unable to issue the 721 opinion based on his post-signing recognition of facts known pre-signing, a condition would have failed, quite unexpectedly and with more than the whiff of either a lack of care or less innocent causal factors, including improper client pressure. Stuff like this happens in complex mergers. But, what also typically happens then is that both parties work together to resolve those problems in good faith. If one party does not, and that party also committed to a particular level of effort to fulfill such conditions, that may constitute a covenant breach. 

This is a problem for future deals: If one side's obligations are conditional on a tax opinion, and if it can get out of its obligations by hinting to its lawyers that it would be helpful if they couldn't give the tax opinion, then merger agreements are not quite as binding as everyone thought. Here is a roundup from Cleary Gottlieb Steen & Hamilton LLP of how recent merger agreements have addressed the issue. One solution is not to make tax opinions a closing condition. Another is to say: Fine, you can demand a tax opinion from your lawyers, but if they won't give it to you, and our lawyers will, then you have to take their opinion and close the deal.

Elsewhere in M&A opinions: "In Defense of Fairness Opinions: An Empirical Review of Ten Years of Data."

Should index funds be illegal?

The charming theory that cross-ownership of stock by large diversified mutual funds -- "quasi-indexers," in the lingo -- might be an antitrust problem, because large shareholders who own multiple firms in the same industry might push those firms not to compete too hard with each other, does not exactly seem to have captured the imagination of, say, the Trump Justice Department. It has, however, caught the attention of BlackRock, Inc., which yesterday put out a Viewpoint paper titled "Index Investing and Common Ownership Theories." You will not be surprised to learn that BlackRock doesn't buy the mutual-funds-as-antitrust-violators theory:

In short, no plausible causal story has been provided that reflect the realities of asset managers operate, and explains the findings of these papers. 

Elsewhere, here is a paper, by Jie He, Jiekun Huang and Shan Zhao, finding that cross-holdings by mutual funds lead to better corporate governance:

We show that an institution’s holdings in peer firms increase the likelihood that the institution votes against management in shareholder-sponsored governance proposals.

The intuition is, roughly, that improving governance at one firm in an industry has spillover effects on other firms. (For instance, if one firm wildly overpays managers for poor performance, that makes it harder for other firms to recruit managers with strict pay-for-performance policies.) If you own all the firms, you get to capture those spillover effects:

Therefore, relative to stand-alone institutions that only invest in one of these firms, cross-owners have a stronger incentive to internalize corporate governance externalities among their portfolio companies, because for them the same marginal cost of improving governance in one company would yield a higher marginal benefit. 

Should that make you more or less worried about the antitrust stuff? One thing that I sometimes think about is that there might be a domain in which "good governance" is bad: The sorts of things that are good for shareholders might be bad for workers or consumers. Perhaps good governance leads to a more shareholder-focused capitalism, more stock buybacks, more short-termism -- even to a focus on enriching shareholders by competing less vigorously.

Limits to arbitrage.

We talked the other day about David Einhorn's proposal to create value out of thin air by splitting General Motors Co. stock into two different share classes. The idea is that you could divide each current GM share into two pieces -- a "Dividend Share" that would have the dividend and a "Capital Appreciation Share" that would have most of the rest of the rights of shareholders -- that would be worth more separately than they are together. Some people want dividends, others want growth, and the division would allow them each to focus on what they want.

Reader Malhar Mehta emailed:

If Einhorn is right, this is pure arbitrage. He could just set up a trust whose only job would be to buy GM stock and issue his two securities. If people were willing to pay more for these securities, then he would pocket all the profit himself. There is no need to involve the company at all.

It's a great point! Why doesn't Einhorn just buy a bunch of GM stock for $35, plop it into a trust, and sell the dividend rights for $19 (to people who want dividends) and the appreciation rights for $33 (to people who want growth)? If he's right, he can make $17 a share or so by doing it himself.

Obviously I hope Einhorn tries this next. (GM doesn't seem particularly interested in his original idea.) But I don't think he will, and I don't think it would work if he did. The essential subtext of Einhorn's proposal is that the market is inefficient: that investors do not value GM's stock properly. But the underlying story behind a lot of market inefficiency is one of market segmentation and investment mandates: Investors don't value GM's stock improperly because they're morons, but because they have constraints on their buying that prevent them from seeing the value that he does. Einhorn's point, loosely speaking, is that there are "income investors" who would buy the Dividend Shares, and "growth investors" who would buy the Capital Appreciation Shares, but there's no natural home for current GM shares. But there's certainly no natural home for trust securities like this. They might be an economic improvement -- they might allocate risk in ways that should be more attractive to different groups of investors -- but they would also be a weird new thing, and weird new things often don't fall neatly into categories that funds can buy. A mutual fund whose mandate limited it to buying common stock issued by U.S. public companies could buy current GM shares, and it could buy Capital Appreciation Shares, and it could probably buy Dividend Shares, but it might have trouble with Einhorn Trust Certificates. 


Here is a story about Canadian retail financial managers who are not fiduciaries. As is so often the case in retail finance, some of their customers thought they were fiduciaries, and were mad when they find out that they're not. But this is a wrinkle that was new, and incredible, to me:

A common trick for misleading customers, according to Elford, is the banking industry's use of the term "financial advisor" — spelled with an "o."

He says "advisor" is an unregulated title that anyone can use, whereas the title "adviser" — spelled with an "e" — can only be used if the employee has a fiduciary responsibility to the client.

"Advisors can sell you the third, fourth, fifth or least beneficial product to you," Elford said. "They do that a great deal of the time if it makes them more commissions, or if their bank manager is telling them they need to sell more of the house-brand product."

The Ontario Securities Commission confirms that "adviser" is a legal term under securities law that describes a person or company that is registered to give advice about securities, whereas "advisor" is not.

This does not seem to be especially true. Here is an Ontario Securities Commission webpage that uses the term "adviser" (with an "e") broadly, to include conflicted commission-based brokers. ("Make sure you understand how your adviser is paid and think about how this may impact the advice they give you," says the OSC.) But it is amazing, an amazing theory about how the world might work. I mention it here not so much for its truth as for its charm, this notion that the difficult problem of how to save for retirement can somehow be reduced to a series of magic tricks, and that you can keep yourself safe by saying the right words -- or, in this case, letters -- in the right order. 

Work Stuff.

"Staples Tries to Become a Hip Co-Working Hangout," it says here. And this is just a terrific quote from Shira Goodman, Staples Inc.'s chief executive officer:

“If you go to most people on the street and ask about Staples they’d go, ‘Oh yeah, the office-products superstore.’ But the reality is that’s very far from where we are today, and even farther from where we want to be.”

On my commute home today I am going to ask a bunch of people about Staples and see if any of them say "Oh yeah, the office-products superstore." If they do, I'll spend a week co-working at a Staples.

Food Stuff.

Are millennials killing lunch? It seems implausible. And: "Laser cutter used to assemble ham sandwich bust of Vin Diesel."

Things happen.

Aramco Hires JPMorgan, Morgan Stanley, HSBC for IPO Roles. Saudi Aramco Plans to Raise $2 Billion With First Bond Offering. Justices Side With Free-Speech Challenge to Credit Card Fees. This Chinese Stock Soared 4,500% on Nasdaq and No One Knows Why. Chinese Firm Takes Stake in U.S. Investment Bank Cowen. Have a Donkey to Trade? China Has an Exchange for That. Margin Debt Hit All-Time High in February. Ackman Is ‘Profoundly’ Sorry for $4 Billion Valeant ‘Mistake.’ J.P. Morgan Scours Europe for Best Post-Brexit Home. JPMorgan Said in Talks for Dublin Office That Holds 1,000. BofA Shakes Up Merrill Lynch Leadership Under New Chief Sieg. US raids on cheaper rivals send European M&A soaring. Hey M&A Bankers, Trump Won. Merkel's Party Blocks Executive-Bonus Curbs as Campaign Heats Up. Trump’s Free Hand on Bank Deregulation. Trump Administration Signals It Would Seek Mostly Modest Changes to Nafta. Too-fat-to-die turkeys. The Broomway, which runs from the Wakering Stairs to the Black Grounds near Foulness. Why are knights pictured fighting snails in medieval manuscripts? Daimler Shareholder Demands Right to Be Naked at Annual Meeting. Good job Linlo!

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(Corrects hypothetical per-share profit for David Einhorn in the fourth item, from $8 to $17.)
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