the SEC inspector general is investigating the agency’s office leasing practices–again

a new lease

The point at issue:  the SEC, which has been leasing office space for itself for the past twenty years, inked a ten-year contract last July for 900,000 square feet of prime office space in downtown Washington.  According to the Financial Times, rent for the new space in Constitution Center amounts to $51.8 million annually.

unusual or not?

What’s unusual about the signing?  For the SEC, a critic might say it’s just business as usual.  Anyway:

1.  It comes at a time when the agency is cutting back on investigations for lack of resources

2.  The SEC bypassed government competitive bidding requirements for leasing office space, by declaring this situation was an emergency

3.  Normally, government agencies wait for Congress to appropriate the money before spending it.   The SEC didn’t in this case.  And it now appears the extra funds will not be coming any time soon,

4.  The SEC doesn’t need the space.  It’s moving a bunch of people from the suburbs, where rents are presumably much cheaper, to fill some of it up.  And it’s trying to get out of its obligation for two-thirds of the space it just signed up for.  My guess is that it will end up subletting the space at a loss to some other arm of the Federal government.

the lease expense is huge

Two other factors make this deal stand out:

1.  If you take the $51.8 million and add to it the $83 million the SEC already spends each year on real estate, the SEC was committing a whopping 15% of its budget to real estate.

2.  According to the Wall Street Journal, the SEC’s offices are 2.5x the size that’s the norm for the federal government.

What’s also noteworthy is that this isn’t the SEC’s first office snafu–though arguably the largest.  Of the incidents we know about, in 2005-06 it had to cut back on investigations to fund a $48 million cost overrun on office construction expenses.  The agency is reported to have paid for years for office space in New York that it wasn’t occupying.  Recently, its leasing practices in San Francisco have also come in for criticism.

Where do they get these people?

more on insider trading

A number of new ( to me, anyway) pieces of information about the current FBI/SEC insider trading investigation have emerged over the past few days.  They are:

1.  Many commentators have noted that the investigation resembles much more closely an FBI operation against organized crime than the “usual” kind of SEC action.  The latter case typically has involved followup from red flags that emerge from SEC monitoring of trading patterns in individual stocks.

In this case, in contrast, the investigation has apparently been going on for three years, involves the FBI, includes wiretapping, and seeks criminal penalties.

No one I’m aware of has publicly drawn an obvious inference from this behavior, though.  If the focus of this probe is organized criminal enterprises, it seems to me that the government will be seeking, or at least threatening to seek, penalties under the Racketeer Influenced and Corrupt Organizations (RICO) Act of 1970.

Under RICO, which requires that prosecutors establish a pattern (meaning at least two acts) of illegal activity, those found guilty can be sentenced to twenty years in prison for each racketeering act and fined $25,000.  They can also be sued in civil court by those they have wronged for triple damages.  Defendants’ assets can be frozen prior to trial (making it hard to pay your lawyer).  The government’s reach is also extended to include all a person’s assets, not just those connected with the legal entity where a crime has occurred.  In other words, if you’ve traded in insider information as an agent of a corporation or partnership, your house, your bank accounts, your art collection, your cars…are all at risk, not just corporate or partnership interests.

RICO has a history of being used in combatting financial markets crimes.  Corrupt junk bond king Michael Milken was indicted under RICO in 1989.  Drexel Burnham Lambert, the firm Milken worked for, was threatened with a RICO indictment as well.  Both pled guilty to lesser charges.

I think RICO is the next shoe to drop.

2.  Former SEC head, Harvey Pitt, has been making the rounds of financial TV shows giving his opinion about what the FBI/SEC are doing.  The most interesting point he makes, I think, is on CNBC, where he points out that this investigation can’t involve a gray area that may, or may, not be insider trading.  For the resources involved in this case, and given all the publicity the agencies have generated, it must concern clearly illegal activity.  (Mr. Pitt says this around minute 3:10 of the CNBC interview.)

Points Mr. Pitt makes in other interviews:  this action is focussed on hedge funds and comes as a result of authority explicitly granted to the SEC by the Dodd-Frank Act.

3.  Don Ching Trang Chu, an employee at  a California-based “expert network”

firm, Primary Global Research, was arrested by the FBI on November

24th and charged with conspiring to distribute inside information.  The way Mr.

Chu’s business is described in the US Attorney’s press release and by

Bloomberg among others, it seems to have consisted in large part in finding

compliant middle-level employees in technology companies.  These

employees would disclose company operating results, sometimes in great detail, to

hedge funds some hours in advance of their being made public in return for money.


In a narrow sense, for a long-term investor the question of whether a company’s

short-term results are 1% higher or lower than the Wall Street

consensus is of little consequence.  The larger issue, however, is that the

perception that monied interests can rig the game in even one aspect can

undermine the public’s confidence in the markets–thereby delivering lower price

earnings multiples for everyone.


And of course, a sheriff must fear that if everyone believes he’s asleep on the job

he’ll be thrown out office and replaced.

This story will likely get more interesting as it unfolds.

insider trading, hedge funds, expert networks and skilled securities analysis (l)

News reports over the past day or indicate we may be in the early days of what could prove a widespread regulatory crackdown on insider trading.  The FBI has raided the offices of several hedge funds, a number linked with SAC Capital.  A west coast independent technology analyst has publicized a failed attempt by the federal police agency to trade more lenient treatment for alleged offenses in return for recording (presumably incriminating) conversations with a client, hedge fund SAC Capital.  “If felt like a street mugging,” he’s quoted as saying.  The analyst reported this encounter by email to his customers, instead.  They, in true Wall Street fashion, immediately ceased doing business with him.

All this prompts me to write about four loosely linked topics:  insider trading, expert networks, hedge fund information gathering and issues that the fuzzy nature of what constitutes insider trading create for professional securities analysts.

Two posts, today and tomorrow.

insider trading

First, a pedantic point.  Insiders, like the top managements of publicly traded companies, can trade legally.  There are, however, clear restrictions on what they can do and when.

But that’s not what people usually mean when they talk about insider trading.  They’re referring to illegal insider trading.  There’s actually a good, if a bit dated, survey of insider trading regulations and their purpose on the SEC website.

Here’s my take on what insider trading is.  Remember, though, that despite the fact I’ve sat through 25 years+ of mandatory compliance training that included a heavy dose of insider trading information, I’m not a lawyer.  As you’ll see below, this can be a pretty fuzzy concept, with lots of gray area, border line cases.

The standard definition of insider trading is that it is based on material, non-public information.  Doing so is illegal for two reasons:

1.  It’s like stealing.  It’s taking information that is supposed to be used only for a corporate purpose and using it for personal benefit instead.  For the corporate employee who has such information, trading on it is a violation of the duty of trust and care he is expected to have for his employer.

2.  It’s like fraud.  That’s because the inside information trader is taking advantage of the fact he knows the person on the other side of the trade can’t possibly be aware of the material information he is acting on.

That’s straightforward enough.  But inside information also has a viral or fungal quality to it.  Today’s rules maintain that anyone, whether employee of the company involved or not, becomes a “temporary” or “constructive” insider the minute he reads/hears the information.  This means he has the same fiduciary obligation that a company employee would have.  He can’t trade on the information, even if he had figured out 95% of it on his own already.

It also means that the last thing any securities analyst worth his salt wants is inside information.  It’s like a runner getting a knee injury.  It puts him out of the game and on the sidelines.

Another modification to the rules concerns selective disclosure, which under Regulation FD (Fair Disclosure) is no longer allowed.  At one time, companies routinely disclosed information to sell side analysts but not to shareholders or their representatives.  Or they gave extra information to favored institutional shareholders in private meetings.  I remember vividly once being asked to leave a briefing by Sony about its video game strategy, even though I was representing owners of the company’s stock, because I didn’t work for an investment bank.  That’s crazy, to tell company secrets to strangers but not the owners, but it happened.  (I refused, by the way, and wasn’t thrown out.)

expert networks

Analysts and expert networks are different.

Most sell side analysts specialize in a single industry.  Their buy side counterparts usually cover several industries, sometimes closely related, sometimes not.  Both kinds read industry literature, attend trade shows, go to company analyst days (where top management explains how the company in question makes its money and where it stands among its competitors), read company SEC filings, listen to earnings conference calls.  They also produce detailed spreadsheets modeling company operations, hoping to project future earnings with a high degree of accuracy.  Gradually, even if they have no prior industry background, they become extremely knowledgeable about the areas they cover.

Expert networks, in contrast, are collections of industry consultants who are assembled by a middleman and whose services–usually a one- or two-hour meeting–are offered to professional investors for a fee, most often paid in soft dollars.

Say a company wants to find out about communication networking equipment and doesn’t have an experienced analyst who covers the area.  Or maybe the company does but a portfolio manager wants an especially detailed or technical question answered.  Then he calls the expert network organizer to say what he needs.  What he probably gets is a middle-level manager or technical employee from, say, Cisco, who is willing to talk for two hours for $1,000 (the payment to the network organizer may be $2.000-$3,000).

The legal issue is that the guy from Cisco may have no idea how much of what he knows is inside information.  So the result of the meeting may be that inside information is passed from the expert network consultant to the investor.  If so, it’s the functional equivalent of whacking every investor at the meeting in the knee with a crowbar.  What the SEC is investigating is whether obtaining inside information is the intent of the meeting and, in particular, if some hedge funds use these networks as conduits to get illegal information that they can trade on.

Back to analysts, for a minute.  I don’t John Kinnucan, the analyst the FBI tried to wire, and I’ve never seen his work.  The Wall Street Journal description of his business suggests he operates in a gray area.  According to the article, his specialty is “channel checks.”  That is, he schmoozes with tech company salesmen and with distributors, to see what’s selling and what isn’t.  He then synthesizes the information he gets and passes it on to clients.  It’s also possible that clients ask for specific items of information–I don’t know whether they do or not, but I think it’s a reasonable supposition that they do.

The big question is whether Mr. Kinnucan’s sources of information tell him very specific things that they have an obligation not to reveal to people outside the company.  In other words, is this activity like #1 above, a use of confidential company information for personal benefit.  If so, Mr. Kinnucan and any of his clients who receive his reports are infected.  They’re insiders and can’t trade on the information.  The FBI appear to have waned Mr. Kinnucan’s taped conversations with SAC Capital to build/buttress an insider trading case against SEC.  So they must either think, or hope, that the information in the reports do contain inside information.

That’s it for today.  Tomorrow:  why I think hedge funds use expert networks and highly specialized analysts like Mr. Kinnucan; and practical issues for any securities analyst.

New SEC rules allow shareholders to nominate company directors

new rules on electing company directors

The SEC wasted no time in acting on the authority it got under the recently enacted Dodd-Frank (or Frank-Dodd) Wall Street Reform and Consumer Protection Act to determine shareholder ability to add materials to proxy materials of publicly traded companies.

Yesterday it set new rules that permit shareholders to place their nominees on the ballot for election to the board of directors, providing:

–the shareholder owns at least 3% of the company’s shares,

–it has been a 3% holder for three consecutive years,

–it doesn’t hold the stock as part of an effort to change control of the firm, and

–it has no side agreement to support the existing management.

A qualifying shareholder can submit nominations for up to 25% of the board.

The new rules will go into effect in about two months.

the “system” this replaces

Any shareholder could submit names to a corporation and ask that they be considered for inclusion on the proxy ballot.  But the firm had no obligation even to consider these requests, which I would imagine went directly into File 13.  A shareholder wanting change could raise his objections at the annual meeting–a futile undertaking, since management would already have obtained enough proxies to control any vote.  The only other alternative for an unhappy shareholder has been to wage a proxy fight, that is, to contact other shareholders directly and ask for their votes–a very expensive process.

Until July 2009, a proxy fight was an even more futile process than it sounds, since a brokerage firm could vote all the shares it held for clients in “street name” (basically, all of them) for the directors the broker desired, provided he had received no instructions from the shares’ owners.  Effective with voting at meetings after January 1, 2010, brokers must either vote the shares they hold for customers in accordance with their instructions, or–without instructions–not vote them at all.  Since a company’s management control the flow of investment banking business, guess who brokers tended to vote those silent shares for?

are new rules needed?

Yes, in my opinion.  Think about the recent GM bankruptcy.  Through 35 years of almost continual loss of market share, a complacent board defended stunningly incompetent management.  Both were in denial to the very end.  Both rebuffed all outside attempts to change a corporate culture of failure.

two observations–my opinions–about boards and individual shareholders

1.  In theory, shareholders elect the board of directors to supervise the operation of  company.  Directors set strategy and hire the management that carries out the board’s wishes.  In practice, the opposite is the case.  Typically, management in effect controls the board both by influencing its composition and by regulating the amount and completeness of information that it supplies to board members.  Many board members are managers or former managers of the company.  “Independent” directors may come from politics or academia and have little experience in, or even knowledge about, the industry the company is in.  All are paid for serving on the board and are indemnified by insurance against lawsuit damages for any action they may take.

It’s easy to pick a company and check.  Google the board members.  Ask yourself what industry background the independent directors have.  What’s their “day job” and how much of their time does that take?  How many other boards are they on?

2.  Oddly–to me, anyway–individual shareholders tend to be intensely loyal to management and the sitting board.  The invariably support management/board recommendations, even when company performance is poor and when proposals they are asked to vote on seem to very clearly run against shareholders’ interests.  I’ve never gotten why.  Maybe it has to do with the just-abolished practice of brokers voting clients’ stock for them.

much ado about nothing?

The consensus seems to be that the teeth have been pulled from the new voting rules by provisions two and three above, concerning change of control and three-year ownership requirement.  And you might argue that even if someone gets control of a quarter of the board, they’ll still be a frustrated minority that isn’t able to crack an “old boy” board.

maybe not

1.  25% of the board is more than it seems to be at first glance.  Suppose a large pension fund (the obvious large, benign holders of corporate stock) ended up with such representation on the board of a given firm.  I think this would say two things:  a) the company is receptive to change, and b) if you can ally with the pension fund, half the work of being able to force change through control of the board is already done.  Arguably, the first step in becoming open to change, the one taken by the pension fund, is harder, so maybe well over half the work is done.

2.  The new rules may change legal leverage in unusual ways.  I can imagine that if a few leading pension funds begin to place directors on corporate boards, they may establish a new standard for good stewardship of pensioners’ assets.  Other funds may  follow suit, if for no other reason than fear of negligence lawsuits if they don’t.

Also, when a board is a closed club that speaks with one voice and provides no information about its deliberations to the public, members may feel there are no penalties for acting as a rubber stamp for management.  If board minutes contain well-reasoned dissenting comments, or if a new board member is willing to make deliberations public–even to campaign against sitting board members in the next election–that may change.

Pressure on sitting board members to take an active part in the management of the company can come in two ways, I think.  One is possible public embarrassment, or loss of a board seat, for members who simply collect a check from the firm (for big companies, payments to directors can be hundreds of thousands of dollars) and do nothing.  Another is perhaps the greater worry that clear evidence of board members’ negligence will invalidate the liability coverage that they think protects them from the consequences of their actions.

investment implications

I think the first few proposals of alternate director candidates will be crucial in setting the tone for what will follow.  It should be interesting to watch.  It may well be that either the proposal itself, or the election of new board members, will be a signal for a period of stock outperformance.

The SEC accuses Goldman Sachs of fraud

Goldman charged with fraud

The SEC announced Friday that it is charging the investment firm Goldman Sachs and one of the professionals in its bond area with fraud in connection with the creation and sale of a collateralized debt obligation (CDO) where the ultimate backing was a collection of  sub-prime mortgages.

The details

As I read it, the SEC complaint contends that in this particular issue the odds were stacked against investors in the CDO, because:

1.  the hedge fund Paulson & Co. did an extensive study of sub-prime mortgages early in 2007, identifying over a hundred mortgage-backed securities that its analysis concluded would most likely face financial difficulties.

2.  Paulson approached Goldman with the list and paid it $15 million for help in creating a CDO whose performance would be tied to most or all of the securities.  Paulson also intended to effectively sell this CDO short.

3.  Goldman got ACA Management, a firm experienced in managing credit risk with residential mortgage-backed securities, to act as the official selection agent for the securities linked to the CDO.  Goldman served as a middleman between Paulson and ACA in negotiations over the mortgage securities that would underlie the CDO to make sure they were satisfactory to both.  Goldman also knew that ACA had the mistaken belief that Paulson wanted the CDO to succeed, rather than fail, assuming Paulson would buy part/all of the riskiest tranche, but did not correct that misapprehension.

4.  Neither the offering document nor any of the CDO marketing materials contain any mention of Paulson’s role in selecting the sub-prime mortgages underling the CDO or of Paulson’s economic interest in seeing the mortgages fail.

As Paragraph 3 of the complain puts it:

“3. In sum, GS&Co arranged a transaction at Paulson’s request in which Paulson heavily influenced the selection of the portfolio to suit its economic interests, but failed to disclose to investors, as part of the description of the portfolio selection process contained in the marketing materials used to promote the transaction, Paulson’s role in the portfolio selection process or its adverse economic interests.”

In short order, virtually all the underlying mortgage-backed securities were downgraded.  Investors lost $1 billion.  By shorting tranches of the CDO, Paulson gained $1 billion.

Goldman’s response

The company has denied the charges, calling them “completely unfounded in law and fact.”

In addition, Goldman issued a press release after the close on Friday, in which it said (with some added interpretation from me):

a.  no matter what “help” it received from Paulson, ultimately ACA agreed to the CDO structure and put its name on the dotted line as Selection Agent

b.  Goldman never told ACA that Paulson was going to be a long investor in the transaction.  Further, as a middleman its duty is to protect the identities of both sides of any trade.  (I read this as a very narrow statement; as saying that, yes, Goldman may have known what ACA thought–and may not have put any obstacles in ACA’s way in going down that road–but it never said “Paulson” and “long investor” in the same sentence.  The SEC, in contrast, seems to be saying that the offense is in the failure to set ACA straight about Paulson’s role.)

c.  The investors, ACA and German bank IKB, are sophisticated professionals with a lot of experience with sub-prime.  They had all the materials they needed to analyze the relevant mortgage-backed securities themselves.  They made an independent (though horribly incorrect) judgment about the quality of the deal.

Besides, there’s always a guy on the other side of the transaction.  ACA and IKB knew that.  His identity and intentions aren’t relevant.

d.  Goldman itself lost over $90 million on this deal (no details on what this means; in particular, does this figure include any offsetting hedges?).

What the SEC is not saying (as I see it)

The SEC is not complaining that Goldman is

–acting as an agent In almost every trading situation, both buyer and seller think they know more than the other side.  Neither is obligated to educate the other, either before or after the fact.  When I bought AAPL at $13, I didn’t have to tell the seller I thought the iPod would transform the company.  He didn’t have to tell me what an idiot I was to take off his hands shares in a firm that was doubtless headed for Chapter 11.  No one wants the broker who acts as a middleman to put his two cents in, either.   Knowing more than the other guy isn’t acting against the other’s interests in the sense the SEC is talking about.

–providing liquidity Sometimes, when no “natural” counterparty can be found, a big client will ask a broker to facilitate the trade by either buying the securities itself or shorting them to the client.   The trade may, or may not, turn out to be a good idea.  In the latter case, and depending on how he trades out of the position (long or short) he has taken on, the broker may make a lot of money.  This isn’t acting against a client’s interests in the way the SEC means, either.

–trading against a client In some markets outside the US, it is the custom, when a broker provides research support that has a material influence on the client’s buy or sell decision, to transact through that broker.  The thought is that this will encourage the broker to provide more investment ideas, as well as to ensure the flow of maintenance research on this particular one.

The US custom is the opposite—to sever the connection completely between trading and research, so that brokers will have as little clue as possible about a firm’s intentions.  If the client’s traders are skillful enough, even if brokers wanted to act against its interests, they would have only a vague idea of what they are.

(Note that a trading issue came up last year when someone (my money is on analysts who thought the practice is unethical) leaked information about its trading “huddles” to the press.  These were weekly meetings that generated short-term trading recommendations that sometimes went against Goldman’s “official” recommendations and were only made known to a select group of big clients.  Goldman pointed to fine print in the Disclaimer section of its publications that said it might do this.)

What the SEC is saying

If I understand the Goldman statements, it’s saying it was acting in this private placement as a marketer/trader/middleman.  The SEC, I think, is maintaining that Goldman was an originator/underwriter of the security and therefore must comply to the higher standard of full and complete disclosure of all material facts.

The fact that Goldman knew Paulson was trying to put as many holes as it could into the bottom of the boat is presumably material.

my thoughts (so far)

1.  I’m not a lawyer.  I have no idea how this will play out in court.  It would be interesting, however, to see a list of Goldman’s clients by revenue generated.  My guess is that Paulson is on the first page or two and ACA and IKB are afterthoughts.

2. Given all the high-profile financial crisis-related cases where the SEC has declined to prosecute and settled instead, in part judging that it didn’t have enough evidence to prevail in court, it may consider this case a slam-dunk.  Or it’s under enormous pressure to do something and it’s just Goldman’s bad luck to be in the firing line.

3. Any good marketer tries to take a purely commercial relationship with his customers and turn it into one of friendship and trust.  For the best companies, they actually mean what they say.

For Goldman, the pitch has been something like–we’re very smart and have good ideas; you have assets and a distribution network; let’s team up to generate great investment performance and we’ll grow rich together.  The SEC account of this incident reads more like a chapter out of Liar’s Poker, where the broker’s intent was more to suck the client dry and toss him on the junk pile.

The real damage to Goldman is reputational, not the lawsuit.

4.  Goldman’s response so far is to say it has broken no laws.  I think a better tack would be to say (assuming the SEC complaint is more or less factually accurate)–yes, what we did was legally correct.  But it doesn’t live up to our high ethical standards.  It’s an isolated incident by rogue employees.  We’re going to punish those involved and make restitution.

Of course, this is a problem if the SEC has a dozen more similar cases lined up or witnesses who will testify that this deal was approved at the highest levels.  It’s also a problem if the SEC won’t allow Goldman to settle, or if Goldman is completely blameless.  According to Bloomberg, talks had already been going on for nine months about the case before the SEC made its lawsuit announcement last week.

Also, reporters are already beginning to ask how “political” the SEC decision is in this matter.  Is the desire to prosecute this case and right now based solely on its merits?  or is it a response, perhaps the first of a series, to the deep dissatisfaction of many Americans with the apparent lack of interest by Washington in investigating those who caused the financial crisis?  We’ll know better if further SEC complaints are filed against other financial companies in the coming weeks.