...Archive for June 2011

A license to lie, backdated

In a party-line, 5 to 4 split, the Supreme Court last week severely curtailed investors’ practical ability to hold financial intermediaries accountable for fraud. The case, Janus Capital Group, Inc. v. First Derivative Traders, seems arcane. But for perpetrators of fraudulent securitizations, it is a jubilee. The Supreme Court has eliminated the danger of their being investigated and sued by the people whom they fleeced.

The decision limits the reach of Rule 10b-5:

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,

  • To employ any device, scheme, or artifice to defraud,

  • To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or

  • To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person,

in connection with the purchase or sale of any security.

The case concerned a mutual fund whose prospectus was alleged to contain misleading statements that harmed investors. The question before the Supreme Court was not whether the statements were in fact misleading, but who should be construed as having made the statements. The answer, the Court determined, is perhaps nobody at all. Misleading statements were made, but literally no one can be held accountable.

When an ordinary firm issues securities, the firm itself is the “person” who makes the statements that appear in prospectuses and other disclosures. But with dedicated investment vehicles, things are more complicated. Investment vehicles — mutual funds and ETFs, but also securitizations like RMBS and CDOs — segregate the management and operation of the fund from the legal entity whose securities investors hold. If you “own” a Janus mutual fund, the securities you hold are likely claims against an entity called Janus Investment Fund. But Janus Investment Fund exists mostly on paper. Another company, Janus Capital Management, actually does everything. The human beings who make day-to-day investment decisions, as well as the offices they work in and the equipment they work on, are provided by Janus Capital Management. Communications and legal formalities, including prospectuses, are drafted by employees of Janus Capital Management.

The Supreme Court held is that, even though employees of Janus Capital Management company actually wrote any misleading statements, even though they managed nearly every substantive aspect of the operation of the fund, they cannot be held responsible because they did not “make” the statements. The “person” under law who made the statements was the entity on whose behalf the offending prospectus was issued, the investment fund, which has no capital other than the money it invests for shareholders. Under Janus, the management company is beyond the reach of aggrieved investors.

Then can the fund be meaningfully held accountable? The fund does have an “independent” board of directors, who in theory work for shareholders and “negotiate” the terms of the management contract. In practice, the management company typically organizes the fund and selects its directors. Still, if the investment fund “made the statement”, then surely those directors would be accountable, right? No. The investment fund’s directors supervise the fund at a very high level. In a large “fund family”, the same directors may be responsible for tens or hundreds of different portfolios. They may not have understood that statements in some prospectus were misleading. A violation under Rule 10b-5 must be knowing or reckless to be actionable. So the fund’s directors may prove beyond reach. Outright lies may be told, yet investors may find they have no practical means of holding anyone accountable. Justice Breyer, who dissents from the Court’s decision, writes

The possibility of guilty management and innocent board is the 13th stroke of the new rule’s clock. What is to happen when guilty management writes a prospectus (for the board) containing materially false statements and fools both board and public into believing they are true?

Plausible deniability is the order of the day. Managers can be as nasty as they wanna be. As long as their misbehavior is obscure enough that fund directors can plead ignorance, nobody gets in trouble. (If directors could be held liable, then the management company might be in jeopardy as well, under Section 20(a) of the Securities Exchange Act. But if the directors are innocent, then so are the managers.)

The really high-stakes fraud lately has been in the securitization business. The Janus decision gives CDO arrangers a huge get-out-of-lawsuits-free card. Each asset-backed security or CDOs is its own little investment company, a “special purpose vehicle” with its own notional directors or trustees, often incorporated in the Cayman Islands. Under the reasoning of Janus, any misleading statements in the offering documents for a securitization were made by the SPV, not the investment bank that put together the documents or arranged the deal. The SEC relied in part on Rule 10b-5 in prosecuting Goldman Sachs for its failure to disclose material facts regarding the ABACUS deal. Under Janus, that would no longer be possible. Investors in securitizations can hold literally no one accountable for lies or misstatements in the offering documents. (The directors and trustees of an SPV have little substantive role in managing its operations or controlling its communications, so they would almost certainly be “innocent”.)

In theory, Rule 10b-5 is not investors’ only redress against securities fraud. Mutual fund operators and arrangers of securitizations are underwriters as well as managers. Underwriting is fraught with conflicts of interest, so Sections 11 and 12 of the Securities Act of 1933 give investors the right to sue when misleading statements come to light. These sections offer powerful tools to investors in public offerings of ordinary shares. But they are not so useful to buyers of mutual funds or securitization deals.

When material mistruths about an ordinary firm are exposed, its share price typically drops. This provides a measure of the loss “caused” by the misstatement. The value of mutual fund shares, however, is computed according to the NAV of the fund’s assets, and so is not usually affected by a revelation. Sections 11 and 12 of the Securities Act specify that investors are to recover losses “resulting from” the misstatement. Showing that any losses are due to some other cause is an affirmative defense. So mutual fund managers argue, often successfully, that the proximate cause of investor losses are declines in the value of portfolio assets, declines which are unrelated to any misstatement on their part. Rule 10b-5, on the other hand, doesn’t provide for such a defense. In Rule 10b-5 actions, courts can take into account “transaction causation” (“but for the lie, I wouldn’t have invested!”) and consider investor losses more flexibly.

Securitizations are often organized so as to avoid US registration requirements. For an unregistered security, Section 11, which creates liability for false registration statements, obviously doesn’t apply. According to Thomas Lee Hazen and David Ratner, a 1995 Supreme Court decision

…which surprised almost everyone [held that] 1933 Act §12(a)(2)…does not…apply…unless [offerings] are made publicly by means of a statutory prospectus… [I]t appears that there will be no liability under any provision of the 1933 Act for written or oral misstatements in offerings which are exempt from that Act’s registration requirements, and that persons making such misstatements can only be sued under 1934 Act Rule 10b-5

So, until last week, the only effective remedy that investors in both mutual funds and securitizations had against misleading statements in prospectuses was Rule 10b-5. Now investors have no practical remedy whatsoever. [*] The government can still hold these vehicles accountable, under Section 17 of the Securities Act. But investors are not permitted to sue under that section, and regulators may be reluctant to pursue powerful or politically favored firms.

The Supreme Court’s decision in Janus is a license to lie. And it is backdated. The statute of limitations on Rule 10b-5 actions is five years. Perhaps naively, I had hoped that some of the egregious fraud of the securitization boom would be punished by investors, despite the “let’s look forward”, see-no-evil attitude of the regulatory community. Thanks to Janus, lawsuits-in-progress may be disappearing as we speak. Lawsuits regarding the particularly rancid 2006 / 2007 vintage of securitizations may never be filed. Going forward, if you are considering an investment in a mutual fund or ETF, you should understand that you will have little recourse if information provided in the prospectus turns out to be misleading or incomplete, even outright fraudulent. Perhaps you are comfortable relying solely upon your fund managers’ reputation, perhaps not. If you have a say in how a pension fund or endowment or bank invests its money, I can’t imagine why you’d permit investment in any sort of securitization while you have no meaningful assurance that what is being sold to you is actually what you are buying, even or perhaps especially if the deal is being offered by a big, famous, “deep-pocketed” bank. Much of my own savings is invested in various ETFs. I am significantly more nervous about that than I was a week ago.

Update: Jennifer Taub, who wrote a wonderfully detailed eight-post series on the Janus case in January (1, 2, 3, 4, 5, 6, 7, 8, followup), points out that in the case just decided, it was not mutual fund investors who were suing, but shareholders in the parent of the management company, Janus Capital Group, whose stock lost value when when the misstatements and related misconduct were exposed. This was the mutual fund “market timing” scandal, which received a great deal of press when it broke in 2003. In this very prominent instance, the SEC pursued and reached a settlement with the management company on behalf of fund investors, so no private action was necessary. However, the reasoning of the Janus decision creates a very large barrier for investors in general when, for whatever reason, the SEC declines to act as their champion.

[*] Justice Breyer, in his dissent, notes another potential remedy, to which he suggests the majority opinion hints obliquely. But pursuit of that remedy — liability based on the provisions of Section 20(b) of the Securities Exchange Act — would be at best a speculative enterprise. Justice Breyer points out, “‘There is a dearth of authority construing Section 20(b),’ which has been thought largely ‘superfluous in 10b–5 cases.’ 5B A. Jacobs, Disclosure and Remedies Under the Securities Law §11–8, p. 11–72 (2011)”

Update History:

  • 20-June-2011, 8:25 a.m. EDT: Added parenthetical about indirect liability under 20(a).
  • 20-June-2011, 10:40 a.m. EDT: Added bold update, clarifying, per Jennifer Taub’s comment, that Janus Capital Group, Inc. v. First Derivative Traders involved investors in the parent of the management fund, not investors in the mutual funds themselves.
  • 21-June-2011, 12:35 a.m. EDT: Removed a superfluous “as well”. In the bold update, changed “8 post” to “eight-post”, un-parenthesized a parenthetical and changed a “that” to a “, which”. No substantive changes.

Private participation

So, Greece is the word today.

If I understand the current impasse, much of the trouble is about how to engineer “private participation” in the losses that lenders to Greece and other debtors must eventually bear. The Eurocrats have decided they cannot allow Greece simply to default and impose haircuts on all of its creditors, and they cannot prevent a default by covering Greece’s solvency gap with public sector transfers alone. Despite European leaders’ best efforts to obfuscate and obscure transfers, creditor-state publics know they will be saddled with the lion’s share of these losses. They demand that private sector lenders bear at least a portion of the costs. Yet, there is no way to force a private bondholder to accept anything less than payment in full and on-time without that act constituting a default, thereby triggering the legal controversies and dangerous precedents that the Eurocrats are struggling to avoid.

Suppose the EU were to organize a debt forgiveness fund. This would be a public sector entity whose purpose would be to help Greece and other troubled states retire their unpayable debt. Initially it would be financed by loans from EU member states. With the fund’s help, Greece would make all payments on time and in full. The fund’s contributions would constitute outright transfers. Greece would have eliminated, not postponed its obligations.

However, the fund would repay its loans to member states with income from a dedicated tax. The tax would attach to interest and principal payments on Greek debt, and to capital gains on sales of that debt. This would not constitute a default by Greece and its successors. The troubled sovereigns would make their payments. It would not bind all holders of any class of bond: public-sector and conventionally tax-exempt holders would be unaffected, so it should not constitute a formal credit event (ht @Alea_, @dsquareddigest). For even greater assurance that the EU-wide tax would not constitute a default, it could attach to the debt of all Eurozone states, but at rates computed as a function of various state solvency criteria. Greece, Portugal, and Ireland needn’t be named at all in the law defining the tax, but Greek bondholders might find themselves paying 30% of interest and principal receipts to the, um, “Unity Fund”, while German bondholders pay less than 1%. The rates and total receipts, ultimately the share of the solvency gap that will be borne by the private sector, becomes a political decision within the EU rather than a technical question of smoke and mirrors. Given the discount at which PIIGS debt currently trades, the EU could impose large taxes without further depressing prices, as long as the market is persuaded that the tax scheme eliminates the possibility of default.

To avoid moral hazard, assistance to a particular state could be calibrated to tax receipts from that state’s bonds. (The modest quantity of funds collected from currently solvent states might be held as a form of overcollateralization.) Or there could be some burden-sharing among private bondholders. Again, that’s a political choice.

I don’t necessarily love this plan. But it does seem like it could work, and I haven’t seen the option discussed. So, for your consideration.

Note: An oddity about the Eurocrats apparent determination to impose haircuts without a formal default is that by avoiding a CDS credit event, they impose losses on European bondholders that would otherwise fall to American banks. The scheme above shares that deficiency, but apparently the EU’s leaders prefer paying off American banks to the difficulties that would attend a “hard” default.

Bank bailouts and the rentier class

Robert Kuttner has a great column about the “rentier class” and the struggle between “between the claims of the past and the potential of the future”. See responses by Adam Levitin, Mike Konczal, Paul Krugman, Yves Smith and Matt Yglesias.

I want to make an obvious political economy point. The most organized and active agents of the rentier class are, of course, banks. As Konczal points out

[Financial sector] profits are based off milking the bad debts of the housing and credit bubbles while Americans struggling under a crushing debt load. Instead of sharing the losses, the financial sector has locked itself into the profit stream and left the real economy to deal with the mess.

Financial sector lobbying plays an outsized role in tilting policy away from risk-and-loss-sharing arrangements and towards an alchemy of blood from turnips.

But it didn’t have to be this way. Banks, after all, are not only creditors. They are also the economy’s biggest debtors. In theory, bank loyalties ought to be mixed. On the one hand, banks prefer deflationary, zero-forgiveness tight-money policies, to maximize the real value of their assets and of the lending spread from which they draw profits and bonuses. On the other hand, troubled banks are very happy to support loose money and expansionary policy, even at risk of inflation. For bank managers and shareholders, it is bad to have the value of past loans eroded by inflation. But it is much worse to lose their franchises entirely, to have their wealth, prestige, and freedom put at risk in the aftermath of an explicit bank failure. When banks are in trouble, they are perfectly happy to support all manner of expansionary policy, as long as short-term interest rates are kept low. Even a broad-based inflation helps troubled banks twice over, by increasing borrowers incomes and by steepening the yield curve. Increased incomes ensure that loans will be repaid in nominal terms, preventing insolvency due to credit losses. A steep yield curve permits banks to recapitalize themselves via maturity transformation, using deposits to purchase Treasury notes while the central bank promises to hold short rates low for a few years.

But banks’ interests are aligned with those of debtors only to the degree that banks, like debtors, are at risk of real insolvency. When we committed to a policy of “no more Lehmans”, when we made clear via TARP and TGLP and the Fed’s alphabet soup that big banks would have funding on demand and on easy terms, when we modified accounting standards to eliminate the risk that bad loans on the books would translate to failures, when we funded their recapitalization on the sly, we changed banks. We transformed them from nervous debtors into pure rentiers, who see a lot more upside in squeezing borrowers than in eliminating a crippling debt overhang. And since banks are, shall we say, not entirely disenfranchised among policymakers, we increased the difficulty of making policy that includes accommodations between creditors and debtors, accommodations that permit the economy to move forward rather than stare back over its shoulder, nervously and greedily, at a gigantic pile of old debt.

Our problem is not that our banks are still weak, our financial system too fragile. Our problem is that we have made our banks strong and cocky, so they needn’t care about abstractions like lives disrupted, production foregone, human capacities undeveloped. We’d have better policy if banks themselves were at risk of foreclosure when Joe Sixpack still can’t find a job. We should work to put them in that position.

Should we be scandalized by IPO pops?

So, I’m late to this. There’s a big link parade at the end of the post.

LinkedIn had an IPO on May 19, priced at $45 per share. The stock briefly sold in the $120s that day, and closed at $94.25. In the lingo, there was a big “pop”.

From a certain perspective, IPO pops are puzzling, even scandalous, events. Here is the theory of the outraged:

  • Shares are assets with real economic value that professional investment bankers, after communicating with “the investor community”, are capable of discerning.
  • The price at which those shares will trade in public markets, on the first day and thereafter, is a reasonable approximation of real economic value, because stock markets are efficient.
  • Therefore, if investment banks (who, in consultation with the issuer, set the IPO price) sell the shares for substantially less than the price at which the shares trade on the open market, they have screwed their client. The issuing firm and its original investors have “left money on the table” by failing to extract the full value their shares. Meanwhile, someone, some flipper, will have purchased shares at the IPO price and resold them after the pop, taking profits that might have gone to the issuer.
  • So issuers really ought to be upset about IPO pops (even though they mostly aren’t). “I don’t understand why competitive forces don’t drive this kind of egregious underpricing out of the system,” a finance professor tells the Financial Times.

Puzzle, puzzle, toil and trouble. Here’s a tidbit to taunt the good professor: In the 1990s and especially during the tech bubble, pops tended to be larger for IPOs led by “top tier“, high market-share investment banks than when shares were offered via midlevel underwriters. It’s a topsy turvy world, apparently. During hot IPO cycles, when underpricing is especially pronounced, “competitive forces” seem actively to favor underpricers.

Pretty much every premise of the case against IPO pops is false. Shares of all but the most staid firms do not have known, predictable economic values that highly trained professionals can predict ex ante. Further, share prices are autocorrelated, which is a fancy way of saying that if a stock trades for $100 today, it is more likely to trade above $100 three months from now than a stock that trades today for $50. There are lots of ways to interpret share price autocorrelation. Perhaps markets are efficient, so that a high price today is indicative of durable economic value. Perhaps markets are not so efficient, but investors nevertheless use yesterday’s price to determine the price at which shares will trade today.

Regardless of which story you believe, consider the situation of insiders and early investors in IPO firms. These investors face a “lock-up” period of three to six months after the IPO, during which they cannot sell. (This is intended as a kind of guarantee to new buyers that the shares are not total lemons.) If you hold a share of stock that you cannot sell for several months, you are better off, in a statistical sense, if the shares that you hold trade for $100 today than if they trade for $50 today. Sure, even after a pop, share prices could wither to worthlessness by the time the lock-up period ends. And sometimes that happens. But overall, if you are a preexisting investor in an IPO firm, the expected future value of your shares is substantially higher if your shares trade at $100 now than if they trade at $50.

So, if you are an early investor in a firm now making its debut, an IPO pop is mixed news. On the one hand, discovering that the shares you continue to own are very valuable is good news. On the other hand, if it is true that you could have sold the shares that you did sell for this much higher price, you’ve been screwed. On balance, how should a rational shareholder evaluate these conflicting signals? Should she be glad or disappointed? Should she fire her shoddy investment bank or celebrate its success?

If you are sure that stock markets are completely efficient and so share prices are independent of all the schmoozing and marketing done by your underwriter, then you should be outraged. You would have learned the same good news had you gone with a different investment bank, and your underwriter, if it were more competent or less corrupt, could have set a higher price and made you a great deal more money. But if you think that the stuff investment banks do when they underwrite an IPO actually does affect the price at which shares eventually trade, you might not be so angry. You might consider the “money left on the table” to be part of the fee you pay in order to be made as rich as possible.

IPOs are not all alike. In the lingo, they are sometimes “financing events” and they are sometimes “pricing events”. When IPOs are financing events, insiders are selling substantial fractions of their firms, trying to to divest their holdings or raise large sums for corporate purposes. When they are “pricing events” insiders are selling a small fraction of their shares in order to gain various benefits that come with being a public firm. In a “financing event”, when insiders are selling a lot of stock, the money left on the table from an IPO pop might amount to a substantial fraction of total equity value, too much money to be treated as a transaction cost. But in a “pricing event”, the money left on the table in a pop — the “opportunity cost of issuance” — may not be so large.

A very good predictor of how much an IPO will pop is “overhang”, the ratio of shares retained by insiders to shares sold during an IPO. IPOs with high overhang — that is, IPOs where insiders are selling only a small fraction of the firm — are much more likely to pop than IPOs in which investors are selling a lot of their shares. (This is true even controlling for the absolute value of shares sold, so it is unlikely to be just an artifact of scarcity.) To my mind, the explanation for this regularity is simple. Investment banks behave differently for high overhang IPOs (“pricing events”) than for low overhang IPOs (“financing events”).

For low overhang IPOs, in which much of the firm is being sold, underwriters go for accuracy. Investment banks do not want clients to spread word that they lost half the value of their firm to flippers on the big day. So bankers work to keep the IPO price and the immediate market price aligned. They try to set a reasonable price in the first place, they place shares with investors likely to sell pops and buy dips, they stabilize prices directly via their own activity in the market. (Underwriters have a partial exemption from market manipulation rules that allows them to “stabilize” new issues.)

But for high overhang IPOs, investment banks, in consultation with their clients, go for broke. The “book-building” process, often described as an anodyne sounding of investor interest, becomes an occasion to market the hell out of the issue. Investment banker activity, proxied by changes (even downward changes) to the planned issue price are predictors of IPO pops. For high overhang IPOs, underwriters and their clients agree that everything that can be done should be done to get the shares trading at the highest valuation possible, despite a necessarily conservative issue price.

When only a small fraction of a firm is being sold, issuers quite rationally permit investment banks to underprice their IPOs, because doing so aligns underwriters interests with their own. Issuers want their firms to be highly valued. An issuer who makes it clear that she will hold her underwriter accountable for underpricing is behaving foolishly, threatening to punish an outcome she desires. A smart issuer understands perfectly well that money left on the table will be used as kickbacks to favored clients of the investment bank. But why should she mind? She views that money as performance pay, a transaction expense. Given the small fraction of shares sold, it represents a modest cost. Further, she understands that the reason she chose her market-leading, high reputation underwriter is precisely because of the bank’s relationships with institutional investors, the bank’s ability to persuade people in its rolodex to take up and hold (not flip) new issues. If the issuer is not naive, she knows that the underwriter’s ability to place shares comes from plum deals the bank frequently offers the people in its rolodex. With the money she leaves on the table, the issuer is paying for exactly what she is trying to buy.

Efficient markets proponents will blanche at this whole scenario. How can underwriters affect share values? Surely, investment banks can’t “fool” the market over a six month lock-up period?! But nobody is fooling anybody, exactly. Nobody — not Warren Buffett, not the firm’s CEO, not even your psychic friend at Goldman Sachs — knows the “true value” of a speculative firm. A small rejiggering of earnings growth assumptions or the appropriate discount rate can double or halve estimates of “economic value”. The dirty little secret of fundamental analysis is that it can never tell you the correct price of a stock. Fundamental analysis can indicate that a price is wrong, that it is deeply below or outrageously above any reasonable valuation. But an independent analysis (one that ignores the market and estimates value based on a discount rate and expected cash flows) will very rarely approximate actual share prices (unless the analyst cheats, and reverse engineers the market). What issuers believe a good investment bank can do, with its marketing and its reputation, is get the shares trading on the optimistic end of the range of reasonable valuations. And that, to preexisting shareholders, can be much, much more valuable than a bit of money left on the table from underpricing.

So, is there any scandal here at all? I think so, but it’s not about investment banks screwing underwriting clients. On the contrary, I think investment banks usually serve both their underwriting clients and their favored investors pretty well. The scandal, I think, is that the IPO process offers issuers, underwriters, and favored investors too much and the rest of us too little. After the first day pop, IPOs tend to underperform other issues over the long term. Not by enough to reverse the first-day pop over the lock-up period. On average, new IPOs don’t underperform the market very much in the first six months after the pop. (During the 2000s, IPOs did perform poorly even in the first six months, but that is probably because the tech bubble crashed within 6 months of many IPOs.) IPOs get optimistically priced on their first day, and whoever winds up holding the shares from the end of the lock-up period and out several years pays for that. In general, buying IPOs at the issue price is a great deal, while buying IPOs on the secondary market is hazardous even a year or two after the offering. The IPO process ends up being a boon to insiders (the issuer, its underwriter, and favored investors), which is paid for over time by less connected investors who fail to demand a sufficient premium to hold recently IPO-ed shares.

In the scheme of things, this is pretty small beans. Caveat emptor and all of that. Still, a practice that taxes investors broadly in order to reward people for systematically mispricing securities does deserve some tut-tutting.

P.S. The academic literature on IPO underpricing is all about kickbacks. I prefer my conspiracy theories to be fringe, but this is all pretty mainstream. Famous explanations describe underpricing as a kickback necessary to induce uninformed investors to participate, or to induce informed investors to reveal what they know during the book-building process. For a real conspiracy theory, check out spinning, which has investment banks offering kickbacks to managers so that they’ll tolerate underpricing that screws their own firms’ shareholders.

Update History:

  • 4-June-2011, 4:25 p.m. EDT: Changed an “and” to a “so”, so it’d read better. Also change “And sometimes that does happen” to “”And sometimes that happens”.
  • 11-July-2011, 11:30 p.m. EDT: Replaced a “they” with “shares”, the intended but missing antecedent. Removed an ungrammatical “to”. No substantive changes.