The Dow Drops a General
(Bloomberg Opinion) -- GE and the Dow.
The Dow Jones Industrial Average will remove General Electric Co. next Tuesday after a run of underperformance. At the Financial Times, John Authers explains why you shouldn’t care about the Dow, but you are sophisticated and didn’t care about the Dow, so I will not repeat his arguments here. I will only mention his headline, which is “General Electric managed to outlast a cull of great names.” He means Westinghouse, Bethlehem Steel and Woolworth, which all left the Dow on the same day in 1997, “in a cull of great names from US industrial history that had ceased to be of any relevance.”
But there is a broader and more literal point, which is that the early Dow had some great names. When General Electric was part of the first Dow Jones Industrial Average in 1896, its fellow members included American Cotton Oil Co., American Sugar Refining Co., American Tobacco Company, Distilling & Cattle Feeding Co., National Lead Co., North American Company (North American what Company?), United States Leather Co. and United States Rubber Co. They are fun to say. It is all so American and National and United States, so leaden and rubbery, so industrial. GE left the Dow for a bit in 1898, but when it returned in 1907 it joined a similarly terrific set of names including Amalgamated Copper Mining Co. I have long thought that “Amalgamated” is the single best corporate word.
GE will be replaced by Walgreens Boots Alliance Inc., which is … well actually it’s an okay name, by those standards? “Walgreens” I don’t love, but “Boots Alliance” feels almost like it could be a 1907 Dow component. If it made boots I mean. “Allied Boots” would be better. But the rest of the Dow, I don’t know man. Apple, Goldman Sachs Group, Microsoft. These are not particularly old-timey industrial names, as names. United Technologies Corp. is pretty great. American Express Co., fine. But there are fewer bold claims to being the National or General or Consolidated or Amalgamated Whatever, and more confessions to being Micro, or Soft.
Here is my Bloomberg Opinion colleague Brooke Sutherland arguing that the Dow drop is an opportunity for GE Chief Executive Officer John Flannery to radically rethink, and possibly break up, GE:
In a way, that should be kind of freeing for Flannery as he contemplates GE's future and the appropriate structure for its myriad businesses. I've wondered before whether he might be held back by GE's historical identity and the inherent difficulties of reshaping an institution that molded him over a more than 30-year career. I don't think it's a good thing that GE was dropped from the Dow, but it’s one less shackle to the past that might discourage Flannery from undertaking a complete top-to-down rethinking of its identity.
You can make that argument just from the names. If you’re an 1896 Dow component in a 2018 world, there is still a temptation to be … General. National. United States. North American. Amalgamated even. You are part of a grand old-timey tradition of representing the whole stock market, the whole economy, of being a champion and a bellwether rather than a maximizer of shareholder returns. If you cut that link to the past, though, it’s fine to be Specific Electric.
Bank of America Merrill Lynch had a habit, for a while, of lying to customers about how it bought stock for them. The customers would see, say, 500 shares of XYZ stock on the market at $10.00 bid/$10.01 offered, and they’d put in an order with Merrill to buy 100 shares at the market price, and Merrill would say “here are your 100 shares at $10.01.” So far so good. But the way Merrill would fill those orders was by going to some “electronic liquidity provider”—a high-frequency trading firm like Citadel Securities, D.E. Shaw, Two Sigma Securities, Knight Capital, etc.—and seeing if they wanted to sell the stock. And then, instead of telling customers that Citadel or whoever had sold them their stock, it told them that Merrill had sold them the stock: The trade reports that customers got back had a code indicating that the trade had been executed internally at Merrill instead of being routed to an electronic liquidity provider. (Merrill would change the trade reports to obscure what happened, so this practice is referred to as “masking.”)
We talked about all of this back in March, when Merrill Lynch settled with New York Attorney General Eric Schneiderman and agreed to pay $42 million for masking. It is back in the news this week because yesterday Merrill Lynch settled with the Securities and Exchange Commission, for doing the same stuff, also for $42 million. The SEC describes Merrill’s rationale for doing the masking:
When implementing masking, a Merrill Lynch employee stated that the “[g]oal is to increase the volume sent to these trading partners.” Masking offered a way for Merrill Lynch to increase its order flow to ELPs without informing customers, including those who had specifically expressed concerns about ELPs. When orders were executed by ELPs, Merrill Lynch avoided the access fees typically charged by exchanges while receiving commissions from customers. In addition, listing ELP executions as having occurred at Merrill Lynch gave the misleading impression that Merrill Lynch was a more active trading center than it actually was.
There is not much new in the SEC case; the lesson is pretty much that if you’re a bank in 2018 and do bad stuff (or get caught in 2018 for doing bad stuff in 2008-2013, really) then you will have to pay the same fine multiple times. But I do want to discuss one thing from the SEC order, about why the masking was bad:
As a result of Merrill Lynch’s masking practice, Merrill Lynch’s customers did not know that (1) some of their orders were executed at ELPs; and (2) other orders were exposed to ELPs before being executed at other venues. This information was material. These customers wanted to know, and expected Merrill Lynch to inform them, if Merrill Lynch sent their orders to ELPs. Certain customers used the execution venue information provided by Merrill Lynch to assess its performance and make strategic choices about their broker-dealer relationships and tactical routing decisions. Certain customers were concerned that orders routed to ELPs could be subject to information leakage.
“This information was material.” Merrill Lynch defrauded its customers, not only because it lied to them about how it executed their orders, but also because those lies were material: The customers would have cared if they had known the truth. “‘Institutional traders often make careful choices about how and where their orders are sent out of a concern for information leakage,’ said Joseph Sansone, Chief of the Enforcement Division’s Market Abuse Unit,” in announcing the action.
We have talked from time to time recently about banks that lied to their customers about the prices they paid for residential mortgage-backed securities. It seems—though the law is unclear and this is certainly not legal advice—that if you are a mortgage-bond investor, and you ask a bank’s trader “how much did you pay for this bond,” and she says “80,” and in fact she paid 70, and she sells it to you for 81, then her lie might not count as fraud, because it might not be material. (It is not best practices, and the SEC would certainly say it is fraud, but it is debatable.) Meanwhile in the stock market, if you send an order to buy a stock trading at $10.00 bid / $10.01 offered, and Merrill Lynch fills it immediately at the $10.01 offer, but tells you that you got filled out of Merrill’s inventory and you really got filled out of Two Sigma’s inventory, then that is material. (Says the SEC.) It seems—in some generic sense—less material. The bond trader lied to you about the market price of the bond. Merrill never lied to you about the price or characteristics of the security; it just lied about which counterparty saw your order in which microsecond time division, before it was filled at the exact market price. And yet Merrill’s lies might be legally material while the bond trader’s might not be.
This is not just a regulatory quirk; it is totally real. If you ask institutional equities investors if they care whether the fourth venue on their routing list sees their order a microsecond before the third firm, steam will come out of their ears as they hop up and down and scream “OF COURSE WE CARE, IT IS THE MOST IMPORTANT THING IN THE WORLD.” (I mean, if you ask the traders. The portfolio managers will have no idea what you are talking about.) If you ask institutional RMBS investors if they put any stock in bank traders’ claims about what they paid for bonds, they’ll be like “nah, man, they are all lying about everything, we never believe them.” (A few will disagree, and they tended to testify against the lying traders in their criminal cases.)
In securities law, something is “material” if it “would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.” It is a slippery standard. Nothing is objectively material or significant. There are only market customs and norms and expectations. In equity markets, price is a given—you can see it on your screens in real time—and customers want precision to the microsecond about exactly who sees what order when. In (some) bond markets, price is a mystery and nobody expects any information about anything.
The Ross hypothetical.
We talked yesterday about reports—which he has denied—that Commerce Secretary Wilbur Ross shorted the stock of a company after reporters called him up to ask him about it; when their story about the company’s allegedly shady activities and ties to Ross came out, the stock dropped and Ross (the story goes) made a profit. Again, it seems according to Ross that it didn’t go down like that, but the point is that as an insider-trading hypothetical it is fun: If that was the story, would it be legal?
I wrote yesterday that “I think the answer is sure, why not,” and I stand by that, but I got into a Twitter discussion with some law professors about it, and you might want to check it out if you enjoy a good insider-trading hypothetical. My view is that “You have no inside information about the company, no nonpublic information at all other than the fact that a reporter is working on a story — and you have no duty to the reporter to keep that confidential,” so you didn’t misappropriate any material nonpublic information and are free to trade. (We have shifted here from Ross to the hypothetical “you.”)
But John Coates at Harvard argues that you got material nonpublic information (from the reporter, about the pending story), and that you owe a duty not to the reporter but to the U.S. (as an officer of the government) not to use it for your personal benefit. On this theory, you only got a call about the pending story—and the story was only written—because you were a high officer of the government; it is information that you got because of your position, and so by principles of agency law you can’t use it for private gain. I still think this is wrong, but I can’t prove that; it’s just a vibe I have about how insider-trading law works. Roughly, I do not think that the misappropriation theory of insider trading fully incorporates agency concepts, but is instead aimed at a narrower sort of “misappropriation” that disadvantages the owner of the information. (An insider trading treatise appears to be on my side on that, though that also seems to be vibe-based rather than solid.) I also think that it matters that the reporter called you about your personal stock holdings; it is harder to see how that information “belongs,” in any sense, to the government.
But if you agree with Coates that it’s insider trading, then I have more hypotheticals for you!
- What if you’re not an agent? What if you are nominated to be commerce secretary, and before you are confirmed you get a call from a reporter about your position in a creepy company and you short that company? You didn’t get the information in the course of your employment for the federal government—though you clearly got it because of that pending employment—so can you trade?
- Does it apply in the private sector? If Mark Zuckerberg personally owned some stock in a creepy public company, and a reporter called him up to ask him about it and he dumped the stock, would that be insider trading? Because he had a duty to Facebook not to trade on the information? Because the reporter wouldn’t have called him if he wasn’t the chief executive officer of Facebook? And so his personal stock trading—at least as long as a reporter is interested in it—becomes the property of Facebook, just as Ross’s apparently became the property of the U.S. government? This seems highly unlikely to me, but again that is vibe-based rather than solidly grounded in written law.
The point is, insider trading law is weird. The other point is, nothing here is ever legal advice.
Here is some financial engineering for you: SoftBank Group Corp. is apparently having trouble raising the last $7 billion of its $100 billion Vision Fund, and so it is turning to its employees for the money. Sort of:
To plug the hole, SoftBank is drawing up plans for what amounts to an employee incentive scheme, or partners pool, for current and future staff at the Japanese company, accounting for $5bn of the remaining $7bn it needed to raise.
If approved, it will require employees to contribute a small amount of funding to a newly created facility while SoftBank will provide the bulk of it in the form of a loan to the employees, these people said. SoftBank has been in touch with Japanese banks to arrange the lending for the vehicle.
There is a lot going on here, but I guess I will start with: Is the loan recourse? Like, if SoftBank lends its employees $5 billion, and then invests that money in dodgy unicorns at inflated valuations and loses all of it, is it going to go to the employees and say “sorry, now we’re taking your house”? Surely not.
It seems like SoftBank is effectively pre-funding an employee incentive program with Vision Fund stakes: If you work at SoftBank, your bonus for the next few years might come in the form of a collection of pricey unicorn stakes. (And instead of paying you cash, SoftBank would just use the money to pay down the loan?) I guess that is … fine? It aligns SoftBank’s incentives with the fund’s, etc. “What is much less common is for executives to agree to commit to ‘skin in the game’ at such a late stage of a fundraising,” says funds lawyer Jason Glover; ideally you want your employees to be investing in the fund because they want to, not because no one else will.
I think we have talked before about a general rule of Ponzi scheming, which is that if you run a Ponzi scheme and use some of the proceeds to buy yourself blingy luxury goods, the Securities and Exchange Commission is going to mention them prominently in its case against you. “The defendant misappropriated client money to pay for personal expenses” doesn’t have quite the same effect on a jury as “The defendant misappropriated client money to buy a Lamborghini and 15 bottles of Cristal at the club.” I am not saying this is a bad thing. Maybe it’s what you want. Maybe it is a rational calculation for you to say “well, if I don’t get caught, I’ll have a Lamborghini, and if I do get caught, at least everyone will know I had a Lamborghini.” But I have to think that increases your chances of being caught, and charged, and found liable.
A corollary is that if you run a Ponzi scheme and use the proceeds to commission a song about how you buy yourself blingy luxury goods, the SEC is going to quote the song:
As an example of Defendants' use of stolen investor funds, Santillo uses that stolen money to fund a jet-setting lifestyle, including paying for housing in multiple states, car leases, expenditures at a country club and a Las Vegas resort and casino, credit card payments, and other personal expenses. At the same time he was misappropriating investor funds, Santillo threw himself a party at a nightclub in Las Vegas for which he commissioned a song about himself to be played. The lyrics to that song refer to (Perry) Santillo as "King Perry" and describe his typical attire: "ten-thousand-dollar suit everywhere he rides." The song also depicts his lifestyle as follows: "pop the champagne in L.A., New York to Florida; buy another bottle just to spray it all over ya."
“Depicts his lifestyle as follows” is the sort of madly gorgeous prose style I have come to expect from SEC enforcement actions; good job everyone. Anyway the actual case is pretty standard, in the standard horrifying way; the defendants were charged with running a $102 million Ponzi scheme whose 600 alleged victims included an 80-year-old man suffering from dementia. Also one of the companies involved was named First Nationle Solution LLC. That is really not much of an effort at spelling words.
Cryptocurrency prices fell after a big South Korean crypto exchange was hacked.
Cryptocurrencies dropped after the second South Korean exchange in as many weeks said it was hacked, renewing concerns about the safety of digital-asset trading venues.
It’s a little specific, but do you think we can make this a recurring Money Stuff section? Obviously there are only so many South Korean crypto exchanges, but there’s no rule that says they can’t each be hacked repeatedly.
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