Bureaucracy Is Arbitrary
In natural environments, predators and prey live in balance. Consider the reintroduction of gray wolves to Yellowstone National Park in 1995:
“Twenty-five years after gray wolves returned to Yellowstone National Park, the predators that some feared would wipe out elk have instead proved to be more of a stabilizing force. New research shows that by reducing populations and thinning out weak and sick animals, wolves are helping create more resilient elk herds.
“For the past 12 years, elk numbers in the park’s largest herd have leveled off between about 6,000 and 8,000, instead of extreme boom-and-bust cycles due to climate fluctuations.
“’Elk aren’t starving to death anymore,’ says Chris Wilmers, a wildlife ecologist at the University of California, Santa Cruz.”
The wolves of the park scavenge the dead and remove the weak, eliminating overpopulation that competes for scarce resources.
“Although elk is still the primary prey, bison has become an increasingly important food source for wolves. While there is some predation on bison of all age classes, the majority of the consumption comes from scavenging winter-killed prey or bison dying from injuries sustained during breeding season.”
Make no mistake. Wall Street is an ecosystem, too.
Yet, unlike the ecologists and the National Parks Service who appear humbled by the complexity of the environment and who remain mindful of potential iatrogenic consequences, the human interventionists in U.S. financial markets arrogate to themselves massive power to shape markets, costumed in the language of investor protection. In a release dated October 2023, the Securities and Exchange Commission announced new disclosure requirements for a particular type of transaction called a short sale.
“The Securities and Exchange Commission today adopted new Rule 13F-2 to provide greater transparency to investors and other market participants by increasing the public availability of short-sale related data. Congress directed the SEC in Section 929X of the Dodd Frank Act of 2010 to promulgate rules to make certain short sale publicly available.”
Thirteen years after the passage of Dodd Frank, the SEC has roused itself to implement a rule that transforms at its root the practice of short-selling securities in the deepest capital markets in the world.
Why now?
Short selling is a mechanism for speculating that a security will fall in price. The short seller borrows the security, say a chunk of shares of publicly-traded XYZ Corp, and sells it in the open market. They borrow the stock from an existing owner who receives cash collateral for the period of the short sale. Each side earns a fee: the stock lender earns a stock loan fee and the stock borrower earns interest on the cash collateral, paid by the stock lender. The stock borrower pays dividends to the stock owner as XYZ distributes them during the life of the short sale trade, unless it is impossible.
The idea is simple. The short seller waits and then buys back the stock at a lower price, returning it to the stock lender and unwinding the trade. The stock lender has funded his ownership of the stock during this period, freeing up capital for other purposes.
One might think that there is an ethical symmetry to short selling, standing as it does on the other side of the never-ending debate that is the market.
On the long side, we see stock promoters everywhere, pumping up the nature of an investment. During the post-pandemic super-bubble, there was a bonanza for these men, be it in Special Purpose Acquisition Companies (SPACs) or in crypto.
It seems like anyone could and did form a SPAC.
“Former NFL player Colin Kaepernick has formed a special purpose acquisition company (SPAC) that is seeking to raise $250 million in an IPO.
“The former San Francisco 49ers quarterback disclosed in a regulatory filing that his blank check vehicle, Mission Advancement, intends to acquire a company at ‘the intersection of commerce and impact.’”
There were some high-profile trades that worked until they didn’t.
“Palihapitiya’s SPAC, or special purpose acquisition company, took Virgin Galactic public in October 2019. The company’s stock has faced volatile trading since then – climbing above $60 a share in the months ahead of Sir Richard Branson’s test spaceflight, but it recently fell below its public debut price on news of a further delay in commercial service.
“The now former chairman sold his personal Virgin Galactic stake in early 2021 that was worth $200 million at the time. But he indirectly owns about 15.8 million shares through Social Capital Hedosophia Holdings.
“…
“Virgin Galactic’s stock slipped more than 5% Friday from its previous close of $9.01 a share.”
Taking a look at Virgin Galactic today, it closed on October 27, 2023, at $1.38 after peaking in February 2021 at $62.80.
You’ve got to know when to hold ‘em and know when to fold ‘em, apparently.
The sponsor of a SPAC raises cash from investors. The sponsor must find a company to acquire within a fixed period of time or return the cash to the investors. While he’s doing his homework, the cash pays interest to the investors. The sponsor may bear the administrative costs for setting up the company and complying with the regulatory burden, so they’re motivated to find a target. They’re also motivated by the SPAC compensation scheme.
“When the sponsor forms a SPAC, it takes its compensation in the form of a “promote” typically consisting of 20% of the SPAC’s post-IPO shares, which it purchases for a nominal price. The sponsor then takes the SPAC public in an IPO, issuing units containing shares and warrants, typically for $10 per unit. Concurrently with the IPO, the sponsor makes an investment in SPAC warrants and/or shares, the proceeds of which are used to cover the underwriting fees of the SPAC’s IPO plus the SPAC's expenses between the time of the IPO and its eventual merger. At the time of the merger, three changes in the SPAC's capital structure may occur. First, the sponsor may agree to forfeit some of its promote shares. Second, the SPAC often raises new equity in the form of private investment in public equity (PIPE). Third, public shareholders have a right to redeem their shares rather than invest in the merger, and they often redeem a substantial fraction of public shares outstanding.”
It’s nice work if you can get it.
The sponsor raises the money in the public markets, rushes around to find a target, closes the deal, and pays themselves 20%, plus-or-minus. They may also participate in the PIPE which gives them (or their friends) the opportunity to invest at a discount. The PIPE is there to ensure they have sufficient cash to close the deal. The faster this all takes place, the better for the sponsor. Rinse and repeat.
The biggest SPAC deals had the most attractive sponsors. After all, you were investing in the Man. You literally had no idea what he was going to buy. Sometimes, people invested in SPACS because they saw that the promoter was a successful, highly public personality. Being an influencer was sufficient to garner a large deal. For the promoter, 20% of a big deal is better than 20% of a small deal. All you needed to do was to raise a giant sum of money, find a target, and then move on, taking your chips off the table to go raise the next, bigger SPAC.
They call the fee a ”promote” because that’s what the sponsors do. They are out there closing, closing, closing. Always be closing, as the bros say.
“Such mergers burst onto the scene as popular alternatives to traditional initial public offerings in 2020 and 2021. The boom turned into bust during this year’s market reversal.
“An exchange-traded fund tracking companies that went public this way is down more than 70% this year, dragged down by losses in startups such as sports betting firm DraftKings Inc. and electric car maker Lucid Group Inc. Companies that went public via SPACs have performed worse than other newly public companies this year.”
This was an article written in December 2022. It hasn’t improved since then.
Who lost? Retail investors lured by the glamor of high profile sponsors.
Contrast this orgy of promotion playing on the everyman’s speculative greed with the behavior of the short seller.
Just like the Yellowstone wolves, it’s necessary in a capitalist system for the weak to succumb. The short seller goes after stock like Blue Apron or Peloton or Allbirds where the natural buoyant enthusiasm of the American optimist got ahead of itself in valuing a fad or a niche as if it was something more. Sometimes they have identified fraud and the short sale is a bet that the revelation of the fraud will tank the stock. Think Tyco from the turn of the century, for example. “It’s difficult to make predictions, especially about the future,” as Yogi Berra is reputed to have said.
Sometimes, the short seller does so without attracting any attention. For these investors, they are feasting on the carrion. The animal is dead already. It’s just a matter of time until everyone else realizes this truth.
The short seller culls the ecosystem of the weak and the uneconomic so that its resources are more sustainable.
Other times, the short seller may publish his thesis for why the stock is not worth what the market thinks it is. In one sense, he is no different from the promoter. The short seller calls to the attention of anyone who will listen, explaining to them in clear terms why he believes that the stock price will drop.
Unlike the promoter, his case may be more fully baked and well-articulated than someone who relies on sentiment and credibility. It is more dangerous to swim against the tide.
Just like the guy playing the No Pass line in craps, short sellers are not popular. They’re often very disliked by people who benefit the most from the stock price continuing to go up. Short sellers may represent only a small portion of the market capitalization.
They are the outsiders.
One problem they have is the dreaded short squeeze. If enough people can figure out that they are short and certain other conditions are in place, then the stock can run higher as buyers try to push the short-sellers into capitulating to close out their trades, at a loss, transferring some of their capital to the mob trading the long side against them.
It is easy to understand why short sellers prefer to avoid attention.
Another argument that people make is that the short seller is trying to manipulate the share price lower for their personal gain. There is a line between protections that enable people to have and publish an opinion and defamation in which case the individual says things that they know to be false in order to force the price lower artificially.
The SEC exists to put in place the conditions that enable companies to raise funds fairly and efficiently. This means protecting investors so that they feel confident investing in different types of securities, reliant upon the measures that the authorities have put in place to level the playing field.
Investors want sufficient information to develop an intelligent view. They want a debate, both in the price action and in the field of commentary.
But whenever there is money at stake, there is controversy.
Executives with compensation tied to the stock price, long-side speculators, and public cheerleaders all loathe the short seller. They attack the short seller as manipulative and self-interested, alleging that the short seller does no more than seek opportunities to pick the pockets of hard-working, honest people who are just trying to build a business.
The short seller would argue that they are taking out the weak elk to make room for the strong ones. All they’ve done is identify the likeliest candidates.
What does the SEC propose to do? They want to out the short sellers and make them vulnerable to attack.
Here’s the Wall Street Journal’s take.
“But it’s almost certain that the rule’s harm will exceed its benefits. The rule itself admits it ‘may harm price efficiency by increasing the cost of short selling’ by imposing new compliance burdens, potentially revealing short sellers’ trading strategies, and ‘increasing the threat of retaliation against Managers by other market participants.’
“Collecting and releasing data on short positions, the rule warns, may also ‘facilitate manipulative strategies targeting short sellers, such as short squeeze,’ which is what happened during the meme-stock rally. But these risks and costs don’t worry Mr. Gensler, whose single-minded aim is to increase his control over capital markets.”
And the punchline:
“Mr. Gensler’s avalanche of regulation is stress-testing U.S. capital markets. The SEC on his watch has finalized 27 major rules and proposed another 30 that affect every corner of the market. The administrative state marches on, whether it has the legal authority or not.”
In Yellowstone, there are limits to the size of the wolf population: the scale of the resources that can support them, including all the factors that support their pretty such as the elk and the bison.
Why is the SEC making short sale rules now thirteen years after Dodd-Frank’s passage? Why didn’t they regulate SPACs and crypto before retail investors lost millions of dollars? Who was hurt more? Is this a political decision or an administrative one?
At some tipping point, governance of administrative bureaucratic authorities pass from their nominal overseers to the bureaucrats themselves. Where is the Congressional oversight to constrain the SEC (or many other federal agencies) from making too many changes, too quickly?
Bureaucratic extension, i.e., new rule-making, can be impossible to predict. It is arbitrary, all the more so once governance attenuates. If anything, bureaucracies make new rules as a move into self-governance, filling oversight vacuums when they occur.
What will stop the SEC from overreaching interference in the complex adaptive system of US capital markets other than a massive reduction in their functionality? Even then, would we expect the SEC to back off, would the agency try to regulate itself of the poor circumstances it engineered in the first place?