Money Stuff: It Doesn’t Pay to Be Too Ethical

Money Stuff

Everything is securities fraud

You know the theory. If a public company does a bad thing, it is also securities fraud. The company didn't disclose the bad thing when it was doing it—it didn't put out a press release saying "our CEO is going to do some sexual harassment this afternoon," etc.—and, when the bad thing was revealed, the stock went down. Shareholders can say: You didn't tell us about the bad thing, we bought stock in ignorance, you deceived us, it is fraud.

I stress that this is not an exactly correct statement of U.S. securities law, and in fact sometimes the shareholders who bring these cases lose. When I write about it, lawyers sometimes email me to say, no, this is not how the law works, companies don't actually have to disclose everything bad that happens. You are not allowed to lie, in your securities filings, and if you do say things you can't "omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading," but there is no general affirmative obligation to disclose everything, or even every bad material thing. If your CEO is a sexual harasser, there is not an item in Form 8-K specifically requiring disclosure. You can just keep quiet.

Can you, though? Here's a memo on "Codes of Ethics and Securities Litigation" from Davis Polk & Wardwell LLP[1]:

In the years since Congress enacted the Sarbanes-Oxley Act in 2002, many companies have adopted codes of ethics or codes of conduct and made them public. … Listed companies are required to adopt and disclose codes of conduct pertaining to directors, officers and employees.

By adopting codes of ethics or codes of conduct and making them public, companies may unwittingly create a new target for class action lawyers seeking to assert claims under the federal securities laws. Although these documents are not necessarily written for a broader audience of investors, because they are widely available public statements, they have the potential to create exposure under federal securities laws if a company's stock price declines.

In fact, federal securities lawsuits targeting statements about corporate codes of ethics are now common in so-called "event-driven" cases—that is, securities litigations that accompany and arise out of otherwise unrelated legal and compliance issues. Examples include bribery and Foreign Corrupt Practices Act investigations and—more recently—investigations of sexual harassment that have accelerated as part of the #MeToo movement. Although circumstances vary by situation, complaints in this area typically allege that the company's ethics code falsely represented reporting or compliance standards, or that the company used its code of ethics misleadingly to tout the existence of an ethical culture while omitting to disclose allegedly widespread misconduct.

If you are a public company, you have to write and disclose a code of conduct saying how your executives are supposed to behave. Probably that code of conduct will say or imply, generally, that they are supposed to behave well. If they then behave poorly, shareholders will sue you, saying: "You lied to us; you told us that the executives had to behave well, but actually they behaved poorly."

It is not that compelling an argument, really, and Davis Polk notes that "historically, these claims rarely gained traction." But sometimes they do:

On March 26, 2020, Signet Jewelers agreed to settle a securities class action for $240 million. This lawsuit had alleged that statements in Signet's code of conduct and code of ethics—available publicly on its website and incorporated by reference in its annual reports—were false or misleading.

In the Signet Jewelers case, the court allowed claims to proceed based on statements that Signet made employment decisions "solely" on the basis of merit and that it had "confidential and anonymous mechanisms for reporting concerns." In reaching this decision, the court reasoned that these statements were actionable because they were "directly contravened by allegations in the [complaint]." The court pointed to detailed allegations—based on the record in a separate employment discrimination case—that Signet had conditioned employment decisions on female employees acceding to sexual demands and had retaliated against women who attempted to report the harassment. In a subsequent order, the court concluded that the statements in Signet's codes—in context—could not be disregarded as mere puffery: "Signet's codes of conduct and ethics . . . touted certain values and practices that constitute the exact opposite of what the company allegedly valued and practiced."

See, having a code of ethics is securities fraud, if your executives sometimes violate it. I should add that women who worked at Signet started suing the company for discrimination in 2008, there is a class action involving 70,000 of them, there was a New York Times Magazine story about it last year, and it still has not been resolved. The women who were harassed and underpaid have not been compensated; the shareholders, of course, have been.

Capital relief

Big banks often do what you could loosely call "capital relief trades."[2] The idea is, roughly, this. Banks are highly regulated, and they have capital requirements based on the risk of their assets. If a bank owns a lot of risky debt and trades a lot of risky derivatives, it has to have a lot of capital; if it owns only government-backed mortgages and Treasury bonds it can have less. Banks want to have less capital. There are complex regulatory rules specifying how risky different sorts of assets are and how much capital they require. Those rules will always be a little arbitrary at the margins, a little stale, a little out of line with market views. If you write down a rule saying "stocks are twice as risky as bonds," or whatever, by the time you publish the rule the risks will have changed and the market will be pricing stocks as 1.9x as risky as bonds.

Banks, in their natural business, take on a bunch of risks: They make loans and do trades for clients and end up with various exposures. They generally want to make economic decisions about those risks: If a risk seems worth taking they will take it, if it seems too risky they won't. But they are constrained to also make regulatory-capital decisions on those risks: If a risk seems worth taking economically (its expected value is sufficiently positive, etc.), but its capital charge is too high, the banks won't take it. There will be some risks that the regulations say are very bad and risky (they have high capital requirements), but that the market thinks are fine and worth taking (the market price to bear the risk is low).

This creates an opportunity for a trade. You've got a risk that is bad and expensive in a bank's hands (high capital charge), but fine and inexpensive in someone else's hands (low market price to insure against the risk). So the bank passes the risk on, by buying insurance against the risk from someone else. The someone else has to be big and creditworthy, an insurance company, say, or a big pension fund. If they are, and if you do it right, this reduces the bank's capital requirements. If a risk costs a bank $100 due to capital requirements, but the market price of insuring against it is only $50, then the bank can pay $60 to a pension fund for that insurance and everyone can come out ahead.

I mean! Everyone comes out ahead in expectation, if the market prices are right. On the other hand if the risks come true the pension fund feels pretty dumb. Sometimes, at least in hindsight, the market price of risk was wrong and the regulatory price was more accurate.

At Institutional Investor, Leanna Orr writes about AIMCo's volatility trades:

The Alberta Investment Management Corp. — which manages pension assets, sovereign wealth, and other public money — lost billions by protecting Wall Street banks against an extreme stock market crash, experts said.  

AIMCo killed its volatility-trading program in reaction to the blow-out, which has cost Albertans about C$2.1 billion, the organization's CEO said in a Thursday letter. …

AIMCo staffers built and ran the now-defunct volatility program, which involved highly complex trades and esoteric derivatives prone to misuse, experts said.

In one common trade — of so-called capped-uncapped variance swaps — Wall Street banks paid the Alberta fund to cover unlimited losses in the event of an extreme stock market crash. 

Many traders believed that they were effectively getting free money. Banks were paying to get risk off their books in order to pass stress tests regulators imposed after the last financial crisis. But, the thinking went, the insurance would never actually pay out, because such a dramatic crash had never happened.

In trader-speak, these kinds of deals are called "selling the small puts," and are often described as picking up pennies in front of a bulldozer.

"The capped-uncapped strategy is amateurish," said Gontran de Quillacq, a vol market veteran who consults for institutions and attorneys when funds blow up.

"Free money." The theory there is not just "we are writing insurance against risks that will never come true," it is "we are writing mispriced insurance against risks that will never come true because it is demanded by regulation." The theory is that the banks buying insurance from AIMCo were not fully rational economic actors, that they were buying the insurance not because they wanted protection against a real risk but because their regulators told them to.

That theory is important because, in general, if a Wall Street bank comes to you out of the blue and says "hey we'll pay you $50 to take some risk off our hands," you should run away! Wall Street banks are not generally in the business of overpaying for protection that they do not need, and their derivative pricing models are probably better than yours. If they're offering you $50 for a complex hedging trade, it's probably worth $70 and could cost you billions. But if you have a sensible theory of why the bank might want to overpay for the protection—a theory like "arbitrary regulatory capital requirements make this risk too expensive in the bank's hands"—then maybe you can do the trade. Maybe it will be fine. Here it was not, but maybe, in general, it can be.

I should say that my general view of capital relief trades is, yeah, they are fine? Here obviously it is bad that Alberta's pension funds lost C$2.1 billion, but it would quite plausibly be worse if the banks had lost that money. Alberta's pension funds have long-term investment horizons and locked-up funding; banks are highly levered and have lots of overnight funding. A giant stable pension fund is a good bearer of black-swan volatility risk; an investment bank is not. The risk here sort of ended up in the right place, though that is not much consolation for the people who lost money when the risk came true.

People are worried about stock buybacks

Do you think there will be a coal industry in 100 years? I dunno, maybe, I do not make predictions like that, but I have to say that a lot of people think that coal is bad. It is a 19th-century power source, dirty and polluting, and people these days generally seem to be more bullish about natural gas and renewable energy than they are about coal. BlackRock Inc. has announced plans to divest from coal producers in some of its funds. The long-term future for the coal business is maybe not so hot.

On the other hand coal companies are still digging coal out of the ground and selling it to power plants to generate electricity, that is still very much a thing that happens. The coal companies get money from selling the coal. Sometimes even more money than they spend digging up the coal. What should they do with the money? One option would be to spend the money on ambitious exploration projects to find untapped seams of coal in far-flung places and turn them into productive coal mines to meet the world's long-term demand for coal. That option is … bad? Like arguably the market has signaled to the coal companies that the long-term demand is in decline and that opening a ton of expensive new coal mines is not the best idea? Like arguably the worst thing that you could do with today's coal profits is invest them in tomorrow's coal projects? In general, in a growing business, investing today's profits in tomorrow's opportunities is a great idea, but here we are talking about coal.

Another option would be for the coal companies to diversify into renewables. Take all the coal profits and spend them on building wind farms. Eventually the world will transition away from coal, and you will be ready for it. This is not a terrible plan! It has a clear theoretical attraction. There are some practical problems. You are a coal company. Your executives are coal people. They know a lot about coal, where it is found and how to dig it up. They know less about wind. You could hire wind people, but it is not obvious that you'll be any better at building wind farms than any random startup. There is no reason to think that your coal experience will be an advantage in the wind business. It will be a disadvantage. Are the best wind people really looking to work for coal companies? Are renewable-energy advocates and investors going to be excited about getting their wind power from Giant Coal Co.'s But Also Wind Co. subsidiary? 

A third thing you could do is put the money in a bank, or use it to buy Treasury bonds. That way you'll have a lot of money even if people stop using coal. If coal demand goes to zero, you can keep paying executive salaries and miners' wages even without selling coal. This is nice for your miners, and especially for your executives, but it is not very efficient. If no one wants coal, probably coal miners should do something else; certainly coal executives should. 

That leaves you with stock buybacks. You dig up coal, you sell it for more than it costs to dig, you have extra money, you give the money back to your shareholders. The shareholders can then invest that money in other businesses that maybe generate less free cash flow today (so they want to raise money from investors) but have better future prospects (so the investors want to give them money). The profits from a declining business can fuel the next rising business, circle of life etc.

This is all as standard as can be, this is the most boring obvious corporate finance 101, but here you go:

In the coal industry's long decline, the years 2017 and 2018 were pretty good ones. But instead of stashing away cash for tough times, coal producers spent billions of dollars in dividends and stock buybacks to benefit their investors.

Now, the industry is facing "historically bad" conditions, according to a bankruptcy filing by Murray Energy Corp., the nation's largest private coal producer.

Electricity demand has collapsed as the coronavirus pandemic has swept the U.S. That has added to the industry's difficulties as competition from natural gas and renewable energy sources has pushed coal's share of U.S. power generation below 20% for the first time in 50 years, according to IHS Markit. Coal generated half of U.S. electricity as recently as 2008.

Electricity generation from coal-fired power plants is forecast to decline 20% in 2020 from a year ago. Plants powered by historically cheap natural gas will see a dip of just 1%, according to the Energy Information Administration. Renewable sources solar, wind and hydropower topped coal for the first time on a quarterly basis in the first quarter, according to the Institute for Energy Economics and Financial Analysis. U.S. coal production in the first quarter was down 17% from a year ago, according to the EIA. …

Rather than build up cash reserves when times were good, executives used their windfalls on buybacks and dividends, credit analysts say.

"While the coal industry generated significant free cash flow in 2017 and 2018, credit quality did not improve meaningfully" for the companies because they returned much of their cash to shareholders, Moody's Investors Service senior credit officer Benjamin Nelson wrote in a March 26 note.

Yes yes yes yes yes if you are generating lots of cash today, but people will not want your product tomorrow or ever again, the thing to do is to give the cash back to your investors. Putting the money in the bank to eventually pay your creditors when you go bankrupt is … fine, responsible, good really, though less attractive for your shareholders. (The creditors are investors too, though, and it is perfectly defensible to give the money back to them.) Giving the money to the shareholders lets them spend it on other, better things than coal.

If you think that the main problem facing coal producers in 2020 is that they spent too much money on stock buybacks you are, I think, missing something essential about the coal industry, and stock buybacks, and the purpose of corporate finance generally.

Elsewhere in stock buybacks:

Sentiment turned against share repurchases after the pandemic hit, sometimes violently so. Not at Alphabet Inc. or Apple Inc.

A day after Google's parent said it bought back $8.5 billion of its own shares in the first quarter, the iPhone maker led by Tim Cook added $50 billion to its own program. The authorizations come as politicians all the way up to President Donald Trump have expressed unease with the practice at a time of worker hardship and cash shortages at some companies.

No such shortage exist at either of the tech giants, which explains the willingness to keep spending. But the actions could leave them exposed to political lumps, says Matt Maley, equity strategist at Miller Tabak + Co.

"There are better ways for a company to use their cash, but when a company has as much as Apple has, it makes sense that they return some of it to their shareholders," Maley said. "They'll probably get some criticism, but I hope they don't get too much."

I do think that when you say that there are better ways for Apple to use its cash you should be required to say what they are. Apple has a pretty good track record of inventing valuable new stuff, but it hasn't thought of any better ways to use that $50 billion; perhaps there are not that many of them. Anyway we talked the other day about a prediction that U.S. companies will cut dividends by about 10% this year, down from last year's record high of $491 billion. That's about $50 billion of projected dividend cuts; Apple's increased buyback, on its own, will make up for all of that.

Tax planning

"Rich Americans Seize Historic Chance to Pass On Wealth Tax-Free" is the headline of this Bloomberg article, in the middle of a pandemic, and I immediately thought … you know. There is one very standard way to pass on wealth to your heirs, and a pandemic will tend to increase the number of people who avail themselves of that method. (The method is dying.) I often mention Michael Graetz's two laws of tax—it is always better to make more money than less money, and it is always better to die later than sooner—and I tend to add that occasionally the second law is wrong. If you die on December 30 of a year with low estate taxes, that is better, for tax purposes, than dying on January 2 of a year with high estate taxes, and it is a famous empirical result that people sometimes time their deaths to optimize their taxes. And in fact the article suggests that this year might be an opportune time to die, for tax purposes:

There's also the threat that tax laws could change if President Donald Trump is defeated in the November elections. Former Vice President Joe Biden, the Democrats' presumptive nominee, has proposed closing estate-tax loopholes.

But, no, the article is really about using "plunging interest rates and volatile equity markets" to pass on wealth while you're alive:

The simplest way for the rich to take advantage of the low rates is to loan cash or other assets to family members. Heirs can borrow millions of dollars, then invest the money and profit from any upside.

Beneficiaries can lock in today's ultra-low rates for years or even decades. The IRS-required rate on "mid-term" loans of 3 to 9 years is 0.58% in May. …

An especially popular tool is the grantor retained annuity trust, or GRAT, which lets beneficiaries profit from any future investment gains -- with no risk of losing money -- as long as those returns are higher than the IRS-required interest rate. The lower the rates, the easier for heirs to make money.

Low rates aren't the only reason advisers say they're preoccupied re-arranging client estate plans. While volatile markets have dented many portfolios, low valuations also make it possible to transfer assets to heirs without using up as much of the gift-tax exemption.

We talked yesterday about the boredom hypothesis in equity markets: White-collar workers tend to be stuck at home without access to their traditional entertainments, so they are, apparently, gambling on the stock market for fun instead, fueling a stock rally. You could apply that hypothesis to a lot of traditional white-collar pastimes, including estate planning:

In fact, pandemic-induced lockdowns mean that many once-busy rich people find themselves with lots of time to maximize estate plans. Stuck at home, wealthy entrepreneurs finally have a moment to think about the next generation.

"It's a little crazy -- I'm busier now than I was before this pandemic," said Jim Bertles, managing director at Tiedemann Advisors. "It's because clients and prospective clients reaching out to us have a lot of time on their hands."

I mean to be fair a pandemic is arguably a good time to think about your estate planning even if you are not especially bored. But the general point is that, in the midst of a recession, we are seeing a bit of a boom in the boredom-driven parts of the economy.

Things happen

Boeing Rules Out Federal Aid After Raising $25 Billion of Bonds. Boeing and Bond Traders Brace for Junk. For Many Small Businesses, U.S. Coronavirus Aid Falls Short. Exxon Posts First Loss in Decades as Oil Giants Signal Trouble Ahead for Industry. New York Hedge Fund Claims It's Being Smeared in Tegna Proxy Fight. Investors Bet Oil Crash Will Weaken Middle East Currency Pegs. Iran Is Hauling Gold Bars Out of Venezuela's Almost-Empty Vaults. Did CLK20 Get TAS-ed? A Private Equity Firm Is Blocked From Buying .Org. SUVs Get Parked in the Sea, Revealing Scope of U.S. Auto Market Glut. The Office You Left Is Not Going to Be the Office You Return To. "I — who have chosen instead to day-drink, fail as an algebra teacher and almost get divorced — will listen as you explain."

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[1] James Angel at Georgetown pointed out this memo, and its connection to "everything is securities fraud," to me by email.

[2] People tend to use this name mainly for one particular sort of trade, synthetic securitization of credit risk, but the concept is more broadly useful.


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