Dystopian Future Securities Fraud

Hi! It’s been a while. This column has been on hiatus since August as I have been on parental leave. I am back now. A lot of news has happened since August. Also, I am aware that there are a lot of new readers here, for reasons. Welcome!

I thought that, for this first week, we might ease back into Money Stuff by talking about some of the stories I missed while I was on leave. Not everything, of course, and not even all the important financial stories, but some of the more … Money Stuff-ier ones? It’s going to be a weird week anyway; we might as well remember the highlights of late 2020, such as they were. And then next week we’ll get back to more normal programming.

Cyberpunk

Let’s start with video games? I don’t know a ton about Cyberpunk 2077, but I gather that it is a highly anticipated video game that was released in December and turned out to be full of funny glitches, one of which involves "characters going into ‘T-Pose’ — standing with their arms raised to either side — and suddenly losing their pants." Not wearing pants does sound pretty cyberpunk! But is it securities fraud?

Two different law firms announced [in December] they were filing suit against CD Projekt, alleging the company violated securities law by misleading investors (and everyone else) about the state of Cyberpunk 2077 and whether it would be playable on current-generation consoles, the PlayStation 4 and XBox One.

Statements CD Projekt Red made about Cyberpunk throughout 2020 were "materially false and misleading," the complaint (PDF) alleges, because the company failed to mention that the game "was virtually unplayable on the current-generation Xbox or Playstation systems due to an enormous number of bugs."

CD Projekt SA is the company that makes Cyberpunk 2077. It is a publicly traded Polish company; its stock trades a little bit in the U.S. Before Cyberpunk 2077 was released, when it was a highly anticipated video game, CD Projekt’s stock went up. After it was released, when it was a hilariously glitchy video game that was effectively recalled for being unplayable, CD Projekt’s stock went down. People who bought the stock when it was going up, because they thought the game would be good, have lost money, because the game is bad. And so they are suing. I mean, "they are suing" is a bit of an exaggeration; really some entrepreneurial lawyers have filed class-action lawsuits in the name of those shareholders, hoping to get a cut of the damages.

We talk about this a lot around here. I like to say that "everything is securities fraud": Any time a public company does a bad thing, or a bad thing happens to it, some clever lawyer can sue it because its stock went down. The company knew about the bad thing and didn’t disclose it, or didn’t adequately warn shareholders about the possibility of the bad thing, so the shareholders were deceived when they bought the stock. And so companies are sued for securities fraud over global warming and customer data breaches and sexual harassment and mistreatment of killer whales.

Usually when we discuss this theory, the bad thing tends to be a big discrete event, a scandal or crime or data breach. But there are cases like this too, where the bad thing is just, the company made a product, and the product wasn’t as good as the shareholders were hoping for. Just being bad at your business can be securities fraud.

In a way, this makes as much sense as anything. Companies tend to make a lot of optimistic announcements about their upcoming products, and those announcements matter to shareholders. If a company repeatedly says "we are really excited for our new product, which will be good," and then the product is bad, then it doesn’t seem like such a stretch to say that it was lying to shareholders in a material way.

In the larger sense, though, this is kind of a weird thing for shareholders to sue over. Like, your job as a shareholder is to pick the right businesses to invest in. Your expectation should be that if you invest in a business that makes good products you will make money, and if not you will lose money. If your expectation is that if you invest in a good business you will make money, and if you invest in a bad business you can go to court and complain and the court will give you your money back, then maybe your job is a little too easy.

I gather, though, that Cyberpunk 2077 is about a futuristic cyberpunk dystopia. (I mean, from the name?) And I guess these lawsuits are kind of cyberpunk? Like my fictional techno-dystopian future will be a world controlled by corporations in which there are no laws except securities laws, and you can run around, naked from the waist down, murdering people with lasers, with no consequences except shareholder lawsuits.

Wait, is everything securities fraud?

Here is a paper from Emily Strauss of Duke Law School, titled "Is Everything Securities Fraud?"

Securities litigation is a virtually inevitable fact of life for any public company. Often, investors sue because the firm’s managers engaged in fraud that directly harmed the shareholders – say, by doctoring the firm’s financials, or lying about known business prospects. However, shareholders also sue their companies when those companies engage in conduct that primarily harms a different set of constituents. When a drug on the market proves to have dangerous side effects, a faulty car battery bursts into flames, or an oil rig explodes, it’s difficult to say that the most direct victims are the companies’ shareholders. Yet shareholders commonly sue under the federal securities laws based on precisely this kind of conduct, on the ground that the managers should have better disclosed the underlying facts, and investors were harmed by the resulting drop in stock price because they did not.

This paper assesses the pervasiveness and impact of these lawsuits. I find that roughly 16% of securities class actions arise from conduct where the most direct victims are not shareholders. However, I find that these cases have roughly a 20% lower likelihood of being dismissed, and settle for significantly higher amounts.

Strauss points out that these cases could have sort of a perverse effect along the lines that I suggested above:

I argue that although these cases may have deterrence value, the fact that they are likely to be more successful and lucrative may diminish incentives for shareholders to monitor their managers to prevent them from pursuing profitable conduct that harms outsiders.

If you are a shareholder of a public company, you want the company’s managers to maximize profits, within reason. If the managers could increase profits by doing a bunch of crimes, you might not want that. You might not want that because you are a good and moral person, but assuming that shareholders are just amoral return-maximizing machines, you nonetheless might not want it because the company would get in trouble for the crimes, and that would be bad for business, and thus for the stock price. But if the shareholders get compensation for that—if they can sue when the stock price goes down due to corporate crimes—they will have less reason to object to the crimes. "Whatever, do crimes, if you succeed then the stock will go up, and if you fail and the stock goes down then a court will make you pay us back."

I am not entirely on board with this theory. One problem with shareholder lawsuits generally is that the shareholders are suing the company, and if they win they take money from the company; it was their money to begin with, so it’s kind of an unsatisfying form of compensation. If you are a shareholder, suing the company for losing money is some consolation for the losses, but not nearly as good as not losing money in the first place.

Actually I tend to think that "everything is securities fraud" is more likely to be pretty good at deterring bad behavior. I have written before that it is weird and troubling to have all corporate misbehavior regulated through the interests of shareholders, but it does seem effective. There is a well-oiled machine for shareholders to sue companies, a group of expert lawyers who know that they can get rich by discovering new forms of securities fraud and so have powerful incentives and tools to police corporate misbehavior.

So for instance here’s another story from the winter, about how Pinterest Inc. allegedly has a "toxic work environment" and a "culture of discrimination," so its shareholders are suing. A toxic work environment is bad for workers, sure, but also allegedly for the stock price (bad press, user boycott, etc.), so the shareholders sued. At the time they filed the lawsuit in November, Pinterest’s stock price was at an all-time high, so I am not sure how empirically sound this theory is, but I suppose if things hadn’t been so toxic the stock would be even higher, etc. Anyway the Pinterest shareholders’ lawyers previously won a $310 million settlement from Alphabet Inc. on a similar theory, so this stuff works.

Of course the lawyers get a cut of those settlements. "Sexual harassment is securities fraud" is an idea that will buy a big yacht for the lawyer who came up with it. It’s so much better—for the lawyer—than suing directly for sexual harassment. If you sue for sexual harassment you have to recruit individual plaintiffs who were harassed, and you have to prove their cases, and they’re all probably different so it’s harder to make it a lucrative class action, and they are actual individual humans who have been harmed and you have to be sensitive to their trauma. If you sue for sexual-harassment-as-securities-fraud, the plaintiffs are easy to find (big shareholders), you don’t really have to prove harassment (just refer to news accounts), your clients are only in it for the money, everything is clean and simple and easy. Also the dollar amounts are larger: In some subjective moral sense, sure, employees are more harmed by a toxic work environment than shareholders are, but if the toxic work environment is at a large public company, and the stock drops, then it’s really easy to argue that the shareholders lost a huge amount of money and should get it back.

So I guarantee you that a bunch of high-powered lawyers are working in the lab right now trying to come up with even more powerful forms of "_______ is securities fraud." They are scanning the newspapers for bad things involving public companies and asking themselves, Is this something? Can we make this securities fraud? And so if you run a public company and don’t want to get sued—for huge amounts of money, by highly effective lawyers who have taken hundreds of millions of dollars off of other public companies—then you perhaps look at all these cases and say, well, we’d better not do any bad things. You’d better not do sexual harassment or have a data breach or make a bad video game, sure, but more generally you’d better not do anything that attracts the attention of these securities lawyers.

It’s a very generic enforcer of good behavior: If you do anything shady, people who specialize in extracting money from public companies will extract some money from you. And a lot of technical defenses that you could use if you were sued by your employees or customers or regulators—technical defenses like "the shady thing we did wasn’t actually illegal"!—will not work here, because the lawyers’ basic argument will be "you did this thing and the stock went down." Everything is securities fraud, even things that aren’t actually illegal; anything that gets bad press or moral disapprobation can lead to a securities lawsuit. It is in its way an oddly principles-based form of regulation: You don’t need specific rules against specific types of bad conduct; all you need is evidence that the company did a thing and the stock dropped because of it. Sometimes—as in Pinterest—not even that.

$900 million

We talk a lot around here about battles among creditors of distressed companies. A common theme in these discussions is that these battles are technical and intricate and sophisticated, and that they provide huge rewards for being clever. Perhaps excessive rewards: There is a whole industry of people who are very well paid for reading bond and derivative documents just a bit more cleverly than their competitors, for creatively interpreting arcane loan terms in a way that gives them an advantage. It is a strange use of intellectual resources, pitting all these people against each other to carve up troubled companies.

On the other hand sometimes these battles are not clever at all. In August, just as I was going on leave, a group of hedge funds were in a bitter fight with Revlon Inc., which had made changes to its debt in a way that disadvantaged those funds. (It stripped collateral that was backing the loan they owned and used it to secure new debt that would be effectively senior to their loan; Mary Childs has a fun explanation here.) Those funds thought Revlon was violating its covenants and defaulting on its debt, making the debt due and payable immediately; Revlon thought it was doing something tricky but allowed. The fight pitted experienced credit funds like Brigade Capital Management and HPS Investment Partners against famed corporate raider Ronald Perelman, Revlon’s controlling shareholder. Undoubtedly the hedge funds came into work on Aug. 11 expecting another day of hard fighting against opponents who would not give an inch.

But then instead the money just showed up in their bank accounts? Citigroup Inc. was the administrative agent for a $900 million Revlon loan that was the subject of the default dispute. It was supposed to wire an interest payment of about $8 million to the lenders on Aug. 11, but by accident it sent the whole $900 million instead. Oops!

This must have come as a relief to the hedge funds. Instead of fighting to declare a default and get any of their money back, all of a sudden they just had the money. Also it came as a source of considerable amusement to the hedge funds:

"I feel really bad for the person that fat-fingered a $900 million payment," a vice president at HPS Investment Partners told another executive the day after the Aug. 11 transfers, according to an excerpt highlighted in court. "Not a great career move."

"How was work today, honey?" the vice president said a little later, imagining both sides of the dinner table conversation that night at home. "It was OK, except I accidentally sent $900 million out to people who weren’t supposed to have it."

By Aug. 14, after major news media had reported the bungled payment, another HPS vice president was discussing the transfer with a third, and riffed on the title of a 1970s hit by the Steve Miller Band, according to a court filing by Citibank.

"As Steve Miller said, take the money and run," he quipped.

Obviously Citigroup asked for the money back, and while some of the creditors gave it back, many of the hedge funds said no. (Of course the money came from Citi, not Revlon; Citi was supposed to be transferring money from Revlon to the creditors but it messed this one up.) So Citi sued the hedge funds, and there was a trial in a Manhattan federal court last month. The trial actually heard from the poor guy who fat-fingered the payment, or at least, the manager who approved it, Vinny Fratta:

At first, Fratta figured the error was due to a technical failure.

But "as the day wore on," he said, "I accepted that the mistake had not been caused by any sort of glitch but rather by human error, and that I was one of the humans responsible for the error."

I don’t know what to tell you. You can read here about the "six eyes" approval procedures that Citi has to prevent errors like this, or here about the software updates that might have been involved. But I am not sure that any procedures, or any software, could get the error rate down to zero. If you are a big enough bank and you do enough nine-digit payments every day, eventually you’re going to do a wrong one.

But usually it is not a big deal? You call up the people who got the money and say "hey we didn’t mean to give you that $900 million can we have it back," and the people say "oh right here you go," and that is that. They can’t keep the $900 million if they have no right to it, just because you wired it by mistake, and the sorts of people who get accidental $900 million wires from banks are not usually the sorts of people who would immediately go to an ATM, take out the $900 million in cash, stuff it in a thousand suitcases and flee to a non-extradition country. They’re usually big institutions with longstanding banking relationships and careful compliance officers. They tease you a little and then they give the money back.

The weird thing here is that—apparently completely by chance—the accidental payment intersected with a real live debt dispute in which the hedge funds were arguing, even before Citi paid them, that they were entitled to get their $900 million right away. So when it showed up in their bank accounts they could say, with a straight face, "yes, this is exactly what we deserve, Citi meant to send us this money and we’re keeping it." I mean, not quite with a straight face—read those chat excerpts!—but they could say stuff like this in court:

Greene said he didn’t realize right away that Citigroup had repaid all the creditors, and reckoned Perelman "was trying to ‘pick off’ smaller lenders" to prevent a majority from authorizing the suit against Revlon.

Frusciante, of Brigade, told the court in his declaration that even after Citibank notified recipients that it was an error, "it seemed more plausible that the payments were intentional than that one of America’s largest banks accidentally paid off our loans down to the penny."

It’s not that plausible—I would guess Citi will eventually win this one—but it’s a real argument. And remember these credit hedge funds are in the business of making novel clever arguments about what they’re entitled to, and they were working hard on those arguments about Revlon anyway. When Citi sent them the $900 million by accident, they were happy to put all that creativity to work on a much dumber problem.

Index insider trading

The popular conception of "insider trading" is that it involves trading by insiders. You work for a company, you know secret things about the company, so you buy or sell stock in the company to profit from your secret knowledge. Or you tip your brother-in-law or golf buddy about the secret things so that he can profit from your knowledge and give you a kickback.

There are two background assumptions here. One is that people at the company (and its bankers, lawyers, etc.) know secret stuff about the company. The material nonpublic facts about the company—its financial and operating results, its merger talks, its drug-trial results—are known to insiders and not to outsiders. The other is that people at the company have an obligation to the company, and its shareholders, not to misuse that knowledge. When you work at a company and are entrusted with its secret information and then you go use that information for your personal gain, you are betraying the company and that is a crime.

I want to suggest that this is a slightly old-timey view of insider trading. Some of the highest-profile modern insider-trading-type cases are not about insiders, people at the company who know the company’s secrets and trade on them. Instead they are about outsiders, people who know other secrets, secrets that are not really about the company’s business but that affect its stock price.

So we have talked about allegations that Senator Richard Burr did something wrong when he dumped stocks after receiving Intelligence Committee briefings about the coronavirus in February. There was a factual dispute about what secret information Burr did or did not receive in those briefings, and about whether or not he traded based on it, but he surely didn’t get any secret information from the companies whose stocks he sold. If he got secret information, it was secret U.S. government intelligence about the progress of the coronavirus abroad. Which could have been material to those companies—and in fact the stocks he sold went down after he sold them—but wasn’t exactly information about those companies. It wasn’t a matter of inside information; it was a matter of outside information that affected the companies’ stock prices.

Or here’s this from September:

The Securities and Exchange Commission today charged Yinghang "James" Yang, a senior index manager at a globally recognized index provider, and his friend Yuanbiao Chen, a manager at a sushi restaurant, with perpetrating an insider-trading scheme that generated more than $900,000 in illegal profits.

The SEC’s complaint alleges that between June and October of 2019, Yang and Chen repeatedly purchased call or put options of publicly traded companies hours before public announcements that those companies would be added to or removed from a popular stock market index that Yang helped his employer manage. When the options increased in value after the announcements, Yang and Chen allegedly liquidated their options positions for a substantial profit. As alleged in the complaint, the defendants conducted all of the illegal trading in Chen’s brokerage account, which allowed Yang to conceal his trading from his employer.

Yang worked at S&P Global Inc., where he sat on the Index Committee that decides what stocks go into big indexes like the S&P 500. When he knew a stock would be added to the S&P 500 (or the small-cap and mid-cap S&P 600 and S&P 400), he would allegedly tell Chen to buy call options on the company. S&P would announce the addition, the stock would predictably go up, the options would go up more, Chen would cash in, and they’d split the money. Being added to the index doesn’t usually cause huge price moves, like a merger, but it causes predictable price moves that are big enough to make reliable profits that you can leverage with call options. Here’s their biggest trade:

On September 26, 2019, beginning at 1:48 p.m., Defendants paid $167,529 to purchase 2,392 call options of Las Vegas Sands Corp. ("LVS"). Almost 2,000 of those calls were out-of-the-money, with strike prices between $57 and $60 when LVS stock had opened at $56.19 that morning. After market close that same day, Company A announced that LVS would be added to Index A, causing LVS stock to open 4.78% higher the next morning. Over the next several days, Defendants liquidated the LVS options for $325,956 in profits.

Yang had no connection to Las Vegas Sands, and he got no secret information about Las Vegas Sands’s operations or results or merger plans. Neither did S&P Global, his employer. S&P Global just makes lists of stocks and gives those lists to fund managers. Being put on a list can make a stock go up, because lots of fund managers buy all the stocks on the list. The lists are not based on any secret corporate information; they’re based on public information—basically, they’re based on how big a company is—but there’s enough room for judgment and subjectivity that no one is quite sure what companies will be added to each list until S&P Global announces it. Yang allegedly knew what companies would be added to the lists, and used that information to make money.

You could take sort of a dumb blank-slate view and say, well, knowing that some third party was going to add a stock to a list is not material nonpublic information about that stock, so this is not insider trading. This is not a correct view, and lots of quite traditional insider trading cases involve people trading on secret information about third parties’ intentions. (It is usually called the misappropriation theory, and is often—but not always—about third parties’ plans to acquire the relevant company.) Still it feels a little weird to say that an index addition, which has absolutely nothing to do with the expected future cash flows of a public company, is material inside information about the company.

But in a world in which index investing keeps getting more important, you should expect more of this. A common critique of indexing is that it disconnects companies’ stock prices from their actual businesses: If everyone is indexing, they are not evaluating companies’ business prospects, but just buying them because they are on a list. On this view, insider trading based on secret earnings information is old-fashioned and possibly ineffective, because earnings aren’t what matter. The index is what matters, so that’s where you should expect to see insider trading.

Things happen

Today in Tabs is back. "The sensations are too wonderful to be thinking about going public." Haven, the Amazon-Berkshire-JPMorgan venture to disrupt healthcare, is disbanding after 3 years. NYSE Scraps Plan to Delist China Telcos in ‘Bizarre’ U-Turn. Virtu Moving Workers to Florida as Pandemic Reshapes Wall Street. Man threatens to kill former boss after he didn’t accept Facebook friend request. Bucatini shortage. "Scientists have discovered that, on occasions, an octopus will ‘punch’ a fish for no reason other than ‘spite’."

1. Technically it has unsponsored American depositary receipts that trade a little bit in the U.S.; Bloomberg tells me average volume is about 47,500 shares per day, worth about $1.1 million. Connoisseurs of "everything is securities fraud" will know that it is mostly a theory of U.S. law (and U.S. legal culture), but that anything a *foreign* company does can be securities fraud, if it has U.S.-listed ADRs, even unsponsored ones. We discussed this in 2019.

2. And we occasionally discuss semi-serious arguments that, like, shooting missiles at Iran could be securities fraud.

3. Also some of the hedge funds not only think that Revlon’s debt tactics constituted a default, but also blame Citi for enabling them. Bloomberg reported in August that "For Firms That Got Citi’s $900 Million, It’s a Shot at Payback": "Brigade has made little secret of the antipathy it harbors for Citigroup for its alleged role aiding cosmetics giant Revlon Inc. in stripping away collateral from term lenders and using it to back new debt. Not only does it fault the bank -- as the loan’s administrative agent -- for facilitating the transaction, but moreover it accuses Citigroup of helping Revlon create a credit line to manipulate a lender vote and override the objections of a majority of debtholders to secure the deal."

To contact the author of this story:
Matt Levine at [email protected]

To contact the editor responsible for this story:
Brooke Sample at [email protected]