How’s Sears doing?
When Sears Holdings Inc. filed for bankruptcy, that triggered payouts on credit default swaps linked to its debt. The way that CDS pays out is that, some time after the default, the International Swaps and Derivatives Association holds a special auction for the relevant debt, and the price of the debt in that auction sets the payout on CDS. The idea is that even in bankruptcy, holders of the debt will get some recovery, and the auction price is an estimate of that recovery value. And CDS is essentially insurance against default, so it should pay the par value of the debt minus the recovery in default; if the debt is valued at 25 cents on the dollar in the auction, then CDS should pay out 75 cents on the dollar.
But a lot of Sears CDS actually covered, not Sears Holdings debt, but debt of a subsidiary called Sears Roebuck Acceptance Corp., and there wasn’t that much SRAC debt outstanding. If there is more CDS than debt, and particularly if one seller sold more CDS than there is debt, then the auction might not work: The one seller can bid to pay 100 cents on the dollar for all of the debt in the auction, which would make the CDS payoff zero. If there is $100 million of debt and $200 million of CDS, and if the expected recovery on the debt is 25 cents on the dollar, then the CDS “should” pay out 75 cents on the dollar (for a total of $150 million). But if one seller sold all of that CDS, then it would prefer to pay $100 million for all of the debt (and zero on the CDS).
This looked like it might happen with SRAC CDS, since there was more SRAC CDS than there were SRAC bonds and since much of the CDS, it has been widely reported, was sold by a hedge fund called Cyrus Capital Partners. But then Sears discovered that it actually had a bunch of SRAC bonds that were owned by other Sears entities, and asked a bankruptcy court to let it sell those bonds. Ordinarily intercompany bonds would be worthless in bankruptcy, but these had special value as tools in the CDS game, and the bankruptcy court agreed to let Sears sell them. Cyrus objected to the sale, but was overruled. So Cyrus did the next best thing and bought all the bonds, so that no one else could buy them and deliver them in the CDS auction.
We have talked about all of this several times before, but it is now being fought over on two fronts. For one thing, today the Searsbankruptcy court will hear arguments that Cyrus should not have been able to buy all those SRAC bonds. The basic argument—from hedge funds, led by Omega Advisors, that had bought SRAC CDS—is that Sears didn’t run a fair auction for those SRAC bonds, and instead cut a sweetheart deal with Cyrus; if the auction had been fair, Omega argues, it would have (1) bought the bonds and (2) paid Sears more for them. Sears announced that it would sell a relatively small chunk of the SRAC bonds, and then effectively sold them all when Cyrus put in the highest bid but made that conditional on getting all of them; the other hedge funds, not expecting that, were caught flat-footed.
I have some sympathy for this argument, but my sympathy is limited by the fact that the unsecured creditors’ committee in Sears’s bankruptcy disagrees with it. There is no reason, here, to care about abstract fairness: This is a highly technical battle between hedge funds, and whoever is cleverest and sneakiest really deserves to win. The only thing the bankruptcy court should care about is whether the SRAC bond sale maximized value for Sears (that is, for its bankruptcy estate—meaning, really, for its unsecured creditors), and if the unsecured creditors are satisfied then I guess I am. The committee said that Sears “exercised sound business judgment” in doing what it did and that Cyrus’s bid was “the most value-maximizing option available” with the “lowest execution risk,” so fine.
Separately, ISDA’s Determinations Committee has received a letter (presumably from a CDS buyer) asking it to change the CDS auction mechanics to thwart Cyrus’s approach. The gist of it is that, by controlling a majority of the bonds, Cyrus can just bid for all of the bonds in the auction and create a recovery value of 100 (for a CDS payoff of zero):
A 100 outcome does not represent the creditworthiness of the Reference Entity: bonds guaranteed by the Reference Entity that are not Deliverable Obligations are currently worth 25/100. Such a result would likely prejudice the vast majority of market participants who rely on the CDS auction to cash settle their trades at a price reflecting economic reality. The DC has the ability under Section 3.2(d) of the DC Rules and should exercise its discretion to prevent the prejudice that would be created by this unfair and commercially unreasonable outcome.
One thing to say here is that of course the letter is correct that pricing SRAC bonds at 100 cents on the dollar “does not represent the creditworthiness of SRAC,” which is, after all, bankrupt. And while a bankruptcy court has no great reason to care about abstract fairness among hedge funds, ISDA sure does. If every bond default ends up with this sort of gamesmanship and counterintuitive noneconomic payoffs, then (1) my job will be fun but (2) who will ever buy CDS? I mean the answer to that question is “people who enjoy CDS gamesmanship and think that they are cleverer than everyone else,” which is probably a large contingent of hedge fund managers, but not quite as large as the pool of “people who have credit exposures to companies that they want to hedge.” If it wants to keep the CDS market functional, ISDA probably will need to do something about all this gamesmanship.
I am at a loss to know what though. The letter suggests a cap in which “any market participant controlling more than a threshold amount (e.g. 20%) of all the Outstanding Deliverable Obligations would be prevented from submitting a buy physical settlement request for more than a certain amount (e.g. 25% in the aggregate) of Available Deliverable Obligations,” but that seems pretty random. There is no particular reason to believe that the solutions here are easy. We have been talking about this stuff for years, and every article about it comes with dire warnings that if ISDA doesn’t Do Something then CDS will stop working. Gretchen Morgenson and Andrew Scurria wrote about Sears yesterday:
The instruments’ value to asset managers, global banks and other investors is diminished if the swaps don’t work as expected.
“When flaws become the point of the product, the product will not be trusted and risks becoming worthless for the purpose it was designed,” said Jeffrey Pierce, managing partner at hedge fund Snow Park Capital Partners.
And here we are again. But each time we’re here, it is for a slightly different reason: There are artificially manufactured defaults and artificially avoided defaults and artificially underpriced bonds and artificially overpriced bonds and artificially orphaned CDS and artificially un-orphaned CDS and whatever is going on with Sears. It seems improbable that the model here is really “there is something wrong with CDS and here is how to fix it.” More probably, the model is “insuring against credit default is a complicated business with lots of unpredictable and negotiable outcomes and a lot of money on the line, and so it attracts a lot of smart people with good lawyers who read the documents carefully and come up with clever ways to get surprising results.” Changing the documents to close the current set of loopholes might just give a new advantage to the cleverest document-readers, who will be fastest to spot the new set of loopholes.
Insider trading
I worry a little that I have been a little too successful in convincing people that “insider trading is not about fairness, it’s about theft.” (And also not successful enough in convincing people that nothing in this column is legal advice.) We talked yesterday about a guy named Peter Cho, who settled insider trading charges with the Securities and Exchange Commission after he overheard his investment-banker fiancée talking about a deal at their apartment and bought short-dated call options on the target’s stock. Several people emailed or tweeted to say: Wait, I thought trading on material nonpublic information that you overhear is just fine?
No! (Not legal advice, but no!) The most basic rule is that, if you work at a company and you are given confidential information as part of that work, you can’t trade on it, because that would be a violation of your fiduciary duties to the company and its shareholders. But the rule expands out from there. In one direction, the broader rule is that you also can’t tip your buddies with the inside information so that they can trade, though there are vast complications about exactly what sorts of tipping count. (In general, a tip involves telling someone the inside information in breach of your fiduciary duties and with the expectation that he’ll trade, either because you want him to make money and pay you a kickback or because he is your brother-in-law or whatever and you want him to get something nice for himself.)
But in another direction, plenty of people who don’t work for the company have similar, derivative duties of confidentiality. If you work for an investment bank and get confidential information about a client as part of your job, you can’t trade on it, because your bank has a duty to the client and you have a duty to the bank. If you are the spouse, or the psychotherapist, or probably the roommate or golf buddy, of an executive of the company (or of an investment banker who works for the company), and that executive (or investment banker) tells you inside information in the confidence of the marital/patient-therapist/roommate/golf-buddy relationship, you can’t trade on it. There is actually an SEC rule that tries to clarify what sorts of relationships “of trust or confidence” create these duties, though it does not explicitly list golfing. (Complications arise here when it’s not clear whether the information was conveyed in confidence, and the recipient violated that confidence, or as a tip, and the tipper and recipient are both guilty. Golf and spousal cases can go either way.)
The unusual fact here is that Cho’s fiancée did not, apparently, tell him material nonpublic information in confidence, expecting him to respect his spousal duties and keep it secret. Instead he overheard her talking about the material nonpublic information, and she had no idea that he even knew about it. But this is not a real difference. People who work for a company and overhear merger news at their job, as opposed to being told about it directly, still can’t trade on it; people who are in a marriage and overhear merger news as part of their marriage, also, cannot trade on it. This should be reasonably clear not only as a matter of insider trading law but also as a matter of marriage. If your husband tells you “I hate my boss, don’t tell anyone,” and the next time you see the boss you tell her “you know Bob hates you right,” your husband will correctly feel that you have violated his confidence. But if he is working from home late at night and mutters “I hate my boss” and you overhear, telling the boss would be just as bad. You have violated a confidence even if it was not confided to you directly. The duty of confidentiality comes from the structure of the relationship, not from how the secret was conveyed.
On the other hand, sure, if you have no relationship and you just overhear someone talking about mergers, then you have no duties of confidentiality and can probably trade on it. (In the U.S., that is. In most of the rest of the world, the rule is stricter, and insider trading really is about fairness.) If Cho’s fiancée had talked about the deal in a restaurant and strangers sitting two tables over had heard, they could probably trade.
Look, I mean, I get that this is ridiculous. Every distinction we are talking about—telling someone as a tip versus telling someone as a confidence, relationships “of trust or confidence” versus casual relationships, overhearing a stranger versus overhearing someone with whom you have a relationship—is vague, subjective, personal, hard to prove, and just generally a weird thing to base securities law on. Insider trading law tends to “impose legal duties of loyalty and confidentiality on a host of personal relationships not otherwise subject to law – effectively basing civil and criminal penalties on ‘corruption’ in purely personal relationships,” as one lawyer, who is also my wife, once put it. It feels like there should be a better approach. You can see why the simple rule of “if you have nonpublic information you can’t trade on it” would be tempting. Resist this temptation, I say—there is value to encouraging investors to try to find out information that no one else knows, and really the simple rule would not turn out to be that simple in practice—but I can understand where it comes from.
Merchant cash advance
Bloomberg’s Zachary Mider and Zeke Faux have had a terrific series of stories about the merchant cash advance industry, which lends money to small businesses with effective interest rates that can be higher than 250 percent and uses harsh tactics—including filing “confessions of judgment” and seizing bank accounts without any court review—when borrowers fall behind. Their reporting seems likely to lead to changes in the industry, as state and federal legislatorshave proposed changes to the rules to stop predatory practices.
But until then the stories keep coming, and today’s might be my favorite one yet. The merchant cash advance works largely through a series of legal and financial innovations: The loans are shielded from consumer-protection laws because they are made to small businesses, they are shielded from usury laws because they are not technically characterized as loans, and they are shielded from repayment risk because the confessions of judgment allow the lenders to seize borrowers’ bank accounts quickly and without notice or litigation. But today’s installment of the series has nothing to do with any of that and is about merchant cash advance lenders using the oldest lending technique in the book, which is sending a muscular ex-convict to the borrower’s place of business and having him say, hey, nice place of business you got here, shame if anything were to happen to it:
Ten of Gioe’s unannounced visits to borrowers, from Chicago to small-town Alabama, were described in court papers and interviews with Bloomberg News. He made “threats of violence and physical harm” to employees of a California rehab center, according to one court complaint. A tire-shop owner near Boston said in another court filing he “felt that physical harm would come to me and my family” when Gioe walked into his shop in 2016 demanding immediate payment.
This approach offers a way around the automatic stay in bankruptcy: When a debtor tells you that he is under bankruptcy protection and a court has stayed collection actions by creditors, you can just say, as debt collector Gino Gioe allegedly did, “We don’t deal with courts, we have our own ways to collect.” Otherwise, though, there is not much financial novelty here and so I don’t have much to add to it, but if you like tales of old-school finance it is a great one. For instance, here is part of a description of an interview with Gioe:
But don’t get the wrong idea, he said. He never tried to intimidate anyone. He considers Mansouri a friend. His goal was always to work out a reasonable deal. “I don’t curse,” Gioe said. “I don’t tell them I’m going to f— ‘em up, I’m going to beat the living s— out of you. It doesn’t make any sense.”
Wearing a skintight sweater that accentuated his biceps, Gioe held forth for an hour, his mood veering from affable to bored to indignant. He spun an elaborate metaphor about an ambitious stripper and showed off a chest scar from a near-fatal motorcycle wreck.
Gioe worked for a merchant cash advance company called Par Funding, which is run by a guy who changed his name to conceal his criminal record and who, when asked about the mafia, replied “I don’t believe there’s any such thing.” That is one very specific way to go with that question! Supposedly if you’re in Skull and Bones and someone mentions it you have to leave the room, to preserve the secrets of the society or whatever, but if you stop and think about that for a minute it makes no sense: If you actually leave the room, it’s kind of a tell!
Farting Teslas
Uh sure: This week Tesla Inc. delivered a new software update that includes “the ability to make a Tesla vehicle fart on demand or every time a turn signal is used.” There are six available fart noises. They have names. One is named “Short Shorts Ripper,” apparently because Tesla CEO/prankster/micro-manager Elon Musk “simply can’t seem to stop trolling short sellers.” Animosity to short sellers has crept into product design at Tesla. Presumably the next Tesla model will have a suite of short-seller detection sensors and a mechanical hand that pops out and extends a middle finger when you pass David Einhorn on the street. I was a little surprised that the list of fart noises does not include one named “SEC Lawsuit.”
In other Elon Musk news, here’s a report from the opening of Boring Co.’s first tunnel. “At a s’more station, a young woman wearing a company jacket used a Boring Co.-branded flamethrower to warm a marshmallow held at the tip of a sword” while, presumably, some Teslas farted their way through the tunnel. People who read this newsletter seem to think that I am a harsh critic of Elon Musk, but I do not really think of it that way. It is just that Musk is comically bad at securities regulatory matters, and kind of unsound on corporate governance, and those are topics that we talk about a lot around here in this financial newsletter. But there are more important things in life. The man does seem to have fun.
By Matt Levine
Non Prototype Language... 