(Bloomberg View) -- How's Theranos doing?
A well-known fact of securities fraud is that it creates valuable mailing lists. If you come into possession of a list of people who have been defrauded before, there is a good chance you can find a way to defraud them again. This is perhaps a little counterintuitive -- they were just defrauded; shouldn't they be on guard for more frauds? -- and you need to be a bit thoughtful about how you defraud them again, but there are effective approaches. (Not legal advice!) "We will recover the money that those fraudsters took from you, for a modest up-front fee" is a popular one; "sure the investment those fraudsters sold you is worthless but with a little more money we can find a way to make it pay off" is another. The bet, and it seems to be a good one, is that the personality traits that led people to be defrauded in the first place are more powerful than the lessons that they drew from the experience.
In other news, BuzzFeed published a letter that Elizabeth Holmes, the founder and chief executive officer of Theranos Inc., the disgraced Blood Unicorn that settled fraud charges with the Securities and Exchange Commission last month, sent to Theranos's beleaguered shareholders this week:
We last wrote on December 22, 2017, shortly after closing a secured debt financing transaction with Fortress Investment Group. We said that the transaction provided us runway to continue work on the miniLab and to position the company for additional financing events—but acknowledged the narrow path forward.
Unfortunately, we are behind schedule on our first product milestone under the Fortress loan, and as a result will soon face a cash shortage. Below we detail our situation, apprise you of our options, and ask for your help as we continue to work to realize value for your investments. As we describe below, we are evaluating parallel paths, including potential investment terms that would provide a large stake in the company at what we believe to be a favorable price.
My anecdotal impression is that very very few people who are not currently Theranos investors believe that there is a "favorable" price for Theranos shares that is not zero. But! Probably some people who are currently Theranos investors remain believers. Why not hit them up for money? The whole letter is worth reading, for its mix of frank admission that things are messed up ("In light of where we are, this is no easy ask"), optimistic assessments of Theranos's "real progress" and "basis for building significant long-term value," and outright threats that if investors don't pitch in more money then they will be (more) hosed: "Holders of Series C-1B and Series C-2A Preferred Stock should also be aware that their failure to participate in a financing having a purchase price of less than $5 per share would result in mandatory conversion of their shares into nonvoting Series C-1B* or Series C-2A* Preferred Stock," and if Theranos doesn't raise enough money to keep going, "Fortress would be entitled to control a foreclosure sale and/or monetization of the assets and to realize up to a three-times return on its investment."
We talk sometimes around here about the SEC's "bad actor" bars, which say that if you are caught doing certain kinds of bad behavior, then you will be barred for some time from being involved in certain kinds of private sales of securities. The SEC tends to waive these bars when big banks are caught doing bad things, and lots of people criticize those waivers, and I tend to defend them. The point of the bad actor bars is to stop the sorts of people who would defraud private investors from defrauding more private investors. When a giant bank does some spoofing in its commodity division, I reason, there's no particular sense in barring its completely separate equity financing division from doing private placements: The commodity badness doesn't reflect the behavior of the financing division, and the automatic bar would just make capital-raising more difficult for innocent client companies without really doing anything to deter or prevent the spoofing that got the bank in trouble. And then everyone gets mad at me on theories of general deterrence, arguing that any additional punishment for the bank is good, because it will make the bank think twice about doing anything bad. I am unconvinced.
On the other hand! It is a little weird that the SEC sanctioned Theranos and Holmes a month ago for defrauding investors in its private stock sales, and that Theranos and Holmes are out again now pitching a stock sale to those investors. I mean it's not that weird: Who else would pitch a Theranos stock sale, if not Theranos and its CEO? And how will Theranos survive if it doesn't raise money? And should the penalty for Theranos's misstatements to investors really be shutting down Theranos and losing all of those investors' money? Still it is a little jarring to see Holmes and Theranos right back on the horse (unicorn), raising money from investors a month after being punished for defrauding those same investors.
I sometimes cite around here Michael Graetz's two laws of tax, which are that it's always better to have more money than less money, and that it's always better to die later than sooner. An imprecise but occasionally useful corollary of the first law is that it is often -- by no means always, but often -- better to pay higher taxes than lower taxes, because in a tax system that broadly taxes you on the money you make, the more taxes you are paying the more money you have made. By that standard, John Paulson has quite a lovely problem:
By April 17, the hedge-fund manager must make federal and state tax payments of about $1 billion, on top of roughly $500 million in taxes he paid late last year, said people close to the firm. That sum is so big it dwarfs the maximum amount the Internal Revenue Service will allow any single taxpayer to pay with a single check. (That’s $99,999,999, in case you’re wondering.)
Mr. Paulson bet big against subprime mortgages ahead of last decade’s financial crisis, earning about $15 billion of profits for his funds and approximately $4 billion for himself. He deferred the bulk of the taxes on these profits, using a tax provision available at the time to hedge-fund managers, said the people close to the firm. Now the bill is due. ...
Paying the tax bill may itself be something of a chore for Mr. Paulson. He could wire the money but may wish to pay by check if he’ll earn interest on the money until tax authorities cash the check. If so, the IRS accepts only checks or money orders of less than $100 million. He could submit multiple payments, though tax attorneys note that clients can have problems fitting such huge numbers onto the line on a check.
Look. I am not, myself, fabulously wealthy, so I cannot tell you with confidence what I would do in this situation. But I would like to think that if I were ever faced with the problem of paying $1.5 billion of taxes on my $4 billion of profits, I would find a few hours to embrace the process. Like I'd write more than the minimum 15 checks, in a wide range of amusing amounts ($99,999,999.00, $99,999,998.75, $4.20, $0.11, etc.). I would practice my penmanship in order to fit the numbers on the line. I might buy a new fine-tip pen. Heck, I'm rich in this scenario, I might order oversized checks. I'd probably open a bottle of Champagne to pair with the check-writing. I suppose there is a sense in which writing out "Ninety-nine million, nine hundred ninety-nine thousand, nine hundred ninety-nine dollars and 00/100" on a check -- 15 checks! -- could be considered a chore, but the fact of the matter is that I rather enjoyed typing it right now, and the $99,999,999 check that I am writing is purely hypothetical. If I actually had all those $99,999,999s in my bank account -- and then some -- I think it would be a real pleasure.
Graetz's laws of tax are profound, but my corollary is admittedly trivial. Duh, paying more taxes means you're richer, and being richer is good. But it's worth saying about Paulson, because that Wall Street Journal story about his tax issues is only very briefly about the difficulty of fitting numbers onto a check. It's mostly a survey of Paulson's career as a hedge-fund manager. You might be familiar with the basic outlines of that story: Paulson "produced steady gains" in merger arbitrage for a while, foresaw the financial crisis, bet against subprime mortgages, made a vast pile of money, "was managing $38 billion and was firmly among Wall Street’s elite," and "then he went cold," losing lots of client money on bad bets on gold miners and a Chinese forestry company and pharmaceutical companies and an S&P 500 short. "Today, Paulson & Co. is managing under $9 billion—most of it Mr. Paulson’s own assets."
Generally speaking, if you make billions of dollars of capital gains one year, and have billions of dollars of capital losses the next year, you can offset those results to lower your taxes. That is only fair: If you make a billion and then lose a billion, you are back where you started, and shouldn't have to pay hundreds of millions of dollars of taxes on income you don't really have. But that's not Paulson's situation -- not only because he's still ahead of where he started, but also because that $4 billion isn't purely capital gains in the traditional sense:
“It is safe to say it is one of the largest tax bills on earned income in history,” said Henry Bregstein, co-global head of the financial services group at the law firm Katten Muchin Rosenman LLP. Billionaires in the technology and private-equity worlds usually achieved the bulk of their wealth through the appreciation of shares, he said, not from earned income. ... As with most hedge funds, Paulson & Co. enjoys profits from fees amounting to 20% of gains generated for investors.
If you make billions of dollars for clients, and then lose billions of dollars for them, and you charge 20 percent of profits, then you come out ahead. The taxes are almost a ratification of how well your business model worked out for you.
"Narrowly tailored credit events."
The International Swaps and Derivatives Association is getting increasingly concerned about the nonsense going on at Hovnanian Enterprises Inc. We have talked about it a bunch, including this week, but the gist is that Hovnanian is going to do an extremely surgical default on its bonds (it will fail to make a payment on a small batch of bonds that are held by its own affiliate) in order to trigger its credit-default swaps, and it will issue some extremely goofy bonds that will create a large payout on those credit-default swaps. This will be a windfall for owners of that CDS, including Blackstone Group LP's credit unit GSO, and GSO will allow Hovnanian to participate in that windfall in the form of attractive financing terms.
It's a good trade! For Hovnanian, and for GSO. It is embarrassing, though, for the CDS market, which ISDA represents; I wrote this week that, "exaggerating slightly, after Hovnanian, a CDS contract looks like a derivative that pays off $100 if the company wants it to, and $0 if it doesn't." That is not a contract that anyone would be particularly interested in buying or (especially) selling, and so ISDA is alarmed. It published a statement yesterday from its board of directors, expressing that alarm:
“The ISDA Board of Directors has noted recent press reports of instances of credit default swap (CDS) market participants entering into arrangements with corporations that are narrowly tailored to trigger a credit event for CDS contracts while minimizing the impact on the corporation, in order to increase payment to the buyers of CDS protection. ...
“We believe that narrowly tailored defaults, those that are designed to result in CDS payments that do not reflect the creditworthiness of the underlying corporate borrower (the reference entity in the CDS), could negatively impact the efficiency, reliability and fairness of the overall CDS market. We have therefore instructed the ISDA staff, as part of its ongoing dialogue with the market, to consult with market participants and advise the Board on whether further amendments to the ISDA Credit Derivatives Definitions should be considered.”
That's fine. Even for GSO it's fine. Obviously, with its Hovnanian trade, GSO will be killing the goose that lays this particular golden egg. The question is whether GSO will be killing the loophole in CDS that allows it to get paid off for a more-or-less fake default, or whether it will be killing the whole CDS market. Killing the whole CDS market would be bad for GSO! It's a credit fund; it uses CDS. And it's a clever credit fund, so it wants to be able to make different, clever use of CDS in the future. Clearly it would prefer the blowback to this particular clever trade to be narrowly tailored.
Is Bitcoin money?
JPMorgan Chase & Co. was sued for charging "sky-high" interest rates and fees to customers who used their credit cards to buy cryptocurrencies such as Bitcoin.
Brady Tucker, a Chase credit-card customer in Idaho, claims the bank in January began treating his cryptocurrency buys as cash advances instead of purchases, and charging him interest rates of as much as 30 percent a year and additional fees.
I was not aware that JPMorgan did that, and now I want to go to their offices and high-five them. That's great. (It does not seem to be unique to them, among credit-card issuers.) "What, Bitcoin is money, right? You want to buy money with your credit card? Cash advance. What's the problem?"
Elsewhere in Bitcoin: "Claudio Guazzoni de Zanett said he’ll accept $29.95 million in U.S. dollars or about $45 million in digital currency for his six-story townhouse on New York’s Upper East Side." "You could just ... sell the Bitcoins for $45 million ... and buy the house for $29.95 million ... and keep the extra $15 million?," was my first thought, but that is because I am a nocoiner. In the words of that meme, one does not simply sell $45 million worth of Bitcoins, certainly not for $45 million. But the point is, a 50 percent illiquidity premium would be pretty harsh for a functioning currency.
Elsewhere in crypto: "The former Wall Street deals lawyer who leads the U.S. Securities and Exchange Commission said one of the biggest surprises of his first year heading the agency has been learning about the levels of fraud surrounding initial coin offerings and penny stocks." Look, I'm with him on that. He did big deals for big banks and big companies at Sullivan & Cromwell LLP. He wasn't hanging out with penny-stock scammers. Now he is. I get that there is a popular perception that big-time Wall Street finance is a hotbed of fraud, but objectively, it isn't. Big banks hire good lawyers, like Jay Clayton, and they call him up and ask him for advice on how to follow the law. Dealing with people who just cheerfully ignore the law probably is a new experience for him.
Meanwhile, here is an argument that "the use of SAFTs" -- Simple Agreements for Future Tokens, in which companies do initial coin offerings by private placements of securities that eventually flip into non-security "utility tokens" when their projects go live -- "should be DEAD." The theory is that the SEC considers even "utility tokens" -- tokens that can actually be used to do transactions in a working network, instead of having only speculative value -- to be securities, and so those tokens would need to be registered, and doing an unregistered sale of securities (SAFTs) that can flip into registered securities (tokens) is a no-no. I am not convinced. No one really knows how the SEC would treat a working "utility token," because they basically don't exist. The closest things we have are tokens like Bitcoin and Ether, which can be used in robust networks, and which the SEC has not, so far, tried to regulate as securities. I suspect if someone built a token-based network, and the tokens could really be used to buy and sell some real product on that network, and the tokens' value was relatively stable and tied to the value of the product rather than a speculative bet on the network, then that really wouldn't be a security, and a SAFT that flipped into that sort of token would be fine. I suppose the worry is that the SEC will step in to shut down SAFTs long before we can ever find out.
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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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