Tuesday, February 17, 2009 0 comments ++[ CLICK TO COMMENT ]++

SEC accuses Stanford Financial Group of massive fraud

The New York Times reports that the SEC just charged the Stanford Financial Group of a massive $8 billion scam:

Stopping what it called a “massive ongoing fraud,” the Securities and Exchange Commission on Tuesday accused Robert Allen Stanford, the chief of the Stanford Financial Group, of fraud in the sale of about $8 billion of high-yielding certificates of deposit held in the firm’s bank in Antigua. Also named in the suit were two other executives and some affiliates of the financial group.

In the complaint, filed in Federal District Court in Dallas, the S.E.C. accused Mr. Stanford and two associates — James M. Davis, a director and chief financial officer of Stanford Group and the Antigua-based bank affiliate, and Laura Pendergest-Holt, the chief investment officer of both organizations — with misrepresenting the safety and liquidity of the uninsured CDs.

The CDs were sold by Stanford International Bank through the firm’s registered broker-dealer and investment adviser, which are in Houston. Both the bank, which claims $8.5 billion in assets and 30,000 clients in 131 countries, and the brokerage unit, which operates about 30 offices in the United States, were named in the S.E.C. suit. Stanford Financial asserts that it advises about $50 billion in assets.

...


In its complaint, the S.E.C. said it could not account for the $8 billion in assets that were housed in the Antigua bank after issuing subpoenas for bank records and to various witnesses. Most witnesses, including Mr. Stanford, Mr. Davis, and the Antigua-based bank’s president, failed to appear to testify nor did they produce documents shedding light on the assets.


This is an obscure bank but I'm mentioning it because it shows a potential risk in risk arbitrage investing.

Some investors took an arbitrage position in the buyout of Emageon (EMAG), which was financed by Stanford International Bank. The deal didn't close last week and EMAG's shares promptly collapsed. EMAG seems to have received a break fee but this is the type of business that does not seem attractive to own (it seems to be losing money).

I thought about this deal but dismissed it because there was some "shady" dealings in late December when the bank refused financing and then changed its mind a few days later. It seemed weird and I stayed away.

I also didn't pursue it because I didn't understand EMAG's business and it was losing money. Professional risk arbitrageurs may be ok with it but I personally don't want to enter M&A deals where the buyout firm is bleeding badly. If the deal collapses, it won't be a pretty sight and I wouldn't want to own those firms (in contrast, I have no problem owning BCE or Puget Energy.)

I think there are two lessons for arbitrageurs from this affair.

Firstly, if there is even a hint of questionable dealing, stay away. One will miss opportunities by using this rule but they will also avoid some dubious deals. This is always a judgement call that seems more obvious in hindsight so it's not quite straightforward.

Secondly, and most importantly, as James Altucher has said of Warren Buffett's arbitrage deals, always look for a backdoor. Buffett isn't flawless but he always makes deals, in M&A or in straight investing, with a potential backdoor exit. Buffett has made some mistakes in the past but the backdoor saves him. A classic example of a backdoor (I'm talking general investing) is the ability to buy securities that you can "put back" to the issuer e.g. bonds or non-perpetual preferred shares.

For newbies like me, the backdoor is to own the stock upon failure. This isn't much of a backdoor but I try to enter deals where the buyout firms are decent businesses that are worth owning. You will take a permanent impairment if a deal fails but at least you can make up some of that back, as the company grows. For instance, if you lose 30% upon a failure, if the stock can return 10% per year, you can make it back in 3 years. You'll underperform the market and pay an opportunity cost, but if you don't have a significantly better opportunity, you'll at least have the possibility of minimizing losses or breaking even.

Having said that, professional arbitrageurs likely sell out at a loss if the deal fails since they aren't in the business of owning businesses. I suppose small investors can follow that strategy if they have a large number of holdings. Unfortunately, many of us don't have enough capital and/or enough time to analyze multiple deals, so selling failed deals will be painful. Maybe if someone did 10 solid M&A deals per year, they can sell out with losses.

Regardless of what strategy one follows, it's important to consider (ahead of time) what to do if the deal fails. If you decided to sell (upon failure) when you entered the position, it's probably best to sell if the deal collapses (unless the fundamentals are more positive than you initially thought.)

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