The Big Squeeze

On April 13, the Securities and Exchange Commission filed a complaint in the United States District Court for the Central District of California charging several defendants with manipulation of the stock price of GenesisIntermedia, Inc. (GENI). The complaint alleged that the manipulation scheme resulted in the misappropriation of more than $130 million, the collapse of several broker-dealers, and the largest bailout in the history of the Securities Investor Protection Corporation (SIPC).

SIPC was created by Congress in 1970 to insure investors’ funds which are under the control of financially distressed brokerage firms. SIPC achieves this by returning non-negotiable securities in the name of the investor to the investor, and by satisfying the rest of an investor’s claim up to $500,000; a maximum of $100,000 cash claim may be restored. In short, SIPC is the capital markets’ equivalent of the FDIC.

The scheme began with acquiring the capital: the principals of GENI wanted to raise cash quickly, based on the value of their company’s equity. They formed a holding company called Ultimate Holdings to unload the equity shares, and they approached Deutsche Bank Securities, Ltd. about trading the shares for liquidity. Deutsche would not accept the stock from anyone but a broker; therefore, the GENI principals through Ultimate Holdings approached Native Nations, a broker-dealer, to facilitate the transaction. Once Native Nations went to Deutsche, Deutsche approved the loan of money in exchange for shares.

The share price acted as an index by which to measure the appropriate measure of capital allocated to Ultimate Holdings. It had similarities to a revolving line of credit, in that funds distributed to Ultimate Holdings based on the security in the collateral were not distributed in one some based on market value or other valuation method at time of loan; rather, Ultimate Holdings’ debits and credits with the broker-dealers fluctuated with the ever-changing price of the shares. This is called being “marked to market.” Marked to market is essentially recording the price or value of a security to the market value of the security, rather than the book value of the security. It is a practice which originated in the derivatives market but has since been expanded to use in corporate accounting and banking. Its most notorious use occurred in the accounting practices of Enron.

The scheme’s structure provided an incentive for Ultimate Holdings and its actors to attempt to influence the price of the shares. The greater the price of the shares, the more money owed to them.

What would have been the exit plan? Could there ever have been a way in which they could have caught up? If they only expected to make money via the price of the shares, they could never have caught up. If their only source of income was the shares on which they owed money, their balance ultimately would have dropped to zero – or worse. How much of the market in those shares did they control?

They could have controlled the price of the shares via supply and demand, via perceived notions about the strength of the company – this last option could implicate price-earnings ratio, and other gauges of corporate health. Options on the shares?

If the shares are loaned, then how would the other parties make money? Deutsche would make money because the shares were ultimately in their possession. They would make money by having the ability to pledge or otherwise hypothecate the shares to another party. Assume for instance, they paid out to Ultimate Holdings (through “Native Nations”) $130 million for shares of GENI. They have paid the market value. If Deutsche then placed those shares on the open market, assuming they could, they market value is $130 million. They are no better off than they were before. However, they can make money on this if the shares go up between the time that they acquire them and the time that they transfer ownership. They simply have bought low and sold higher. However, there is a problem with this assumption as it relates to this problem. If the stock price rises, Deutsche is supposed to transfer that difference in value in the collateral to Ultimate Holdings. Therefore, Deutsche is still stuck at $0. Even the only scenario in which Ultimate Holdings is supposed to transfer cash back to Deutsche garners no measurable gain to the bank – the shares they hold as collateral have declined in value.

Where is the difference in value that makes this a profitable transaction for Deutsche? The first party to which they can turn is the open market. There will be no profit from buying low and selling high. However, for each transaction, there will be a fee (maybe even multiple fees). Those fees are where they can make a profit. Second, they can turn to Ultimate Holdings itself. While each party is arguably on equal footing (transferring to each other party a thing of equivalent value with a promise to maintain parity through subsequent cash transfers), one party is the lender and one party is the borrower. One argument favors Ultimate Holdings as the lender; after all, they did lend the shares to Deutsche, and Deutsche will ultimately be obliged to return those shares.

However, another argument militates in favor of Deutsche as the lender and Ultimate Holdings as the borrower. At first blush, this transaction looks simply like a cash loan from a large bank to a party (Ultimate Holdings) which needs cash and pledges assets (shares) as collateral in case of default. Even if this is viewed as something of a revolving credit line with regular cash transfers pegged to the value of the collateral, one party holds the collateral and the other party credits or debits cash to or from its account based on that collateral.

For the sake of simplicity and the likelihood of this being the correct course, assume that Deutsche was the lender and Ultimate Holdings the borrower. For a cash loan, a lender will generally require a payment of interest from the borrower for temporarily sacrificing present liquidity. This goes to the time value of money. (The time value of money is, roughly defined, how much more valuable money is today, rather than later. It is comprised of present value and future value, and the correlation between the two is defined as the discount rate. The discount rate is the rate earned from lending money for one year).

This path will permit Deutsche to make money on the transaction. In this stock-lending context, the fee is called a rebate. Alternatively, they could charge a flat fee for providing the service. Of course, the principal will, in this case, fluctuate, but fluctuating principal has never obstructed reliable, accurate calculation of interest.

Why would Ultimate Holdings engage in this sort of float? Ultimate Holdings arguably has nothing to gain. They lend their shares, and they receive cash. At some point in the future, Deutsche will demand repayment. Ultimate Holdings will have received, for example, $130 million, and they will repay $130 million. Even if the share values have increased, Ultimate Holdings will already have received its monetary benefit for that gain. They are stuck at $0. However, the principal that warrants the payment of interest of Deutsche (loss of liquidity) cuts both ways. Just as Deutsche has lost the value of playing with a certain quantity of money, Ultimate Holdings has gained the value of playing with a certain quantity of money (gain of liquidity).

Ultimate Holdings’ liquidity gain could not have occurred if they had merely held on to their own shares. The value of their shares is, other valuations excluded, the equity in their business. In accounting terms, equity in a business is the difference between assets and liabilities. However, if the equity in a business is not liquid, it is difficult – albeit, not impossible – to leverage that equity in further gains. In order to make those other gains, Ultimate Holdings had to convert that equity into liquidity. They could do this in a number of ways. Two simple ways are selling and lending. In this case, Ultimate chose to lend the shares. Why not sell them? First, selling shares of one’s own organization is not an easy process. If your organization is not in the business of issuing shares of stock, then economies of scale and marginal costs militate against the efficient issuing of shares by your organization; in terms of time, energy, and sheer money, it is a costly process.

The second problem with issuing one’s own shares is partially an offshoot of the first reason regarding cost – issuing equity means issuing securities. The industry of issuing securities is, by virtue of the Commerce Clause, and ultimately, the Securities Act of 1933 and the Securities Exchange Act of 1934 and the resulting authorities, a complex and, therefore, costly process. Errors in this process will not only hurt a company’s balance sheet; they could also result in civil action, criminal prosecution, and possibly the demise of the organization (unless you’re Google and you’re in Playboy).

Deutsche, by virtue of its position as a bank in the business of dealing in securities, and by virtue of its reputation and market presence essentially eliminates all of these concerns for a company situated as was Ultimate Holdings. Ultimate Holdings provided assets and received readily-available liquidity, from which they hoped to make money; Deutsche provided a service, receiving a fee, and received assets from which they hoped to make money.

So why lend the shares to Deutsche instead of selling them? If Deutsche sold the securities, Deutsche would have been in the position of an underwriter. This increases both its liability and its costs. Moreover, when Deutsche entered into the transaction, the shares were not worth very much Which makes more sense? Incur all the costs of underwriting service for a deal which is going to cost more than it is worth? Or simply exchange some short-term liquidity for a small, but profitable fee? The answer is obvious.

(Note: for purposes of this entry, Ultimate Holdings is the entity discussed; Ultimate Holdings was, as stated earlier, a holding company, a dummy company and alter-ego of the owners of GENI, the company whose shares were at issue).

Something else is worth noting: during its life as a public company, GENI lost approximately $160 million; it never turned a net profit. On its merits, therefore, GENI could not have issued its stock and expected to make a profit on its shares. Quite simply, any further investment by any investors would have amounted to throwing good money after bad; rational investors would not have poured money into the stock based on fundamentals. GENI’s share prices could move up only through irrationally positive perceptions about the stock, or through market manipulation. And move up it did. Between GENI’s IPO on June 14, 1999, and just prior to its collapse in September 2001, GENI’s share price rocketed up from $2.83 per share to $25.00 per share. (At the time of its collapse, the shares were virtually worthless – at pennies per share).

GENI tried both tacks. First, it paid a financial commentator to disseminate baseless, positive reports about the company, thereby driving up demand for the stock. Second, GENI itself attempted to manipulate the market; this second route was designed to limit supply, prop up the share price and, thereby, the stock float with Deutsche, thereby pumping cash into Ultimate Holdings, and back into GENI. Besides being fraudulent, the first tactic is not reliable per se. Even after the fraudulent reports have been disseminated, buyers still have to snap up the shares and boost the price. The second tactic is quite effective, and in some regards cannibalistic.

The second route worked this way: Ultimate Holdings and its related parties prevented Deutsche from lending the stock to other parties. Additionally, when Native Nations took stock back, they held onto it, and GENI and Ultimate Holdings even snapped up stock on the open market, using proceeds from the stock loans themselves, to squeeze supply, and conversely, to increase demand and the share price. These acts also had the effect of preventing other parties – i.e.: speculators – from selling short the GENI stock and driving the share price down (which would have forced GENI to return the loan money).

Besides being fraudulent, the scheme had no exit strategy. Every part of the scheme was designed to keep the price of GENI stock at a certain level. At first, the stock loan proceeds may have funded the actual activities enumerated in the GENI corporate charter. Such activities, in theory, could have led to actual profits, and thus created a way for GENI to pay back the loans, market its shares, and exit the scheme. By the time the company collapsed, however, any money GENI took in from the scheme was used to pay for the scheme – in short, the python feasted on its own tail, making a loop that drew ever tighter, until there remained no room from which to extricate oneself.

The above entry does not constitute legal advice.