Fraud Is No Fun Without Friends
Also SEC priorities and penny stocks.
Fraud Is No Fun Without Friends
Also SEC priorities and penny stocks.
Everything is seating charts
The way a lot of financial crime works is by slow acculturation. You show up at work on your first day, bright-eyed and idealistic, and meet your new colleagues. They seem like a great bunch of people, they’re so smart and know so much and seem to be having so much fun. They go out for beers after work a lot, and sometimes they let you tag along and listen to their hilarious jokes and war stories.
During the day, they teach you how to trade Treasury futures, and it is all so exciting and high-stakes and important. You shadow one experienced trader and quickly find yourself imitating his mannerisms, looking up to him, hoping to be like him one day. “Here is where I put in some fake orders to spoof the price higher,” he says; “a little razzle dazzle to juke the algos.” “Isn’t that, uh, illegal?” you ask timidly. “Hahahaha illegal!” he replies ambiguously. You do not press the matter. Three months later you are bragging in the desk’s electronic chat room about your own big spoofing victories. As you type “lol i just spoofed em so good hope i dont go to jail” into the chat window, you feel a rush of pride; now you really fit in, you are one of them. You go out for beers that evening and you are the center of attention; everyone congratulates you and celebrates your achievements. It is a great day. Six months later you are arrested.
Now imagine the same story except that you show up at work your first day on Zoom, and your colleagues seem kinda nice but talking to them is awkward and disjointed, and you have no idea what they do after work because nobody leaves their house, but you have a Zoom happy hour once and that’s pretty awful. And there is an electronic chat room, sure, and your colleagues make jokes in the chat, but you don’t get a lot of them because they reference stuff that happened in the office, in person, before you arrived. You learn to trade Treasury futures by reading some training materials. “I just put in some fake orders to spoof the price higher,” says one experienced trader in the chat one day. You frown and reference the training materials, which say “spoofing is super duper illegal and should be reported to compliance immediately.” You shrug and send the chat transcript to compliance. Your colleague gets fired and prosecuted. He may or may not feel a sense of personal betrayal that you turned him in, but you’ll never know or care.
The SEC knows what I’m talking about:
The work-from-home phenomenon has triggered a fresh frustration for U.S. corporations: Americans are blowing the whistle on their employers like never before.
The proof is in the data, with the U.S. Securities and Exchange Commission receiving 6,900 tips alleging white-collar malfeasance in the fiscal year that ended Sept. 30, a 31% jump from the previous 12-month record. Officials at the agency, which pays whistle-blowers for information that leads to successful investigations, say the surge really started gaining traction in March when Covid-19 forced millions to relocate to their sofas from office cubicles.
The isolation that comes with being separated from a communal workplace has made many employees question how dedicated they are to their employers, according to lawyers for whistle-blowers and academics. What’s more, people feel emboldened to speak out when managers and co-workers aren’t peering over their shoulders.
“You’re not being observed at the photocopy machine when you’re working from home,” said Jordan Thomas, a former SEC official who helped set up the agency’s whistle-blower program a decade ago. “It’s never been easier to record a meeting when you can do it from your dining room table,” added Thomas, who now represents tipsters as an attorney at Labaton Sucharow in Washington.
Adam Waytz, a psychologist and professor at Northwestern University’s Kellogg School of Management, agrees.
“When you feel disconnected from work, you feel more comfortable speaking up,” said Waytz, who has studied the motivations of whistle-blowers.
Also I would guess that somewhat more financial crime is now coordinated via email and electronic chat than it was a year ago, when you could just turn to the person sitting next to you and talk live about your crimes. And if you’re going to blow the whistle to the SEC, it helps to have electronic chats to forward to them. Though I would not put too much emphasis on this explanation; traders seem to love talking about their crimes via electronic chat even when they are sitting right next to each other.
I guess this story is good news from a prevention-of-financial-crime perspective, but it is sort of a sad story from a human perspective. All these people feeling disconnected from their work and their colleagues, with no strong personal ties of loyalty and friendship and common mission. Sure the common mission in these particular cases was crime, but still.
One way to read this story is that one sort of business that is conducted at offices is fraud, and people in the fraud business have become 31% less loyal and motivated and conscientious since the pandemic started, which is causing some previously viable fraud businesses to have to shut down. (Because the SEC caught them.) Which is not a loss for society or anything. But the mechanism here, of people feeling disconnected from their jobs and disloyal to their colleagues, is not unique to the fraud business. This story is a sort of leading indicator of a breakdown in morale and group cohesion generally as so much work is done from home. That is probably bad for a lot of projects; it’s just that one of the projects it’s bad for is fraud.
It is being reported that Gary Gensler, the head of the Commodity Futures Trading Commission during the Obama administration, will be Joe Biden’s nominee to run the U.S. Securities and Exchange Commission. Here is Bloomberg News on the choice, noting that, at the CFTC, “his aggressive agenda made him the financial industry’s No. 1 adversary in Washington -- a label he relished,” and that this “was an extraordinary turn for the former Goldman Sachs Group Inc. partner.” I am tempted to say that he was tough on Wall Street in a way that only a former Goldman Sachs partner can be—“Why does Wall Street have to be so greedy? I am already rich”—but never mind that.
Here I want to talk about this DealBook article on the choice, with a list of “five potential focuses for the next S.E.C. chair”: disclosure about corporate political donations, limits on stock buybacks, disclosure about boardroom diversity, disclosure about climate change risks, and “clearer rules on cryptocurrencies and the blockchain.” I sort of doubt that this list will accurately reflect the SEC’s priorities over the next few years, in terms of what the SEC staff spends the most time working on and what has the biggest effect on capital markets. Maybe the crypto stuff, that’s big. Perhaps even stock buybacks; people are worried about stock buybacks. But probably the SEC will spend a lot of time on technical tweaks to bond market structure and stock-exchange data feeds and “best interests” rules and other things that are unglamorous but hotly controversial within the financial world.
But you can see where DealBook is coming from: When politicians ask an SEC nominee about his agenda, and when the SEC nominee talks about his agenda for a popular audience, nobody wants to hear about technical tweaks to bond market structure. Much of the finance-y work of the SEC does not have an especially broad appeal, and it can be hard for an outside audience even to understand what side it is on: If you say “we will rigorously cap stock-exchange data fees,” is that … liberal or conservative? Should you be mad about it, or happy? It does not map in any obvious way to normal politics.
Climate change, on the other hand! You can have an exchange about climate change at a confirmation hearing that is like:
Senator: And what will you do about climate change, as SEC chair?
Nominee: I will stop climate change, through the power of corporate disclosure.
That’s the good stuff! That’s some political relevance for a securities regulator right there. We talk frequently about the idea that the SEC is a meta-regulator of everything, because every substantive harm that involves public corporations can be filtered through securities disclosure rules, and everything is securities fraud. If you want to stop global warming, you make fossil-fuel companies disclose much more about the risks of global warming, you sue coal and oil companies for being too blasé (in their securities disclosure!) about climate change, you make rules requiring banks and mutual funds to consider long-term climate risks in their investing and financing decisions, 1 you generally make life hot for public companies that contribute to climate change, and you hope at the margin that will improve the environment. Some oil company will face some choice to pollute or not, and it will say “well if we pollute our SEC disclosure will be worse and our cost of capital will go up,” and they’ll decide not to pollute. The SEC can harness the power of the capital markets for a non-financial goal—a goal that has very little to do with investor protection, 2 but one that is important and politically salient.
Joe Biden will also nominate a head of the Environmental Protection Agency, of course. But it can be weirdly hard for the EPA to make climate-change rules, because everyone knows that the EPA makes environmental rules and they are controversial and the subject of lots of lobbying and litigation and confirmation fights and legislative second-guessing. It is relatively easier for the SEC to make (weaker!) climate-change rules because, what, they are just demanding more corporate disclosure, surely no one could object to disclosure.
Similarly boardroom diversity. Companies regularly put pictures of their directors in their proxies, so investors already have access to at least some crude measures of boardroom diversity. But you could require companies to disclose their policies on boardroom diversity, to articulate why their board is made up the way it is. This may or may not be relevant to investing decisions, but it is reasonable to expect that being forced to describe their diversity policies will push companies to have more diverse boards. Nobody really wants to disclose a diversity policy that says “we do not care about diversity,” or “our diversity policy is to have an all white male board,” so everyone will have a diversity policy that says “we value diversity and strive to have a diverse board.” And if you say that in your proxy and have an all white male board anyway, you get sued for securities fraud.
Or here’s another paragraph from that DealBook article, about another potential SEC priority:
Requiring companies to disclose their political donations publicly, in a standardized way, an issue that Democrats were pushing even before it became the biggest business story of the day.
Corporate political donations “became the biggest business story of the day” because some U.S. politicians tried to overturn a democratic election to keep the losing presidential candidate in office, and then some companies announced some variant on “we would prefer not to fund the end of democracy so we are going to pause our donations to those politicians.” And the SEC can make rules on how companies disclose their contributions, and I suppose those rules can require companies to give a narrative description of whether they support or oppose democracy, whether they have any explicit policies on backing violent coups, etc. And just as with board diversity, being forced to articulate those policies will tend to push corporations in the direction of, you know, not backing coups. Is the SEC the last bastion of defense of the American constitutional order? Sure, why not.
Signal vs. noise
We talked last Friday about Signal Advance Inc., a micro-cap medical-device company whose stock rose 527% on Thursday after Elon Musk tweeted “Use Signal.” I presumed, and wrote, that Musk was referring to the encrypted messaging app Signal, which has nothing to do with Signal Advance. Signal Advance’s stock was up, I suggested, due to mistaken identity.
I wrote about it at around noon on Friday. At 2:12 p.m., Signal, the app, tweeted a picture of Signal Advance’s stock chart and said “It’s understandable that people want to invest in Signal’s record growth, but this isn’t us.” After the market closed, CNBC also reported on the confusion. So there was a growing public consensus that the stock was up due to mistaken identity and maybe should stop going up.
Nonetheless the stock was up 91% on Friday, closing the week at $7.19 per share, up from $0.60 on Wednesday. Okay! Then everyone went home for the weekend and read Money Stuff and had a good think and came back on Monday and the stock, uh, went up 438%? It closed on Monday at $38.70, for an equity market capitalization of about $480 million. It traded 2.3 million shares, worth about $90 million, on Monday. As of last Wednesday, it had a market capitalization of about $7 million, and it had traded an average of about 5,639 shares per day, worth about $3,000, over the past six months. More shares of Signal Advance traded on Monday, after everyone knew it wasn’t the right Signal, than traded in all of 2020, and at higher prices.
By the end of Monday more places had reported “hey this is nuts,” and yesterday the stock dropped all the way back down to $10. It was at $8.90 as of 10:30 a.m. today, for a market cap of about $110 million, on about half a million shares’ volume so far today. Signal Advance last filed financial statements with the SEC for the 2016 fiscal year, when it reported a net loss of $180,213 on revenue of zero dollars. There is no news out of Signal Advance. “‘We strongly recommend people do their due diligence and always invest with care,’ the company’s chief executive officer, Dr. Chris Hymel, said when reached by phone on Monday.”
It is hard to have an efficient-markets theory about any of this. An efficient-markets theory would suggest that stock prices rapidly incorporate all available information. Here, markets were perhaps properly incorporating all the information about Signal Advance (that it had no revenue and no recent SEC filings, etc.), and valuing it at about $7 million. Then Elon Musk tweeted something about a similar word, and markets immediately and enthusiastically incorporated some wrong information about Signal Advance: that it made the Signal app, and that Elon Musk liked it. Then Signal and CNBC and Money Stuff all said “lol this is the wrong Signal.” And then rather than incorporating that information, the market pushed Signal Advance way higher. “Hahaha information, get outta here with your information, we’re having fun here,” the market said.
Eventually more information came in and the market said, “ugh, fine, information,” but Signal is still almost 1,400% above where it was before Musk’s tweet, on continuing heavy volume.
One could have a sort of impenetrable-stupidity theory about this: People logged into Twitter this morning after a few days away, scrolled back through Musk’s feed, saw the tweet about Signal, thought “hey I should buy that,” ignored all other news sources, checked Robinhood, saw that it was up a lot, and put in an order to buy some. I suppose someone may have done that. It’s hard to imagine a lot of people doing it.
We talk a lot around here about ticker-mixup stories like this, cases where something good happens to Zoom Video Communications Inc. and Zoom Technologies Inc. stock goes up, that sort of thing. When I first started noticing them, my reaction was along the lines of “hahaha dumb algorithms, can’t tell which Zoom it was.” But I revised that view, mainly because micro-cap stocks tend not to be especially algo-driven, and started thinking instead “hahaha dumb retail traders, can’t tell which Zoom it was.”
But I long ago abandoned that view too. If you bought Signal Advance the day after Musk tweeted about it, that was not dumb. You have made a fortune! I mean, a small fortune; you didn’t buy that many shares. But you’re up hundreds of percentage points! It was a great trade.
My view on these situations, certainly by last year, evolved into “hahaha clever retail traders, jumping on this mistaken-identity trade knowing that the stock will go up.” Knowingly trading on mistaken identity can be completely rational, as long as you think that either (1) other people will be genuinely fooled and will buy the wrong stock from you, or (2) other people will do the same trade that you’re doing, the trade of anticipating that other people will be fooled, and that you’ll be able to get out first.
But this becomes recursive. Last year I might have thought: “It is rational to knowingly buy the wrong stock if you think that other people will unwittingly buy it and you can dump it on them.” After Signal Advance’s three days of huge gains, I would remove that condition. You rationally buy the wrong Signal knowing that other people will rationally buy the wrong Signal, and other people do the same, and the reliance on ignorance drops away and you are all just playing a sort of gambling game with each other. You all keep buying Signal Advance at higher and higher prices, hoping to sell it to each other at even higher prices; eventually some people are left holding the bag but lots of others have taken a nice profit and had a lot of fun. Signal Advance as a company is irrelevant to all of this; it is just a gambling token. It has a low dollar price, doesn’t trade that much, and has no real prospect of releasing any corporate news: These are all good facts, on this view, because they ensure that nothing will affect the price except the fun gambling activity.
I suspect that the Elon Musk tweet didn’t really confuse anyone; it just provided a point to coordinate around. “Hahaha let’s trade this word that Elon Musk tweeted, that’ll be fun,” is a plausible thought process. This is stock trading totally divorced from news and financial logic and corporate information; this is stock trading as a mix of trolling and gambling. It is the logical endpoint of the boredom market hypothesis.
Elsewhere: “A Handful of Penny Stocks Just Made Up a Fifth of U.S. Volume,” yes, right, exactly. And yesterday a reporter tweeted: “CONFIRMED: Carole Baskin tells me her Zomedica mention that may have triggered a 230% rally in the penny stock came from a $299 Cameo request.” I don’t know what any of those things are, but people keep tweeting at me asking me to write about it. I suspect I covered it above.
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Or, if you want to encourage global warming, you make rules *preventing* them from considering those risks, as the Trump administration has tried to do. Depends which side you’re on!
Obviously in making the rule the SEC will say that it has a lot to do with investor protection, that it is very important for investors to know about the long-term financial risks to their investment that come from climate change, etc. But that is not *why* people want rules like this; they are not primarily concerned with the effects of climate change on *oil-company shareholders*.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
To contact the editor responsible for this story:
Brooke Sample at firstname.lastname@example.org