Too Good To Be True

This whole blog post is about things that blow my mind.  Let's start with an investment pitch:

Joe Meals [a consultant for the Firefighters' Retirement System of Louisiana] said that others had already jumped at the chance to invest with Alphonse Fletcher Jr., a flashy Wall Street financier whom Mr. Meals described as a long-established hedge fund manager, according to video recordings. The fund was offering essentially a 12 percent guaranteed return, according to Mr. Meals, secured by a third-party investor, and the opportunity was so hot the board would have to make a decision that day.

“I can tell you, it won’t be on the table this time next month,” Mr. Meals told the group, according to the video recordings. “It won’t take 30 days for somebody else to want it.”

The firefighters’ system eventually said yes, and along with two other pension funds — the Municipal Employees’ Retirement System and the New Orleans Firefighters’ Pension and Relief Fund — invested a combined $100 million in one of Mr. Fletcher’s funds, FIA Leveraged. As they understood it, the fund would invest in liquid securities that could be sold in a matter of weeks.

The details sounded, as one board member put it, “too good to be true.”

You won't be shocked to learn that the investment was, in fact, too good to be true.  I sympathize with these public employees, but I've got to say, when you receive a pitch like that . . .  a certain degree of skepticism is called for.

Fletcher's downfall started when he engaged in that most traditional of New York pastimes - fighting with his co-op board.  Fletcher owned three units in the Dakota (the legendary New York building where John Lennon once lived and outside of which he was gunned down).  Fletcher tried to buy a fourth unit, but was turned down by the co-op board.  Racism!  (Fletcher is black.  He is also perhaps bisexual, having lived with a man for several years and subsequently having married Ellen Pao.  But so far as I know, he accused the Dakota board of racism, not homophobia.)

Unfortunately for Fletcher, co-op boards are widely regarded as being all-powerful for a good reason:  they are all-powerful.  Also, this particular co-op board was advised by a finance committee filled with highly sophisticated bankers and lawyers.  The co-op board said (in a court filing):  We're not racist, we just don't think Fletcher can afford another unit.  Our finance committee tells us that his investment management company is losing money and his fund is overstating its assets.  We're frankly not quite sure how he is paying for the units he already owns.

At this point a couple of pension funds decided their confidence in Fletcher was less than absolute and withdrew their investments.  They expected to receive cash, but instead received promissory notes (basically, IOUs) payable within two years (this, by the way, strikes me as a probable violation of the contract, although I would have to see the contract to know for sure).  They filed a lawsuit.  Today, various Fletcher funds are in insolvency proceedings in the U.S. and the Cayman Islands.

So how did Fletcher invest the money?  According to a report filed by the trustee in the bankruptcy case of one of Fletcher's funds (you can download a copy from a link accompanying this WSJ article), some of it seems to have gone to finance a film his brother made.  (Geoffrey Fletcher won an Oscar for the screenplay to "Precious."  However, Alphonse Fletcher put his investors' money into another film, "Violet & Daisy," which was far less successful in financial terms.)  But a lot of the money went into PIPEs, that is, private investment in public entities (some people say "equities" instead of "entities" - I don't know the product well enough to say, so I am following the usage of the trustee's report).  In essence, an investor places a negotiated investment with a public company, sometimes including options to buy shares at a specified price.  (As the trustee notes, there is nothing inherently suspect about PIPEs - Warren Buffett invested in Goldman Sachs and General Electric using PIPEs.  Actually, I think it would be fair to say that the U.S. Treasury used PIPEs to invest in AIG, Fannie Mae, and Freddie Mac.  It's just an investment in which the shares are sold directly to an investor under negotiated terms, rather than sold on the markets.)

And now we come to the part that I find truly fascinating.  This part is also potentially a little hard to follow, so I'll try to be as clear as I can.  If you stick with me, I think you will be amazed.

In connection with PIPEs, Fletcher would take warrants (warrants are essentially options - a warrant is just an option written by the same company that issues the shares that are the subject of the option - I'll use the terms interchangeably) in the companies in which he invested.  This means that the fund would have the right (but not the obligation) to buy shares at a specified price during a specified period of time.  If the company's shares were worth more than the "exercise price," then obviously Fletcher would exercise the options and buy the shares (and probably immediately sell them for a profit).  So for instance, let's say the exercise price is $100, the fund has a right to buy 10 shares, and the stock is actually trading at $200.  The fund will buy 10 shares for $1,000 and sell them for $2,000, netting a $1,000 profit.

But actually, it can be a hassle coming up with the cash to buy the shares at the exercise price, and the company doesn't necessarily want to dilute its shares by so much (and at such a disadvantageous price).  So the parties add a "cashless exercise" provision to the contract.  The idea is to replicate the investor's profit from the trade, but without any money changing hands.  So in our example, the company would simply deliver 5 shares of stock to the investor, which could sell the stock for a $1,000 profit.  It's the same profit as before, but without any money changing hands.  Everyone is happy.

So the formula looks like this (I am paraphrasing from the trustee's report):

X = N(S - K)/S

where:

X = the number of shares of stock to be issued pursuant to the cashless exercise provision

N = the number of shares of stock which would be purchased in a traditional (not cashless) exercise

S = price per share of the stock

K = the exercise price for the stock

Plugging in our earlier example:

5 shares = 10 shares($200 - $100)/$200

Makes complete sense.  But Fletcher didn't use that formula.  Here is the formula that Fletcher inserted into the "cashless exercise" provision of his PIPE agreements:

X = N(S - K)/K

A subtle change!  One that slipped by a lot of lawyers, apparently.  But think about how it would work.  Let's use our example from earlier.  Recall, we've negotiated the right to buy 10 shares at a price of $100/share.  The actual price is $200, and so we are going to exercise the option.  If we use a "traditional" (not cashless) exercise, we will have to tender $1,000 to the company, for which we will receive 10 shares.  What about the cashless option?

X = N(S - K)/K
X = 10 shares($200 - $100)/$100
X = 10 shares × $100/$100
X = 10 shares

So under the cashless option, in which I tender $0 to the company, I get . . .  10 shares!  The same amount I would get if I tendered $1,000 under the traditional option exercise.  So the cashless exercise is considerably more profitable for me (I can sell those 10 shares for $2,0000 whereas I would have earned only a $1,000 profit under traditional exercise).

And let's say the stock is worth $300, instead of $200:

X = N(S - K)/K
X = 10 shares($300 - $100)/$100
X = 10 shares × $200/$100
X = 20 shares

Now I can get 20 shares by tendering $0 to the company (cashless exercise), or I can get 10 shares by tendering $1,000 to the company (traditional exercise).  The cashless exercise is even more dominant than in the previous example.  And this is a generalizable result - in the trustee's report, there is a graph showing that the return on cashless exercise of the options increases much faster than the return on traditional exercise, as the share price of the company increases.  (This is presumably what was meant in one of Fletcher's prospectuses, which stated his intention to profit by entering into deals "immediately, quantifiably worth more to the buyer than the seller."  That is, he planned to dupe the companies he invested in.)

Needless to say, no one actually thinks about cashless exercise this way.  Cashless exercise is intended to be economically equivalent to traditional exercise.  And indeed, when two companies separately noticed the crazy provision (after signing the agreement), they each insisted on removing it.  (In one case, the amendment followed a litigation about other matters.)  But until someone notices it, you could theoretically value the option as if its non-standard terms were fully enforceable, which would result in a massively inflated value.  And this is exactly what Fletcher is alleged to have done.  Those inflated values meant that his funds appeared highly profitable, even though actually realizing those profits would require the companies to honor the terms of the "cashless option" provisions without litigation (an unlikely outcome - recall that both of the companies that discovered the nonstandard formula insisted on changing it).

Now I think there's an interesting discussion to be had about whether this provision should be enforceable in court.  I would never want to see a slimy term like that enforced against an ordinary person.  But these were publicly traded companies, sophisticated and presumably well-represented by counsel.  So I wouldn't be totally outraged if Fletcher had sued and won.  But on the other hand, the "cashless exercise" provision is so absurd that it clearly wasn't the intent of the parties, and on that basis I would expect it to be unenforceable.  If you really wanted to create a financial instrument with those characteristics, you could do it - but you wouldn't hide it under the guise of "cashless exercise," with no other indication that the parties intended to agree to these crazy economic terms.

But that's not really the point.  No matter what, any attempt to exercise a "cashless exercise" would be almost certain to result in litigation, and there is substantial doubt that a court would enforce the "cashless exercise" terms.  And so attributing full value to the options, on the basis of the inflated "cashless exercise" value, is highly aggressive.  And bear in mind, the value attributed to the options determines the "return" attributed to the fund, which in turn determines Mr. Fletcher's compensation for managing the fund.  By inflating the value of the funds, Fletcher extracted money from his investors even though the actual returns he earned for those investors were highly doubtful.

I'll wrap things up with yet another thing that blows my mind.  Henry Louis Gates is the Alphonse Fletcher University Professor at Harvard University.  I seriously wonder how he feels when he is introduced by that title.