Sometimes the Documents Are Wrong

(Bloomberg Opinion) -- Oops!

In 2014, Ligand Pharmaceuticals Inc. issued $245 million worth of convertible bonds. The bonds pay 0.75 percent interest and are due in 2019, and each $1,000 bond can be converted into 13.3251 shares of Ligand stock, a conversion price of about $75.05 per share. Ligand’s stock closed yesterday at $215.37, so the bonds are very in-the-money, and if you bought them you did very well: Each $1,000 bond is convertible into about $2,870 worth of stock. Some of the bonds have been converted or redeemed, but the $223.2 million of bonds still outstanding are now convertible into about $640 million worth of stock 

There are some technicalities here that I am eliding. Technically the bonds are cash-settled. That just means that, instead of converting into $2,870 worth of stock, they convert into $2,870 of cash. Like, you take the conversion rate and multiply it by the stock price, and you give bondholders that much cash. And for reasons having to do with how the bonds are normally traded and hedged, you do that using volume-weighted average prices over a 50-day period. You can read the whole indenture for the bonds, but I highly advise against it and promise that you do not need to know the details for anything that follows.

All you need to know is that, because of those mechanics, the way the conversion formula works is not “number of bonds times 13.3251” but rather something more like “number of bonds times 13.3251, times the average stock price, divided by the average stock price.” (Times the average stock price again, to get the cash amount.) It sounds dumb when you say it like that, and I am simplifying a bit, but it has to do with how the cash-settlement and averaging mechanics work, and it makes sense in context. It is standard procedure in convertible bonds, and there are lots of convertible bonds with formulas just like that.

The other thing you need to know is that there is a typo—the polite term is a “scrivener’s error”—in the indenture for the bonds, where instead of saying “number of bonds times 13.3251, times the average stock price, divided by the average stock price,” it says “number of bonds times 13.3251, times the average stock price, divided by $20.” (This oversimplifies, and exaggerates slightly, but it is close enough for our purposes.) That means that the conversion rate effectively scales linearly with the stock price: The higher the stock price gets, the higher the conversion rate gets. There is no reason for this! This was not the plan! It’s just a bunch of very complicated verbal formulas buried in the back of a bond indenture, and someone messed one of them up.

With the stock price at $215.37, though, it makes a big difference. Like, if you divide a number by $20 instead of $215.37, the result is about 10 times bigger. (I am simplifying the formula, though, and really the difference is more like 6 or 7 times.) Ligand eventually noticed the mistake and corrected it in a supplemental indenture this year, but some holders of the bonds, quite understandably, would prefer to receive the much, much, much larger amount of money called for under the original terms of the indenture. So they sued Ligand in Delaware Chancery Court last Friday, claiming that the bonds should pay out, not $640ish million, but $3.9 billion:

Based on the terms of the Indenture, if Plaintiffs were to convert all of 6 their Convertible Notes, utilizing the stock price for the fifty trading day period prior to the filing of this complaint, Plaintiffs would be owed approximately $3,877,011,480.00 in the aggregate.

“The Company believes the allegations are completely without merit, rejects all claims raised by the plaintiffs and intends to vigorously defend this matter,” responds Ligand.

Ligand is, I must say, totally right. When the notes were originally issued, investors got an offering memo that contained a “description of the notes” that set out the terms of the notes. The description of the notes, apparently, described the formula correctly. (The notes were sold in a private placement and the offering memo is not public, but no one seems to dispute this.) Then when the bonds were finalized, the lawyers prepared an indenture with the official terms of the notes. The indenture got the formula wrong. But it also says (section 9.01(b)) that Ligand can amend it without the consent of bondholders to “conform the terms of this Indenture or the Notes to the ‘Description of the Notes’ section of the Offering Memorandum.” That’s what it is doing, so it can do it.

The suing bondholders make a lot of noise about the fact that the indenture, not the offering memo, is the legal document that controls the terms of the notes, which is true, but doesn’t matter, since the indenture specifically says it can be amended to conform to the description of the notes.

The bondholders also say that “the Indenture governs the relationship between Ligand and the holders of the Convertible Notes (the ‘Holders’) and represents the final and complete agreement between the parties concerning the subject matter thereof,” and that “Plaintiffs relied on the clear and unambiguous language of the Indenture to determine the terms and conditions under which they could convert their Convertible Notes and to establish what they would receive from Ligand upon conversion,” which seems less true. For one thing, it’s not like the bondholders agreed to the indenture: They bought the bonds based on the offering memo, not the indenture, and the indenture wasn’t finalized until August 18, 2014, six days after they put in their orders and the bond offering was priced.

For another thing, the bondholders are real grown-up convertible-bond funds (Calamos! Citadel! Wolverine!), and they know very well that convertible bonds don’t work that way. They have a fixed conversion rate, not one that goes up as the stock price goes up. The Ligand 2019 convertible bonds don’t trade that often, but when they do it has been at prices in the ballpark of $2,000 to $3,000 per $1,000 bond—not the $17,000 or so implied by the lawsuit’s formula. Nobody really thinks these $223 million of bonds are supposed to convert into $3.9 billion.

It’s just that, if you find a $3.2 billion typo in a bond document, it’s hard not to sue over it! I mean, people often resist the temptation. I once put a $25 million typo in a merger document, and the other side made fun of me for a bit and then agreed to change it. It is the sporting thing to do. But when the dollar value of the typo is big enough, and when you manage money as a fiduciary for investors, it can be hard to be sporting. You almost have to try a lawsuit, just to see what will happen. I have oversimplified everything massively in this description, and the actual documents are stuffed with convoluted verbal formulas, and a Delaware judge is unlikely to be intimately familiar with the normal workings of convertible bonds or to find any of these formulas intuitive. You might just convince him that actually people thought these bonds were supposed to work the weird dumb way, and that you should get the extra $3.2 billion. Even if the odds of that happening are one percent, it is still probably worth a shot.

Anyway the point of this story is, if you are the law-firm associate who slapped together this indenture at 2 a.m. with no supervision, secure in the knowledge that no one ever reads the indenture, and who now might have cost your client $3.2 billion, please email me, I would love to buy you a drink.

Market structure.

A brief potted history of U.S. equity market structure is that once upon a time stocks were traded by human beings on the floor of the stock exchange, and the humans yelled and gestured and wore funny jackets and ate cheeseburgers at unreasonable times of the morning and charged large fixed commissions, but at least you could see what they were up to. Then the humans were in large part replaced by high-frequency trading algorithms, which charge much less and work much faster, but which people worry are less reliable than the human floor traders, less likely to be there in a crisis, less likely to use human judgment to make markets stable. People also worry that the algorithms are doing unseen nefarious things, that high-frequency trading firms are paying kickbacks to brokers and dark pools to obtain their order flow, or paying kickbacks to exchanges to get their orders to the exchange faster than everyone else, or gaming exchange rules to get kickbacks for themselves. All of these kickbacks, the worry goes, are fractions of a penny per share, but on huge volumes they add up into potentially vast transfers of value from investors. And meanwhile a few humans hang around the exchange, as vestiges and television extras and people to interview if you want a quote about how the machines are ruining markets. 

Meanwhile here is a New York Stock Exchange regulatory action accusing a human floor broker of corruptly routing millions of dollars of stock orders in exchange for—and I cannot tell you how ashamed I am to have to type this—in exchange for $10 Venmo payments. I mean look at this, this is horrible:

Starting in March 2017, and continuing until at least early February 2018, the BD Employee made numerous payments totaling approximately $2,000 to Lodewick via Venmo, a mobile phone cash transfer application. The payments ranged in size from $10 to $125, and occurred as frequently as four times per day. For example, on January 24, 2018, the BD Employee sent Lodewick four Venmo payments throughout the trading day as more orders came from Lodewick. Lodewick routed almost $500,000 of securities to the BD Employee on that day.

The BD Employee made numerous payments to Lodewick for Lodewick’s order flow and Lodewick’s introductions to other potential clients. …

Lodewick also affirmatively solicited payments from the BD Employee in return for order flow. For example, Lodewick on multiple occasions called the BD Employee before the market open telling the BD Employee to get his Venmo ready because it was going to be a big day.

Can you imagine? Like, there you are at the New York Stock Exchange, the center of the financial world, the great temple of capitalism, and you enter into a nefarious scheme to enrich yourself by routing orders to your buddy’s firm in exchange for kickbacks, and the kickbacks are Venmo payments ranging from $10 to $125? Come on! Come on! Have some pride! If this stuff is true then they should be banned from the securities industry for life just for being pikers, and every floor trader on the NYSE should resign out of embarrassment at being in the same room with these guys. Ten dollars! Every dumb insider trading case that I’ve ever written about here has involved more than $2,000. These guys work on the floor of the New York Stock Exchange! How low it has fallen.

By the way, the Wall Street Journal reports that this might all just be a misunderstanding:

One person familiar with Messrs. Lodewick and Wilezol said NYSE Regulation was inflating the importance of the Venmo payments, which he characterized as two friends reimbursing each other for expenses incurred while partying. “They’re young guys. They go out three nights a week,” this person said.

That had better be the explanation. I mean, don’t get me wrong, calling your high-finance buddy in the morning to be like “get your Venmo ready” (what does that mean?) “because we are going to have two, maybe three beers after work and I will need you to reimburse me $20”: That is terrible, and even if that is the explanation they still ought to be banned from the securities industry for it. But “get your Venmo ready because we are going to misroute millions of dollars of stock orders and I will need you to pay me $20 for it” is too horrific to think about.

Who owns the relationship?

An obvious fact of the investment banking business is that your client is the corporation, but your client relationship runs through individuals. You don’t have dinner with the corporation, you don’t play golf with the corporation, you don’t ask how the corporation’s child is enjoying Vassar. The way you win business from the corporation is by charming the chief executive officer and the rest of the management team, who are humans. There is the constant possibility of principal-agent problems, which are the source of much of the drama and scandal in investment banking. It can be hard to keep straight what’s okay (buying the CEO dinner, asking about his kids) from what’s not okay (handing him sacks of cash, giving his kids jobs in a too-obviously bribe-y way.)

Anyway though this runs in reverse too: The engagement letter is signed by the investment bank, but the client relationship runs through individual bankers. And if those bankers quit it is awkward:

Bankers switch firms routinely and often have existing deals ongoing when they depart. Those mandates are governed by contracts called engagement letters that set out fees and obligations. These letters typically state that the mandate is explicitly with the bank with no “key man” provision allowing for escape if the team leader leaves.

However, should a banker jump ship there can be a negotiation to keep him or her involved in order not to disrupt the transaction. 

I was such a bad banker; I feel like if I quit in the middle of a hairy deal I would take particular pleasure in using my departure, and my gardening leave, to get out of that deal. Like what is the point of quitting if you’re going to keep working on the same deals? (I know, I know, the point is more money; I told you I was a bad banker.) Anyway that is from a Sujeet Indap story about how some restructuring bankers left Perella Weinberg Partners in such acrimonious fashion that the firm refused to let them keep working on their live deals, even when clients as big as Monsanto “pleaded” to keep them. That is … aggressive client service! The bankers who left got the last laugh though; the Monsanto deal they had been working on died, and they got the next one:

Germany’s Bayer eventually acquired Monsanto for $63bn. Monsanto paid a record-setting deal advisory fee of $165m, of which $45m went to Mr Kramer’s new firm, Ducera Partners, which is stocked with his PWP colleagues.

People are worried about stock buybacks.

Here is the standard article, this time from Annie Lowrey at the Atlantic:

Stock buybacks are eating the world. The once-illegal practice of companies purchasing their own shares is pulling money away from employee compensation, research and development, and other corporate priorities—with potentially sweeping effects on business dynamism, income and wealth inequality, working-class economic stagnation, and the country’s growth rate. 

The proposed solution is to replace stock buybacks with dividends. People are really into that solution for some reason. Stock buybacks, the story goes, waste money by giving it back to shareholders instead of investing it in research and development or employee compensation or whatever. And so the solution is to ban buybacks and encourage dividends, which also give money back to shareholders. It just seems weird. Like if the problem is corporations giving money back to shareholders, why not ban dividends too? Why not have the rule be that once shareholders invest money in a corporation, the corporation can never give it back to them? Wouldn’t that be better for business dynamism? I am going to leave these questions as exercises for the reader but if you think you have the answers please do not email them to me, I’m good, thanks.

Things happen.

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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 Opinion columnist covering finance. 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 3rd Circuit.

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