Streetwise Professor

May 1, 2010

A Legitimate Complaint

Filed under: Derivatives,Economics — The Professor @ 12:20 pm

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.

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  1. I wonder why Lower Saxony felt no urge to sell a part of their 20% ? At five fold the already over priced stock, they could have made a killing!

    Comment by Surya — May 1, 2010 @ 3:32 pm

  2. But they would have been killed politically. They were essentially holding a blocking interest that would prevent a takeover of VW.

    The ProfessorComment by The Professor — May 1, 2010 @ 4:22 pm

  3. Also, if they had sold it would have cratered the price. No way that they could have sold in any quantity at that price. It only reached that level b/c the weren’t selling.

    If they had sold, it would have been like what happened when the US Treasury sold gold to break the Fisk-Gould gold corner on Black Friday, 1867.

    The ProfessorComment by The Professor — May 1, 2010 @ 4:24 pm

  4. […] This post was mentioned on Twitter by blogs of the world. blogs of the world said: It is clear that if the basic facts in the complaint are correct, that this was a garden v… #complaint […]

    Pingback by Tweets that mention Streetwise Professor » A Legitimate Complaint -- — May 1, 2010 @ 10:36 pm

  5. Private action by the victims of a manipulation is the most effective deterrent against this form of opportunistic behavior as long as the courts are willing to judge a case on its merits. Don’t forget – in the S.D.N.Y. its still unlawful to adjust options or any equity driviatives to account for a stock split. 😉

    Comment by Charles — May 2, 2010 @ 11:35 am

  6. @Charles–yes, and I’ve also been quite critical of manipulation jurisprudence. It SHOULD be a straightforward matter to treat manipulation as a tort, and penalize manipulators through the imposition of damages. The offense is detected with probability 1 (or close to it). Successful cornerers are not judgment proof. The likelihood of a false conviction is low and the likelihood of a proper conviction is high if the right evidence is employed.

    The problem is that courts have too often proved hopelessly confused.

    But that doesn’t mean that letting regulators (eg CFTC, SEC) handle it is better. To the contrary. They’re even more confused. Indeed, many of the worst decisions in manipulation cases have been handed down by the CFTC.

    The ProfessorComment by The Professor — May 2, 2010 @ 12:03 pm

  7. Hi Professor,

    Do you have any ideas as to how the Porsche case will be impacted by the various incarnation of the Senate’s 2 bills (RAFSA s.3217 and MSIPA s.3258) along with HR 4173 which had some radical F-cubed provisions (foreign investors purchasing foreign shares on foreign exchanged)near the end of its 1,280 pages… The doom scenario that Helen Thomas (at FT/Lex) was stating was that predatory suits against Euro companies would emerge if the original 4173 was passed… Do you think this is still going to happen?

    Kavkazwatcher (and Wall Street too…)

    Comment by Kavkazwatcher — May 3, 2010 @ 5:45 am

  8. I suspect BaFin might have taken a different stance had the squeeze been orchestrated by a “locust” rather than a German corporate.

    Comment by J — May 12, 2010 @ 8:20 pm

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