In my former career, I was in the business of structuring derivatives, which in my case often meant that I was in the business of saying no to derivatives. “Derivatives” is sort of a vague term, and there is a persistent folk belief that they have magic powers, that any legal or financial problem can somehow be solved by doing a derivative. In this folk belief, the derivative structurers are wizards with arcane powers, respected and feared as long as they can make the rains come, but also treated with great suspicion when the harvest fails. I had a lot of conversations like this:
Coverage banker: Our client has some shares of XYZ, and he would like to eliminate his downside risk in the stock. He doesn’t want to pay much for that protection, but he is willing to give up his upside exposure. Can you structure some sort of derivative to help him hedge?
Me: He owns the stock, he doesn’t want to lose money if it goes down, and he doesn’t care about making money if it goes up?
Banker: Exactly, yes, can you help him?
Me: He should just sell the stock.
Banker: Oh no he can’t do that, he signed an agreement with the company that doesn’t let him sell the stock.
Me: Did he also agree not to hedge it?
Banker: I don’t think so, I’m sure hedging is fine.
Banker: Let me send you the agreement. [Sends contract]
Me: It says right here “you shall not sell, hedge, reduce your exposure, trade in options or swaps or other derivatives, or otherwise do anything at all that anyone might even think looks a little bit like hedging.”
Banker: Well but we were thinking there might be some sort of … derivative?
Me: Come on!
Banker: This is not very helpful. Are you even a real derivatives structurer?
At this point I would say I had to jump to another call, but it is important to point out that I wasn’t very good at this. If you were really good, you would construct a magical derivative that would somehow thread the needle, hedge the client’s risk and not violate the agreement. If you were slightly less good, you would construct a derivative that wouldn’t hedge the client’s risk, but you’d be a good enough salesperson to pitch it to the banker and maybe even to the client. (Short a basket of correlated stocks, sure!) If you were … let’s say, average … you would construct a derivative that would hedge the client’s risk and definitely violate the agreement, sell it to the client, and let him worry about getting sued.
Anyway here’s a goofy story from The Information about the initial public offering of Lyft Inc.
Lyft threatened Morgan Stanley with legal action earlier this week, demanding in a letter the investment bank stop marketing a short-selling product that the ride-hailing firm believed was disrupting trading in its stock, according to four people familiar with the situation.
The letter, sent on April 2, cited an article in the New York Post published on Monday night that said the bank was marketing a product that appeared to offer Lyft’s pre-IPO shareholders a way to get around lockup agreements that prevent them from selling for at least six months after the IPO. If true, the letter said, Morgan Stanley “is engaged in tortious interference” and the company demanded the firm stop sales of the product or face legal action. …
For weeks during the roadshow, Morgan Stanley salespeople had been calling early Lyft investors and pitching them on a short-selling transaction that would enable them to lock in gains, regardless of the lockup, the executive said. … One of the transactions was called a “total return swap,” a way for the investor to get the returns from short-selling the stock, while not technically selling the stock.
We talked about these rumors last week, and I pointed out that the lockup absolutely clearly prohibits Lyft’s pre-IPO shareholders from using total return swaps to hedge their exposure. “A person familiar with the situation said the lockups were bullet proof and the Morgan Stanley product was clearly in contravention of the agreements,” and: “Some of the VC firms who were contacted checked with Lyft’s bankers and their own lawyers to see if the suggested trades would breach the lockup agreements,” and were told that they did. So, yeah. A total return swap is not a way around the lockup, except in the narrow sense that Lyft can keep track of its shares but can’t necessarily keep track of who’s doing total return swaps. It’s a way around the lockup if Lyft doesn’t notice.
Meanwhile CNBC reports that Morgan Stanley denies Lyft’s claims, saying that its “activity has been in the normal course of market-making,” and that it “did not market or execute, directly or indirectly, a sale, short sale, hedge, swap or transfer of risk or value associated with Lyft stock for any Lyft shareholder identified by the company or otherwise known to us to be the subject of a Lyft lock-up agreement.” And it does seem somewhat unlikely to me that a big investment bank would go around marketing a lockup-violation product. I wouldn’t be at all surprised if someone asked for one, though.