Regulating in a disruptive world
Disclaimer: this is not investment advice. I’m not objective on Tesla since I’m a firm believer in their mission. I do own Tesla stock.
Before taking any investment decision, do your own research.
I’ve been disappointed with the way the SEC has handled Tesla so far. It may be just that I support Tesla’s mission and I don’t like to see it struggle because of regulation. But looking at what bothers me most and understanding the purpose of the SEC, I feel there’s more to it. I feel the SEC is failing in its mission. I’ll elaborate each point, but the basic ideas are the following:
- Wall Street doesn’t understand disruption and exponential innovation.
- The SEC is fed by Wall Street, having very much the same model of the world. Which means it also doesn’t understand disruption and exponential innovation.
- Wall Street insiders manipulate media and the SEC to short innovative stock based in this world view.
- This harms progress and access to innovation for retail investors.
I’ll will elaborate on this points in the rest of this article.
The story of innovative companies in the Internet era has been very similar:
- Find a business model that can escalate quickly.
- Find funding for the business.
- Loose money to grow the business as much as possible.
- When private funding is no longer available to keep on growing, do an IPO.
- Use the IPO money for a final stretch of growth.
- Make a profit to show the world that you’re not a scam.
- Continue growing at a more sustainable pace.
This has been pretty much the story of Google, Amazon, Facebook, Uber, AirBnB, Netflix, Spotify (with the last four still missing the profitability phase.)
There’s two important consequences of this kind of company:
- If a company in “growth mode” doesn’t have a real sustainable business it can grow as a huge scam, as has been shown by the story of Theranos.
- If funding is suddenly cut at any point of growth phase, a real innovative company may fail.
Then come the evil short sellers
To start, there’s nothing intrinsically evil in short selling. Short sellers take higher risk to short a stock than the long holders and as long as they do it in a fair way there’s nothing wrong. It’s even considered helpful for markets because they add information and efficiency: short sellers add a big magnifying glass to the companies they short which may allow others and the market as a whole see problems that otherwise would not be seen. They also help in price finding.
Problem arise when short sellers try to make a company fail not based on real problems but on fabricated ones. As I mentioned on the previous section, innovative growth companies are particularly vulnerable to this because they are constantly dependent on funding during the growth phase and can get in trouble if there’s a sudden stop in funding. To illustrate I recommend this post, synthesized by “The collective hedge funds may have initially genuinely believed that Fairfax was corrupt or incompetent, but their even stronger belief was that enough bad press and market momentum would crater the firm”.
Precision and personality
Another aspect of Wall Street’s inability to understand innovation is precision. Wall Street likes precise guidance that’s not of by more than 10%–20%. That’s very difficult to achieve when your company is growing at 50%-200%. Wall Street reaction to this is mistrust, which facilitates short narrative of “lies and fraud.”
There’s also a matter of personality and communications of innovative companies. Visionaries like Reed Hastings, Elon Musk, Jeff Bezos and Richard Branson like to dream and speculate about the future. If difficult for them to talk about the future of their companies without irritating regulators so they end up having troubles, like Hastings and Musk, or keeping quiet like Bezos and Branson.
What to do? What can we do?
The important question to answer is: are we losing something from all this? Is society worse based on these problems? My answer is YES. If things don’t change, innovative growth companies with geeky leaders will end up avoiding IPOs as much as possible, making retail investors lose on the biggest economic growth and widening the wealth gap. Or even worse, regulators may end up harming the best companies in the world be obstructing their leadership.
So what can we do to improve? I’ll give my answers for different actors but the basic idea is: more information and transparency.
What can regulators do?
It’s important that regulators (and Wall Street in general) understand that this innovative growth companies are a different kind of beast than regular companies and need to understand how to differentiate good ones from scams. Having a deep understanding about Facebook and (specially) Amazon is a must.
To avoid companies failing by mere “short attacks” it would be helpful to add more transparency to short positions. Any position that’s more than 1% of float should be public knowledge. Also regulators should keep files on short funds relations to keep an eye on coordinated attacks.
A full fledged investigation on short attack tactics may be required at some point to deter bad actors.
Penalization on public companies should adapt to new communication channels and styles. It would be helpful to have a safe way for leaders to speculate about the future. Clear differentiation between guidance and speculation. Penalization should consider stockholders best interest. Some examples based on Elon Musk’s history:
- “Funding secured” saga: it’s not reasonable for a company leader to post publicly that a taking private attempt is likely. It’s also unreasonable for regulators to kick out the founder of a company without proof of criminal intent. Doing so affected stock holders more than the original damage. A more reasonable approach would be to require independent directors and a open stock holder vote on chairman.
- “Twitter sitter”: this is a Pandora box. Fairness about what is a reasonable twit and what should have checked supervision is imposible. Each time SEC looks to enforce it will create a stock price swing that worse than what it attempts to fix. Better approach: a growing fine amount for each time that SEC sees a communication as outside guidelines. 50% increase with each violation and threat of litigation if not paid. That way the company leader is always paying the highest cost and has highest responsibility of stock swings.
- “[…] around 500k in 2019”: this is clearly in the “future speculation” arena. It’s inside guidance and it was general statement of incredible growth. The context and ambiguity of “around” in a almost 200% annual growth company should be enough for regulators to disregard any complain from speculators.
What should companies do?
High growth innovative companies should be aware of the hostility of Wall Street and regulators and this can be abused by short sellers. The most important action is to have a clear “out of the woods” plan that they can execute at any moment. That was clearly missing in SolarCity and was definitely present in Amazon and Facebook. Tesla is in the process of executing its plan and it’s clear that it was at high risk for some time. Still is, but not as much as during inicial Model 3 ramp up.
Avoiding unnecessary polemics is also a good idea, something that Tesla (specially Elon Musk) has been very bad at. Difficult to do having a company that’s always at risk, but knowing the short attack playbook and preparing staff for their attacks could be a good idea.
Being careful on what leaders say publicly that can be related to company prospects is paramount. I would love for leaders to have a clear code, starting with a disclaimer whenever they want to speculate of the future and regulators respecting this. Elon Musk could add something like “speculative:” to all twits related to Tesla and twit away.
What should investors do?
Individually, being aware of all these problems is the best you can do. As a whole, helping to add transparency would be a nice additions. Independent research on short hedge funds and their tactics, counter acting their effect on regulators by adding the opposing view with better information, etc.
In general, we should all strive for more transparent and accessible markets so that everybody can be part owners of humanity’s future.
What should media do?
Not sure what the future is for media. There’s just not enough independent revenue streams to keep them working independent from particular interests. For individual reporters and analysts, there may be a future in building their own brand in platforms like Medium. But as whole, I have little hopes for media as a source of information. Too many interests. Too much click bait.
That said, efforts like Tom Randall’s (Bloomberg) Model 3 tracker are a good way to go. It’s data driven so can’t reasonably be argued as biased. And it adds a lot of value to investors and general public.