By James H. Nolt
This week I depart into fantasy, but informed by real-life financial operations. I watch very few TV series, but sometimes there is a compelling show that draws me in. Lately that has been USA Network’s “Mr. Robot.” This corporate dystopia is topical these days because of the crucial role of computer hacking and financial crisis in its drama.
“Mr. Robot” features a somewhat overused dramatic device (and a fair warning, there are spoilers ahead): the main character, Elliot, a computer security specialist, has a split personality, the twist being that his other self is his deceased(?) father, who always wears a jacket with the logo “Mr. Robot,” the name of said father’s former computer repair store. Elliott is drawn into a plot by a revolutionary hacker group called “fsociety,” probably led by his alter ego. The group plans to hack into the computers of a huge industrial-financial conglomerate, Evil Corp, and destroy all its records as revenge against its misdeeds.
By the end of the first season, the plot has gotten convoluted since it seems that the CEO of Evil Corp is knowledgeable about and possibly involved in fsociety’s plot. He seems pleased when it succeeds in crashing his massive conglomerate’s computers and records, and, with so much uncertainty, world stock markets collapse.
Two parties at the end of the season illustrate the contrasting perspectives of fsociety and Evil Corp. The fsociety plotters organize a farcically ironic “End of the World” party to exuberantly celebrate breaking their adversary. Yet simultaneously, a luxurious private party featuring well-heeled business leaders from around the world, including the CEO of Evil Corp, seems unruffled, unbeknownst to fsociety. The writers of the series leave a giant question mark, presumably to be resolved during the second season, about why Evil Corp’s CEO is so smug.
Based on what you have learned from reading my blog so far, you might join me in anticipating one possible resolution. One giant clue is that the corporate logo for Evil Corp is a tilted capital ‘E’ strikingly similar to that of Enron, a notoriously corrupt corporation whose collapse in 2001 precipitated the crash of the stock market that year and also bankrupted Enron’s complicit accounting firm, the previously venerable Arthur Andersen. Will art imitate life?
Enron, like Evil Corp, was a conglomerate with a variety of financial and industrial divisions, including core businesses in electrical power and natural gas. Enron developed an active market in energy derivatives. Enron traders used derivatives to bet on future energy prices simultaneously as the company manipulated the supply to create or resolve shortages, thus assuring that the most of its bets paid off. Its executives also profited personally from manipulating the stock price.
The leaders of Enron probably felt themselves relatively immune from prosecution because they had generously supported the Republican Party and the newly elected President, George W. Bush, former governor of Texas, where Enron was headquartered. As it turned out, Enron’s considerate clout was insufficient to cover up the audacity of its crimes. Kenneth Lay, Enron’s Chairman; Jeffrey Skilling, CEO; and Andrew Fastow, CFO, were eventually convicted and sentenced to jail. Another executive, Cliff Baxter, shot himself, similar to one of the officers of Evil Corp in the TV series.
The corruption of Enron and other corporations at that time, including WorldCom, induced Congress to pass the Sarbanes-Oxley Law in 2003, increasing the penalties for corporate fraud.
What is unexplained (so far) in “Mr. Robot” and was little explored during the Enron crisis is exactly how CEOs might profit enormously from destroying the companies they run, if only they could get away with it. Of course, we hope law enforcement is sufficiently vigilant to prevent this, but part of vigilance is public awareness of the possibilities.
I first discussed derivatives in my blog entitled “Derivative Duels.” As I said there, every derivatives contract has two sides, a bear and a bull bet. Derivatives get their name because they derive their value from some specific underlying asset. Derivatives can be purchased on almost anything with a standard public price and even on some quantifiable values with no price, like the weather. All derivatives contracts specify the underlying asset on which the contracting parties wager a bet. Either side of a derivative bet may be sold to third parties, often including people who are unaware of what they own within pension funds, insurance policies, mutual funds, etc.
Someone hoping to profit from troubled times would buy the bearish side of any derivatives contract, the side that predicts a price drop. There are many possibilities. Suppose you are Ken Lay or the CEO of Evil Corp and you wish to bet that your fraud will soon be discovered and therefore the stock price of your corporation will soon plummet. Most people would just think to sell whatever stock they now own.
You do this, of course, but a much more profitable play would then be to buy what are called ‘put options’ (or an option to sell assets at an agreed price on or before a set date) on as much stock as you can afford. If you do not want to be too obvious to regulators and law enforcement that might have their eye on you, you use cutouts (people otherwise not obviously connected to you) or anonymous offshore accounts as much as possible and bet against not only your own company’s stock, but also other stocks likely to fall with it.
For example, suppose you have $10 million in liquid capital to commit. The cheapest put options you could buy are those that are out-of-the-money — e.g., if the current price of the stock is $50, out-of-the-money for a put option means you choose a strike price below that, say, $40 per share. Since, thanks to your clever accounting fraud, few investors expect the price to drop that low, many dealers may be willing to sell put options at that rate for very little, perhaps as little as 1 percent of the face value. Options are also cheaper if their maturity date is soon, giving less time for the price to change. So let’s say you pay 1 percent to buy 30-day puts for a total of 25 million shares (25 x 40 = $1 billion). That means you spend only $10 million to buy $1 billion in puts at 1 percent of face.
If within 30 days the stock price falls to $30, you buy 25 million shares for $750 million. Now, immediately exercise your put options to sell those shares for $1 billion. Your profit is the difference: $250 million — not a bad return on $10 million ventured for a few weeks! If the stock price fell even more your profit could be much bigger. On the other hand, if the share price does not fall below the strike price within the 30 days, your puts are worthless and the $10 million is lost. You must be confident that your news will move the market sufficiently.
Buying and selling on this scale is hard to do without attracting someone’s attention, and indeed, affecting the price by your own activity, but this example does provide a clue how profitable it can be to bet on loss, especially if you can do it deceptively, leaving little trace. If you control vital information that will move the price, all the better.
This also illustrates the extreme leverage possible with derivatives. As always, people seldom get rich just by employing their own capital, but by leveraging other people’s money effectively. In future blogs we will further explore the strategic possibilities to consider why Evil Corp’s CEO is so confident, although in real life the perils of execution of any strategy may derail it.
James H. Nolt is a senior fellow at World Policy Institute and an adjunct associate professor at New York University.
[Photo courtesy of Ged Carroll]