Streetwise Professor

Back in 2008 I wrote a few posts on the Porsche corner of VW stock.  The FT has posted the amended complaint in the securities fraud and manipulation lawsuit filed by VW shortsellers.  It makes for very interesting reading.

It is clear that if the basic facts in the complaint are correct, that this was a garden variety corner.  A very intense one, due to the nature of stock markets.  Whereas in commodities additional deliverable supplies are usually available at some price above the competitive level, the strictly finite supply of stock in a company makes the relevant supply curve effectively vertical, which means that the only thing that limits how how the price of the cornered instrument can go is the cost that shorts incur from defaulting on their obligations.  As I mentioned in one of the earlier posts, this event was like the great stock corners of the old days, most notably the 1901 Northern Pacific corner.  In this case the price shot up nearly five-fold, something that would be extremely unlikely in a commodity corner.

Porsche’s strategy was pretty straightforward.  It owned 50 percent of VW stock.  20 percent was in the hands of the German state of Lower Saxony, which was unlikely to sell.  Index funds (who could not sell their shares because of their need to match indices in which VW was a component) owned more than 5 percent.

Porsche stated publicly that it had no intent of gaining a controlling 75 percent stake in the company, but bought calls and sold puts on shares representing 25 percent of the company.  This long call-short put strategy created a synthetic forward contract on VW stock.  It did so knowing that if its long position equaled 75 percent, given index funds’ and Lower Saxony’s positions of greater than 25 percent, any short seller would not be able to obtain stock to make delivery, and would be cornered.

The sellers of the synthetic forward hedged their exposure by buying shares; they bought shares from short sellers who believed that the stock was overpriced, based in part on comparisons to the prices of other, related stocks.

Porsche concealed its efforts by engaging in the options transactions with a variety of different counterparties, making it difficult for anyone to understand what the company’s total position was.

According to the complaint, a decline in the price of VW stock caused by the financial crisis caused problems for Porsche; its puts moved into the money, imposing a substantial financial burden on the company.  So it decided to spring its trap, and the price of VW stock skyrocketed from about 200 Euros/share to nearly 1000.  For a brief time, VW had the world’s largest market cap.

All in all, a very straightforward and compelling story.

The complaint makes a big deal out of the fact that Porsche’s VW options were not, as some contemporary press reports claimed, cash-settled.  Instead, they required the call option seller to deliver shares upon exercise.

This isn’t that critical.  VW could have manipulated even if the options were cash settled.  Just the means of manipulation would have differed.

With delivery settled options, Porsche could effectively determine the price of VW stock by choosing the number of options to exercise, and hence the number of shares of stock to buy (X shares, say); this would have determined the number of shares that the shorts would have had to come up with at the time of exercise.   This, in turn, would have determined the demand for the stock and hence its price.  Porsche could have profited by selling the remaining options at a value reflecting the inflated stock price.

But if the options were cash settled, VW could have achieved the same result by buying stock in competition with the shorts scrambling to cover.  If they bought X shares on the open market (i.e., the same number of shares acquired by exercise of the physically settled options), shorts would have faced the same supply curve for shares, and would have driven up price to the same level.  Porsche would have profited by the cash settlement of its options at the same price.  Thus, VW could have achieved the same outcome regardless of whether the options were cash settled or not.  (One caveat: perhaps regulations constrained open market purchases differently than the exercise of options.)

Regardless, this is about as classic an example of a corner as you will see in this day and age.  Which makes it all the more amazing that German financial regulator BaFin did a great Sergeant Schultz impersonation, and saw nuthink!  nuthink!, both during and (even more amazingly) afterward.  Another stellar moment in the regulation of market manipulation–and a clear demonstration of why private action by the victims of a manipulation is the most effective deterrent against this form of opportunistic behavior.