There is a fascinating story up on Bloomberg about how various large hedge funds are exploiting the current option back-dating scandal in a new and unsettling way. Here is how it works:
- A public company announces it is under investigation for option back-dating.
- Rather than certify incorrect financial statements and violate Sarbanes-Oxley, the company says it may have to delay routine financial filings until the investigation is resolved.
- Hedge funds take a big position in the company’s bonds, and announce that because of non-filing the company is in violation of bond covenants.
- The company technically must repay debt at 100 cents on the dollar, often on debt that is trading at 90 cents on the dollar or lower.
Creative, is it not? Absolutely, and profitable too, with the bonds often rising in anticipation of these antics. Sometimes companies are also paying special fees to appease bondholders too, on the order of 10 to 500 additional basis points.
This is a classic example of unanticipated consequences of new regulation. No-one, I’m sure, anticipated that SarbOx would force someone into technical default on debt over an option back-dating investigation, but here it is happening — and here are hedge funds reaping returns as a result.
Yes, bondholders are doing what is their right, but “companies are getting screwed for technicalities”, as one fund manager told Bloomberg. This is, fundamentally, a punishment disproportionate to the alleged crime, sort of like sending someone to jail for jaywalking. It is also, however, an interesting example of how creative hedge funds can be at engineering returns from unusual places.