Money Stuff

Citi Told Some Customers to Buy the Sells

Also not-quite-insider-trading, CDS games, crypto crime and spring hunting.


One way to think about sell-side equity investment research is that it is one product for retail investors and a completely different product for institutional investors, and the dividing line between the two products is right at the top of the report. At the top of an analyst's research report it says "Buy" or "Sell" or "Hold"; that's for retail. Everything below that (the financial modeling, the analysis of news, the industry overviews), and everything outside of the report (phone conversations with analysts, meetings with corporate executives), is for institutions. The institutions make their own buy/sell/hold decisions; they value research for context and nuance and background and access. The retail shareholders have day jobs; they are not reading research reports carefully to inform their own financial models, and they're certainly not getting corporate access. They just want to know what stocks to buy, and for that purpose, the big "Buy" at the top is very helpful.

So it's not great that Citigroup Global Markets Inc. told its retail clients the wrong recommendations:

FINRA found that from February 2011 through December 2015, CGMI displayed to its brokers, retail customers and supervisors inaccurate research ratings for more than 1,800 equity securities —more than 38 percent of those covered by the firm. Because of errors in the electronic feed of ratings data that the firm provided to its clearing firm, the firm either displayed the wrong rating for some covered securities (e.g., “buy” instead of “sell”), displayed ratings for other securities that CGMI did not cover or failed to display ratings for securities that CGMI, in fact, rated. The firm’s actual research reports, which were available to brokers, and the research ratings appearing in those reports, were not affected by these errors.  

Oops! The Financial Industry Regulatory Authority ordered Citi to pay $11.5 million for this mistake, which seems to have been a pure technology accident. If you actually read the research reports, you got the correct recommendation. But if you actually read the reports, presumably you didn't care that much about the recommendation on top. If, on the other hand, you just wanted the recommendation, you could get it from the feed of ratings, or from your broker, without bothering to read the reports. Sadly, though, you got the wrong recommendation.

I mean, "wrong" in some subjective sense. What Finra does not tell us is whether the wrong recommendations outperformed the right ones. In an efficient market, a research analyst's rating will have no correlation to a stock's subsequent performance, and it is not obvious that a stock that Citi rated "Buy" should outperform a stock that Citi rated "Hold" but accidentally listed as a "Buy." But I guess neither Finra -- which wants to punish Big Bad Harmful Misbehavior -- nor Citi -- which wants you to trust its research -- has much incentive to check.

Insider trading.

Insider trading, I like to say, is not about fairness, it is about theft. It's not illegal to trade when you have information that no one else has. The financial industry employs thousands of people whose job is to find out things about companies and then trade their stocks. That job is well compensated and at least a little bit socially useful: It makes prices accurate, makes markets efficient, allocates resources properly, etc. It's not illegal. What is illegal is trading on information that belongs to somebody else: a chief executive officer trading her company's stock based on news she hasn't told shareholders, a lawyer trading on takeover news he learns about under an obligation of confidentiality. The problem is not that insider traders have an advantage in the market -- any informed professional trader has an advantage over uninformed amateurs -- but that they obtained that advantage by taking it from people who owned the information.

That is, I think, a good general approach to U.S. insider trading law, but there is a weird exception called Rule 14e-3. Rule 14e-3 says that if you have material nonpublic information about a tender offer, and you got that information from someone involved in the tender offer, then you can't trade on it, unless you are the person doing the tender offer. Even if -- and this is the weird part -- even if the person doing the tender offer wants you to trade on it.

This rule does not make much conceptual sense. If, say, Company A wants to acquire Company B in a merger, Company A can buy some Company B shares before announcing its merger proposal, to try to lower its average cost and lock up some votes for the deal. Or it can team up with Activist Fund C to do the same thing: Activist Fund C can buy a "toehold" before the merger is publicly proposed, which can lower the overall cost of the deal and lock up some votes. That's not illegal insider trading, because Activist Fund C didn't misappropriate the information from Company A. Company A wanted it to trade on the information, and Company A owned that information. 

But if Company A wants to acquire Company B in a tender offer -- which in modern U.S. practice looks pretty similar to a merger -- then it can also buy some Company B shares first. But it can't enlist Activist Fund C to do it, because of Rule 14e-3: Even if Company A and Activist Fund C want to team up to buy Company B stock, which they could perfectly legally do before proposing a merger, they can't legally do it before proposing a tender offer.

As you may know, Company A was Valeant Pharmaceuticals International Inc., Company B was Allergan Inc., Activist Fund C was Bill Ackman's Pershing Square Holdings Ltd., and last week Pershing Square and Valeant agreed to pay $290 million to settle an investor insider-trading lawsuit over their (failed) effort to acquire Allergan back in 2014. They had some decent defenses: When Valeant and Pershing Square teamed up to buy Allergan shares before announcing Valeant's takeover offer, they were proposing a merger, not a tender offer, so arguably they didn't trigger Rule 14e-3. (Later they switched to a tender offer, so arguably they did.) Also the tender offer documents said that both Valeant and Pershing Square were offering to buy Allergan, arguably making them both exempt from Rule 14e-3. But these were debatable points, and so they settled a lawsuit that Ackman still says has "absolutely no merit." 

When I talk to people about this case, their reaction is often "well it may not be technically insider trading but it sure looks bad." My reaction is exactly the opposite. Ackman's trading in Allergan stock ahead of Valeant's takeover offer might technically have been illegal insider trading under Rule 14e-3 (thus the settlement), but it doesn't look bad. It's how markets are supposed to work. No shareholders were harmed, and in fact they were helped: Ackman and Valeant teaming up is what got them a higher price for their shares. Ackman and Valeant had the advantage of being able to trade knowing their own takeover plans, but knowing your own plans is not an unfair advantage. Warren Buffett frequently buys stocks, then announces that he's bought them, and then they go up. For that matter, Bill Ackman frequently buys stocks, then announces that he's bought them, and then they go up. He buys them knowing that he has plans for them, and then he announces the purchases and the plans, and the market reacts by pushing the stock price up. The people who sold to him not knowing about his plans didn't get the benefit of his information, but why should they? It was his information, his own plans. If you think it should be illegal to buy up shares before announcing your own plans to change a company, then you might be missing the point of insider trading law, and of activist investing, and really of financial markets generally.


Oh man, Hovnanian did the thing:

In a flurry of pre-New Year disclosures, homebuilder Hovnanian Enterprises Inc. said it’s taking a financing package offered by Blackstone Group’s GSO Capital Partners over the objections of a rival hedge-fund group.

The move could lead to payouts on credit-default swaps held by GSO, while helping Hovnanian win favorable terms to clean up its balance sheet.

We talked about this trade in November: GSO had purchased Hovnanian CDS and offered Hovnanian favorable financing terms if Hovnanian would agree to trigger the CDS by defaulting on its existing bonds. Hovnanian has done that -- an affiliate is going to buy back some of the company's 8 percent bonds due in 2019, and the new bonds have a covenant forbidding Hovnanian from paying interest on those affiliate-held bonds -- so the CDS should trigger when the interest is due in May. But just triggering the CDS doesn't get GSO much, because most of Hovnanian's bonds trade near (or even over) par. When CDS is triggered, it pays out the difference between the face amount of the bonds and their trading value; if a $100 bond is trading at $109 then triggering CDS doesn't get you anywhere.

But as we discussed, GSO had a clever solution to that: Hovnanian's new bonds could be worth much less than par. Hovnanian's refinancing of its $185 million of 8 percent bonds due 2019 involves issuing $199.3 million face amount of new bonds, roughly half in a new eight-year 13.5 percent bond and roughly half in a new 22-year 5 percent bond. Casual math suggests that the eight-year should probably trade above par but the 22-year should be worth something like 50 cents on the dollar. If those bonds set the price of the CDS -- and generally the cheapest-to-deliver bonds determine how much the CDS pays out -- then $100 worth of CDS should pay back something like $50. GSO has engineered a bond that is custom-designed to deliver into a CDS auction to make it some money.

It's quite a trade! One thing that is elegant about it is that it doesn't require Hovnanian to "really" default: It has to miss an interest payment, but only an interest payment due to its own affiliate. (Outsiders who keep the 8 percent bonds after the exchange offer will still get paid.) No third-party creditor will be harmed by the default, so no bond or loan investor will have any cause to complain, or to refuse to finance Hovnanian in the future, or to sue Hovnanian's directors for defaulting in bad faith. The only people harmed by these machinations will be the people who wrote credit-default swaps -- and I suppose it is reasonable for Hovnanian not to care too much about what they think.


I spent the last week mostly avoiding bitcoin news, though I did get a haircut from a barber who accepts bitcoins and who patiently explained to me how it works. (There's something about bitcoin and barbers. Paul Krugman's barber asked him about it too. Actually I wonder if Krugman and I share a barber. Probably not, though Henry Blodget and I do.) Anyway what did I miss?

An executive of a UK-registered cryptocurrency exchange kidnapped in Ukraine this week has been released after paying a ransom of more than $1m in bitcoins, according to an adviser to the Ukrainian interior minister, in a crime he dubbed “bitcoin kidnapping and extortion”.

Pavel Lerner, who runs the Exmo exchange and is a locally-renowned cryptocurrency expert, was kidnapped near his office in Kiev on Tuesday but freed on Thursday, Anton Gerashchenko, the Ukrainian adviser, said.

“He was kidnapped by an armed gang for the purpose of extorting bitcoins,” Mr Gerashchenko told the Financial Times, adding: “We have operative information that he paid more than $1m worth of bitcoins.”

Sure. I believe that is known in the cryptocurrency community as a "$5 Wrench Attack," though I guess an armed gang will set you back more than $5. Still a decent profit margin on a million-dollar bitcoin ransom. Anyway I get that many bitcoin enthusiasts distrust governments as meddling censors and profligate currency debasers, but on the other hand it is nice to have a government to protect you from armed gangs who want your bitcoins.


Bitcoin is losing its luster with some of its earliest and most avid fans -- criminals -- giving rise to a new breed of virtual currency.

Privacy coins such as monero, designed to avoid tracking, have climbed faster over the past two months as law enforcers adopt software tools to monitor people using bitcoin. 

Yeah I guess in hindsight a currency that preserves an immutable public record of every transaction is maybe not the best thing to use for crime. Still elsewhere: "Ripple's 53% Surge Makes It the Second-Biggest Cryptocurrency." And: "Russia is exploring ways to create a 'cryptorouble' that could help it circumvent western sanctions as the traditionally technophobic Kremlin gets swept up in the cryptocurrency craze."

What's the Juicero guy up to?

Here you go:

The most prominent proponent of raw water is Doug Evans, a Silicon Valley entrepreneur. After his juicing company, Juicero, collapsed in September, he went on a 10-day cleanse, drinking nothing but Live Water. “I haven’t tasted tap water in a long time,” he said.

Before he could order raw water on demand, Mr. Evans went “spring hunting” with friends. This has become more challenging lately: The closest spring around San Francisco has recently been cut off by landslides, so reaching it means crossing private property, which he does under cover of night.

“You have to be agile and tactile, and be available to experiment,” he said. “Literally, you have to carry bottles of water through the dark.”

You might think that the goal of technology is to make our lives easier, but Doug Evans is the world champion of making things pointlessly difficult. He is famous, of course, for Juicero, which built a massively over-engineered $400 device to squeeze juice out of bags of mushy produce. A Bloomberg investigation discovered that you can squeeze the bags just as effectively with your hands, more or less ending Juicero as a business.

But Evans is undeterred! As soon as his business of making juice excessively complicated collapsed, he moved right on to his passion of making water ridiculously excessively complicated. How, in our modern society, can you get drinking water? Well, you put on your ninja outfit, you strap some big jugs to your back, and you steal out under cover of darkness to illegally cross private property to collect water from springs and then lug it back home. I am going to film my own investigation in which I demonstrate that you can get just as much water, much faster and with no risk of being shot by landowners, by just turning on your faucet.

No, no, it's good. The telos of Silicon Valley is to (1) build electronic tools that will eliminate the need for human beings to work and (2) then replace human work with dumb pre-industrial magic rituals. In a science-fiction future where robots do all the jobs and satisfy your every need, what will you do all day? Well, maybe you'll get really into elaborate quests for water, why not. 

Things happen.

Steve Cohen Prepares Return With Help of Big Brother Oversight. Lynn Tilton Beats $1 Billion Zohar Racketeering Suit. Europe’s bank bosses see need for consolidation in sector. How high-frequency trading hit a speed bump. Judge Says PricewaterhouseCoopers Was Negligent In Colonial Bank Failure. New York Fed Takes Names in Search for Next Chief. Deutsche Bank says ‘normal’ bonuses and pay rises are back. Goldman Takes One-Time $5 Billion Hit From New U.S. Tax Law. Pension Funds’ Dilemma: What To Buy When Nothing Is Cheap? US considers mortgage credit check shake-up. Ray Dalio's New Year's resolution advice. Woman Ruined $300K Worth of Art on Date With Lawyer. Flight returns to Detroit after bird found in cockpit. It's So Cold in Canada That a Zoo Has to Bring Its Penguins Inside.

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