#MeToo Is a Due Diligence Issue Now

(Bloomberg Opinion) -- The Weinstein clause.

Advisers are adding guarantees to certain merger agreements in light of the sexual misconduct scandals that have enveloped the producer Harvey Weinstein and other high-profile businessmen -- ones that legally vouch for the behavior of a company’s leadership.

The development is a concrete example of how business is trying to adapt to the #MeToo era, at least in terms of legal liability. … In some cases, buyers have even negotiated the right to claw back some of the money they paid if subsequent revelations of inappropriate behavior damage the business.

The clawbacks are in some private-company acquisitions, but the representation appears even in big public-company deals. “At least seven deals announced this year involving public companies include such representations,” with Brookfield Asset Management’s deal to buy Forest City Realty Trust Inc. this week being the latest. Here’s the Brookfield/Forest City merger agreement; the Weinstein rep is Section 5.8(n): “To the Knowledge of the Company, in the last five (5) years, no allegations of sexual harassment have been made to the Company against any individual in his or her capacity as an employee of the Company … at a level of Senior Vice President or above.” You can find it easily by searching the document for the word “sexual,” which is otherwise quite rare in merger agreements.

One thing that you learn as a mergers-and-acquisitions lawyer is that a representation saying “we don’t have any sexual harassment” is not necessarily in the merger agreement because it’s true, or even because the acquirers want to claw back money if it turns out to be false. The point of a representation is to force disclosure. The representations and warranties in a merger agreement are preceded by a preamble saying “Except as disclosed … in the Disclosure Schedule …, the Company hereby represents and warrants,” etc. And along with the merger agreement, the parties also negotiate a disclosure schedule that lists all the exceptions to the reps and warranties. Section 5.8(n) of the disclosure schedule will list all the allegations of sexual harassment against SVPs and above that the company is aware of. If there are none, it will say “none.” 

So the Weinstein rep—also apparently called “the #MeToo rep”—is mainly a tool of due diligence. The acquirer’s lawyer writes it into the merger agreement, and the target either (1) tries to strike it out (pretty suspicious!), (2) makes the rep with no exceptions (super!), or (3) makes the rep but includes the exceptions in the disclosure schedule. Approach (3) is pretty common, for most reps and warranties. Disclosure schedules tend to be much longer than the merger agreement. But the acquirer gets to read them, before signing the merger agreement. It can evaluate the disclosures, ask for more information about any particular cases, and decide whether any of them are so serious that it should walk away from the deal or reduce the price or demand other changes to manage the risk. The acquirer knows what it’s getting into.

And that is the important attitudinal shift here, which is that acquirers want to know what they’re getting into as far as sexual harassment goes. This is now an important question in M&A. More than that, though, it is an institutionalized question. It is not the sort of thing that the acquirer CEO whispers informally to the target CEO when they make their handshake deal, “hey you don’t have any sex monsters there do you?” It’s not the sort of thing that only comes up when the acquirer has heard rumors. Rather, it’s the sort of thing that the acquirer’s law-firm associate puts into the draft merger agreement as (new) standard procedure, and that the target’s law-firm associate asks the target’s assistant general counsel about, and that the target’s assistant general counsel goes and collects information from human resources about, and that they put into the due-diligence online data room and write in the disclosure schedule, and that the acquirer’s advisers and internal human-resources due diligence teams examine, and that they try to quantify as a risk, and that perhaps affects the acquirer’s willingness to do the deal or the price it is willing to pay. Sexual-harassment diligence is on its way to becoming a routine part of M&A due diligence.

(This process is pretty irreversible, by the way. Every merger agreement contains a rep saying that the target isn’t violating any environmental laws, which became important when big industrial companies started facing massive liabilities for polluting, but which is now in the agreement even if the target is a software company that has never polluted on any grander scale than spilling a Diet Coke. It’s just pretty much costless for the buyer’s law firm to throw in all the standard reps, and awkward for the target to push back: If you refuse to give the environmental rep, does that mean that you are secretly polluting? So things are added to the list of M&A representations, but once they are well-established they rarely get taken off. Even if, in the distant future, sexual harassment becomes rare and fades from the public consciousness, it might still be in merger agreements, because why take chances?) 

One other thing about disclosure schedules is that, despite the name, they are not disclosed. I mean they are disclosed to the acquirer—that’s the point—but they are not made public. Forest City—and I do not mean to pick on them, they are just the most recent company to file a merger agreement with a Weinstein rep—filed its merger agreement with the Securities and Exchange Commission as an exhibit to its Form 8-K announcing the deal. It did not file the disclosure schedule. In fact, the 8-K contains a standard boilerplate warning—it goes by the delightful jargon name “Titan disclaimer”—to investors not to take the representations and warranties in the merger agreement as true:

The representations, warranties and covenants of each of the Company, Parent and Merger Sub contained in the Merger Agreement have been made solely for the benefit of the parties to the Merger Agreement. In addition, such representations, warranties and covenants (i) have been made only for purposes of the Merger Agreement, (ii) have been qualified by confidential disclosures made by the Company in connection with the Merger Agreement, (iii) are subject to materiality qualifications contained in the Merger Agreement which may differ from what may be viewed as material by investors, (iv) were made only as of the date of the Merger Agreement or such other date as is specified in the Merger Agreement, and (v) have been included in the Merger Agreement for the purpose of allocating risk between the contracting parties rather than establishing matters as facts. Accordingly, the Merger Agreement is included with this filing only to provide investors with information regarding the terms of the Merger Agreement, and not to provide investors with any other factual information regarding the parties or their respective businesses. Investors should not rely on the representations, warranties and covenants or any descriptions thereof as characterizations of the actual state of facts or condition of the parties or any of their respective subsidiaries or affiliates.

Intuitively, if you see a company sign a merger agreement saying that it is not aware of any allegations of sexual harassment against its senior executives, you might assume  that it is not aware of any allegations of sexual harassment against its senior executives. But that assumption would be unfounded. All it really means is that, if it is aware of any allegations of sexual harassment against its senior executives, the buyer is too.

Incidentally here’s the underwriting agreement for the initial public offering of Sonos Inc., which priced last night. No Weinstein rep. That is perhaps an indication that IPO due diligence is not as focused on sexual harassment as M&A due diligence is, but I wonder if that will change. 

How much should an index fund cost?

You could imagine index funds being free to investors because they are free to providers. The theory would go something like this:

  1. The cost of providing an index fund is very low. You don’t need any fancy stock pickers or even fancy algorithms; you just need a list of all the stocks. If you write that list yourself, rather than licensing it from a famous index provider, it’s cheap to do. You have to have a way to take money from investors and keep track of it and send them statements and so forth, but technology keeps making that cheaper, particularly if you are a huge fund company with lots of other, higher-fee funds.
  2. There are little incremental profit opportunities in running an index fund. You can lend out the fund’s stock to short sellers, and share some of the fees paid by the short sellers with the fund, while keeping some for yourself.
  3. If you can balance the profits in 2 with the costs in 1, the fund can be, on certain accounting assumptions (about how you split costs with your other funds, and about how you attribute profits from stock lending), free.

But Fidelity Investments announced yesterday that it will offer some free index funds, and that does not quite seem to be the reasoning:

Fidelity unveiled two new index funds Wednesday to individual investors with a zero expense ratio, a move that roiled fellow asset managers. Fidelity may use the funds, as well as the other index products it reduced prices on, to attract investors to more profitable businesses such as financial advice and higher-priced active vehicles.

“For a number of companies, not just Fidelity, these passive assets are a loss leader,” said Kevin McDevitt, an analyst at Morningstar Inc. “It is a way of bringing in assets and selling other services, especially financial advice.”

That is, Fidelity is not really an index-fund company that needs to make money from index funds. Instead, it is a full-service financial company that needs to make money from providing financial services, and free index funds are plausibly a way to get more money to provide financial services to. The other services can subsidize the free index funds, and the free index funds can be good advertising for the other services. “Fido is going to hope you diversify with other higher fee funds or work with one of their high fee advisors,” tweeted Cullen Roche. “I don’t know if it will move the needle to shift assets to its index funds, but Fidelity can afford the race to zero on the commoditized businesses because that’s a smaller percentage of their overall revenue,” says “Jim Lowell, editor of Fidelity Investor, an independent newsletter.”

How much should an FX trade cost?

As a former derivatives marketer, here is how I think about the opaque pricing of derivatives:

  1. Some clients are very smart and mean, and will negotiate your profits on a trade down to zero, maybe worse.
  2. You can’t not do trades with them, because they are big and important and you need to be in the market and so forth.
  3. Other clients are not very smart, or are nice, or both, and will do trades with you at whatever price you propose.
  4. You have to make a huge profit off of them, to make up for the smart mean ones.

This is in many ways a bad dynamic! It is bad for you: You gouge the clients you like to make up for your losses from giving favorable terms to the clients you hate. You’d much rather do the reverse, and gouge the ones you hate, but you can’t. It’s also bad for the clients, or at least for the dumb nice ones, who pay giant multiples of what the smart mean ones pay, and then, if they eventually find out about that, feel understandably aggrieved, and call up their salesperson and say “but I was so nice to you,” and also maybe sue.

One other thing is that, if you are not a particularly smart client—but you’re smart enough—you can pretty much opt out of this whole system. Just call up three dealers, say “I am bidding out this derivative,” and ask for their bid. You’ll get the smart-client price! Better to give you the smart-client price than to lose you to another dealer, the dealers will think. The difference between smart clients and dumb ones is much less “the smart ones understand every last nuance of how to price derivatives” and much more “the smart ones ruthlessly bid out everything while the dumb ones are content to have a close and exclusive relationship with the friendly bank that brought them the trade.”

Again this dynamic is sort of terrible! In a perfect world you’d want clients and banks to develop relationships, to know and trust each other, to build mutually beneficial sequences of repeated interactions rather than just trying to gouge each other in atomistic arm’s-length trades. But the incentives run the other way.

Anyway here’s a European Systemic Risk Board working paper on “Discriminatory pricing of over-the-counter derivatives”:

New regulatory data reveal extensive discriminatory pricing in the foreign exchange derivatives market, in which dealer-banks and their non-financial clients trade over-the-counter. After controlling for contract characteristics, dealer fixed effects, and market conditions, we find that the client at the 75th percentile of the spread distribution pays an average of 30 pips over the market mid-price, compared to competitive spreads of less than 2.5 pips paid by the bottom 25% of clients. Higher spreads are paid by less sophisticated clients. However, trades on multi-dealer request-for-quote platforms exhibit competitive spreads regardless of client sophistication, thereby eliminating discriminatory pricing.

If you are an unsophisticated customer, you will pay 12 times as much as a sophisticated customer. That sounds about right. Probably the fair price—the price at which the dealer makes a reasonable living—is, like, a bit more than what the sophisticated customer pays. The sophisticated customer gouges the dealer a little bit, and the dealer makes up for it by gouging the unsophisticated customer a lot. If you go do your trades on the competitive platform, though, you are automatically, structurally sophisticated. That is basically what being sophisticated means. And then you get the good price.

What’s Guy Gentile up to?

The last time former pump-and-dump promoter and FBI informant Guy Gentile appeared in these pages it was because he had been photographed in front of a tow truck pulling his Mercedes out of his pool, where his ex-girlfriend had put it, as one does. It seems unlikely he will ever top that, and he hasn’t yet, but here’s a story about how he is back in the micro-cap stock-trading game: His brokerage firm announced stakes in three tiny companies, including $13 million waste-management firm Avalon Holdings Corp., whose prices all “skyrocketed and then dropped.” The fun part is Gentile’s explanation:

“This is no pump-and-dump scheme,” Gentile, chief executive officer of MintBroker, said over the phone. “We were going to try to do a hostile takeover of the company.”

Ah. But here’s what Avalon said:

In response to inquiries regarding a potential change in control, Mr. Ronald Klingle, Chairman and Chief Executive Officer of the Company, holds approximately 67% of the voting power in Avalon, and has advised the Company that he has no present plans to divest any of his holdings.

What … happened here? Did Gentile not know that the company’s stock was controlled by its CEO? (It’s easy to find out!) Did he know that but think that he could do a hostile takeover anyway? (By, like, calling up the CEO and being real hostile on the phone until he agreed to sell?) Was it a pump-and-dump scheme, but Gentile was too lazy to make up a plausible cover story? 

People are worried about stock buybacks.

This one is big again now for some reason. Here is a comprehensive summary of the worries, this time from Emily Stewart at Vox.

Things happen.

Barclays ‘Running Free’ as CEO Staley Lauds Surge in Trading. Wells Fargo to Pay $2.09 Billion to Settle U.S. Mortgage Probe. Tesla Slows Cash Burn as Musk's Model 3 Production Picks Up. Regulators Probe Major Clearinghouse of Options Market. Tech Firms Surrender Their Crucial Billion-Dollar Tax Deductions. Index Quirk Helps Vanguard Fund Dodge Facebook Fall. Carl Icahn Has Sizable Stake in Cigna, Plans to Vote Against Express Scripts Deal. MoviePass Repays $6 Million Emergency Loan to Hudson Bay. The model, the medallions and David Boies. 'Uber For Poop' Aims To Break Up Senegal's Toilet Cartel. Computer-optimized floor plans.

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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