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Ten PIPE-ers PIPE-ing
As we ring out the Old Year, we appear to be ringing in a return to old market abuses.

The Wall Street Journal (December 29, page C3, ‘Wall Crossings’ Provide Fund-Raising Edge) reports the resurrection of a financing facility of the past decade: the PIPE. The article does not call them PIPEs, even as it describes a new wave of private investments in public companies. We are titillated that PIPEs are viewed as so unsavory that Wall Street had to make up a new name for them: Wall Crossings.

Managing PIPE offerings required high-energy teamwork. For the investment bankers and brokers, there were desperate scrambles to raise capital on the spot. Many deals were shopped to only one or two investors and often closed within one or two business days. For the buyer there was the need to come to a purchase decision and provide financing on the spot.

As the PIPE became increasingly common, many deals looked like they were pre-arranged. There were patterns of people shorting the stock of companies in the middle of PIPE offerings before the offerings were announced. The PIPE transaction became a radioactive zone for Trading While In Possession Of Inside Information. It soon appeared that the whole purpose of structuring PIPEs was to permit people to short the stocks illegally prior to the deals being announced. The structure of the PIPEs marketplace was, ultimately, vulnerable to regulatory penetration. There was a proliferation of PIPE offerings from small investment banking firms, which often lacked the resources to stage a major legal battle.

On the buy side, between hedge fund managers, it became somewhat a standard practice to pool information between potential investors. Bound by nondisclosure agreements, hedge fund managers and other investors would nonetheless talk to each other about deals they were being shown. The regulators’ theory is that this was in itself illegal, as they were sharing what was defined as Material Non-Public Information (knowledge of an impending offering, which would likely drive down the price of the stock in the market) in violation of a clear duty of confidentiality (the non-disclosure agreement).

Why did investors confer about deals? The PIPE market was limited and there was strong competition for good deals. PIPE offerings were generally from small-cap or micro-cap companies, often under ten million dollars, and would seek to close within one business day. Money managers would negotiate with each other over deals they were being shown, which controlled the pricing. Money managers agreed to stay away from deals that other managers were keen on, thus removing competition for the deal. The manager who dropped out this time around would be given first crack at the next PIPE deal. And manager who declined the transaction would short the shares that his compatriot was buying – also a violation of the laws on insider trading.

There is no way to know how widespread this practice is. When the SEC Office of Compliance Inspections and Examinations (OCIE) tried to drill down through these offerings, the hedge fund world pulled out all the stops in lobbying the Commission in Washington. Ultimately, the OCIE was instructed to back off. Now that this facility is in the hands of the Big Boys, we doubt that too many safeguards will be built in. In this market environment, companies will want to raise cash and may not be too particular about how badly their share prices suffer. And we readily concede the value of on-the-spot offerings. Professional investors have different standards of due diligence from the rest of the investing public, and it may be legitimate to provide them a streamlined investment process in some cases. However, investment banks, having just received taxpayer largesse to the tune of $700 billion, are not likely to be called to heel by the regulators when they are in the midst of transactions designed to get the markets back on their feet.

We look forward to Mary Schapiro as the new Top Cop. We think she has the goods, but she will only be as effective as she is allowed to be. OCIE will have to be given a fat new budget if its examination staff is to reach both the size and the level of experience to ferret out improper activity. And the Administration will have to take the lead in specifying what types of practices will not be tolerated, otherwise it will be Business As Usual on Wall Street.

It takes a seasoned market participant to recognize these issues, and Ms. Schapiro can’t be everywhere at once. We wish OCIE well in trying to beef up its resources, because if the SEC is not a cop, it is nothing at all.

The PIPE marketplace was largely populated by Nasdaq member firms. With their smaller capital bases, they were easier prey for regulators. We don’t fancy the chances of a team of FINRA examiners going into Morgan Stanley and auditing the personal trading records of the bankers on a multibillion-dollar raise for GM in the first quarter. In the hope that our government responds to noisy citizens, we urge shareholders to do their own look-back and examine trading patterns in the weeks preceding an announcement of a “wall crossing” private placement.

And by all means, write your Congressman.

How REIT You Are
The Real Estate Investment Trust industry is up in arms over the way their stocks are being whipsawed in the marketplace, and a recent Wall Street Journal article ties the proliferation of REIT Exchange-Traded Funds (ETFs) to recent volatility in REIT shares (WSJ, Dcember 26, “REIT Moves Rub Executive Wrong Way”).

The process of ETF issuance and redemption means that large blocks of stock may be traded multiple times in the course of a day as ETF shares are issued and redeemed. In theory, the ETF price always reflects the prices of the underlying instruments. It now appears that trading in the ETFs may cause large swings in both price and volume in the stocks on which they are based.

On top of this, there are ETFs based on assets such as gold, silver, or currencies, markets that do not trade coterminously with the stock exchanges. This means ETF issuers may find themselves scrambling to pre-position against anticipated demand for the next trading day, creating artificial imbalances in the underlying markets. It also means that trading in an ETF in the window after the close of the underlying market may not be tied to any real price.

The REITs look like victims of portfolio adjustments in the final minutes of trading, but with a cascade effect. If one ETF has a large trade – say an institution unwinding a basket of shares, versus an ETF hedge – there can be a double-whammy effect in the market. The institution trades its own shares, most of which are also components of the ETF. The ETF is traded, creating an excess position in the shares in custody. These price moves in the components of the ETF also set off trading in ETFs from other issuers. Finally, at the end of the day, the ETF managers buy or sell shares to flatten the custody position. The effect in the marketplace will look like waves of activity, perhaps taking the stocks down, then up several percentage points in short periods of time.

Meanwhile, other ETFs in the same space are trading many of the same underlying shares. As the components swing several percentage points over the course of the day, traders of other ETFs trade in and out, trying to catch the price swings, causing further instability in the pricing. The ETF managers now have ballooning positions to either create or close out in the final minutes of trading, and the professionals who trade the ETFs in large quantities are sensitive to small price moves.

Look for studies of the relationship between ETF trading and market pricing to start to hit the press, followed shortly for an outcry to regulate ETFs. We suspect the effort will be modeled on the approach used to tackle mutual fund market timing and late trading. As with the mutual fund brouhaha, we should expect excesses of regulation and over-the-top legal action.

Mutual fund late trading was illegal, and should be illegal, as it is clearly a form of fraud on the market. Market timing, however, was not illegal, but people were threatened with jail and had to pay large sums of money to settle the SEC action.

If we were the betting kind, we would look for regulation by the spring to limit the activity of ETF managers and the professionals who trade them. This will likely factor into the new ham-fisted regulatory package sure to be introduced to clobber the hedge fund industry. Much of the volume in ETF trading is tied to statistical arbitrage programs undertaken by the You-Know-Whos.

We believe the ETF rules will be modeled largely on the theory that underlay the rules surrounding mutual fund late trading. And, as with the mutual funds affair, we assume a large number of traders who are neither breaking the law, nor violating any ethical standard, will be strong-armed over their involvement in the world of ETFs. This is the legislative equivalent of using a 9MM Glock, when a flyswatter would do just as well. It is the way regulation typically works. We suggest you step aside until it hurtles by, or risk getting swept up and bludgeoned.

I Only Work Here…
Our working definition of Libel is: writing something for publication which we know to be true, and which will prove irremediably embarrassing to some other person, said person possessing a large enough bank account to tie us up in court for years.

Bearing this in mind, we offer the following. Names and other facts have been altered. Read on and you will see why.

We came into possession of a letter sent to investors by one of the best known money managers in the business. This money manager is known for being smart, and he is also known for promoting himself. This latter is, we agree, a good way to become known, though not a notable thing to be known for.

In his year-end note to his investors, this manager says that he stopped trading altogether in December, and is waiting for the new year to reassess his prospects. By his own admission, our manager tells us he turned a profitable year into an unprofitable one because he broke his own rules. We find this baffling.

We have been around this business for some time, and we are well aware that every money management contract has a clause stating that the manager may do “anything else the manager believes may be profitable for the portfolio” or some such legal folderol. In the past, we did not pay these catch-all clauses much heed. We submit that today may be a different story.

Investors in hedge funds and mutual funds rely on the experience, intelligence, and overall savvy of their managers to do things with money that the investors themselves cannot do. On top of the high level of confidence – nay, esteem – the investors feel for their managers, every money management contract contains language describing the investment process. Some are more forthcoming than others, but the underlying theory is that the investors should know what the manager intends to do with their money, and they should approve it in advance. This may come as a surprise, but that theory, and the implicit protection it guarantees, applies to the wealthy no less than to the proverbial widow or orphan.

In simple English: rich people can sue you, and they can win. The presumption of sophistication does not extend to expecting an investor to second-guess their hedge fund manager. If a fund departs materially from their stated or established investment process, they are generally required to inform their investors. We would hazard a guess that turning a profitable year into an unprofitable one would qualify in most investors’ minds as “Material”.

Household-name money managers – the crème de la crème – now admit in writing that they violated the trading practices that had made them successful. You will no doubt agree that any money manager whose portfolio was up going into December was pretty darned good. Question number one is: why would they change? Question number two is: why on Earth would they admit it? In writing? To the people whose money they had lost? Are we supposed to feel sorry for these people? Perhaps secure a Government bailout for them?

The money manager appears to be looking for sympathy. Hey, it’s been a crumby year and nobody could have seen this coming. We have heard this excuse from Vikram Pandit, Dick Fuld, and Henry Paulson, to name a few. Outside of the blatant idiocy of making such a statement, how could this man’s lawyers have possibly let this letter go out to clients? Anyone who needs a compliance officer may feel free to contact us. We have a list of highly qualified friends.

It has always been shocking to us to contemplate the degree of complacency with which investors accept the actions of those entrusted with their wealth. If you disagree with this statement, we suggest you Google “Bernard Madoff”. Now there are a lot of out of work lawyers in America. Many of them are smart, and all of them are hungry, and we predict they will soon be suing hedge funds for losing money on the theory that, in the face of unprecedented market conditions, the fund managers departed from their regular trading strategies, in violation of their contractual obligations to their investors.

The prospect of a rash of lawsuits against the hedge fund industry is both very believable and quite scary. As hedge funds have proliferated, they have become the high-end equivalent of stockbrokers. Those of us who worked in the broker dealer compliance world in the 1990’s watched the tsunami of lawsuits in the wake of the dot-com market collapse. Who is going to be the lucky lawyer to be the first to specialize in suing hedge funds?

And think about the orders of magnitude: stockbrokers faced customer claims for tens of thousands of dollars, occasionally hundreds of thousands. Sometimes many millions. How about a hedge fund settling a class action lawsuit claiming four billion dollars in improper losses? This industry should not assume that rich people do not sue.

Here. Let us make it simple for you.

Q: What do you call it when only one lawyer wins only one case for only one plaintiff in only one court?

A: Precedent.

Happy New Year.

Moshe Silver
Director of Compliance
Research Edge LLC