Overstock’s Patrick Byrne’s Promotion of tZERO is False and Misleading

[Author’s note: A version of this document was filed as a complaint with the U.S. Securities and Exchange Commission, January 22, 2018.]

Patrick Byrne, CEO of Overstock.com (OSTK) has made, and continues to make, materially false and misleading public statements for the purpose of promoting the ongoing offering of $250–300 million of securities in Overstock subsidiary tZERO in an initial coin offering (ICO).

From 2015 to the present, in various public venues, including media interviews and speeches at cryptocurrency conferences, broadly available to the public via YouTube, Cheddar, and other venues, including most recently the North American Bitcoin Conference on January 18, 2018, Byrne has made a series of false and misleading statements seemingly designed to induce prospective investors to participate in the tZERO ICO, and to artificially inflate the price of Overstock.com common shares.

For background, tZERO is an 83%-owned subsidiary of Overstock.com which plans to make money as a “cryptocurrency investment bank.” Specifically they plan to profit by:

· disrupting the stock loan market (by far the focus of Byrne’s promotional efforts)

· serving as the “first and only SEC approved venue for initial coin offerings”;

· becoming the first and only SEC approved trading venue for crypto-securities.

The core of the story repeatedly told by Byrne is summarized below. Note that each of the three elements of this story is materially false. The entire story is largely a fantastical fiction which overstates the business opportunity for tZERO by as much as 25,000 percent in order to mislead investors about tZERO’s true prospects. Here is the tale:

- Overstock.com spent $30 million in litigation to learn a secret, that 75% of the revenue of Goldman Sachs and 75% of the revenue of Wall Street banks is from securities lending.

- The stock loan industry is opaque. Neither lenders, the pension funds, nor borrowers, the hedge funds, have any idea what the rates are. Spreads in the securities lending industry are massive. A pension fund might routinely get 60 cents for lending a stock while prime brokers collect $20 for lending those shares.

- The spreads that Wall Street receives from pension funds each year are equal to 2 to 3 percent of the total assets of the pension funds. There is a pension fund crisis in the United States because pension funds are only earning 4%. They would be earning 6%-7% a year if it weren’t for Wall Street stealing their money via the massive spread on stock loan desks. Stock loan shenanigans are the cause of the pension crisis, and if pension funds adopt tZERO for securities lending, they can solve the pension crisis. Pension funds should become clients of tZERO because to do otherwise would be a violation of their fiduciary responsibility.

Byrne false claim #1: Overstock.com spent $30 million in litigation to learn a secret, that 75% of the revenue of Goldman Sachs and 75% of the revenue of Wall Street banks is from securities lending.

In Byrne’s tZERO presentations, he explains Wall Street’s “big secret,” namely that he claims the majority of investment banks’ revenue comes from securities lending. He typically first states that 75% of prime brokerage revenue comes from securities lending, but then consistently and repeatedly presents that statistic as 75% of Goldman Sachs’ revenue and/or “75% of the revenue of Wall Street”[i]; for example: “Seventy-five percent of Goldman Sachs’ revenue comes from an activity that they have kept, that has been obscured from the public. It’s called securities lending.”[ii]

Byrne’s claim, the one he has repeated to prospective investors time and time again for more than two years now as the introduction to his investment pitch for tZERO, is completely bogus. Each of the big six prime brokers files public annual financial statements every year. In those statements, securities lending revenue is included as part of the revenue of one specific business segment for each company. It is easy for anyone to calculate the maximum possible revenue that each bank is receiving from securities lending, and does not cost $30 million to calculate that number.

The segment of Goldman Sachs that includes securities lending represents only 5.8% of the revenue of Goldman Sachs, meaning that securities lending is less than 5.8% of Goldman’s revenue. Across the major banks on Wall Street, securities lending represents less than 5% of revenue. Byrne’s 75% claim is off by more than 15-fold, likely something on the order of 30-fold, or 3,000%, as each of these business reporting segments include functions other than securities lending.

Byrne’s False Claim #2: The stock loan industry is opaque. Neither lenders, the pension funds, nor borrowers, the hedge funds, have any idea what the rates are. Spreads in the securities lending industry are massive. A pension fund might routinely get 60 cents for lending a stock while prime brokers collect $20 for lending those shares.

Here’s what Patrick Byrne has been telling prospective investors, in his own words:

“They [prime brokers] have got a monopoly, the buyers and sellers are in the dark, and they are extracting enormous monopolistic rents.”[iii]

“In part because of the attention we started to bringing to this about 10 years ago, the pension funds started getting smarter and saying ‘If you’re making money loaning our stock out, we want a piece of the action, we want you to kick back thirty percent to us,’ and so how that should work is the prime broker gets their $20, and $6 goes up to the pension fund. Well, what the prime brokers figured out they could do in that case is they go to a friendly prime broker in between, and they say, ‘We’ll give you the locate’ for let’s say two dollars, and they cut in the pension fund for their 30 percent or 60 cents, and then that middle prime broker gives the locate on, takes the $20, and there’s a back-office game in the repo market where they basically give a half of the kickback ($8.30) and this has all come out in a variety of lawsuits on Wall Street that this turns out to be this regular practice that there’s this kickback done in the overnight repo market, that they equalize the cut, so that’s what really happens. I just refer to this as mischief. There’s amazingly few controls, no controls, to keep this going on in the back offices of Wall Street in the last decade.”[iv]

The claim that buyers and sellers in the stock loan market are “in the dark,” if it was ever true, is simply no longer grounded in reality. Securities lending market participants offer daily reports providing commentary on both the magnitude and direction of rates, and several free and paid services such as iborrowdesk.com, Interactive Brokers Stock Loan Availability database, BLACK App (from S3 Partners), and Markit provide information about rates and the availability of shares.

BLACK App, for example, displays data on the spread between what lenders (e.g. pension funds) receive for their shares and what borrowers (e.g. hedge funds) pay to borrow shares. The average percent of the stock borrow cost taken by intermediaries (i.e. the prime brokers) can be readily calculated. Are prime brokers keeping 97% of the stock borrow premium they collect ($19.40 out of $20), as in the example Byrne repeatedly shares with prospective investors? Are pension funds really receiving only a paltry 3% of the total stock loan cost?

The answer is a resounding NO. Using BLACK App, we screened for the 500 U.S.-listed securities with the highest notional short interest (in dollars), and from those selected the 100 securities with the highest cost to borrow. Based on this analysis, securities lenders receive on average 69.5% of the cost that security borrowers pay, meaning pension funds are receiving about 70% of the stock loan proceeds, and prime brokers only about 30%.[v]

Even retail “mom and pop” investors can get a vastly better deal than what Byrne claims sophisticated pension funds are getting. Interactive Brokers, for example, provides a universal 50% spread for those who opt-in to receive payment for lending securities. Byrne is simply weaving false and misleading claims into a seemingly compelling, but false and misleading investment thesis for tZERO.

Byrne’s False Claim #3: The spreads that Wall Street receives from pension funds each year are equal to 2 to 3 percent of the total assets of the pension funds. There is a pension fund crisis in the United States because pension funds are only earning 4%. They would be earning 6%-7% a year if it weren’t for Wall Street stealing their money via the massive spread on stock loan desks. Stock loan shenanigans are the cause of the pension crisis, and if pension funds adopt tZERO for securities lending, they can solve the pension crisis. Pension fund should become clients of tZERO because to do otherwise would be a violation of their fiduciary responsibility.

Byrne repeatedly and dramatically overstates how much stock lending is affecting pension plans. For example: “The pension fund crisis can really come down to this number: they’ve been assuming about a 7% return on average, American pension funds. In reality, they make 4% over the long run… of that 3%, about 2% has been thieved from them… in that game [securities lending] I just showed you.”[vi]

“I think it’s a way we can break the pension fund crisis. In fact there was an analysis that the pension funds are going broke because they’ve been assuming a seven percent actuarial assumption and the truth should have been a four. Well, that missing three percent, is about the revenue that comes out of this game, and gets turned into 75% of the revenue of Goldman Sachs. If what we can do is adopt the pension funds to adopt this technology, which I think shouldn’t be too hard a sell, what it effectively does is replumbs that pipe, so instead of being 75% of their revenue, it goes back to the pension funds where it is about a missing 2-and-a-half or three percent. It could solve the pension fund crisis. So everybody’s happy.”[vii]

Byrne uses this narrative to persuade prospective investors to think that there will be a natural huge push from pension funds to use the tZERO platform. Unfortunately for them, this narrative is a fantasy.

According to the Federal Reserve, there are approximately $19.55 trillion of assets in United States Private and Public pension funds as of Q3 2017.[viii] Two percent of $19.55 trillion, what Byrne claims the stock loan industry is stealing from pension funds, would equal $391 billion each year. As we demonstrated above, public financial statements show that the big six prime brokers, together, receive well less than $12 billion from securities lending each year, and probably on the order of less than $6 billion given that securities lending is only part of the revenue from the business segments shown. In other words, the entirety of securities lending revenue from large U.S. prime brokers isn’t 3% of pension funds, it is less than 0.03% of pension funds!

Byrne’s figures are plainly false, no matter what sort of credible analysis one does. Just to be absolutely certain, we analyzed a different dataset, using BLACK App to look at the entirety of the stock loan market for stocks in the Russell 3000, an index of the largest 3,000 U.S. companies by market capitalization, which includes 98% of the value of the entire U.S. equity market. Data was available for 2,952 companies. The compensation received by stock lenders (e.g. pension funds) is approximately $2.57 billion dollars, whereas the total amount paid by stock borrowers (e.g. hedge funds) is approximately $4.73 billion.[ix]-[x] The entirety of securities lending revenue from the Russell 3000, 98% of U.S. equity market cap, is 0.024% of the assets of pension funds. The entirety of the spread, the share kept by prime brokers, is $2.17 billion, or 0.011% of pension fund assets. Byrne’s “three percent” claim overstates the market opportunity by more than 25,000 percent!

Byrne advises his audience to write their pension fund managers to tell them to join the lawsuit against Goldman Sachs, saying “pension funds who don’t join this lawsuit, are I think sort of betraying their fiduciary obligations and [so are] pensions who stick in the system and forgo the extra money they can make [by becoming tZERO customers].”[xi] Byrne’s suggestion that pension funds have a “fiduciary obligation” to use an unproven service, which doesn’t integrate well with existing industry practices or regulation (see below), and which recently reported “$10,000 a week[xii]” in revenue, is false, misleading, and frankly absurd.

Byrne has pitched tZERO’s stock loan business as one able to disrupt a massively large market with massively large margins. In reality, the market is a tiny fraction of what he has said it is, and the margins are a tiny fraction of what he has said they are. That’s pretty bad, but the reality for tZERO and Overstock.com investors is even worse, because not only has Byrne made glaringly false statements about the market opportunity for tZERO, he has also neglected to mention the massive, material barriers to the acceptance of tZERO as anything other than a microscopic player in the stock loan industry.

tZERO Employees have previously, for many years, operated similar stock-loan platforms without the word “blockchain,” and they were not wildly successful.

Byrne seldom if ever mentions that tZERO co-founder John Tabacco was long involved with a stock borrow platform that offered similar functionality to tZERO (sans “blockchain”), including pennies per share pricing and a unique numeric identifier for each stock locate. Tabacco sold this business, Instilend, for only $2.4 million in 2012.[xiii]

Tabacco’s brother, Todd Tabacco, the SVP of Business Development for tZERO, also previously operated a similar stock loan platform (sans blockchain), this one at Weeden Prime Services, which featured inventory from Industrial and Commercial Bank of China.[xiv] It seems unlikely to be a coincidence that in 2015, Byrne said that tZERO was working to process $250 billion in stock loan inventory for ICBC.[xv] The fact that Byrne recently spoke of tZERO having grown its inventory of lendable stock to $120 billion as of November 1 likely says more about the company’s history than its future growth potential.[xvi]

Existing standards within the prime brokerage space, and existing securities regulation around short selling, are large barriers to tZERO’s adoption.

The stump speech for tZERO that Byrne has repeatedly given fails to tell prospective investors that prime brokers may often not accept tZERO’s stock, may double-bill their clients for stock delivered by tZERO, or may assign tZERO stock to clients other than the tZERO customer who paid for the stock borrow. According to a senior stock loan industry expert, many prime brokerage firms, including Goldman Sachs, do not accept “put throughs” of borrowed stock; in other words, if a hedge fund were to pay tZERO for a stock borrow, in the event that stock were delivered to Goldman Sachs, Goldman would make the stock available to any of its clients, not just the tZERO customer. Additionally, if Goldman did assign the stock borrow to the tZERO customer hedge fund, Goldman would still charge the hedge fund for the borrow, so the hedge fund would end up paying both tZERO and Goldman, for a total of roughly twice the usual price.[xvii] This would make tZERO completely uneconomical for its intended customers, who rely on their prime brokers to custody their assets.

Byrne also doesn’t seem to have disclosed that current securities laws often do not allow the tZERO stock loan program to work as intended. Even in the event that a prime broker was friendly with tZERO and wanted to “put through” stock that a hedge fund intended to borrow through tZERO, there are instances in which the stock borrow would not go to the hedge fund. For example, let’s say Hedge Fund X wants to borrow 20,000 shares of ABC Corporation stock, and pays tZERO for the borrow, then tZERO delivered the shares to Hedge Fund X’s prime broker. If shares of ABC Corporation are particularly hard to borrow, and the prime broker was already “failing to deliver” shares of ABC for other clients’ previous trades, shares of ABC must be used to cover that shortfall, rather than being available for Hedge Fund X. If the prime broker was failing to deliver on 500,000 shares of ABC altogether, it would need to find 520,000 shares of ABC in order to make 20,000 shares available to Hedge Fund X. [xvii]

In the absence of significant, sweeping regulatory change that would likely be opposed by every significant player in the stock loan space, it’s extremely difficult to envision how tZERO would be a meaningfully larger business than the Tabacco brothers’ previous efforts.

Byrne’s false and misleading statements are damaging investors presently.

Overstock.com, a company which was recently previously valued at less than $500 million, has added roughly $1.8 billion dollars of market capitalization due to the company’s cryptocurrency hype. Byrne’s material, false misstatements have directly fueled the rise of the shares, speculation on various social media, and have likely induced investors to participate in the ongoing tZERO initial coin offering, which is seeking to raise $250–300 million or more, for what may well be a worthless security.

On January 19, 2018, Byrne told Internet news channel Cheddar, “Right now we’re doing a tZERO ICO raising $300 million, and when that’s done, people are telling me that’s a business they think has a $3 or $4 billion value, and if I pull off what I expect I can do in the next few years, these big Wall Street investors are saying ‘We think that’s a $40 billion business.’”[xviii]

As would be expected, retail investors, and others, are repeating such claims on social media[xix]:

Meanwhile, seven different Overstock.com insiders have recently sold stock on the open market. Per public filings, three SVPs sold their entire stake of common stock, and notably, Johnathan Johnson III, the executive at Overstock.com who oversees Medici, the company’s “blockchain” division which owns the tZERO stake, has sold more than half of his Overstock.com shares, selling $1.35 million in insider trades since August 11, 2017.

source: insidercow.com

In the interests of protecting investors, we urge the Securities and Exchange Commission to halt the tZERO ICO process until such time as Overstock.com corrects the material false and misleading statements which its CEO has publicly made. If investors had an accurate understanding of tZERO, it’s extremely unlikely they’d be handing over any of their money to the company.

[i] Blockchain in Business: Overstock and tZERO — Patrick Bryne. September 21, 2017 (published Nov 2, 2017) at https://www.youtube.com/watch?v=COQvMsbb-Cw&t=11m35s [11:39, 15:59] and

https://www.youtube.com/watch?v=HTbE8DXyjG8 [1:40:53, others]

[ii] Blockchain in Business: Overstock and tZERO — Patrick Byrne. September 21, 2017 (published Nov 2, 2017) at https://www.youtube.com/watch?v=COQvMsbb-Cw&t=4m35s [04:35]

[iii] Overstock CEO Patrick Byrne announces new financial technology innovations. Published Aug 6, 2015. https://www.youtube.com/watch?v=suhYcwXwV2o&t=41m25s [41:25]

[iv] Blockchain in Business: Overstock and tZERO — Patrick Bryne. September 21, 2017 (published Nov 2, 2017) at https://www.youtube.com/watch?v=COQvMsbb-Cw&t=8m25s [8:25]

[v] Based on Bloomberg & Black App data for US-domiciled securities with a $100M+ Mkt Cap as of 1/18/18 & Aristides Calculations

[vi] Blockchain in Business: Overstock and tZERO — Patrick Bryne. September 21, 2017 (published Nov 2, 2017) at https://www.youtube.com/watch?v=COQvMsbb-Cw&t=10m50s

[vii] The North American Bitcoin Conference 2018 Part 2 (Miami, FL). January 18 2018. https://youtu.be/HTbE8DXyjG8?t=6033

[viii] https://www.federalreserve.gov/releases/z1/Current/z1.pdf#page=108 (labeled p.94 on document)

[ix] Total amount paid to lenders is based on bid. Total amount paid by borrowers is based on average of offer ($4.638 billion) and last reported charged rate ($4.823 billion).

[x] Astute readers will note that the split of revenue in this analysis is 54% to the lenders (e.g. pension funds) and 46% to the prime brokers. This is different than the 70% lenders/30% prime broker split in our analysis of hard-to-borrow securities, because there is a certain minimum spread that brokers want to be paid on easy-to-borrow securities, no matter how inexpensive the borrow is. For example, if a security is among those that are easiest to borrow (“general collateral”), the brokerage firm tends to charge the borrower/hedge fund about 25 basis points (0.25%) more than they are paying to the lender/pension fund. The broker has to be paid some small amount for taking on the risk and administrative work inherent to the transaction. This is still a hugely different reality than the 3% lenders/97% prime brokers revenue split which Byrne uses repeatedly in his example transaction.

[xi] Blockchain in Business: Overstock and tZERO — Patrick Bryne. September 21, 2017 (published Nov 2, 2017) at https://www.youtube.com/watch?v=COQvMsbb-Cw&t=19m5s [19:05]

[xii] Ibid. https://www.youtube.com/watch?v=COQvMsbb-Cw&t=18m20s [18:20]

[xiii] https://www.prnewswire.com/news-releases/investview-announces-definitive-agreement-to-acquire-instilend-inc-170328926.html

[xiv] https://www.linkedin.com/in/todd-tabacco-7a52472/

[xv] Overstock CEO Patrick Byrne announces new financial technology innovations. Published Aug 6 2015 https://www.youtube.com/watch?v=suhYcwXwV2o&t=40m40s [40:40]

[xvi] Securities lending “mischief” to blame for 2008, says Overstock CEO. Securities Lending Times. October 27, 2017. http://www.securitieslendingtimes.com/securitieslendingnews/article.php?article_id=221628

[xvii] discussion with senior stock loan industry participant at major U.S. prime broker

[xviii] January 19, 2018. https://cheddar.com/videos/overstock-ceo-responds-to-bitcoin-mix-up

[xix] https://twitter.com/Sean_PLG_BK/status/951912870383583232

Disclaimer: The author of this article is an Exempt Reporting Adviser. Nothing herein should be construed as investment advice. All assertions herein are accurate to the best of our knowledge as of this date, January 23, 2018. We undertake no future obligation to update or revise this article. The author is the General Partner of two private investment vehicles which, at the time of publication, hold a short position in the common stock of Overstock.com, and hold bearish options positions in Overstock.com. Those positions may change at any time, and we undertake no obligation to update this article if/when those positions change.

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