Slouching Towards Wall Street… Notes for the Week Ending Friday, 22 July 2011
Things That You’re Liable To Read In The Bible
…if we meet, we shall not ‘scape a brawl; for now, these hot days, is the mad blood stirring.
- Shakespeare, “Romeo and Juliet”
A strange episode occurs at the end of the Biblical book of Numbers (Chapter 32). The middle three books of the Pentateuch — the Books of Moses — tell the history of the Israelites from the exodus from Egypt, to their entry into the Promised Land. Leaving aside political commentary, at the end of Numbers, God’s promise to Abraham (Genesis, chapter 15) is about to be fulfilled some 470 years after it was first given. One would think the Israelites would be clamoring to settle even the tiniest plot of Promised soil.
Now two of the twelve tribes approach Moses saying they prefer to stay on the east side of the Jordan River. They possess huge flocks and herds — it is never clearly explained how they got them, wandering in the desert for forty years — and are concerned about their wealth, rather than their role in their people’s destiny. The land of Canaan, they say, is too small to pasture all their beasts and they will have to make compromises.
Moses gives them a dressing down, saying their duty is to their nation. Well, they say, we’ll offer you a deal: we’ll build pens and barns for our sheep and herds to be cared for, then we’ll build houses for our children to live in — then we’ll make a contribution to what everyone else is doing. For these tribes, their wealth is more important than their role as members of the Chosen People. Indeed, they are more concerned about their wealth than about their own children — as witness the order of their priorities.
This week’s news out of Washington is a clear replay of the Biblical narrative. Groups who believe their own financial concerns are more important than the wellbeing of their fellow citizens are content to wreck the Republic to make a point. To round out our quote from Shakespeare: a plague o’ both your houses. From Adam and Eve in the garden, to the refusal of the tribes of Gad and Reuben to put the national interest before their own pocketbooks, every Biblical problem arises from people’s refusal to accept their roles as caretakers of a great cause. More complex than merely exhorting people to act for the greater good, the prophetic message focuses on what is sorely lacking in our society today: a vision for the future and a sense of stewardship.
The debate over global warming is another example. One set of scientists says human activity will destroy the planet, another group says it will not. There are world-class minds and Nobel prizewinners on both sides. Why is the public policy debate framed in terms of dollars and cents, when it should be framed in terms of risk management? If science is uncertain, then there is a clear possibility that those predicting disaster are correct. Would you say 50/50? The risk of being wrong is too great, and public policy must err on the side of caution. Instead, all Washington is caught up in screaming that their experts are right and the other side’s experts are self-serving slimeballs. Ladies and gentlemen, this is no way to run a country.
We discount the rejectionist front in the House of Representatives. Newly-minted members of Congress have swarmed the Hill all full of piss and vinegar, trumpeting their unyielding stand about the debt ceiling, the deficit, and the president they love to hate. But within the first six months (gee, is it that time already?) Representatives realize that they only have a two-year term, which means they have to spend three-quarters of it not legislating, but campaigning for re-election.
But patricians in the Senate show no more commitment to keeping America great. The sensible thing to do would be for both sides to give back equal percentages on all their pet issues. If all spending and entitlements were cut, and all tax loopholes narrowed by ten percent for a defined period — say one year — it would give the economy breathing space to work on a more thoroughgoing deal. It would give the American People confidence that Washington had our best interests at heart. More, it would ennoble the dollar and enable the Fed to dispense with its quantitative shell game.
Alas, there is no sense of stewardship in Washington. Everyone is chasing the narrowest of interests, holding onto every nickel of campaign contributions. We despair of Obama’s leadership. Those on the Right who said he was not ready for prime time were on the money and are playing the remedial presidency for all it’s worth. We bet the president blinks. Even Moses had to accept a compromise and allow the two tribes to have it their way. Money talks — even louder than God. Who will save America now?
The New York Times has leapt into the fracas over Chinese reverse merger stocks with both feet. A recent article (23 July, “China To Wall Street: The Side-Door Shuffle”) recounts the rise and fall of Rino International, a Chinese company that listed for trading in the US a few years ago and attracted significant investor interest — until its share price collapsed amidst allegations of fraud. Rino shareholders, says the Times “lost hundreds of millions of dollars,” just one of the Chinese reverse mergers that have suffered a reversal of fortunes — should we call this a “re-reverse”? a “reverse reverse”? — in the latest wave of blogs, research reports surfacing from previously unknown firms, rumors and whispers, all of which have devastated a large number of stocks. “All told,” says the Times, “investors’ losses on these Chinese ventures have stretched into the billions.”
We do not wish to opine on the veracity of any company’s financial filings — we have not examined the books of Rino International, nor any other Chinese reverse merger company — and we certainly do not mean to imply that any company has acted improperly, much less fraudulently. But we love a good story, so here’s one.
The 1980’s and 1990’s saw waves of reverse mergers, all handled, as the article points out, in perfectly legal fashion. The article describes these offerings as a “Wall Street equivalent of ‘Invasion of the Body Snatchers.’” And in fact, the way in which these offerings are packaged should raise questions — should have raised questions, we might say — in the minds of those charged with overseeing the securities markets.
A tax loss carryforward is an asset created when someone has a significant business failure. Accounting rules allow the new owner of a business to continue to charge off revenues against the previous owner’s bad business decisions, thus turning a financial loss into an asset that can be sold — this is one of the ways in which our system allows people to create money out of nothing. But an even better way to create something out of nothing is to print a stock certificate.
When a publicly traded company goes out of business, its stock ceases trading. But it does not cease to exist. Like old phone numbers that are reassigned, like old email addresses of people who left your company years ago — like the brokerage statement you receive every year from the account that was closed in 1986 — stocks do not get un-created when their companies fail. Instead, they go to a kind of stock certificate Valhalla, where they await their resurrection. These so-called shell companies — stock that is registered to trade in the public market, but with not active business — became sources of vast wealth. The Times says the shell into which Rino was packaged was purchased for about $100,000. At their peak, Rino traded hands at about $35 a share. According to Yahoo! Finance, the company has over 28 million shares outstanding. Do the math. And here’s a better calculation: the public float is only a little over 9 million shares, which means 18 million shares are closely held (the investor who laid out the hundred grand for the shell reportedly took his payment in stock, not cash). The stock may have fallen to pennies, and may not be trading any more. But someone made an awful lot of money along the way.
The Times asks where the regulators were in all this. We ask: where is the regulators’ sense of history? These same type of transactions were at the heart of many a stock scam in decades past. Like the Chinese reverse mergers, they were touted as great stories — two of the sexiest words in current invest-speak were associated with Rino: “China” and “green” — like them, it was never really clear who the insiders were. And like them, they rose from pennies per share to double digits before vanishing into oblivion. And, like today’s suspect transactions, it’s not even really clear which laws were broken, much less whether anyone will be punished.
We remember the days when the alleged Russian mob was allegedly involved in scams using shell companies. (We say “alleged” because we hear that the alleged Russian Mafia allegedly kills people and we have a healthy fear of ending up allegedly dead.) Clearly, real figures about these transactions are obviously hard to come by, but our quick and dirty calculation back in the early 1990’s — allegedly confirmed by some alleged Russians at the time — showed that the person at the top of the stock distribution pyramid pocketed about 8% of the total amount of money that changed hands in the run-up of the shares.
The shell that became Rino International was bought for $100,000, which means the 29 million shares currently outstanding may have cost as little as about 0.3 cents apiece. The stock subsequently traded as high as $35. Somebody made a whole lot of money on this. Statistically, it is fair to assume that you were not one of them.
At this juncture we feel compelled to point out that not all reverse mergers are scams. Like most Wall Street frauds, the reverse merger was a clever idea, has been used to good outcome by reputable entities, and then spun out of control as more and more people discovered they could use it to game the system.
Now that a number of Chinese reverse merger stocks have collapsed, the lawsuits are, predictably, in full swing and the words “reverse merger” are on everyone’s lips like “child murderer.” Lawyers are blaming regulators for not requiring stiffer disclosure, for not policing the investment bankers — all of which is certainly to the point. But we call your attention to an even less well-known corner of the marketplace — one of the last refuges of scoundrels, because it is one of the few remaining unregulated areas of the industry,
Low-priced securities are generally low profile, which also means low liquidity and low distribution. A company with 29 million shares outstanding is, by definition, not going to be widely held. Because of the various difficulties surrounding low-priced securities — and, frankly, because there was so much fraud surrounding them in years past — these securities generally must be negotiated in physical form. This means that, unlike Microsoft or Apple, which is carried on the books of your broker’s firm in electronic book-entry form, your purchase of QRST Undersea Pig Breeders — 400,000 shares at $0.01 a share — must be settled with a physical stock certificate. A piece of paper must be issued in your name — or in the name of your brokerage firm, known as “street name” — for exactly 400,000 shares of stock. That piece of paper must be physically delivered by the firm that sold the shares, against which your broker’s firm will then deliver payment. The street-wide clearinghouse, Depository Trust Company, effects clearing and settlement of trades between all major brokers. DTC clears billions of shares of stock daily, most of it electronically.
Small issues, low-priced shares, or other issues that, for whatever reason, DTC deems problematic will be “chilled” — meaning they can no longer be cleared electronically. Enter the transfer agent, a company whose sole purpose is to issue stock certificates to their proper owners.
Most of the stocks you have ever heard of have relationships with the major transfer agents, whose job is to track ownership of the company’s shares, to process ownership changes and maintain shareholder lists. Transfer agents, in completing transactions between buyers and sellers, cancel and issue share certificates. They also process mailings to shareholders and issue replacements when stock certificates are lost or stolen.
You may have dealt with a transfer agent when your daughter turned 18, and you had to transfer her Microsoft and Disney shares from the custodial account to a new account in her name. The transfer agent would have taken in the old shares and cancelled them, then issued new certificates in your daughter’s name only. Transfer agents perform a critical function in keeping the wheels of commerce turning. They move billions of shares, representing trillions of dollars of daily stock trades. And they are not regulated.
The SEC will point to cases where transfer agents have been sanctioned and insist that they are, in fact, regulated. The fact is, the SEC can only really get involved in clear cases of fraud. Lo and behold, the Commission found one such firm to have behaved so egregiously that it warranted their involvement.
None other than the transfer agent for Rino International was sanctioned by the SEC earlier this year (TheStreet.com, 3 April, “China RTO Transfer Agent Gets SEC Sanction”) after the SEC determined that one of its principals had looted the company. To be precise, “the 75-year-old father of the agent’s founder and president had misappropriated $2.7 million from the firm.” That founder — and that father — were, as we have reported earlier, the brother and father, respectively, of Mr. Timothy Halter, president of Halter Financial Group (their website is “reversemerger.com”), about whom we have written in the past. Halter Financial provided the US-listed shell vehicles for a number of the highest-flying Chinese stocks — Rino included. Their relationship with their family-owned transfer agent surely made it easier for them to get share certificates issued in timely manner. One can only wonder what else it enabled them to do.
The story is fuzzy — the article says the SEC’s action against the transfer agency “doesn’t appear to be related to a broader investigation into the Chinese reverse-merger phenomenon.” TheStreet.com reports that Kevin Halter, Sr., while serving as a part-time bookkeeper for the transfer agent, transferred a total of $2.7 million from multiple client accounts into his personal account. But, they write, it appears he “intended to give the money back.” When the SEC started poking around, Halter Senior reportedly confessed to his son, Kevin Jr., who “demanded that his father repay the money he had misappropriated, and reported the matter to the Commission.” The money was duly repaid and the clients were made whole. While this father-son drama does not attain the level of the Madoff confession, it similarly points to what can happen when there’s no cop on the beat.
The large, reputable transfer agents often refuse to deal with small companies whose shares trade for physical settlement only. It is a high-cost, high-touch business, and a high-risk one. Every manager of a small brokerage office has a tale to tell of an institutional customer who appeared one day unsolicited, promising to open a seven-figure trading account in which they intend to trade blue chip stocks. Oh, and once in a while we do something special, something that comes to us from one of our Asian clients. Oh, they say, and by the way, we want to establish the account today and deposit 150 million shares of this stock quoted at 4 cents, and you’ll hold it for us, and then you can sell it for us.
The SEC has leaned on clearing firms to not merely turn away such business, but to report it when it is brought to their attention, even if no transaction is done. Transfer agents can create money merely by printing share certificates. With no running DTC record, it may be impossible to tell how many shares of a company are actually in existence. And if someone needs a few dollars — say, to pay off a broker who was particularly helpful in placing the shares — they can print up a certificate and deliver it to an offshore account where it can then be sold into the US marketplace. Brokerage firm back office managers will tell you that many smaller transfer agents can not be tracked down. We have heard of some whose office listing was a phone booth — or, in contemporary times, a cell phone that goes right to voice mail. Imagine trying to call your banker at Goldman Sachs and getting a message saying “this number has been disconnected — no further information is available.”
Why hasn’t Congress enacted legislation targeting the possibility for abuse in this unregulated activity? We suspect the stock transfer business is literally off their radar — though that fails to explain why the SEC has not pursued rulemaking in this area. Rather than impose registration requirements on transfer agents, regulators are leaning on brokerage firms to report “suspicious” stock transactions. The definition of “suspicious” is up to the discretion of the regulator, and only after the fact, which has some large firms filing Suspicious Activity Reports every time they see a trade in a physical delivery stock.
So, what do Ben Bernanke, Tim Geithner, Rumpelstiltskin, and XYZ Fugazy Stock Transfer Associates have in common? They can all make money out of nothing.
And hey, Mr. & Mrs. Average Investor — who’s got your back? Once again — nobody.
FINRA, the financial services self-regulatory body, has fined a stockbroker $10,000 and suspended her for a year for “misrepresentative and unbalanced” tweets (NY Times Dealbook, 15 July, “Twitter Messages Land Broker In Trouble”). The broker allegedly issued tweets predicting price rises in certain stocks.
According to the FINRA disciplinary actions report, the broker issued such tweets as “Keep an I on AMD ppl! Just bike abve $5 = margins & institutional can now ‘play ball!’ Barclay upgraded to $7 ystrdy but it should be $10+”. The broker reportedly has some 1400 Twitter followers.
Wall Street has generally shied away from social networking, as it is impossible to police — and knowing that the regulators will treat it the same as paper correspondence, requiring documented surveillance as well as archiving. But Morgan Stanley recently announced that its 18,000 financial advisers will be able to tweet the wealth management clients — subject to an internal pre-approval process, which seems to defeat the notion of spontaneity.
FINRA found that the broker in question “failed to disclose material information” about the stocks she was touting — including her substantial personal holdings in some of them. She also reportedly failed to disclose to her employer that she had a concurrent job in the jewelry business, and the also did not disclose the existence of more than a dozen brokerage accounts she controlled.
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