If you get caught walking out of a Wal-Mart with a carton of smokes that you didn’t pay for, it’s unlikely that you would be allowed to refuse to admit or deny the wrongdoing, simply return the cigarettes to their rightful owner along with the interest on their value, and pay a fine of about $10. This is a good thing. Otherwise, the price of cigarettes would surely rise to compensate for the increase in thefts.
Fortunately for investors in London-based hedge fund giant GLG Partners, the punishment just doled out by the SEC was pretty toothless.
The crime was "multiple violations of Rule 105 of Regulation M of the Securities Exchange Act of 1934. Rule 105, designed to prevent manipulative short selling, prohibits covering certain short sales with securities obtained in a public offering."
That sure sounds complex and boring. No wonder the recent articles about this fine avoid explaining the scheme in depth. If only Paris Hilton crime coverage was so shallow. Here goes:
GLG Partners may sound shady, but they are actually a good hedge fund. Good hedge funds make risk-free or nearly risk-free trades. This is what investors are really paying 2% per year, plus 20% (or more) of their profits, for. If you want predictions, trading, stock picks, and market gyrations, watch CNBC or buy a mutual fund that charges 1% a year (with no cut of profits).
Truly bad hedge funds, which are a fast-growing population, charge GLG Partner-grade fees, but aren’t quite so clever in delivering low-risk returns. They just charge a lot more for their guesses and are open to just about anybody.
Most publicly traded corporations have a few large investors who own big swaths of the stocks – some are founders of the company. When these big fish want to sell a few million shares here or there, they often seek professional help. Rather than selling shares on the open market through their E*TRADE account, they enlist Goldman Sachs to put together a "secondary offering" of stock. This is sort of like an IPO, but the company whose stock is being sold doesn’t get any money – the selling shareholders do.
In 2003, electronics giant Philips decided to sell 100 million shares (American Depositary Shares or ADSs) in Taiwan Semiconductor Manufacturing Company (Ticker TSM) – about a billion dollars worth. For a few million bucks, Goldman and Merrill Lynch helped with the sale.
Normally, these investment banks would have to drum up demand for the stock. It has been frowned upon for an investment bank to issue favorable recommendations for stocks that they are selling ever since the 2000 bubble crash, so this would mean a lot of pavement pounding, which slows down deals.
Instead, the investment bankers apparently found some hedge funds to take big chunks of the stock off their hands. But why would a hedge fund want to speculate on the day-to-day gyrations of a tech stock?
They wouldn’t, which is why the hedge fund shorts the stock in the days before they buy the stock in the offering. ‘Shorting a stock’ means borrowing shares from other investors (probably clients of Goldman Sachs and Merrill Lynch), and then selling them with the hopes of buying the shares back at a lower price.
It’s the Wimpy from Popeye trade: I’ll gladly give you your shares back Tuesday if you give them to me today, and it has risks – big risks. If the stock takes off, the short seller loses money. The short sellers can even lose more money than they earned selling the stock because, although a stock can only fall to zero, it can also triple in price.
But what if a hedge fund knew they could get, say, 7 million shares in the TSM offering at the guaranteed price of $10.77 per share? Well then, selling some shares short at $11.50 two days before you buy the shares for $10.77 from Goldman isn’t so risky after all…they just hand off the $10.77 shares to the person they borrowed them from to cover the short, so to speak.
What about the poor saps who bought TSM shares at $11.50 from the hedge fund, not knowing the offering price was going to be at $10.77 in the very near future? Maybe they should quit whining and start paying the high hedge fund fees to join the "in" crowd.
The securities rule in question is sort of a vague catch-all to try to weed out these sorts of tricks, but it doesn’t really do the job, hence the lame settlements. Frankly, being effectively both short and long, any one stock (directly or through various derivatives or contractual pre-sales) is questionable and is likely a tax avoidance scheme at best and flat-out securities fraud at worst.
But what’s so bad about a hedge fund essentially acting as a stock underwriter anyway? If GLG was genuinely taking on risk by shorting the stock, and if they had no pre-arranged deal to find out what price they were getting the stock at and to thereby cover the short, then no muss no fuss. In reality, somewhere between a 100% risk-free trade and a normal trade took place. Arbitraging the price gap between the outsider and insider price can be as questionable as insider trading.
What’s so bad about a risk-free trade? Nothing, for GLG investors. Remember the great mutual fund timing scandal? The result of hedge funds skimming near risk-free profits from ordinary mutual funds was lower rewards for mutual fund investors.
Risk-free trades effectively skim profits off the market – leaving the same risk but lower returns for everybody else. The market as a whole only has so much profit. This profit comes at a cost, and that cost is risk. Skimming the profit while leaving the risk means less reward for everybody else.
It’s like ordering a $25 porterhouse steak at a restaurant, noticing that the filet mignon part was missing, and being informed by the waiter that a hedge fund patron cut it off your steak on its way from the kitchen.
We’ll leave you with one funny line from the secondary stock offering documents, "...we are not aware of any plans by any major shareholders to dispose of significant numbers of common shares…"
Of course not, they disposed of them before the offering.
Another Hedge Fund Wrist Slap
If you get caught walking out of a Wal-Mart with a carton of smokes that you didn’t pay for, it’s unlikely that you would be allowed to refuse to admit or deny the wrongdoing, simply return the cigarettes to their rightful owner along with the interest on their value, and pay a fine of about $10. This is a good thing. Otherwise, the price of cigarettes would surely rise to compensate for the increase in thefts.
Fortunately for investors in London-based hedge fund giant GLG Partners, the punishment just doled out by the SEC was pretty toothless.
The crime was "multiple violations of Rule 105 of Regulation M of the Securities Exchange Act of 1934. Rule 105, designed to prevent manipulative short selling, prohibits covering certain short sales with securities obtained in a public offering."
That sure sounds complex and boring. No wonder the recent articles about this fine avoid explaining the scheme in depth. If only Paris Hilton crime coverage was so shallow. Here goes:
GLG Partners may sound shady, but they are actually a good hedge fund. Good hedge funds make risk-free or nearly risk-free trades. This is what investors are really paying 2% per year, plus 20% (or more) of their profits, for. If you want predictions, trading, stock picks, and market gyrations, watch CNBC or buy a mutual fund that charges 1% a year (with no cut of profits).
Truly bad hedge funds, which are a fast-growing population, charge GLG Partner-grade fees, but aren’t quite so clever in delivering low-risk returns. They just charge a lot more for their guesses and are open to just about anybody.
Most publicly traded corporations have a few large investors who own big swaths of the stocks – some are founders of the company. When these big fish want to sell a few million shares here or there, they often seek professional help. Rather than selling shares on the open market through their E*TRADE account, they enlist Goldman Sachs to put together a "secondary offering" of stock. This is sort of like an IPO, but the company whose stock is being sold doesn’t get any money – the selling shareholders do.
In 2003, electronics giant Philips decided to sell 100 million shares (American Depositary Shares or ADSs) in Taiwan Semiconductor Manufacturing Company (Ticker TSM) – about a billion dollars worth. For a few million bucks, Goldman and Merrill Lynch helped with the sale.
Normally, these investment banks would have to drum up demand for the stock. It has been frowned upon for an investment bank to issue favorable recommendations for stocks that they are selling ever since the 2000 bubble crash, so this would mean a lot of pavement pounding, which slows down deals.
Instead, the investment bankers apparently found some hedge funds to take big chunks of the stock off their hands. But why would a hedge fund want to speculate on the day-to-day gyrations of a tech stock?
They wouldn’t, which is why the hedge fund shorts the stock in the days before they buy the stock in the offering. ‘Shorting a stock’ means borrowing shares from other investors (probably clients of Goldman Sachs and Merrill Lynch), and then selling them with the hopes of buying the shares back at a lower price.
It’s the Wimpy from Popeye trade: I’ll gladly give you your shares back Tuesday if you give them to me today, and it has risks – big risks. If the stock takes off, the short seller loses money. The short sellers can even lose more money than they earned selling the stock because, although a stock can only fall to zero, it can also triple in price.
But what if a hedge fund knew they could get, say, 7 million shares in the TSM offering at the guaranteed price of $10.77 per share? Well then, selling some shares short at $11.50 two days before you buy the shares for $10.77 from Goldman isn’t so risky after all…they just hand off the $10.77 shares to the person they borrowed them from to cover the short, so to speak.
What about the poor saps who bought TSM shares at $11.50 from the hedge fund, not knowing the offering price was going to be at $10.77 in the very near future? Maybe they should quit whining and start paying the high hedge fund fees to join the "in" crowd.
The securities rule in question is sort of a vague catch-all to try to weed out these sorts of tricks, but it doesn’t really do the job, hence the lame settlements. Frankly, being effectively both short and long, any one stock (directly or through various derivatives or contractual pre-sales) is questionable and is likely a tax avoidance scheme at best and flat-out securities fraud at worst.
But what’s so bad about a hedge fund essentially acting as a stock underwriter anyway? If GLG was genuinely taking on risk by shorting the stock, and if they had no pre-arranged deal to find out what price they were getting the stock at and to thereby cover the short, then no muss no fuss. In reality, somewhere between a 100% risk-free trade and a normal trade took place. Arbitraging the price gap between the outsider and insider price can be as questionable as insider trading.
What’s so bad about a risk-free trade? Nothing, for GLG investors. Remember the great mutual fund timing scandal? The result of hedge funds skimming near risk-free profits from ordinary mutual funds was lower rewards for mutual fund investors.
Risk-free trades effectively skim profits off the market – leaving the same risk but lower returns for everybody else. The market as a whole only has so much profit. This profit comes at a cost, and that cost is risk. Skimming the profit while leaving the risk means less reward for everybody else.
It’s like ordering a $25 porterhouse steak at a restaurant, noticing that the filet mignon part was missing, and being informed by the waiter that a hedge fund patron cut it off your steak on its way from the kitchen.
We’ll leave you with one funny line from the secondary stock offering documents, "...we are not aware of any plans by any major shareholders to dispose of significant numbers of common shares…"
Of course not, they disposed of them before the offering.