Sunday, September 18, 2011

Stock market integrity and the OSC's bizarre Catch-22

Warning: non-sports, non-numbers post. Has to do with securities regulation and put options and bureaucratic illogic. Still, should be comprehensible to all.


The Ontario Securities Commission (OSC) is a government body that regulates capital markets (i.e., stocks, bonds, options, etc.). It declares, among others, a responsibility to "foster fair and efficient capital markets and confidence in the markets." Recently, it made a decision that seems so obviously unfair and wrong that it has the opposite effect -- I am now materially *less* confident of the integrity of the market than I was before. It's not just the precedent this decision sets, but my fear that the OSC just doesn't get it. What unfair decisions will they make next, and is my retirement portfolio in jeopardy?

Of course, I might be wrong in my logic. Please correct me if I am. If you're more up-to-date than I am in how securities regulations work, let me know and I'll post corrections.

I'm going to start with an analogy that illustrates the issue.


I buy a house and a piece of land, for $400,000. I insure the house. There is a regulation on the books, quite reasonable, that it is not legal to sell land that is known to be contaminated, or to sell a house that is known to be uninhabitable. But the house and land are fine, and the sale goes through.

Later, an arsonist burns down half the house and contaminates the land. The state comes in and begins an investigation.

I contact the insurance company. They agree I'm covered for $400,000. They prepare to cut me a cheque.

But, before anything else can happen, the regulator steps in. "You can't do that," they say. "When you settle an insurance claim, it means the house and the land transfer to the insurer. But the house is uninhabitable, and the land is contaminated. So, you can't transfer the house. Therefore, the settlement is illegal."

In any case, the insurer doesn't have to pay. He walks away happy, even keeping my premium, and I'm stuck with the loss.

It's a kind of Catch-22.


Not fair, right? And *obviously* unfair.

What's happened is that the regulator is blindly sticking to a regulation that's not always right. Sure, it might be a good idea to prohibit the sale of contaminated land *as a general rule*. But there are exceptions. This is an exception. In fact, it's an exception where it's exactly the opposite -- where it's absolutely WRONG to prohibit the sale.

It's like, "don't jump out of the fifth floor window, you'll die." Sure. But if the building is on fire, and the smoke is choking you, and the firemen are holding a net below and yelling at you to jump ... then the rule reverses. "Don't NOT jump out the fifth floor window, you'll die."


So here's the real story, which follows the analogy quite closely. Some background first.

Sino-Forest is a Canadian forestry company that does all its business in China. Its stock went from $1 to $24 over the last ten years or so, as it grew and bought forests in China for harvesting. In June, a small company called "Muddy Waters," run by a man named Carson Block, put out a report alleging, with evidence, that Sino-Forest was a fraud -- it didn't really own the forests it claimed it did. The stock dropped immediately from $24ish, and fluctuated between $5 and $8 for the next two months.

The company claimed innocence and hired independent auditors, but no information was forthcoming and the company cited documentation delays. The stock dropped further. At one point, the OSC said it was investigating.

Finally, in August, the OSC claimed there was evidence of fraud. They did not give details, and speculation is that they got their information from the auditors, and from Muddy Waters. The OSC immediately prohibited further trading in the stock, and ordered the CEO to resign.

A few hours later, the OSC was told it didn't have the right to order any resignations. Belatedly realizing it had overstepped its authority, the OSC retracted that part of its order. Nonetheless, the CEO voluntarily stepped down a few days later.

In addition to shares of stock, there were also "put options" trading on Sino-Forest. A put option is a contract between two parties. One party pays the other some money -- say, $1 per share -- and, in return, receives the right (but not the obligation) to force the other party to buy his shares by a certain date, at a certain price. Say, $20 by August 19.

The idea is that you can use a put option as insurance. If you own 100 shares, with a value of $2,000, and you're scared the price will drop, you can buy 100 put options for $100. Then, even if the stock drops, you know you can still get $2,000 for them on August 19.

It's exactly like insurance on a house. You pay $100 for the insurance, and if anything bad happens to your house between now and August 19, the insurance company will take the house away and give you a $2000 settlement.

So, at this point you can guess what happened next. The OSC prohibited the contracts from being exercised. The OSC said, "I don't care if you bought the insurance. Settlement means that you would have to sell the shares to someone else, and we've prohibited you from doing that."

And, of course, August 19 has come and gone. (There are contracts with other expiry dates too -- over different months -- but August 19 was one of them.) The contracts have expired and are now worthless. The OSC blindly followed the rule "it's bad for markets if shares of a fraudulent company are bought." That's not always true. In this case, it's WORSE for the market if the shares are NOT bought.

Normally, people don't want to buy a company when it might be a fraud. In this special case, people DO want to buy a company ONLY when it's a fraud.

This is so obviously wrong that anyone should understand that it's unfair. But, especially, the OSC, which is the regulator, and supposed to be an expert in markets, and how they work, and investor confidence ... how did they make a mistake like that?

Not only is it unfair, but ... if this precedent holds, the entire market for put options falls apart. How do they not get that?

Unless it's me that doesn't get it. Which is certainly possible. If you're a Bayesian, or even if you have normal common sense, you're probably asking yourself: who's more likely to be grossly wrong: Phil, the amateur investor, or the expert regulators at the OSC? If you're Bayesian, you should probably figure that must be me who's wrong, especially when I tell you that I was unable to find anyone in the financial press complaining about any of this. To my knowledge, I'm the first and only one.

But ... I just can't see how this could be right.


Well, this past week, they held a hearing to revisit the decision. I thought they'd say, "oops, sorry, we screwed up," and fix it. But confronted with all the arguments (as I presume they were), they STILL didn't get it. They only "fixed" part of it.

What they did was to say, if you already own the shares, then, OK, you can sell them to the other party for the $20 to complete the transaction and collect on your insurance. But if you happen to have the insurance contract, but you don't have the shares, because you were meaning to buy them later, then you're still SOL. You can't go out and buy the shares from someone else, so that you can collect on your investment. Instead, you have to let your options expire worthless.

Their logic appears to go something like this: "The put option is a contract to sell shares. So we'll make an exception and let you sell shares if you have a previous contact. But we won't let you BUY the shares to sell, because you only have a contract to sell, not to buy. Besides, if you bought a contract to sell, but didn't own any to sell, you're just speculating, so we don't feel much sympathy for you."

But, that's ridiculous. It's a common investment strategy to buy put options on stocks you don't own, if you expect them to drop. Sometimes it's straight speculation that there's fraud, but sometimes it's part of a more complex hedging strategy. Maybe you own a business in China, and you want to insure against a bad Chinese economy, and the easiest way is to buy puts on Sino-Forest. If China goes downhill, and Sino-Forest with it, you buy the worthless Sino-Forest shares, and sell them according to your contract, which gives you the insurance money you need.

(* In any case, since when is speculation something that anyone should be trying to avoid? Speculation is a good thing, as economists will assure you. And, securities regulators, being experts in how capital markets work, know that. Speculators keep the market liquid and efficient, moving prices closer to their true value. I personally would be hesitant to invest without speculators. Right now, I can be pretty sure that I'm paying a fair price for any stock I buy -- if the price were too high, speculators would have stepped in before and sold short to push the price down. Without speculators, I'd be more likely to be getting ripped off.

( But I digress. Oh, and while I'm digressing, a disclosure: I own shares of Sino-Forest, but have never had any Sino-Forest option positions.)

What the OSC has done with its fix is actually worse than what it did originally. It said, "we'll let you enforce your contract if we approve of your investment strategy, but we will screw you around if we don't." That's something the OSC has no business doing, favoring some parties but not others based on the capricious illogic of its bureaucrats. It's also the worst thing you can do for market confidence -- signalling to the world that the rules are unpredictable based on how the regulator feels about you.

For my part, I have bought put options before, on companies I thought were grossly overvalued. I'll be damned if I'm going to do that again, at least in Canada.

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At Monday, September 19, 2011 10:29:00 AM, Blogger Zach said...

You're analogy isn't quite right. If you bought insurance on your neighbors house not blowing up (and thus damaging your house) the insurance agency might be able to void the contract if it turns out your neighbor decided to illegally start a meth lab.

Now, if you specifically bought insurance to protect against fraud or illegality that's one thing. But it doesn't necessarily follow that options, which are more like two party bets than insurance, assume risk of illegality.

At Wednesday, September 21, 2011 1:27:00 PM, Blogger Vic Ferrari said...

I guess the OSC's concern would be that an employee of Sino-Forest could have been aware of the fraudulent activity and purchased put options, esp ones that were out of the money, as a means of benefiting in the event of their company's fraud being exposed.

They could use a third party, or rationalize it by claiming they were hedging the stock options that were part of their compensation package. Criminal activity I know, but if indeed Sino-Forest were engaging in fraud, then it's not outrageous to suspect employees of doing the same with their personal business dealings.

The people who created the Sino-Forest put market need to be protected, no? They clearly weren't working with inside information.

I don't know, just thinking aloud.

Folks who purchased both call and put options as part of their strategy ... they would appear to be hooped, if I'm reading you right. Is there any sort of remedy for them? Anyone to sue?


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