How I Found Myself in the Government’s 'Crosshairs'

How I found myself in the government's 'crosshairs'… When did everything become 'securities fraud'?... 'If you find this whole arrangement incredibly stupid, you're not alone'... Why Wall Street's punishment rarely fits the 'crime'...

For the past 23 years, my partners and I have defrauded each and every one of you...

At least, that's how the state of New York sees it.

You'll be glad to know that New York is working hard to extract a huge fine from us. And I (Bryan Beach) am ready to pay whatever consequences come my way... though I shouldn't have to sacrifice a dime.

In today's Digest, I want to explain all the details about how I found myself in this ridiculous situation... how the chances are good that you'll find yourself in a similar quandary at some point, if you haven't already... and what you should do if it happens.

Let's start in the 1980s, when I was growing up in Virginia...

My mom's mom, Granny, lived with us. She was a creature of habit. Every morning, as I walked into the kitchen for breakfast, she'd rattle off the latest on Exxon's stock...

"Up six cents, heavy volumes."

If it was baseball season, Granny gave me an equally brief morning update on the Atlanta Braves, which usually involved complaining about the bullpen. I was more interested in that; but looking back, maybe the seed for a stock-picking passion was being planted...

Granny had worked for years through the 1950s and 1960s at "Esso" – as it was still called back then. She wrote memos and letters for executives – on a typewriter – and Granny socked away a few dollars from every paycheck into Esso stock.

Those shares became the basis of her retirement... which is why she was constantly stalking the stock price.

In the mid-1990s, long after the company became Exxon, Granny gave me 20 of her shares as a birthday gift. At the time, the Exxon shares were probably worth about $1,200...

I remember getting my first dividend check... for a whopping $14. As Granny pointed out, "There's not much you can do with $14, is there?"

Then, she explained the power of dividend reinvestment plans ('DRIPs')...

Of course, longtime Digest readers know all about DRIPs... instead of receiving dividends in cash, you receive new shares of equal value. It's a great way to compound your share holdings over time, and it's how Granny had socked away enough shares to retire.

I liked the idea. So Granny pulled down her old Smith-Corona typewriter and, just like old times, dashed off a corporate letter to enroll my shares in a DRIP.

After two share splits and roughly $3,500 worth of reinvested dividends, I now own 147 shares of ExxonMobil's (XOM) stock... My total stake is worth about $11,000 today.

That isn't life-changing money for most of us... And the returns have been only slightly better than the broad market over the past two-plus decades.

But because I've held onto these shares through the years – because I own ExxonMobil stock at all – I'm now in the crosshairs of New York regulators, along with the oil company itself.

I'll explain exactly why in a moment, but first you need to understand that what's happening with ExxonMobil is a symptom of a much larger regulatory epidemic.

You see, lawsuits can be hard work – and a massive waste of time – for everyone involved...

Years of evidence discovery. Dozens of witnesses to interview. Proving intent. Navigating gray areas. Not to mention the docket jockeying and inevitable appeals process. It's all so... exhausting. If only there were an easier way to punish companies who do bad stuff...

As it turns out, clever regulators and lawyers believe they've discovered a solution...

In recent years, they've started exploiting a convenient "loophole" in securities law – the rules that govern publicly traded entities.

This loophole gives regulators and lawyers a relatively quick and easy way to punish companies for all kinds of naughtiness...

In short, by charging them with securities fraud... but probably not for the traditional spirit-of-the-law reasons that come to mind like old-fashioned insider trading and stock price manipulation.

Essentially, the loophole that gives federal and state regulators permission to charge companies with securities fraud is stated in the law as "a material misrepresentation or omission to shareholders."

We'll simply characterize it as "lying to shareholders."

And recently, regulators like the U.S. Securities and Exchange Commission ("SEC") and the New York attorney general's office are stretching the definition of what constitutes misrepresentation.

What's more, scores of law firms are engaging in an opportunistic form of "ambulance chasing" involving securities... by exploiting this law designed to protect shareholders.

This loophole really centers around what constitutes 'adequate disclosure'...

Any time a company does a "bad thing," the company needs to explicitly disclose the bad thing to the public. Otherwise, that can be considered securities fraud.

For example, in late July 2018, various women alleged sexual harassment against CBS (CBS) Chairman Les Moonves. The stock immediately fell 11% after the news broke. Moonves ultimately lost his job and forfeited $35 million in compensation in the fallout.

But that isn't where the story ended...

Various firms still brought a class-action lawsuit against CBS for failing to disclose the apparent widespread workplace sexual harassment at the company. The falling stock price combined with the "lack of disclosure" is all these firms needed to allege securities fraud.

No matter how the ongoing case plays out, it'll be costly for CBS shareholders. They'll likely end up footing a bill of around $50 million defending the company against the charges.

As you can see, this loophole leaves a lot of room for interpretation...

The act of lying usually isn't against the law. When you catch a friend, a co-worker, or a politician in a lie, you can't press charges. They've done nothing illegal. The part of the First Amendment about freedom of speech generally protects our right to lie to each other.

One of the notable exceptions is that publicly traded companies can't lie to their shareholders... That actually is illegal. And it makes sense because you don't want investors going around making investments based on lies. Clearly, protections are necessary.

Consider what happened with theme-park operator SeaWorld Entertainment (SEAS)...

In 2013, the documentary Blackfish suggested that cruel practices and questionable conditions led an orca whale held at SeaWorld in Orlando to pull its trainer into the water, ultimately killing her. The backlash against the theme-park chain was strong...

The documentary led to months of news articles about the captivity of killer whales. Angry musicians even refused to perform at SeaWorld parks.

While traditional media and social media skewered the company in the court of public opinion, SeaWorld attendance remained surprisingly stable... falling only 1%-2% in the quarters following the Blackfish controversy.

SeaWorld told investors the dip was due to the timing of the Easter holiday and other factors. That explanation, as it turns out, was a mistake.

An investigation revealed that SeaWorld executives actually believed that Blackfish had been the cause of the tepid attendance numbers, not the Easter holiday.

The SEC and various securities law firms ended up going after SeaWorld... not for treating animals badly, but for lying to investors about the source of the attendance decline.

Rather than dealing with a difficult legal gray area, the regulators and lawyers exploited the "don't lie to shareholders" loophole.

In the backlash of the orca tragedy, SeaWorld paid more than $5 million in fines. The crime? Well, technically... securities fraud.

Bloomberg's Matt Levine is the ultimate authority on these types of cases. "Every! Thing! Is! Securities! Fraud!" is a running theme in his columns. Every week, he has new material to cover.

Why? Because when a company does something bad, the easiest road to punishment for regulators has become to contort the facts into a convoluted "securities fraud" narrative.

That brings us back to Exxon and my role in its ongoing saga...

In 2015, Eric Schneiderman, New York's attorney general, opened an investigation to determine if ExxonMobil had "lied to the public about the risks of climate change." By 2016, other attorneys general had joined in.

At a March 2016 press conference, Massachusetts Attorney General Maura Healey piled on, noting that companies like ExxonMobil:

Have deceived investors about the risks climate change poses to the planet and to their bottom lines [and]... must be held accountable.

Did you catch that? The focus of the investigation had shifted. This was no longer an accusation about Exxon destroying the planet. This was now an accusation of deceiving investors by not disclosing Exxon's supposed role in climate change.

It became clear at that grandiose March 2016 press conference: the weapon these states would use to destroy ExxonMobil on climate change would be... securities fraud.

And, as with all securities fraud cases, the regulators and lawyers making the allegations must position themselves as protecting the shareholders. (And, as a shareholder, I have no way of objecting to this "legal help.")

Specifically, the attorneys general accuse ExxonMobil of not reserving enough money to cover the true cost of its climate change liabilities.

Had the true liabilities been disclosed, the accusers assert, investors would have valued the business at a lower amount. Therefore, securities fraud!

A lawyer I consulted explained that it's no accident that New York fired the first shots against ExxonMobil...

In New York, securities fraud is governed by the Martin Act.

To be found liable under federal securities law, it must be proven that the defendant had an intent to defraud, or at least acted recklessly...

The Martin Act, however, only requires negligence – it's a much lower standard and much easier to prove. (Not surprisingly, the SEC isn't bothering to pursue ExxonMobil on this case of securities fraud).

Now look... I want to be very clear. Companies that do bad things should be punished and held accountable for their actions.

Mistreating animals is bad. Sexual harassment is inexcusable.

But the problem with these enforcement loopholes used by regulators and lawyers is that they ignore the actual victims of these transgressions.

When attorneys general come after ExxonMobil, they're doing so under the guise of protecting Bryan Beach, the shareholder.

But the public – the smog-choking victim of ExxonMobil's alleged climate-destroying malfeasance – gets nothing but a couple of headlines to read.

If you find this whole arrangement incredibly stupid, you're not alone...

Here's Levine's take:

For one thing, if you actually think that ExxonMobil is engaged in a diabolical conspiracy to suppress climate science to wring extra profits out of an earth-destroying business, the last people you should be worried about are Exxon's shareholders. They're the ones profiting from all that destruction!

For another thing, if you are concerned about those shareholders, the last thing you should do is fine Exxon a lot of money. They're the ones who will ultimately have to pay that money!

And yet, here we are.

According to Schneiderman and his band of grandstanding attorneys general, I have, in an odd way, defrauded myself.

I am therefore entitled to compensatory damages which, unfortunately, I will have to pay myself. This "payment," to be clear, will come in the form of lower earnings and dividends from Exxon stock... so I won't literally be writing myself a check.

This happens with all these cases...

That $5 million SeaWorld settlement isn't going to some animal health organization... around 30% went to the SeaWorld shareholders and 70% went straight to the SEC's coffers.

And remember those law firms attacking CBS... They aren't representing the women that Moonves allegedly groped – those firms are representing shareholders.

Any penalty extracted will be paid by the company (i.e., the shareholders) in the form of thousands of checks written to those same shareholders. The law firms, of course, keep a large cut for themselves.

At the core of this situation lies the precarious relationship between a company's shareholders and its management team...

In this, Granny was a noteworthy exemplar. She took her role as an Exxon "business owner" very seriously. She was a stickler for corporate expenses as much as an effective bullpen.

One time, through some kind of clerical mistake, Exxon calculated Granny's dividend incorrectly. It was off maybe a few hundredths of a cent per share. The company mailed her a check for $0.04 to correct the error.

Out came the old Smith-Corona typewriter...

Granny dashed off a missive chastising management for "wasting $0.25 in postage to mail me a check for $0.04." I explained to Granny that the whole thing was probably automated... and that there was nobody down in Texas making a conscious decision to mail out $0.04 checks.

"Well then computers are stupid," Granny groused as she lined up the typewriter page. "I'll be sure to tell them that, too."

I can't imagine how Granny would feel about ExxonMobil paying lawyers tens of millions of dollars to defend itself against lawsuits that might require one set of shareholders to write a check to another set of shareholders.

The whole situation seems so outrageous I reached out to a securities lawyer to make sure I wasn't missing something...

Unfortunately, I wasn't.

It may seem odd to extract a penalty from shareholders like me for the sins of Exxon's management. But the lawyer explained the daisy chain of command...

If Exxon's management purposely defrauds mankind, the malfeasance drifts up to the board of directors... and ultimately up to the shareholders (i.e. business owners) who elected that board of directors.

The buck stops with the shareholders. This seems silly. But it does, in a way, make sense. I mean, who else would pay the penalty, if not the owners?

But, to Levine's point, why go through the trouble of punishing shareholders under the pretense of protecting shareholders?

The answer, of course, is at least partially political.

Climate change is a partisan hot-button issue, and ambitious politicians can quickly make a name for themselves by taking down corporate boogeymen like ExxonMobil.

The resulting fines can soar into the hundreds of millions of dollars... which can keep the media attention on at an attorney general's office for an awfully long time.

Strangely enough, Schneiderman resigned in disgrace in May 2018, in the aftermath of an expose in the New Yorker outlining his history of violently abusing women. But the case against ExxonMobil lives on in the New York attorney general's office.

Other states, including California and Massachusetts, continue to carry on similar cases as well.

Because it works, you're going to see a lot more of this regulatory strategy in the years to come.

So what do you do if you find yourself in my position? It depends...

Shareholder lawsuits and SEC fines and settlements can be big, market-moving news...

Shares of CBS fell nearly 30% – from $57 to $41 – in the five months following the Moonves bombshell and related investigations. It's now seven months later, and shares are back above $50, despite a host of other CBS boardroom drama that has nothing to do with Moonves.

There was a similar situation with SeaWorld... Once management admitted that the Blackfish movie had hurt attendance, shares fell from $28 to $18 – that's 35% – in just three trading sessions in mid-August 2014. It has taken a couple of years, but the market has forgotten all about Blackfish. SeaWorld shares trade at about $30 today.

These situations are complicated. Both CBS and SeaWorld have had legitimate price pressure other than the drama that attracted the regulators and lawyers.

But bad headlines and avoidable drama generally can't turn an otherwise good business into a lousy business...

Over the long term, the market has a way of forgetting about this stuff.

So keep your eye on the news, but don't dwell on headlines. If you're committed to a business for the long term, you don't necessarily need to bail on it because of some noise related to regulators and opportunistic lawyers.

Look, I don't love ExxonMobil's business. I never really have. But I'm certainly not ashamed to be associated with my shares, whether the state of New York considers me part of a fraudulent scheme or not.

It may be sentimental, but I doubt I'll ever sell. I own Exxon for the same reason I listen to the Atlanta Braves broadcasts every night. Granny's stock. Granny's team.

Speaking of that: if you do have a long-term holding, and you also have grandkids... why don't you throw them a few shares for their birthday? They may end up writing about it 30 years later.

New 52-week highs (as of 8/5/19): Sprott Physical Gold and Silver Trust (CEF), DB Gold Double Long ETN (DGP), Franco-Nevada (FNV), SPDR Gold Shares (GLD), Barrick Gold (GOLD), Invesco Value Municipal Income Trust (IIM), NovaGold Resources (NG), Nuveen Municipal Value Fund (NUV), Osisko Gold Royalties (OR), Seabridge Gold (SA), Vanguard Inflation-Protected Securities Fund (VIPSX), and short position in Advance Auto Parts (AAP).

Have a question or comment for us? As always, send it to feedback@stansberryresearch.com.

Regards,

Bryan Beach
Baltimore, Maryland
August 6, 2019