Tuesday, March 22, 2005

Heavy Lies The Head

I was doing some light reading the other night, browsing through some of my favorite publicly traded brokerages' 10K's, when I was struck by an amazing omission.

I couldn’t believe my eyes, so I called some of my accountant and attorney friends to verify that I was reading them correctly.

I was.

First, the ground rules: publicly traded companies are required to disclose to their shareholders all material risks they're aware of - it's pretty simple, actually. If you know it's a material risk, disclose it.

So my question was what's material? Turns out there’s a formula. If you have a trillion dollar contingent liability, and there is a 10% chance of someone suing you and winning damages that amount to 2% of the contingent liability, that would be material. 2% of a trillion is two billion dollars – real money by anyone’s metric. Or if there’s a 5% chance of that contingent liability being actualized, that’s material.

So how, I asked myself, do these publicly traded companies not list the huge contingent liability from the fail to delivers and the margin shares loaned out to short sellers - both in terms of runaway prices if there's a squeeze that results in a liquidation of the customer account, or if there are large class action awards, as in the case of Worldcom or Cendant?

Follow along on the squeeze part. If they sell shares and then fail to deliver, and then the DTCC lends the NSCC the shares to give to the buyer, technically that is an unsettled trade, which means that the liability rests with the broker who sold and failed, until such time as the trade is settled. So they have the liability for those shares, above and beyond whatever the buy-in is at today’s mark to market.

Now to the lawsuit risk - what do I mean by that? Well, if it turns out that company ABC is a sham, or has been up to no good, and the shareholders sue for 5 billion dollars, everyone that is holding a “share” that is a fail to deliver or one that has been lent out as part of their margin agreement to a short doesn’t have the right to extract their share of the settlement from the company – it’s the broker who owes them their portion. That’s how the law's written. So that’s what I mean by liability. The brokers are legally on the hook for any shares they failed, or lent out from margin accounts.

So where’s the disclosure as to how big that contingent liability is, and the description as to what reserves the broker's put into place to cover it?

Simple question, really. Where is the mandated disclosure of that material risk, along with a description of the size and scope of the risk, so that investors in these brokerages understand what they are buying into? Wouldn’t you want to know if your bank had an off-balance sheet liability of hundreds of billions of dollars that wasn’t disclosed anywhere on their financials? Wouldn’t you expect that to show up in their filings? I would. And yet it doesn’t.

So who is in violation of the fair disclosure rules? Certainly the brokers, in my opinion. But also the big accounting firms. They have to buy off on the audits, and they aren’t demanding that those contingent liabilities be accounted for appropriately. That puts them in the class action line of fire.

Could it really be possible that our financial community has failed to disclose a trillion dollar contingent liability, placing them at risk for huge class action suits, regulatory action, etc.? And the big accounting firms as well? And with Sarbanes-Oxley, aren't the CEO's and such personally liable for this sort of a material omission? What kind of a financial reward has to be at stake to take this sort of a risk?

Wouldn’t it be wild if I've just stumbled onto the biggest sham to take place in the financial sector in a hundred years, and one that is provable just by reading things like 17(a) and following the liability chain through the settlement phase? I think that it warrants everyone placing a call to the brokerages' and accounting firms' investor relations folks, and writing the SEC, and to Spitzer, and the like.

Unless of course their position is that public companies on Wall Street don’t have to make full and complete disclosure of all material risks in their 10K’s and 10Q’s, in which case that is a fun bit of information to have as well.

Is this the next scandal for the Class Action boys to go after? If so, it could make Enron look like forgetting to give you a receipt at Mickee Dee’s.

5 Comments:

Blogger rvac106 said...

I'm getting to the point where I think it'll have to be the IRS that brings the entire House of Cards crashing to the ground. RICO, or the fact of shorters' profits flying under the Fed's radar screen, if they can get the company to go BK.

Sorry to be agreeing with you. I'm sure you were hoping for something a little more confrontational. Perhaps later....

12:12 AM  
Blogger Tim Meadows said...

This is an excellent article. We should write to the auditors of the various brokerages to understand why this contingent off balance sheet liability is not revealed.

In fairness, I have seen it disclosed with some of the larger brokerages. They normally say something to the effect that the value of the risk can't be easily determined.

12:40 PM  
Blogger bob obrien said...

Tim:

Which brokers? My take is that the real omission is in the legal redress portion of the story.

Worldcom. Cendant.

Large settlements. In the many many billions. How many shares were legitimately owed funds from the company, and how many are just brokerage statements showing some ledger entries that don't tie back to real shares, or represent shares lent out on margin?

Those are the ones that the brokers are legally liable for if anyone has the foresight to say "prove that you have the right to sue us, and that you are a legitimate shareholder, and not just holding an IOU?"

And those aren't disclosed anywhere. I maintain that's a big risk moving forward. I haven't seen anything to lead me to believe otherwise.

4:11 PM  
Blogger majordanger said...

Interesting angle using this liability exposure to try and extract the amount of Fail to Delivers. The insurance companies use statistics such as your zip code to determine thier exposure to auto theft, tornado damage,robbery before setting your premium.Insurance companies are no dummies, And either are Institutional Investors. Maybe this recent fall in NFI share price is caused by institutional longs being one step ahead of you. If they see NFI as a nekkid short target with a huge FTD imbalance, they call it an unacceptable risk and move on.
Glad to see you blogging. Keep up the good fight. I'm long

5:17 PM  
Blogger smokyjoe said...

Glad to see someone else use the rico term. It is perfectly appropriate. Follow the money trail per DTC's own admissions.

12:39 PM  

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