Dividend policy

Let's put some links together on the broad subject -- one of great relevance to all the themes of this blog -- of corporate dividend policy. How do companies decide how much cash their stockholders get on a regular basis?

Here's a pdf from Deutsche Bank on the theory and practice.

And here are a few words from scholars at UPenn.

One piece of the puzzle is the fact that individuals in the US are generally taxed more for dividends than for the capital gain on the sale of stock. The dividends are "ordinary income." So, shouldn't a rational investor want the company to keep reinvesting its cash, building up that strike price, and earning him that capital gain? Why does anyone even want a dividend?

On the other hand, a stock that doesn't pay dividends has a Madoff-like air to it. I'm holding on to it so I can sell it at a higher price to someone else, you say? Well, why would he want it? Because he expects to sell it to a yet greater fool further down the road? Somewhere, somebody has to receive a stream of income/cash in order to anchor those capital gains. That, at any rate is one common sensical take on the issue.

At any rate, once a company has a history, a track record as to the quantity of dividends it pays, there is a good deal of pressure to keep it up. The dividend level is "sticky." Why? Because any departure can be taken as a signal. A cut in dividends can be considered proof the company is in trouble and desperately needs to hold onto its cash. An increase in dividends can also be taken as a signal that the company is in trouble, specifically that it is making a desperate move to perfume that fact!

Consider that Lehman Brothers, the broker-dealer that famously declared bankruptcy in September 2008 and set off that autumnal crisis, had increased its own dividends by 13% earlier in the year. You may as well give that some consideration -- if you are the member of a board of directors that institutes such a cut, signalling theorists will consider it for you!

Finally, if you are an investor, you might want to consider a dividend reinvestment plan. Especially because it goes by such a neat acronym. Such a plan is known as a DRIP.

Kenneth Starr

The Kenneth Starr in the news just now is not the former special prosecutor of the Lewinsky scandal. Nor is he the rapper, Kenn Starr. Nor the country-music singer, Kenny Starr.

No, this is Kenneth I. Starr, a financial advisor to the Hollywood elite. The clients who were at one time or another on his list include: Goldie Hawn; Wesley Snipes; Al Pacino; Sylvester Stallone; Martin Scorcese, and (justifying my use of a great movie poster with this blog entry) "The Bride," Uma Thurman.

It isn't yet clear which of his celebrity clients have lost money. The news so far seems to be mostly a typical Hollywood spin-fest, with every PR agency in L.A. contending that the stars on its list suspected something was up in time, and got their money out of Starr's hands. Uma Thurman is said to have had almost a Kill Bill style confrontation with him to that end!

Here's a humorous take on the subject from The Reformed Broker.

And here's the release from the district attorney on the job Preet Bharara. Bharara? Isn't that how the bad guys in Hollywood movies laugh?

Andrew Stein has been arrested on related charges. Aficionados of the politics of New York City willl recognize that name. Others may want a quick course from wikipedia.

But back to all the spin about how various celebrities didn't lose money because they got it out in time: we'll see. The law can be draconian in the unwinding of a ponzi scheme. A lot of people who thought they got their money out safely may soon face a demand from an estate trustee that they return those funds, as have many in the analogous situation with Bernie Madoff.

Madoff: Still Messin' With My Head

The legitimate part of the Madoff operation may not have been.

This story has been evolving over roughly five financial quarters now. One constant has been the distinction between the trading (market making) side and the asset management (or investment advisory or just IA) side of Bernie Madoff's operations, a distinction always described as crucial. Madoff's trading operation, which had been quite innovative when launched in 1960, was controversial in some respects (especially among those of us who consider the practice of payment-for-order-flow inherently dubious), but it was legal.

Madoff was often suspected of attaining the unusually consistent results of the account management operation by "front-running," i.e. by making illegal use of information he acquired as a market maker. The SEC would periodically investigate Madoff, only to find that he wasn't front running, so he must be clean! The truth of course is that he wasn't front running because he wasn't really trading through the IA wing of his company at all. It was all a sham, and those surprisingly consistent results were simply invented. So the possibility of front-running was serving perhaps two purposes. First, as noted it was a false scent that kept the regulators harmlessly occupied. But, secondly, it may have helped attract investors. "Pssst, this guy is likely front-running the info from his market maker side. We should get us a piece of that action."

Again, the above two paragraphs state the conventional wisdom. But the new arrest indicates there was still more to the story. Daniel Bonventre, the Madoff associate now under fire, was for thirty years the director of operations of the market-making part of the operation. Here's the criminal complaint against him.

Authorities allege that the income from the ponzi scheme was used to support the market-making operation at least from 1997 onward, and that the necessary transfers were accounted for on the books in such a way as to conceal their true source. Most reports indicate that they caught on to Bonventre because Frank DiPascali has been squealing like a stuck pig of late.

I hereby point out, as is only right, that Bonventre through his attorney has denied doing anything wrong and that he is innocent until proven guilty.

Still, if the investigators are on to something, this changes a good deal. Other potential defendants arise once the supposed wall between the legitimate and illegitimate sides of the supposedly bifurcated operations turns out to have been porous.

Marc Dreier

For those of you who may have forgotten, Marc Dreier was the big finance-world criminal who made headlines just before Bernie Madoff. Madoff's scheme was so large that it drove everything else of that genre out of the minds of the personally unaffected, but the Dreier case has its own charm.

There is, of course a wiki article if you'd like a more detailed refresher course.

Very briefly, though, Dreier was a lawyer who duped a lot of hedge funds into buying forged notes, many of them supposedly issued by Solow Realty, a corporate vehicle of a real-enough client of Dreier's, developer Sheldon Solow.

But he also forged notes supposedly issued by the Ontario Teachers' Pension Plan. This turned out to be a bit of overreaching. People who moved in Solow's circles knew Dreier and vice versa, and they could take it on faith Dreier was speaking for Solow as to the notes. But the OTPP? The would-be note buyers wanted re-assurance. And so it was that it was at OTPP headquarters in Toronto that the scheme reached its bizaare denoument on Tuesday, December 2.

This comes to mind because Bryan Burrough has a fine article on the Dreier case in the November issue of VANITY FAIR. what I especially like about the Burrough story is his discussion of the long and tangled Solow/Dreier relationship.

Dreier was often Solow's pitbull. When Solow pointed out a target, Dreier's fangs could sink truly and deeply. There was for example a tussle with Peter Morton of the Hard Rock Cafe chain, in which a judge dismissed the third Drier/Solow lawsuit on point, saying Solow has "had so many bites at the apple, [he] has swallowed the core."

And there was a dispute between Solow and another Manhattan developer, Peter Kalikow. The Solow/Dreier campaign of vindictiveness at Kalikow's expense led to some positively sputtering language by Judge Burton Lifland, who described Dreier's actions as "tacky, shabby, base, low, malicious, petty, nasty, unsavory" and other like descriptors.

That's laying it out for us, your honor.

DiPascali Pleads Guilty

Bernard Madoff's efforts to portray himself as a "lone gunman" have been to no avail.

One of his key co-conspirators, perhaps the key co-conspirator, has now pleaded guilty. That would be Frank DiPascali, who was Madoff's director of options trading for a decade, from 1986 to 1996.

That title is a crucial fact in understanding the case against DiPascali, even more crucial than the title "Chief Financial Officer" that he assumed in 1996. Because the strategy that Madoff claimed to be pursuing, the investing thesis that supposedly laid all these golden eggs he kept reporting to investors, was what is known as a "split strike options" strategy.

The idea is that Madoff would buy a portfolio consisting of about 35 of the bluest of blue chip stocks, stocks included within the S&P Index. He would then sell call options and buy put options at different strike prices, on the S&P index itself, creating a cushion on both sides of the purchase price of those stocks. The options positions would cost him money if the price of the underlying stocks rose rapidly (but that would be okay, since he owned the stocks and benefitted from that rise), and they would earn him money if the index fell rapidly (which would cushion the effect of that fall).

The claim has been purely fictitious for a long time now -- but the key fact is -- if the claim had been truthful, the director of options trading would be a very busy and strategically crucial person in the overall operation. How could that director not know that he wasn't doing what Madoff kept telling clients he was doing? this was the crucial point that drew attention to DiPascali. He must have been the Mayor of a Potemkin Village.

Concomitant with the guilty plea on the criminal charges, DiPascali also entered into a partial settlement with the SEC on its civil complaint. This complaint lays out the mechanics of the Madoff fraud more thoroughly than any document yet made public. See for yourself.

This could be very bad news for othr co-conspirators, and there clearly are others. DiPascali is not as stoic as his former boss about accepting more than one hundred years behind bars as a sentence. He'll talk. Indeed, he said yesterday: "I know my apology means almost nothing. I hope my actions going forward with the government will mean something."

Yes, but watch out when you do take up residence in prison, Frank. The new neighbors don't have a high opinion of squealers.

Three brief items

1. Chicago Sun-Times solicitations.

The next best thing to a proxy fight is a consent solicitation campaign.

It is a more slow-motion, though. The shareholders seeking a material change solicit written consent to that change from more than 50% of the outstanding voting shares. This is often more difficult than winning a true proxy campaign, after all, in the case of a consent solicitation, inaction always amounts to a pro-management vote, a refusal to consent to the change.

Anyway: the Davidson Kempner hedge fund wants a new board of directors on the Sun-Times. They've sent a letter of solicitation that blames the incumbents for "the near total erosion of stockholder value."

On Thursday, December 11, the Chicago Sun-Times announced that the proxy-advisory firm Glass Lewis & Co. is taking its side.

2. Bullish report on Asian securities exchanges.

The consultancy Celent has posted a report on the Asian securities exchanges as businesses. It's pretty bullish.

The report says that a total of more than 14 trillion shares, with a value equivalent to $21 trillion US dollars, was traded on the major Asian exchanges in 2007. the top six of those exchanges account for 80% of that value.

The author of the report, Arin Ray, says: "The Asian exchange industry, following a worldwide trend, has undergone major changes in structure and governance model, and many exchanges have become publicly traded companies through demutualization. The exchanges are highly profitable and growing, with an average profitability of almost 50 percent.”

3. On Madoff.

When the Bernie Madoff story first broke I wrote here about the "payment for order flow" angle, postulating that Madoff's determined defense of that practice back in May 2000 should already have been a red flag to the observant.

I'm happy to report that I'm not the only one thinking along those lines. On December 24, the Financial Times ran a story by Greg Farrell under the headline "SEC inaction that helped fuel scheme."

The second graf of this story reads: "But it was the SEC's decision in the 1990s not to take a stand on the controversial issue of 'payment for order flow' that helped fuel the rise of Bernard Madoff Investment Securities, the successful broker-dealer operation two floors above Mr Madoff's private fund operation in Manhattan."

That way of putting it implies a government-centered way of looking at the world. There are lots of parties other than the SEC who missed this and shouldhave gotten it -- like the folks responsible for due diligence at the various institutions than invested in Madoff's operations.

Still, I do think the whole idea of payment-for-order-flow stinks. If the Madoff meltdown does help finally discredit it, that will be some slender silver lining.

Payment for order flow

There is an intermittent controversy among those whom manage stock exchanges, brokerage houses and related institutions -- and among those who regulate them -- about a practice known as "payment for order flow."

Back in January 2003, for example, the then-chairman of the Securities and Exchange Commission, Harvey Pitt, wrote to the heads of each of the five US exchanges where stock OPTIONS are listed, just to give them what one might call a heads up.

"Hey guys, we're looking at this issue down here in DC. I'm not saying nothing, I'm just sayin'." [Not his exact words].

The idea was that an exchange would pay a brokerage firm for routing an order to them rather than elsewhere -- the payment might be a penny per share.

The controversy arises because your broker is suppsoed to be working for you, the investor, trying to get you the best deal. If he can get you a better deal for certain options on exchange A than on exchange B, shouldn't he rout your order through exchange B? If a payment from exchange B persuades him to do otherwise, aren't they cheating you?

The same might well be asked also if you're trying to buy the underlying stocks, though Pitt's January 2003 letter involved options for reasons I won't get into today.

Likewise, the same questions might be asked when it is a market maker, rather than an exchange, that is paying to keep orders on some form of security or other flowing. From whomever the money is coming, the broker who receives that money may be putting itself into a conflicted situation vis-a-vis its client.

I'm thinking about such matters today because an investment manager named Bernard Madoff is all over the news this weekend, even putting the continuing controversy over the auto bail-out in the shade for the moment.

Prosecutors claim that Madoff told senior employees at his firm, a market maker, that his operations were "all just one big lie," and "a giant Ponzi scheme."

If there is anything to the charges, the ongoing scandal may further discredit the whole idea of anyone -- exchange or market maker -- paying for any kind of market flow. Because Madoff had been closely associated with the practice, and was in fact a public voice in its defense.

He once told a reporter from CNN who interviewed him on the subject (May 2000): "If your girlfriend goes to buy stockings at a supermarket, the racks that display those stockings are usually paid for by the company that manufactured the stockings. Order flow is an issue that attracted a lot of attention but is grossly overrated."

The analogy is borderline absurd. The stocking manufacturer isn't in a relationship of contractual privity with the shopper, so such issues don't normally arise.

Here's some further reading for the curious.

Anyway, when this is all sorted out we may think of the whole idea of payment for order flow as an important warning sign. For the mark of a pyramid schemer is an increasingly desperate desire to keep increasing order flow.