We're taking it to the Supreme CourtHere are some things that Goldman Sachs Group Inc. told its shareholders in its annual reports in the first decade of this century:[1] We have extensive procedures and controls that are designed to identify and address conflicts of interest. … Our clients' interests always come first. Our experience shows that if we serve our clients well, our own success will follow. … We are dedicated to complying fully with the letter and spirit of the laws, rules and ethical principles that govern us. Our continued success depends upon unswerving adherence to this standard. … Most importantly, and the basic reason for our success, is our extraordinary focus on our clients. ... Integrity and honesty are at the heart of our business. …
Then a global financial crisis happened, and, uh. Well. In the years after 2008, there was a widespread view that integrity and honesty were not at the heart of Goldman's business, that Goldman's dedication to complying fully with the letter and spirit of the laws was less than total, that Goldman's clients' interests sometimes came second, etc. (Disclosure, I worked at Goldman at around this time, and integrity and honesty were always at the heart of my business.) Goldman got in all sorts of political and public-relations and legal trouble for things it did pre-crisis, with the most notorious example probably being the Abacus synthetic collateralized debt obligation trade for which Goldman paid $550 million in penalties to the U.S. Securities and Exchange Commission. Also Goldman's stock price went down, because of the financial crisis, and the fines. So some Goldman shareholders sued. You know their theory. We talk about it all the time. It is "everything is securities fraud." Here: - Goldman said publicly that it followed the law, put customers first, managed conflicts of interest, and generally was good.
- Investors bought Goldman's stock, relying on Goldman's representations that it followed the law, put customers first, managed conflicts of interest, etc.
- In fact Goldman was lying: It did not follow the law, put customers first, manage conflicts of interest, etc.
- When the investors found out about this—after the global financial crisis and the SEC lawsuit over Abacus—the stock went down and the investors lost money.
As I often write, this theory can turn anything bad that a public company does into securities fraud: A company will put out some generic statements saying that it is good, follows the law, has a code of ethics, etc.; then it will turn out that the company secretly does bad things, breaks the law, has unethical executives, etc.; the stock will drop (because the bad things are bad for the company); the shareholders will sue, saying "you said you were good, we believed you, we bought the stock, but you were bad and we lost money." And so climate change and sexual harassment and lax customer data protections and mistreatment of orcas can all be transmuted into securities fraud. Here the underlying bad deed that was transmuted into securities fraud was also securities fraud—Goldman said it put customers first, then it did a fraud on the Abacus CDO buyers,[2] then it got caught, then its stock dropped—but that is just a coincidence. If instead of defrauding the Abacus CDO buyers Goldman had murdered them, that would not have been securities fraud with respect to the Abacus CDO buyers (it would have been murder), but it would still have been securities fraud with respect to Goldman's shareholders (if the stock dropped after Goldman was charged with murder). Now, two things I will say about this theory are: - I don't like it, it feels weird, and
- It's not really the law.
It's kind of the law? It's not the law in the sense that they teach you this in law school, but it is law-like in that lots of plaintiffs' securities lawyers have been hard at work developing new theories about what bad things could be securities fraud, and have gotten good at it. And so if a company does a bad thing and the stock drops, someone will bring a class-action lawsuit against it alleging securities fraud, and that will be expensive and risky to defend and likely to lead to a big settlement, even if it is not exactly securities fraud in the strict legal sense.[3] I am not alone in not liking it. Public companies, obviously, hate it; it creates all sorts of huge and unpredictable monetary liabilities. Insurers who sell directors' and officers' liability policies particularly hate it, since they often pay out these settlements: They thought they were insuring companies against the risk of accounting misstatements, but it turned out they were also insuring them against the risk of climate change and data breaches and everything else that can go wrong. There is a feeling that this can't all be securities fraud, that securities fraud cases should be about securities fraud, and that climate change or sexual harassment should be litigated somewhere else. And now it's going to the Supreme Court. In December, the Supreme Court agreed to hear Goldman's appeal of the shareholder lawsuit against it. Goldman hadn't lost that lawsuit, exactly; we are still in the early stages of that lawsuit, which was filed in 2011. (It is called Goldman Sachs Group v. Arkansas Teacher Retirement System.) What Goldman is appealing is a district court decision to certify the case as a class action. If you're a company that gets sued over this stuff and you defeat class certification, you more or less win; these cases are only fun for plaintiffs' lawyers if they can sue on behalf of every shareholder who bought stock over some multi-year period. But if you lose that argument and the class is certified, the risk of the litigation gets bigger, and you more or less settle. So class certification is often the crucial decision of the case, the one that determines whether the company pays up or not. The Supreme Court agreed to hear Goldman's appeal on the question of "Whether a defendant in a securities class action may rebut the presumption of classwide reliance … by pointing to the generic nature of the alleged misstatements in showing that the statements had no impact on the price of the security."[4] The shareholders claim that they relied on Goldman's statements—about managing conflicts, putting customers first, etc.—in buying Goldman's stock; they also claim that every shareholder who bought Goldman stock between early 2007 and mid-2010 effectively relied on those statements, because those statements were incorporated into the price of Goldman's stock. That is, if Goldman had instead said "we have lots of conflicts of interest but we don't care, and we gouge our customers ruthlessly and illegally," its stock would have been lower,[5] so anyone who bought during the class period was defrauded by paying too high a price. (This is called the "fraud-on-the-market" theory and comes from a 1988 Supreme Court case called Basic v. Levinson.) Goldman says no, come on, those statements are all generic feel-good stuff, and they didn't fraudulently drive up the price of the stock. Nobody writes an equity research note or a hedge-fund investment memo like "Goldman Sachs is undervalued because the market does not give them enough credit for integrity and honesty." Goldman has economic studies that it argues show that these statements didn't push up the price of the stock, so it isn't true that everyone who bought the stock during the class period was defrauded by those statements, so the case should not be certified as a class action. I am glossing over many details of securities class-action law, which is boring and technical, and I do not propose to get into it any more. Instead I want to quote from a few amicus curiae briefs that were filed in the case on Monday supporting Goldman's position. The quotes are not about the details of class-action law but about how Everything Is Securities Fraud, and how maybe it shouldn't be. Here, for instance, is an amicus brief from two directors-and-officers insurers, American International Group Inc. and Chubb Group Holdings Inc.:[6] Event-driven securities litigation can transform nearly every allegation of corporate negligence or misconduct into securities fraud. It was not always this way. For decades, fraud allegations focused on financial disclosures, where the "biggest disaster was an accounting restatement." Now, as Professor Coffee explained, "the biggest disaster may be a literal disaster: an airplane crash, a major fire, or a medical calamity that is attributed to your product."
And, from the same brief: Frequently, event-driven claims allege that generic or aspirational statements, similar to ones made by virtually every public company, maintained inflation in a company's stock price. Allegations of wrongdoing nearly always conflict, at some level of generality, with a company's code of conduct or other statements of corporate policy. So it is not difficult for plaintiffs to allege that negative reporting or disclosures "corrected" a prior, generic policy statement (e.g., "We strive to comply with all applicable laws."). The result is that just about any corporate controversy that coincides with a drop in stock price can be re-characterized as a securities fraud. Examples abound. COVID-19 exposure on cruise ships, wildfires, data breaches, and sexual-harassment allegations have all served as grounds for event-driven claims of securities fraud supposedly tied to generalized statements.
Here's one from the Society of Corporate Governance: This Court should reverse the judgment of the court of appeals to avoid a severe chilling effect on companies' willingness to make public statements, and to avoid penalizing more robust and socially beneficial statements with potentially crippling liability in securities-fraud class actions. If affirmed, the Second Circuit's approach will have the practical effect of discouraging public companies from making positive or aspirational public statements of principle on important internal and external issues. That result, in turn, would deprive those companies and their stakeholders of a crucial goal-setting mechanism on a broad range of issues, from corporate governance reforms, to environmental and societal goals and beyond.
If it's securities fraud to (1) have a code of ethics (or a policy on environmental, social and governance issues) and (2) also do something bad, then some companies will respond by not having codes of ethics. (Since that is easier and more reliable than not doing anything bad.) That is not an entirely good result! You want companies to promise to do good things! Ideally to do them too, but that is harder. Oral argument in the case is scheduled for March 29. No doubt this case will produce new technical rules for securities class certification, but for our purposes the big picture is that this case could decide whether or not everything is securities fraud. If statements of generic goodness are enough to certify a class—as U.S. courts mostly seem to think these days—then any bad thing a company does really can be securities fraud. If not, then perhaps only lying about securities is securities fraud. How's GameStop doing?What if this becomes a recurring bit? What if every day, for the rest of this column's existence, we check in on the price of GameStop Corp. common stock? Right now, there's a pretty good chance that, if you're reading this, you already know where GameStop is trading, and there's no need for me to tell you. That was even more likely a week ago. Three weeks ago you probably had no idea where GameStop was trading, and it would never have occurred to me to tell you. By next week there is a pretty good chance that you will once again have no idea where GameStop is trading. But I have been scarred by the GameStop experience, and I've got a newsletter; I could just write down the price of GameStop every day. I could probably automate it. In five years I'll end each column with "Oh also GameStop is at $_____," and the new analysts at investment banks will be like "this Levine character is okay but why is he so obsessed with this mall-based video-game retailer?" But the grizzled veterans will know. Anyway GameStop closed at $90 yesterday, down 60% for the day; it opened a bit higher today and was trading at around $93, give or take, as of 10 a.m. At yesterday's close, GameStop was up about 378% year-to-date. What a great stock! From Bloomberg's EEO function I see that $90 represents 67 times consensus 2023 earnings estimates (2021 and 2022 earnings estimates are negative), or roughly double Apple Inc.'s price/earnings ratio. The market must expect big things from this little company. How'd the hedge funds do?We're going to see more articles like this in the coming weeks and I am absolutely here for them: Jason Mudrick's hedge fund reaped almost $200 million on its stakes in firms that skyrocketed during a Reddit-fueled trading frenzy in recent weeks, according to people familiar with the matter. Mudrick Capital Management earned 9.8% in January, one of its best months ever, making the bulk of its gains on debt and equity options of AMC Entertainment Holdings Inc., said the person, who asked not to be identified because the information isn't public. The firm also profited from the volatility in shares of GameStop Corp. The $3.1 billion hedge fund booked most of the gains on its debt holdings in AMC and about $50 million selling out-of-the-money call options on the stock last week, the person said. The shares surged more than 500% in January before retreating sharply Tuesday. Mudrick also profited by selling out-of-the-money call options on GameStop, the person said.
Obviously a lot has been written about the individual traders on Reddit who made and lost money on GameStop and AMC, and there has been some writing in general terms about how it was the hedge funds and other professionals who made the real money, but what I want to read is a detailed oral history of how hedge funds decided to play the meme stocks last week. It was a wild time, and an unbelievably rich test case for investment processes. Like, here is how it's supposed to go, at a hedge fund: Analyst: I think the market [undervalues]/[overvalues] XYZ and we should [buy]/[short] it. Portfolio manager: Why? Analyst: [Gives cogent reasons relating to the business and market environment.] PM: Okay but what's the catalyst for the market to realize that we're right? Analyst: [Lays out compelling story about what will change and when.] PM: Great, but why do you think we have any edge here? Why are we smarter than anyone else? Analyst: [Points to the fund's proprietary data sources, advanced analytics, industry relationships or some other source of edge.] PM: Good job, let's do it.
Here is how, I assume, GameStop went:[7] Analyst: I think the market overvalues GameStop. PM: Ahahahahahahahaha come on man, of course. Analyst: So we should sell some out-of-the-money call options. PM: This is the most nightmarish thing I've ever seen, the stock doubles every day, why would we sell calls? What is the catalyst for it to settle down? Analyst: I've been reading Reddit and I think a lot of them have poop hands. PM: I don't know what that means but it sounds bad. But you are just reading Reddit, right? Anyone can do that, and everyone does right now. What is our edge here? Analyst: Our edge is that no one else is dumb enough to be in this trade.
None of this is wrong! It worked out! Also it is sort of analytically correct: GameStop was overvalued, the Reddit people couldn't hold out forever, and "no one else is dumb enough to be in this trade" is a good sensible limits-to-arbitrage story. ("The market is overpriced because most people who know it's overpriced are afraid to mess with Reddit, which gives us an edge if we are just willing to mess with Reddit," etc.) Also Mudrick was thoughtful about how it bet against GameStop, selling call options rather than shorting the stock.[8] Still it is bold![9] I wrote last Wednesday that "'Lol GME to 1000 [rocket emoji] [rocket emoji] [rocket emoji]' is a perfectly good hedge fund thesis right now,"[10] and I meant it—there were clearly hedge funds on both sides here—but I wouldn't want to be the one making it. Or think of the meetings with investors: Portfolio manager: We have a repeatable investing process based on deep expertise that delivers reliable alpha in all markets. Client: This sounds good, this is what we want. PM: Also we were up like 100% last quarter. Client: Ooh that's even better. PM: Because we gambled on GameStop at the top, YOLO. Client: Wait what.
But I am making a lot of assumptions here, and I would love to read about how I'm wrong, about how some big hedge funds calmly applied their usual informed repeatable alpha-generating process to GameStop and came out ahead. Why not. Maybe you have a strategy that analyzes social-media sentiment and momentum, and all your signals were off the charts last week, and you just went with it and made a fortune. And obviously some big professional traders did handle GameStop in a business-as-usual way: If you are a high-frequency trader or an options market maker, your special expertise is precisely in trading a lot on the other side of irrational retail flows, and you really should expect to make a ton of money when the retail traders go wild. "High-speed traders reap windfall from retail investor boom," it says here. I'd read an oral history of how they felt last week too. Elsewhere: "A Morgan Stanley mutual fund that bet on GameStop recorded the best performance of any of its peers in January, showing how some Wall Street firms managed to play the retail trading surge to their benefit." And here is a sort of sweet story about two professional investors who "Were Buying GameStop Stock Before It Was Cool": Last spring, when GameStop Corp. was just a struggling videogame retailer and before Reddit took it to the moon, two small money managers teamed up in an audacious bid to shake up its board of directors. They thought the stock was worth a few more dollars. They won, and then things got wild. Shares have zoomed from $4 all the way to above $400 and back to $90. John Broderick's Permit Capital has made more than $100 million, and Kurt Wolf's Hestia Capital is up around $50 million, at least in paper gains, according to regulatory filings. The duo risked their reputations on the future of GameStop and in doing so helped plant the seeds that turned into a stock rally that has captivated Wall Street. "It's sort of like after the Super Bowl when they ask someone how it feels and they say it doesn't feel real," said Mr. Broderick. "I guess I can go to Disney World."
Yeah those investor meetings are probably pretty good. "We have a repeatable investing process based on fundamental value principles and committed thoughtful activism that adds real value to our targets, and we applied it here successfully, but then also Reddit manipulated the stock up for fun so that was a nice tailwind." Forbidden indexThis is a great way to define "meme stocks": The 50 stocks that Robinhood originally put on its restricted list had added $276 billion in value from the end of 2020 to the height of the recent mania, according to data compiled by Bloomberg. But now, $167 billion has been wiped out in just a matter of days, and there's little sign the pain is easing.
Last Thursday, Robinhood Markets Inc. restricted customer trades in a list of stocks that at one point had 50 names on it, stocks that were especially meme-y or heavily shorted or volatile or otherwise problematic. And now apparently Bloomberg News tracks the performance of the stocks that made the list. Let's check back in December and see how the Robinhood Forbidden Meme Stocks did this year. If nobody starts an exchange-traded fund of these stocks by end of business tomorrow, I will do it myself. Casual Bloomberg searches suggest that available tickers might include "MEME," "WSB," "STOP," "BAD," and "DONT." Also "NOPE." "NONO." "TABU." "ARGH."[11] Why would you buy GameStop stock when you could get the diversification benefits and low expense ratio of a passive ETF made up of all the stocks that were briefly too dangerous to trade? Or of course you could short it, lol. How does this ETF not exist already; imagine having an investment thesis, in February 2021, that is not either "the meme stocks will go up" or "the meme stocks will go down." Forbidden capital raiseWell this is no fun: And then let me just mention one third area that we're looking at very closely, and that is these issuers. Now, for the most part, there's no new information in the market from these issuers. But we are going to make sure as we - you know, as we look to what they're doing, whether or not they are trying to raise money in the middle of this. And if so, can they adequately disclose the risks associated with that?
That's Allison Herren Lee, the acting chair of the U.S. Securities and Exchange Commission, warning companies not to raise capital if their stocks have risen to stupid levels due to social-media enthusiasm. I have written about this before, and I would sum up my views as: - Of course issuers should be allowed to sell stock to redditors at dumb meme-driven prices, YOLO, but
- If I personally were on the board of directors of one of these companies, I would get very nervous about issuing stock at prices that nobody thinks are justified by fundamentals. "Not quite fraud but fraud-ish," I called it.
I think that is consistent with what Lee says here: It's not exactly illegal for a meme-stock issuer to sell stock into a Reddit-driven rally (and, for instance, AMC Entertainment Holdings Inc. has done so, to delightful effect), but … you know … maybe don't. It's not the sort of thing the SEC likes. But if you must, make sure you can "adequately disclose the risks associated with that." I tell you what, if you work at GameStop and are thinking about doing an at-the-market offering, and you are struggling with how to adequately disclose the risks of "our stock price is stupid because some people on Reddit manipulated it up in a weird game, and if you buy it here it's gonna go down a lot and you'll feel dumb," give me a call, I will happily try to re-activate my law license so I can help you write that prospectus. I won't even bill you, that's just a prospectus that I need to write. I am not the sort of writer who has a novel inside me straining to get out or anything like that, but it is very possible that I have a GameStop ATM prospectus inside me that needs to come out into the world. Things happenAmazon's Bezos to Cede Chief Executive Officer Role to Jassy. How Billionaire Robert Smith Avoided Indictment in a Multimillion-Dollar Tax Case. Robinhood's C.E.O. Is in the Hot Seat. "It's Time for Real-Time Settlement," says Robinhood. Hedge Funds Hunt Frothy Names to Short, Even After GameStop. Bill Gross Releases Investment Outlook, "Gamestonk/Gamestink." Jane Austen plot unfolds in the high-yield debt market. The Down Side to Life in a Supertall Tower: Leaks, Creaks, Breaks. US toddler to release debut album recorded in the womb. If you'd like to get Money Stuff in handy email form, right in your inbox, please subscribe at this link. Or you can subscribe to Money Stuff and other great Bloomberg newsletters here. Thanks! [1] I am quoting from this Second Circuit opinion from 2016, part of the long winding process of the Arkansas Teachers Retirement System v. Goldman Sachs Group Inc. case. [2] In my personal life I have more nuanced views on whether the Abacus CDO situation was actually a fraud on Goldman's customers, but for our purposes here it's enough that (1) the SEC said it was and (2) Goldman settled for a big fine. I'm going to call it a fraud in the text, but deep in my heart I have a soft spot for Abacus. I disclosed up above that I worked at Goldman during this period, but maybe I should disclose it again down here. [3] We talked last month about a paper by Emily Strauss of Duke Law School titled "Is Everything Securities Fraud?" Strauss found that only about "16% of securities class actions arise from conduct where the most direct victims are not shareholders," sexual harassment or orca mistreatment or selling bad CDOs or whatever. (The remaining 84% are classic securities fraud, companies lying to shareholders about the state of their business, accounting restatements, that sort of thing.) But she found "that these cases have roughly a 20% lower likelihood of being dismissed, and settle for significantly higher amounts." [4] I am quoting from Goldman's brief to the Supreme Court, though I'm omitting some words. [5] Would it? [6] Citations omitted, here and in the rest of these quotes. Though I cannot resist pointing out that the AIG/Chubb brief cites me in a footnote for, roughly, the proposition that "everything is securities fraud." I did not invent this phenomenon, but I do kind of think I named it. [7] AMC was different, for Mudrick, because it was a sort of capital-structure arbitrage: They thought the debt of AMC was undervalued, so they owned it, and they thought the stock was overvalued, so they sold call options on it. The basic theory of capital-structure arbitrage is that eventually the company's different securities have to converge: If the company is good, the debt will rise in value; if the company is bad, the stock will fall in value. Here both legs worked out: The stock was at stupid levels and eventually fell, but while it was at stupid levels AMC used it to raise a bunch of money and shore up its credit. [8] Selling calls is both a bet that the stock price is too high (if the stock falls, you don't have to pay out on your calls) and a bet that the *implied volatility* in the options market is too high (if the stock doesn't bounce around as much as people expect, the calls you sold lose value). (If you delta-hedge the call options you sold by buying some stock, then that is *just* a bet on volatility and *not* a directional bet on the stock price; options market makers normally hedge, but I assume Mudrick was making an outright bet and did not hedge.) There was a lot to be said for selling call options last week, terrifying though it would have been: The stock price *was* too high, and implied vols of listed options had shot through the roof due to all of the Reddit traders trying to push up the stock by buying calls. Dealers who were selling piles of call options to redditors would no doubt have been happy to buy some back from Mudrick, to hedge their own gamma risk, so Mudrick probably got a rich price. (Though as we discussed the other day, *two* weeks ago buying put options was the right way to bet against GameStop, since the puts gained value even as the stock went up. The trick is timing your volatility call right.) [9] While I have you here I want to complain about a random thing that annoys me. There is an absolute ton of excited conspiracy theorizing out there about how short sellers are evil, they are naked shorting, it is illegal, there is "counterfeit" or "phantom" stock, on and on. Mudrick did not bet against GameStop by literally shorting its stock, borrowing it and selling it and hoping to buy it back at a lower price. Instead, it bet against GameStop by selling call options. The way that you do that is you just sign a contract saying "if GameStop stock goes above $500 [or whatever], I will sell you 100 shares for $500 each." You don't borrow any stock, and you certainly don't borrow any call options: A call option is not a thing that exists independently in the world, it is just a way to describe this contract that you enter into. You collect some cash now in exchange for making a (contingent) promise to deliver stock at some point in the future, hoping that the stock price will go down and the cash you get now will be worth more than your future obligation. Those are the same basic mechanics as short selling, but here it's easy for everyone to understand why *you don't need to have the shares now*, so nobody writes endless conspiracy theories about it. "Oh, right, you get paid now and promise to deliver shares later, I get it," everyone shrugs. [10] To be clear, that's a long thesis, while Mudrick's was (essentially) short. Either side had a certain YOLO flavor to it, though, if you were trading last week, and either could have made or lost a lot of money depending on your timing. [11] "YOLO" is taken; it's the AdvisorShares Pure Cannabis ETF. Fair, honestly. | 
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