Big Companies Can Keep Big Secrets

(Bloomberg View) -- Programming note: Money Stuff will be off for the next few days, back on March 8.

Materiality.

How much money does YouTube make? It is a secret: Alphabet Inc., which owns YouTube, does not break out revenue for it separately. Alphabet's Form 10-K gets as granular as "Google properties revenue," meaning advertising revenue from Google search, Gmail, Google Maps, YouTube and other Google properties; that was $95.4 billion in 2017. If 10 percent of that -- a number that I just made up -- came from YouTube, then YouTube had more revenue than almost half of the companies in the S&P 500 index. 

But it is also a secret from Alphabet Chief Executive Officer Larry Page, or rather, it's something he doesn't care about very much:

The SEC on Monday published correspondence between Alphabet and U.S. regulators that seeks to understand the company's reasoning for its approach to financial reporting. Through nearly half a year of back-and-forth, one theme is prevalent: Who knows about YouTube revenue, and when do they find out?

This is a very important question at the moment, as new revenue-recognition rules suggest that investors should receive the same information as the top executive in an organization. In other words, if Alphabet's top decision-maker gets YouTube financial information, so should we, a point MarketWatch has made more than once as YouTube has become one of the most important online services in the world.

... Basically, Alphabet explained that Larry Page -- co-founder of Google and chief executive officer of the umbrella organization named Alphabet -- would be considered its top decision maker, and he only sees very base YouTube revenue information on a quarterly basis because Alphabet views YouTube advertising the same as the search ads that are the core of Google's business.

Alphabet views it that way: YouTube is just an undifferentiated bit of the great firehose of money coming out of its Google unit. Google views it differently: Sundar Pichai, the CEO of Google, "receives weekly and quarterly reports," says Alphabet, which "include disaggregated financial information for Google product areas, including YouTube." But Google is not a public company; Alphabet is, and "the financial information included in the weekly reports provided to Larry Page is limited to operating results for Google as a whole." And since Alphabet doesn't break out its YouTube results for Page, it doesn't have to break them out for investors.

This is partly a -- perhaps intended -- result of Google's restructuring into Alphabet, in which Google became just one operating unit (albeit the one that makes most of the money) in a broader company whose other units -- called "Other Bets" in its financial reports -- try to build driverless cars or end death or whatever. By making Google its own division with its own CEO, Google/Alphabet insulated Page from knowing too much about the details of Google's advertising business. No doubt this had mostly to do with his own enjoyment -- he'd rather spend his time thinking about human immortality than about preroll video ad targeting algorithms -- but it also has the effect of making Alphabet's financial statements less revealing.

But this is also a result of something else, which is that Alphabet and Google are really really gigantic. YouTube, as a business, is big. If it was its own public company, it would be a big one, quite plausibly in the S&P 500. And its shareholders would know not only its top-line revenue but also all sorts of details about its finances and operations, how much money it makes on different sorts of ads, how much it spends to make that revenue, etc. But they don't, because YouTube, big though it is, is only a unit of a unit of a behemoth.

This Article argues that the securities disclosure regime contains previously unexamined structural deficiencies that pertain to the information provided by the largest public companies. These deficiencies arise from the operation of the materiality standard, a core element of the disclosure regime that is used in a number of SEC disclosure rules. The materiality standard is designed to limit firms’ disclosure to information that would be of importance to investors, and to prevent the overproduction of information. I suggest, however, that in the case of large firms the materiality standard can also lead to the underdisclosure of information — or to “materiality blindspots.” The materiality standard determines whether firm-specific information must be disclosed by assessing its importance relative to the size of the firm and the “total mix of information” about that firm. Since the threshold for what is material increases as firms get bigger, however, at the very largest firms even matters that are significant or sizeable in absolute terms may be deemed immaterial and remain undisclosed. Such firms are “too big to disclose” and, in a perfectly legal manner, take advantage of the materiality standard to avoid disclosure of important matters.

Georgiev argues that this is bad for investors: "Materiality blindspots may undermine investor protection and corporate governance, including by diminishing the accuracy of security prices and by making inside and outside monitoring for fraud or suboptimal management practices more difficult."

He also argues that it can "in effect serve as a regulatory subsidy for bigness." If YouTube were a public company it would need to spend money on lawyers to draft hundred-page disclosure documents describing its business in detail; now it does not. If YouTube were a public company its competitors could read those disclosure documents and get useful information about its competitive positioning; now they cannot. It is one more factor pushing companies to get bigger by acquisition: YouTube is more regulatorily efficient as part of Alphabet than on its own.

Of course that is just one of many incentives for bigness, and most large tech companies that sell out to gigantic tech companies aren't doing it to avoid disclosing their revenue. But it does have the effect that they can stop disclosing their revenue, or at least that they can stop disclosing lots of things that would be material to them individually but are not material to the giant conglomerates that they join.

And so a market dominated by fewer larger more profitable companies will be a market with less information than one with more smaller more variable companies. Corporate disclosure becomes less interesting and revealing, and you can learn less from it, and so analyzing companies becomes less valuable. And so why not index?

Expert networks.

Here is a story about the return of "expert networks" -- companies that connect investors with subject-matter experts for background conversations, for a large fee -- that is fascinating on all sorts of levels. For one thing, it is a story of unbundling: The article frames the renewed interest in expert networks (which became less popular after they were involved in a string of insider-trading cases) as a response to new European MiFID II rules that require investment firms to pay for research directly rather than receiving it for "free" from banks and compensating the banks with trading commissions:

Now that banks have stopped giving equity research for free under a new European Union law, some money managers are opting instead to spend their cash speaking with experts in fields as trendy as artificial intelligence or as niche as sausage packaging.

If your research and trading are bundled together, your standards for research are lower. If you have to pick a bank to help you buy shares of a sausage company, and if one bank sends you a nice five-page background report on that sausage company complete with a financial model, you will no doubt feel warm feelings toward that bank and be inclined to use it (and pay it a commission) to buy the shares. On the other hand if the bank asks you for thousands of dollars for that background report you might decide to comparison-shop. Maybe there is someone out there who knows more about sausage-making than an equity analyst at a bank? Perhaps you should be giving that person your money?

Obviously you will still use some bank to execute your trades -- the sausage savant can't help with that -- but you will pay it less. You would expect this to be more efficient -- you can pick the best and most cost-effective sausage expert, and the best and most cost-effective execution trader -- unless there are any economies that come from combining sausage expertise and execution trading in a single firm. You can see why European regulators might think there wouldn't be.

Also striking are statements like this:

Hermes Investment Management, which allocates almost 33 billion pounds ($46 billion) of client money, started using expert networks a couple of years ago for niche perspectives on areas like geopolitical risk, urbanization and automation. But “it would be dangerous and probably somewhat foolish to rely on them solely without additional work yourself,” investment chief Eoin Murray cautioned.

Or this:

“I can provide some of the financial institutions information in five minutes that takes them weeks and months to acquire through their due diligence and data analysis,” said Plank.

These statements sound pretty straightforward and normal, but what is strange about them is the distinction they draw between talking to an expert, on the one hand, and "work" or "due diligence" or "analysis," on the other. You see this sort of thing a lot in discussions of insider trading, particularly when prosecutors are doing the discussing. The idea is that there is some sort of quiet virtuous manual labor -- digging holes and filling them up again, or reading and highlighting 10-Ks -- that securities analysts are supposed to perform, and that makes markets more efficient, but that those analysts are somehow cheating and shortcutting the process when they just call someone up and ask him to tell them the answer.

This, it seems to me, is mostly the wrong way to think about securities analysis. You can never add information to the market just by reading 10-Ks; the information is already in the 10-K. The way to add information is to find things out that someone knows -- perhaps an insider, or perhaps just a guy who knows a lot about sausages -- but that no investors know yet. The work, the due diligence, the analysis, regularly consists of calling people up and talking to them. If you assume that those phone calls are cheating then you will have a distorted view of how markets work.

Don't do this.

"SEC: Insider Bought Minutes After Warnings Not to Trade" is the headline of this Securities and Exchange Commission enforcement release, and honestly I sometimes feel a little bit like I am the intended audience for these releases. "Ooh, this guy bought stock in a merger target minutes after getting a warning telling him not to, let's put that in the headline, Matt will like that," I imagine the SEC enforcement lawyers saying. Perhaps I have just been reading these releases for too long but I really do feel like they are speaking directly to me.

But this one is a little unfair! Yes sure Yang Xie, who worked at Merck & Co. evaluating drugs, (allegedly) insider traded minutes after getting an email from a Merck lawyer warning him not to trade in the stock of a company (Cubist Pharmaceuticals) that Merck was considering acquiring. But that email also seems to have been the first he heard of the deal, and the insider trading warning was in an attachment. It's not like they sat him down and said "one thing you can never do is insider trade" and he was like "insider trade? Don't mind if I do!" It's more like they emailed him to say "hey Merck is buying Cubist for a big premium, also here is an attachment that you should read." And he naturally focused more on the first part than on the second.

Though there are hints that he read the attachment. His response to the email was a thing of great and confusing beauty:

Xie replied to the email six minutes later, at approximately 4:10 p.m., acknowledging his receipt of the email. Xie’s reply stated in full: “I am on your distribution list so I got the email, but I’m not on the list in your word document. I don’t know if should be on your list or not as this is my first time hearing about Project DIEGO. But judging from the other people on the list I might be. Can you check and let me know? Thanks!”

You get the sense that his reaction was, well, am not on the Cubist deal team, so surely this memo wasn't meant for me, so I can probably go right ahead and trade. That is not ... quite ... right ... legally? Like if the Merck lawyer who had sent the email had replied "quite right, you were cc'ed by mistake, never mind," he probably still shouldn't have traded. (Also he does seem to have done some work on evaluating Cubist for Merck.) Still you can sort of imagine the thought process. He didn't insider trade minutes after they warned him not to insider trade. He (allegedly) insider traded minutes after he saw them warning other people not to insider trade. He thought he was in the clear!

Poor Martin Shkreli.

"Pharma bro" fraudster Martin Shkreli's hopes for a light prison sentence were dealt a huge blow Monday as a judge ruled that his crimes caused a loss of $10.4 million.

The ruling by Judge Kiyo Matsumoto means that federal sentencing guidelines will likely call for a prison term of up to a decade or more for Shkreli when she sentences him March 9. She is not bound by those guidelines, however.

You can read her decision here and, it is ... not wrong. Shkreli's argument is that the investors in his two successive hedge funds -- which he was convicted of lying about a lot, and which lost all their money on weird options bets -- actually never lost any money, because he gave them stock in Retrophin Inc., a public company he controlled, and the Retrophin stock turned out to be worth more than their original investments. Like many securities fraudsters he kept stringing investors along and putting them into new harebrained schemes hoping to get them their money back; unlike most of them, though, he actually succeeded.

The government's argument is that those investors did lose money; it's just that Shkreli eventually paid them back after they started complaining. If your fraud loses money for investors, and they catch you, and you pay them back, then the losses still count. And while Shkreli has an argument that that's not what happened here -- that he gave Retrophin stock to the funds out of the goodness of his heart after they suffered honest losses, rather than to settle legal claims from disgruntled investors accusing him of fraud -- it is frankly not a very good one. And so he is getting tagged with the full amount that investors put into his funds, even though those investors all ultimately got paid back.

That seems analytically correct, though also a bit rough on him. Shkreli is obviously an unpopular character but he is not, as these things go, a particularly bad fraudster. His lawyers were seeking a sentence of "perhaps just 16 months or less," and that actually sounds about right to me for this sort of fraud. If he gets much more than that, I suppose it can be technically justified by legal arguments about the amount of loss that he caused, but I suspect it will really be driven more by his all-around dreadfulness. Which to be fair is a perfectly legitimate sentencing consideration! Generally speaking you can't be thrown in jail for being smug and awful, but once you have been convicted beyond a reasonable doubt of a crime, the judge is free to take into account your smug awfulness in deciding a sentence.

Jamie Dimon says stuff.

JPMorgan Chase & Co. had its annual investor day yesterday and CEO Jamie Dimon was in his usual form:

“Shareholder meetings . . . have become a complete waste of time, let’s call it what it is,” Mr Dimon said on Tuesday before a question-and-answer session with Wall Street analysts.

He added that the meetings had become “a joke . . . hijacked by people who have only political interests and don’t have any interest in the future health of the company”.

I do not think that anyone who has ever been to a shareholder meeting would disagree with that. If you have a financial interest in a company, going to the shareholder meeting is pretty much the least efficient way to communicate with management: You have to travel there, and there's a queue to ask questions, and if your question gives away your investment strategy then everyone else will know about it too. If you're a big shareholder, better -- and easier -- to just set up a private meeting with the CEO. If on the other hand you are a retiree with 10 shares, a lot of time on your hands, and a passion for a particular political issue, you might well want to travel to an annual meeting to ask the CEO about it. Annual meetings are for small shareholders with non-economic concerns; the professionals interact with managers elsewhere.

Still there is a tradition of lip service; CEOs are supposed to pretend that all shareholders are entitled to respect as co-owners of the company, and to treat all of their questions seriously. And now that tradition might be breaking down: The normal way to own stock really is through institutions, so CEOs feel justified in treating the institutions as the real shareholders and the direct retail investors as cranks.

Dimon also mused about seeking the same tax benefits for JPMorgan that Amazon.com Inc. will undoubtedly get for building its new headquarters, and "joked that he’d find out which state offered the second-best package to Amazon and move 50,000 people there to get that deal." Yes! Joked! If you work at JPMorgan you're definitely not going to have to move to Indianapolis for the tax benefits, don't even worry about it.

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This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

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.

To contact the author of this story: Matt Levine at mlevine51@bloomberg.net.

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