Slouching Towards Wall Street… Notes for the Week Ending Friday, 27 April 2012
Those who cast the votes decide nothing. Those who count the votes decide everything.
Most Wall Street analysts that we know would define a set of statistics that repeat in similar circumstances as a Trend. In our layman’s view of the world, this is the way scientists understand the phenomena they observe: measurable occurrences that arise with the same frequency under similar circumstances are called Patterns. Scientists take Patterns as the basis for Theories. Wall Street analysts take Patterns as the basis for Predictions. Economists take Patterns as indicative of Trends. Thus do Statistics make fools of us all.
The malicious mischaracterization of scientific process and knowledge has become a staple of current political shriek fests — we certainly can not use the word “debate” to describe the bi-lateral screeching that currently dominates both Washington and the media — and we find ourselves in a bizarre twilight zone where “science” is trotted out to prove the most extreme positions, while the government is castigated for wasting money on… science.
The subversion of scientific research by corporate interests is an old story, whether it is the deliberate withholding of research by tobacco companies or the more recent wave of medical practitioners who skew research paid for by drug companies. More insidiously, scientific research has been conflated with economics. This notion has taken hold in the minds of politicians who know no better anyway — their job is to exercise their mouth and their personality, not their intellect or judgment — and is underwritten by the media which, in the post-Ted Turner age, is devoted to producing headlines that will generate a rage response, rather than balanced analysis of complex situations. Who wants to read a story titled “The Current Economic Situation Is Really Complicated And Reasonable People Disagree Dramatically About What Needs to Be Done, So We May Not Come Up With A Solution Any Time Soon — If Ever”?
This leads to debate being shoved aside on, for example, whether industrial processes that contribute to global warming should be regulated. “We have to consider the cost,” is the stern warning — as though there were a level of revenues that would justify the destruction of our own habitat. Ask the critic: how much would you charge me to let me burn your house down? How about with you and your family trapped inside it?
In this spirit, and strictly for kicks, we offer the following observations.
Citigroup has experienced a corporate reversal, as the widely reported results of its latest shareholder vote have been received as something of a shock (ABC News, 17 April, “Citigroup Shareholders Reject Executive Pay Plan.”) The shareholder vote is non-binding, but is nonetheless seen as a wake-up call to corporate America. ABC quotes an executive from ISS Proxy Advisory Services saying “it is unusual for a big firm to lose a vote and it has been very unusual for a financial services firm to lose.” At over 54% of shareholder votes going against the compensation package, “this wasn’t a near miss.” The executive said only 41 out of the 3,000 publicly traded companies that make up the Russell 3,000 Index failed shareholder “say on pay” votes in 2011.
The ABC story says proxy advisory firms have criticized Citigroup “for designing pay packages that don’t do enough to increase shareholder value,” though it did not specify whether ISS was one of them.
What caught our eye in this story was the size of the vote. When you read these things for a living, sometimes stuff stays with you. And what has stayed with us for a long time is what we perceive as a repetitive cycle of poor management and lax corporate governance on the part of major financial firms, generally led by Citigroup.
The history is critical, because Citigroup only came into existence when the Clinton administration drastically rewrote the law of the land, doing away with Glass-Steagall and tearing down the wall between banking and investment banking. This is, we argue, the single largest contributing factor to the current global financial malaise. If that wall had held firm, it is likely that the abuses of the mortgage-backed marketplace would have blown up much sooner, causing much less carnage, and with more easily identifiable causes and Bad Actors.
Through the earlier days of the financial crisis, we recall then-FDIC chair Sheila Bair saying Citi should be broken up — a position she clung to not on purely philosophical grounds, but because she perceived the firm as sprawling, ill managed, out of control, and likely to torpedo what remained of the financial system. She has not been proved wrong. The mere fact that a disaster has not yet happened (a) does not mean it won’t, and (b) does not make the decision a good one.
We also recall a specific bit of distressing news from the corporate governance wars that oddly bears the same statistic: about 54% of shareholder votes. That number got us thinking, and so we dug out our archives and turned up a story we reported on shortly after the Ark found its rest atop Mt. Ararat — in May 2009, to be exact. The item, called “Citi For Conquest,” covered the re-appointment of C. Michael Armstrong, former CEO of AT&T, and former CIA director John A. Deutch as outside directors of Citigroup. This was a routine matter, the result of a shareholder vote. What was not routine about it was that Citigroup shareholders voted overwhelmingly against the reinstatement of the two. Specifically, in the case of Mr. Armstrong, 54% of shareholders who voted cast votes against his re-appointment.
After tallying up all votes, Messrs Deutch and Armstrong had enough votes in their favor to retain their lucrative board seats. This includes the votes of those shareholders who voted, and those shareholders who did not vote.
Are you still confused? Don’t be.
There are two ways the average investor can own shares. You can own them yourself, and hold the certificates. Perhaps a grandparent gave you a gift of a single share of Disney stock or AT&T back when you were a kid. You received a fancy embossed document with your name on it announcing that you were the owner of ONE (1) share of common stock of the corporation. The other way — which is the way quite a lot of investors own shares — is to have your broker own them for you. This is called “street name,” and means your shares are a book entry together with all the other customers of the firm who own the same stock. Street name shares are both segregated and commingled.
They are segregated, in that you can sell your shares. A book entry is made in your account, matched by a deduction from the broker’s inventory, while the broker on the other side of the trade receives a book entry for the purchase of your shares. They are commingled in that they can be loaned out for shorting — if you have a margin account you signed a hypothecation agreement, which permits your broker to loan shares for other customers to sell short. For corporate governance purposes, they are also voted as a block, almost always in favor of management proposals.
When a corporate matter is put to a vote your broker delivers to you a proxy, advising you that a corporate vote is being held, and asking you to vote Yes or No on a proposal. If you execute the proxy and deliver it to your broker, your shares are voted according to your instructions. If you are like many other people, you generally throw away mail that does not contain either birthday cards or checks. You would be amazed at how many retail investors show up at arbitration hearings against their brokers and say “come on — no one actually reads that!” when confronted with the account agreement they signed. Even more amazing, arbitrators accept this as a fact and often give little weight to a signed document when hearing a case.
Corporate governance specialists cite numerous studies that show a large percentage of shareholders assume their broker will vote their shares for them, and so they do not need to bother with proxies. They are right. What they do not recognize is that brokers will not necessarily vote in what the shareholder would consider their own best interest. Brokers routinely vote street name shares in favor of management recommendations. In a sense, this is justified. Proxy voting is under tremendous scrutiny by the SEC, and any process for voting proxies must be subjected to a robust internal legal review. A broker can not be bothered to do a full legal analysis of every matter proposed for a vote — nor is it their job to analyze every shareholder’s interest. Brokers vote in favor of management proposals on the colorable premise that, if the shareholder was opposed to the way management was running the company, they would dump their shares. You may not like this outcome — but then you should vote your shares. As much as we dislike this, the problem is not so much with the self-serving logic of the brokers but frankly with the lack of self interest on the part of shareholders. Who exactly is minding your store if not you?
In 2009, directors Deutch and Armstrong ran unopposed for reappointment to their board seats. Since there were no challengers, the brokers were permitted, under New York Stock Exchange Rule 452, to vote street name shares in favor of management’s proposal. But “unopposed” does not necessarily mean “approved.” In fact, 54% of shareholders who did vote cast their ballots against Armstrong, and 51% against Deutch. Broker votes at Citi soared in 2009. In 2008 there were about one billion broker shares voted. That number leapt to 1.7 billion in 2009, handily beating 1.1 billion votes against Mr. Armstrong’s candidacy. Mr. Deutch came in stronger still, with a billion votes against, but almost 2.8 billion in his favor, largely counting broker votes.
There are two bits of information needed to fully round out this scenario. We do not have them, nor are we ever likely to obtain them. The first is: how many shares of Citigroup were held in street name at Citi itself at the time of the vote? If I were a regulator making a general rule, would it make sense to prohibit the firm from voting its own customer street name shares in its own interest?
The second question is: how many Citigroup shares recorded in street name all over Wall Street were actually “phantom long” shares?
We credit award-winning journalist Lucy Komisar with the phrase “naked long” shares — anyone else who wishes can claim to have used it first, but we first heard it in chatting with her about the phenomenon of naked short selling and have not seen it anywhere else.
Naked short selling is nothing new. What is not completely on folks’ radar, though, is the magnitude of the phenomenon. Economist Robert Shapiro — former undersecretary for economic affairs and economic adviser to Bill Clinton, Al Gore and John Kerry — has run something of a crusade against naked short selling. He says that between 500 million and one billion shares of stock are sold as naked shorts on an average day. Shapiro’s left-leaning political affiliations notwithstanding, his academic pedigree includes a Harvard PhD, and degrees from the University of Chicago and the London School of Economics. You may not agree with his politics, but it is hard to dispute his bona fides.
Shapiro is featured, along with a motley cast of characters, in a new film, “Wall Street Conspiracy,” that delves into the phenomenon of naked short selling. The public face of the battle against naked shorting is Overstock.com CEO Patrick Byrne, cast by the Wall Street-centric media as something of a misfit, and still held up to ridicule for his characterization of behind the scenes market manipulators as “the Sith Lords” of finance. This seems to be what it comes down to: either you believe Patrick Byrne is a nut — in which case you will roll your eyes and snort as you watch this new movie — or you believe the “Sith Lords” characterization is not so far off the mark. Either way, the film is well worth viewing.
There is no doubt in our mind that the naked shorting phenomenon is much bigger than the SEC, for example, will let on. The sheer volume of business transacted in the course of a day means that not all shares sold will be accounted for by the market close, and stray shares will be double booked — not yet delivered from sellers’ accounts, while showing as long in buyers’ accounts. This is not even assuming any hanky panky in the clearing and settlements process. When a large number of shares are not properly delivered, they can be double counted — showing up as long in both the seller’s and buyer’s account. And they can be double voted. We do not know whether, in the 2009 vote that affirmed the two unpopular board members, there were phantom votes based on “naked long” shares.
In 2010 the NYSE amended Rule 452 to prohibit brokers from voting street name shares in certain matters. One area was executive compensation. If we read these tea leaves correctly, then, no street name shares were voted in the compensation issue and the only shares counted in the latest Citigroup vote were those actually submitted by shareholders. You’re not so tough without your brokerage firm buddies, are you?
The 54%+ figure in the latest story sure caught our eye. All right — as we wrote above, we know that two data points do not make a trend. But could it be that there remains the same level of shareholder dissatisfaction today as when the directors were reaffirmed in 2009?
Citi’s own annual report from that year contains a chart and table comparing five-year cumulative return on Citi stock, versus broad market averages. According to Citi’s own figures, $100 invested in the S&P Financial Index through the five-year period through 31 December 2009 would have declined in value to $55.27. An investment in the S&P 500 Index, on the other hand, would have grown slightly, to $102.15. Citigroup stock, by contrast, showed a five-year cumulative return value of $9.26. And yes, that assumes reinvestment of all dividends. Any wonder that shareholders wanted the directors out?
Another speculation we permit ourselves from this admittedly inconsequential coincidence of two data points: could it be the majority of shareholders of Citi in 2009 are still in place today? If a similar level of dissatisfaction is expressed, we might be justified in assuming the same thought process lay behind both votes. Which is pretty scary — if it means professional investors did not dump the stock in disgust after having the rug yanked out from under them in 2009. As though they could not think of anything else to do with the money. Are these the same people managing your pension?
We always love it when we find stories in the category of “we couldn’t make this up if we tried.” This week’s entry comes courtesy of the SEC who have filed an enforcement action against British twin brothers Alexander and Thomas Hunter. The complaint alleges the pair were just 16 years old when they came up with a scheme to defraud investors in the former Colonies and launched a scheme that ultimately defrauded 75,000 investors, almost all in the US (AP, 20 April, “Young Twins Charged With Faking ‘Stock-Picking Robot’ To Swindle Investor Out Of Millions.”)
Using an “internet pump-and-dump scheme,” the pair sold on-line newsletters to tens of thousands of investors, at $47 per subscription, claiming that they were peddling the stock-picking expertise of a computer program called Marl, purportedly created by a former senior algorithm programmer from a major investment bank. Marl, they said,l could analyze trading patterns in small-cap stocks and identify low-priced securities that were set for large price moves.
The twins allegedly ran one website where they touted Marl’s stock picking expertise, and a second one called “equitypromoter.com” where, says the SEC’s press release, the pair “marketed their newsletter subscriber list to penny stock promoters and boasted, ‘One email to this list of people rockets a stock price,’”
The Hunters sent out emails to their investor subscribers at the beginning of the trading day, with “Marl’s picks.” Sure enough, price and volume of the penny stocks “spiked dramatically as newsletter subscribers rushed to purchase shares.” As with many a manipulation scam, the price of the stocks quickly collapsed — though not before the Hunters’ stock promoter clients had dumped large blocks of their worthless shares into the frenzy of Marl-driven buying.
The twins sold the newsletter for $47 a year. Subscribers were also invited to buy the “home version” of the Marl program for an additional $97. All told, investors reportedly paid some $1.2 million for access to Marl. The complaint alleges they also took in $1.9 million from stock promoters who benefitted from Marl’s pumping up the price of their stocks.
AP reports that a music publishing company called UOMO Media doubled in price after the twins put it into their Marl email in 2008, to 69 cents a share. “Another round of promotion in 2009 lifted UOMO’s stock to $1.06,” continues the story. “UOMO has not traded above a penny since September 2010.”
The name “Marl” was a combination of the nonexistent program’s fictional creators, Michael Cohen and Carl Williamson. The Hunter twins told subscribers that Cohen had created a trading algorithm that netted Goldman Sachs $4 billion in trading profits.
Talk about tipping their hand, the SEC alleges that the Hunters placed an on-line job posting in 2007 for computer programmers who could design “a small software program which will appear to the user that once running it is analyzing thousands of penny stocks.” Free-lance code writers were being sought to create the home version of Marl. The ad reportedly stated: “IMPORTANT — This software does not actually find stocks at all. It should connect to my database and simply request any new stocks I have put in.” The new program, wrote the Hunter brothers, “is almost a ‘fake’ piece of software and needs to simply appear advanced to the user.”
The Hunter twins, who were sixteen years old when they launched Marl, are now 20 and reside in the UK, from whence the SEC seeks to force them to disgorge their ill-gotten gains, plus interest and civil penalties.
We guess the Commission will find the UK authorities cooperative — though they may be sniggling up their sleeves as they turn the twins over for American justice. The SEC complaint claims that, “starting at the age of sixteen,” the Hunter brothers “developed an elaborate scheme to manipulate the prices of penny stocks at the expense of unwitting investors.”
Only an SEC examiner could find this scheme “elaborate.” Or, as Charles Mackay — the author of the classic Extraordinary Popular Delusions and the Madness of Crowds — might have said: when you have “Unwitting,” you hardly need “Elaborate.”
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