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Tuesday, March 12, 2013

Joe Nocera's Piece on the eToys Litigation is Utter Nonsense

Reading one of my favorite blogges, Matt Levene on Dealbreaker, I learned that Joe Nocera of the New York Times had recently gone ballistic about Goldman Sachs favoring investors over the issuer in the last-century IPO of eToys, which raised a lot of money and went out of business shortly thereafter within a few months, without ever making a profit. Apparently the thought behind the lawsuit is their stock had one of those first day of trading pops that happened often in the dot-com boom, and the litigation trustee for the bankruptcy estate contends that some of th rise in price should have been captured for the issuer through a higher IPO price (totally ignoring that, by any honest measure of its business viability, its IPO proceeds should have been 100% less).Nocera contends that "the company had been scammed" because money "that rightly belonged to the company had instead gone to investment clients."

Matt does a good job explaining why Nocera has no grasp of how IPO's work.  I only want to point out two things:  (1) the status of the lawsuit, which Nocera seriously misdescribes, and (2) the total contradiction between Nocera's apoplexy and his views at other times on legal responsibilities in securities offerings. 

True Status

The eToys lawsuit has been kicking around the New York state courts for a long time.  The most recent decision was in 2011 when an intermediate appellate court affirmed summary judgment in favor of Goldman Sachs that it owed no fiduciary duty to eToys. (I don't know if the case has been taken to the Court of Appeals.)

How does Nocera describe these facts?  Does he tell us that Goldman won so far?  Not at all. Here is all he says: "Goldman has argued that, contrary to popular belief, underwriters do not have a fiduciary duty to the companies they are underwriting. In recent years, this argument has held sway in the New York court system, although it has yet to be argued before the Court of Appeals."

That's clearly wrong.  An argument that has lost has not "held sway" in any court system.  And it's no longer just "Goldman argues."  Two levels of the judicial system have so held. 

And as for "popular belief", what in the world is he talking about?  Is there some Gallup poll on underwriters' fiduciary duties?  In fact, prior to writing that column, Nocera's own "popular belief" was pretty much the opposite, that institutions working with issuers are supposed to be looking out for investors in securities offerings.

Nocera's Contradictory Positions

Here's Nocera on PBS in 2010, discussing his book on the financial crisis: "I certainly would put the rating agencies right at the top of my list of bad guys, my list of devils."  "They're supposed to be protecting investors."  And writing in his Times column, Nocera refers to their "absurd conflicts of interest — starting with the fact that the rating agencies are paid by the issuers of the bonds they are rating." So there's the "conflict of interest" that makes them "bad guys": they're "supposed to be protecting investors" but they are "paid by the issuers."

Compare that with underwriters, like Goldman on the eToys IPO.  Underwriters are selected by the issuer, just as rating agencies are.  They sign a contract with the issuer that provides they will be paid out of the proceeds of the offering, reducing the amount of proceeds that the issuer receives.  So, as a practical matter, they too are paid by the issuer. 

Yet the Securities Act of 1933, as historically interpreted and applied, imposes on underwriters of IPO's "an affirmative obligation of due diligence" that "arises out of a securities firm's general obligation to deal fairly with its customers." [Charles Johnson & Joseph McLaughlin, Corproate Finance and the Securities Laws, section 5.02 (2006 ed.)]  As early as 1953, the SEC declared that "an underwriter owes a duty to the investing public." The Second Circuit endorsed this view Chris-Craft Industries, Inc., v. Piper Aircraft Corp., 480 F.2d 341 (2d Cir.), cert. denied, 414 U.S. 910 (1973): "[p]rospective investors look to the underwriter -- a fact well known to all concerned and especially to the underwriter -- to pass on the soundness of the security and the correctness of the registration statement and the prospectus."

So if Nocera were intellectually consistent, he would treat IPO underwriters like rating agencies and say they should put the interests of investors first.  If an issuer with no intrinsic value fails to enrich itself at investors' expense, too bad; next time, put together something with real value for investors.  But instead, he has a story that fits the narrative of "evil, greedy Wall Street" and from that point on, intellectual coherence is just an impediment.

Nocera doesn't tell the reader that the appellate court described the relationship between underwriter and isssuer in a firm commitment underwriting is "adversarial" not fiduciary, because such an underwriter bears all the risk of loss if the offering is a flop.

It's also ludicrous to pretend dot-com issuers were "naive" as Nocera writes, and ignore what they were trying to do, which was get their company public as soon as possible, regardless of how half-baked it was.  They had to know they were in a period of irrational demand and they wanted to go public before the bubble burst. First-day pops were routine and well-reported in the financial media.   IPO allocation criteria were also well known; you can be sure that the decisionmakers at eToys had a "friends and family" allocation that was as self-enriching as anything Goldman is being accused of.  Seriously, can anyone with a straight face say that, if eToys had only known what Goldman and the IPO buyers were saying to each other, that eToys would have canceled the IPO?  Although issuers may not have known precisely the dollars and the names of the institutions involved, they certainly had a general sense that IPOs frequently had large first-day pops and there was money to be made by the IPO buyers by dumping into that pop. As the appellate opinion recites, the deposition "testimony of various eToys executives ... established that eToys was well-aware that underwriters generally offer IPO shares to their most valued customers" and eToys' claims that "Goldman fraudulently promised that eToys shares would be allocated to long-term institutional investors, rather than to known 'flippers' was ... belied by contrary evidence in the record."  Nocera makes no mention of that.  Nor does he acknowledge that the only reason a company like eToys was in a position to go public in the first place was because dozens of precedent IPOs had been done on the same basis as it now complains of.  

Nocera's column is full of snippets from emails produced in the litigation that Nocera says he "came across" Nocera says he "came across ... sitting in a file in the New York County Clerk's office". I doubt these things just happen. I suspect that someone on the plaintiff's side, having a complete loss on their hands after a decade of failed litigation, is desperately trying to get some kind of settlement out of Goldman and has resorted to trying the case in the press so they tipped him to the availability of the file.  If that is the case, he served their purpose, with a one-sided, often completely misleading and certainly incoherent analysis that contradicts his own prior views and fairly settled legal doctrine. But, it fit the narrative the Times wants to put out there, so inside the echo chamber of Times Nation, I suspect it goes unquestioned.