Research Bundles and Paper Color
Programming note: Money Stuff will be off tomorrow, back on Thursday.
In Europe, banks that provide research to customers will soon be required to charge those customers for that research. One regulatory goal there is price transparency and unbundling: Rather than pay one bank for research and execution, you can shop around for the best and cheapest research, and pay separately for the best and cheapest execution.
In the U.S., banks that provide research to customers are required to make it free. Well, not exactly, but firms that provide standalone paid research have to be registered as "investment advisers," and "under SEC rules, investment advisers must give extra protections to their clients." The regulatory goal there is investor protection: If you charge someone for research, you have fiduciary duties to them to get the research right and avoid conflicts of interest.
This creates an obvious conflict, which big U.S. banks and brokers are trying to solve by asking the Securities and Exchange Commission to waive the investment-adviser requirement when it conflicts with the European MiFID II unbundling rules, for instance when selling research to European customers.
But this request "is causing tension with public pension funds and other large investors that are some of their biggest clients." Not because they disagree with the banks, but because they want a broader exemption:
Colorado’s public pension fund, noting the brokers’ maneuver in its letter to the SEC, urged the regulator to make the MiFID no-action relief so broad that it would allow direct payments for research in any situation, including when dealing with U.S. clients. That, the pension fund noted, would create a “level playing field” across the globe.
“Whereas Europe’s investors will benefit from the unbundling and transparency dictated by MiFID II, U.S. investors will not realize these benefits,” Colorado’s McGarrity wrote in her letter.
It is worth noticing what is going on here. The U.S. has a rule saying that if you pay for certain kinds of investing advice, the people giving you that advice have to register as advisers and have fiduciary duties to you. And the big public-pension buyers of that advice are saying: No thanks. We don't need that protection. What we really need is investor choice, price transparency, the ability to make decisions for ourselves. We're fine buying research from brokers who are not investment advisers and don't have fiduciary duties to us. We don't want you to hold brokers to that standard, because that will just end up entrenching the brokers' current profitable business model.
One might see some parallels to the Department of Labor's fiduciary rule, which imposes some fiduciary duties on some brokers who provide some sorts of retirement advice, and which seems to have led to more bundling and more profitability for those brokers.
Sometimes proxy fights are about dueling PowerPoint presentations describing management's and an insurgent's operational visions for a company, and sometimes they are about personal insults exchanged between the chief executive officer and the activist, but occasionally they are about what color paper stock you use:
Trian was first to get its proxy materials cleared by securities regulators, in July, giving it a slight head start on its campaign and the right to use a white proxy voting card, a color usually offered by management.
The white card may appeal to retail investors, who often side with a company out of a sense of loyalty, and could even be mistaken for the P&G card, proxy experts said.
“There is some strategic importance to the white card, so in that sense, Trian did kind of pick P&G’s pocket,” said Damien Park of advisory firm Hedge Fund Solutions.
That's about Trian Partners' proxy fight at Procter & Gamble Co., which has a ton of retail investors, whom Trian and P&G are trying to influence with direct mail, YouTube videos, Facebook ads, and of course strategic paper-color selection.
It is in some ways an odd story: The world is just beginning to discover the massive and terrible power of using Facebook to influence retail voter behavior, even as retail investors are fading as a force in U.S. public companies. The 2016 presidential election was clearly the election most influenced by social media in U.S. history, but there's a good chance that social media will be even more important in 2020, and 2024, and every election thereafter. But if the P&G/Trian proxy fight is the proxy fight most influenced by social media in corporate history, it might be a permanent high-water mark: As individual investors move more and more into index funds rather than single stocks, how much will Facebook ads and paper colors matter in the future?
Politico has a fascinating story about how senior congressional aides seem to do a lot of trading in individual stocks just before Congress announces new regulations, investigations, etc., that affect those stocks. It is quite a coincidence! It is perhaps "reflective of Congress’ persistent refusal to crack down on stock trading by staffers, even in firms overseen by their committees."
A lot of the scandalized reactions I have seen to this story are along the lines of "this is insider trading, but it's perfectly legal because it is being done in Congress." But the actual facts seem to be that it is not insider trading, but if it were insider trading, it would be totally illegal. The STOCK Act of 2012 explicitly provides that "Members and employees" of Congress "are not exempt from the insider trading prohibitions arising under the securities laws," and that they have a duty of confidence covering nonpublic information they get in their jobs. If they trade on that information, they are guilty of insider trading, and can be investigated and prosecuted
So are they guilty of insider trading? I mean, I don't know, but most of the aides mentioned in the article have the lame but acceptable excuse that they didn't trade, their brokers did:
Swanson, Hoppe and some other senior staffers said their brokers are authorized to buy and sell stocks without their involvement, and thus they were not consulted on the trades listed in their disclosure forms. But ethics watchdogs have long frowned on such personal deals, noting that they can be abridged at any time and that outsiders have no way to verify that they’re being followed. Aides, like members themselves, can create blind trusts that fully bar them from involvement in any trades. If they don’t want to go to the trouble of setting up a blind trust, they could protect themselves from many potential conflicts by investing in publicly traded mutual funds.
As an ethical matter, sticking to mutual funds and blind trusts seems like much better advice. But as an insider trading matter, the important question is whether the aides' trades were made on the basis of material nonpublic information. If they really were made by the brokers without consulting with the aides, then they were presumably fine. Of course, it does seem a little weird to give your broker discretion to trade a lot of individual stocks that you happen to regulate, and it might give rise to suspicion that you are having some secret conversations with the broker to nudge him in the direction you prefer -- but those are suspicions that regulators and prosecutors regularly investigate in corporate insider trading, and could presumably investigate here if they wanted to.
More information is coming out about apparent insider trading by people who hacked into the Securities and Exchange Commission's Edgar database of corporate filings, though I still don't entirely understand it. The hackers got data from the Edgar test-filing system, where companies file confidential fake reports before filing their public real reports:
The test process “is for people to submit test filings to ensure that they format correctly and don’t have submission errors,” the person said.
“They normally use that right before they file their normal reports. They are supposed to use dummy data,” the person said. “However, it is still supposed to be protected the same way in case they do something stupid. A couple companies did, and it wasn’t protected properly.”
Look, I sympathize with them. If I were planning to file an 8-K with my earnings results, and I wanted to make sure the formatting worked, I would test it with real numbers: If I tested with fake numbers, and then had to swap in all the real numbers, I'd worry about messing up the formatting while doing the swap. (I'd also worry about messing up the swap, and leaving the fake numbers in the real filing.) But I'd also do the test filing like two minutes before the real one, and not during market hours, so keeping it secret would not be a huge issue. What happened here seems to be that companies wanted to test the general working of their Edgar filing software, and did it with real unreleased numbers well before those numbers were due to be made public, giving hackers time to trade on them.
(I wonder if other companies did make test filings with dummy numbers, and if the hackers then traded incorrectly based on those filings. "Huh here's a test filing from Alphabet Inc. saying that they will have one dollar of revenue this quarter, guess we should short them.")
Another fun fact about the SEC hack is that the people in charge of discovering hacks found it and shrugged, and the SEC only realized it was a big deal when the people in charge of discovering insider trading noticed it:
Only after the SEC’s Enforcement Division detected a pattern of suspicious trading ahead of company public disclosures did officials go back to the agency’s technology staff and ask if some companies were using authentic data when they were testing the EDGAR system, one of the people said.
The lesson there might be that the SEC is better equipped to monitor suspicious trading than it is to monitor its own computer systems.
Elsewhere, the SEC now has an adorably named Cyber Unit, to investigate the cyber. It is also setting up a "Retail Strategy Task Force" to "develop proactive, targeted initiatives to identify misconduct impacting retail investors." I feel like not that long ago, people -- including me -- were complaining that the SEC was too focused on misconduct impacting retail investors, and that prioritizing institutional market stability might provide more bang for the buck than pursuing small-time fraud. (Back when people worried that bond market illiquidity would cause a systemic crisis, they were fond of pointing out that the SEC had half an employee dedicated to the bond market, while dozens of employees investigated penny-stock frauds.) But now the tide has turned, and the SEC is putting even more focus on small-time fraud.
IPO vs. SPAC.
We have talked a couple of times about Social Capital Hedosophia Holdings Corp., a special-purpose acquisition vehicle that raised $690 million in an initial public offering so that it can go out and acquire a tech unicorn, which would then instantly be public. As I have said before, I don't really get it. Yes, sure, if a unicorn goes public through SCHH, it can avoid the prospectus-writing and roadshow and marketing and pricing process of a normal IPO -- but it will still have to market the deal to SCHH's investors, who can vote on whether or not to approve it. More critically, a unicorn that goes public through SCHH will still have to file reports and deal with a volatile stock price and have all the obligations of a public company, forever. The headache of going public is just a blip compared to the headache of being public.
But everyone else seems fond of SCHH. Last week we talked about an Andrew Ross Sorkin column in which SCHH convinced Sorkin that its fees -- 5.5 percent to its underwriters and 20 percent to its sponsors -- are somehow lower than the 7 percent or less charged by banks to do a regular underwriting. And now here is a James Mackintosh column -- "The Modern IPO is Useless. Let's Reinvent It" -- with this explanation of how IPOs work:
Companies planning an IPO pick underwriters among the Wall Street banks. Because the banks are on the hook to buy the shares if investors don’t subscribe enough, they have an incentive to underprice the issue to reduce their potential losses.
The too-low price creates excess demand for the shares, since they are artificially cheap, so banks have to ration the supply. Rationing is typically done by giving bigger allocations to their best clients, who do well from the usual first-day pop in price that results from the underpricing.
Textbooks often make a distinction between a "firm-commitment underwriting," in which the underwriting banks are obligated to purchase shares from the company at a fixed price even if they can't find any buyers, and a "best-efforts underwriting," in which the underwriting banks can walk away from the deal if they can't find buyers. It is true that basically all large mainstream IPOs are technically firm-commitment underwritings: The banks and the company sign an underwriting agreement saying that the banks will buy shares at a fixed price, whether or not they can resell them. But the trick is that the underwriting agreement is only signed after the banks have done a roadshow, taken orders from investors at various prices, built a book of investor interest, and agreed with investors and the company on a price that gets the deal done. It is a firm commitment as a legal matter -- and if investors somehow fail to close on their orders, the banks are on the hook -- but in practice the banks have no real market or pricing risk, no risk that "investors don't subscribe enough." (Many stock offerings by seasoned public companies are done as "bought deals," in which the underwriting agreement is signed before the deal is marketed, and the banks really are at risk -- but that is not the norm for IPOs.)
So the banks' underwriting risk doesn't explain why IPOs tend (mostly) to be underpriced. What does? Well, an IPO is an offering of stock by a new company. Nobody quite knows what it is worth. It is hard to find out. The way to find out is to have a liquid public market where buyers and sellers can meet and come to a price, but you can't do that until after the IPO. So buying in the IPO is risky, and investors want to be rewarded for taking that risk with an IPO pop.
Also, the banks balance the interests of the company (which wants a high price) and the investors (who want a low price), but those interests are not equally weighted. Investors really want the stock price to go up 10 or 20 percent or so after the IPO, so they can feel good about themselves and make a profit. The issuer really doesn't want the stock price to drop 10 or 20 percent after the IPO. No tech-company founder sees his stock drop 20 percent on the first day of trading and high-fives his bankers, saying "yes, we really got all the money we could out of this dog." The reasons for that are fairly obvious: Companies (and founders) tend to sell only a small chunk of their shares in the IPO, and an IPO that trades well and leaves investors happy will be helpful to them down the line when they want to sell more. So the company might prefer a 10 percent pop, while the investors might prefer a 50 percent pop, but no one is really arguing for no pop. The pop is not explained by evil banks acting in their own interests; it is explained by banks balancing the interests of issuers (who want a pop) and investors (who also want a pop).
Blockchain blockchain blockchain.
Here is a story about a crowdfunding effort to raise at least $3 million to go buy the Wu-Tang Clan album (or is it?) that Martin Shkreli owns (owned?) and may have sold on EBay. The crowdfunding rewards are a little odd: The lowest level -- about a $1 donation -- gets you "memorialized" on the website, but does not get you a copy of the album. (The next level -- about $20 -- gets you a digital download; $199 gets you a vinyl copy in a nice box.)
But the real oddity is that this crowdfunding effort is not listed on Kickstarter or GoFundMe or whatever, and is not described by its creators as "crowdfunding" at all. Instead it is an "initial coin offering," because in 2017, if you are looking to raise millions of dollars from people on a pretty thin premise, an ICO is the way to do it.
What makes Wu-Tang Coin -- yes that's its name, symbol CREAM -- a ... coin? Oh I don't know. "The token creation process will be organized around the smart contract running on the Ethereum blockchain using the ERC20 token standard," says the very brief Wu-Tang Coin white paper, but there is no particular reason to do that. You don't need an Ethereum smart contract to keep a list of everyone who gave you a dollar and "memorialize" that list on a website. Wu-Tang Coin is raising money in ether, because that is how you do an ICO, but then it "will convert all donated ether to USD and propose a purchase to the album's owner, Mr. Shkreli." As an effort to capitalize on the maximum amount of buzzy nonsense -- ICOs, Shkreli -- it is impressive, but it is not exactly a cutting-edge use of smart-contract technology.
Meanwhile in traditional fundraising, Royalty Flow Inc. filed to raise money in the stock market to buy Eminem royalties.
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