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Tesla, Elon Musk and the SEC: an update

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The English Investor

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More information has now emerged on Mr. Musk’s tweet since our last post.

After reviewing Regulation FD and Rule 10b-5, we had concluded that Mr. Musk’s should be fine as long as the funding was truly secured, meaning that there was a signed (i.e. irrevocable) financing commitment to back the statement “funding secured”. While going to Twitter to make such an announcement was unusual, we did find a precedent (i.e. Netflix CEO Reed Hastings making an announcement on Facebook). The SEC has also since stated that under certain circumstances, this should be fine. As long as Mr. Musk’s statement did not mislead the market, there should be no dire consequences for him and Tesla.

But what a week.

Reuters and the New York Times (NYT) indicated that the SEC has since sent subpoenas to Tesla in connection with its take-private plans and Mr. Musk’s statement that funding for the privatization was secured. The SEC has launched a formal probe into the matter and is now seriously investigating the privatization plans.

In a blog post, Mr. Musk tried to explain what he meant by “funding secured.” The Saudi Arabian wealth fund recently bought close to 5% of Tesla stock. Shortly thereafter, on July 31, Mr. Musk met with the managing director of the fund. At this meeting, the managing director “expressed regret” that Mr. Musk had not moved forward with the privatization of Tesla. According to Mr. Musk, the managing director “expressed his support for funding a going private transaction for Tesla.” Mr. Musk understood that “no other decision makers were needed and that they were eager to proceed.” Mr. Musk concludes:

“ I left the July 31^stmeeting with no question that a deal with the Saudi sovereign fund could be closed, and that it was just a matter of getting the process moving. This is why I referred to “funding secured” in the August 7^thannouncement.”

Let’s pause here for a second. All there is, at best, is a handshake agreement. Note that this is Mr. Musk’s reading of the situation. I’m not aware of any formal and public commitment of the Saudi sovereign fund since this announcement. In fact, the NYT indicated that the Saudi wealth fund declined to comment. During the meeting referenced by Mr. Musk, there is no formal commitment and many details still have to be finalized. This is actually further confirmed by Mr. Musk’s post:

“Following the August 7^thannouncement, I have continued to communicate with the Managing Director of the Saudi fund. He has expressed support for proceeding subject to financial and other due diligence and their internal review process for obtaining approvals. He has also asked for additional details on how the company would be taken private, including any required percentages and any regulatory requirements.”

The post discusses various other considerations regarding the privatization of Tesla. Mr. Musk also indicates that he is having further discussions with a number of other investors.

Three things shocked me:

Funding is not secured when there is still due diligence to be done. Due diligence is problematic because this is fully within the control of the parties to the transaction. Subject to material changes, due diligence is usually completed by the end of the commitment stage. Regulatory approvals are also an unknown: the Saudi investment would be a foreign investment that will probably require CIFIUS approval. Unlike due diligence, which should be finalized by signing, it is, however, common to sign a commitment letter subject to obtaining regulatory approvals.

The details of this blog post are incredibly vague. It was only following the announcement on Twitter that the fund requested further information on how the transaction would be structured. In a standard transaction, there would be a step plan or tax memorandum showing all the steps of the transaction. The memorandum can change but at least there is a sketch on how the transaction would be structured. This also forms part of the due diligence process. None of that work has been done.

The Tesla blog post implies that funding is secured with the Saudis. But then, Mr. Musk admits that he is also discussing the matter with other parties. Therefore, there is a possibility that the deal could be done with investors other than the Saudi fund. As a matter of fact, the Saudi fund may not even take part in the deal depending on how it is structured. When the source of your funding may change, then it is hard to say that funding is secured.

From this blog post alone, which is the most tangible and official explanation offered by Mr. Musk, there is no secured funding. The Saudi commitment is not binding at all. What Mr. Musk has secured so far is a vague handshake agreement at best, which could be thrown out the window if there are issues during the due diligence process or if a deal is structured on better terms with other investors.

I thought that this quote from a Bloomberg columnist summed up pretty well Wall Street’s feeling regarding Mr. Musk’s tweet:

“How secured was the Saudi funding? So secure that preliminary non-binding abstract discussions of a hypothetical deal continue.”

As a securities lawyer, I view Mr. Musk’s tweet as incredibly misleading. It was misleading to claim that funding was secured when there was no binding commitment. It was also misleading to claim that the only thing standing in the way of Tesla’s privatization was a shareholders’ vote because the details of the transactions and source of funding were still unknown.

Keith Higgins, a Ropes & Gray partner who previously spearheaded the SEC’s corporation finance division said that “a cautious lawyer would have said you shouldn’t have said ‘funding secured’ unless you had a commitment letter.” I agree and this is in line with the conclusion of our previous blog post.

Since this blog post, further developments confirmed that the funding was not so secured.

First, Mr. Musk has lined up Goldman Sachs and Silver Lake as advisors to help him take Tesla private. One would have hoped that he had already hired advisors when discussing such important matters with the Saudi fund. Worst, according to Bloomberg, Silver Lake had not even formally accepted the role when Mr. Musk tweeted that he was working with them.

Second, the board of directors came out with polished statements. While those statements did not directly contradict Mr. Musk’s statement, they did indicate that Mr. Musk had jumped the gun. The most striking indication is the board’s formation of a committee to evaluate the merits of the privatization of Tesla. The board was probably blindsided by Mr. Musk’s tweets. If that wasn’t the case, the committee would have already been formed. And if the funding was secured and the only thing standing in the way of the transaction was a shareholders’ meeting, the committee and the full board would have at least first approved the transaction and its details. None of this has occurred. Worst, it seems that two separate law firms are now advising the board and individual board members, which shows a degree of concern by board members. Latham & Watkins is acting as counsel for the committee. The formation of the committee was formally announced in an 8-K filing with the SEC, the more traditional route of making public announcements as previously explained.

Third, Tesla’s stock price stands at approximately $305 at the time of this post. We are far from the $420 price tag announced by Mr. Musk. This simply means that the market is not convinced by Mr. Musk’s claims. If it were, the stock price would be closed to $405 or $410 (it would not reach $420 so that uncertainties such as regulatory approvals are priced in).

Fourth, the recent stock decline was partly triggered by a recent NYT interview of Mr. Musk. During the interview, an emotional Mr. Musk confirmed that the tweet was not vetted by anyone, including the board of directors or legal counsel. Mr. Musk sent the tweet from his car on his way to the airport. Clearly, no blueprint of a deal even existed as no one knew about the possible take-private transaction. The New York Times even concludes that the funding was not secured, a conclusion that is in line with most reports.

It seems that Mr. Musk is under a lot of pressure and trying to battle short-sellers. This tweet probably went too far. His last argument saying that he was showing transparency to all investors is pretty weak as there was nothing concrete, and therefore nothing to be really transparent about. And this disclosure could have been done through proper channels in a more measured fashion, before or after market hours.

In the end, it looks like the funding to take Tesla private is not secured. Don’t get me wrong: taking Tesla private could end up happening. But, at this stage, Mr. Musk jumped the gun and his tweet was misleading. It ended up massively moving the stock price of Tesla that day and many short sellers suffered significant losses. It will still be an uphill battle for short-sellers suing Mr. Musk and Tesla to show scienter and damages. But the SEC is actively probing the matter and I won’t be surprised if those lawsuits and investigations end up depressing Tesla’s stock price and diverting Mr. Musk’s attention from other more important matters.

Did Elon Musk breach U.S. Securities Laws?

Legal
Stocks

The English Investor

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Did Elon Musk breach U.S. Securities Laws?

Did Elon Musk breach Regulation FD or Rule 10b-5 by tweeting that he was “considering” taking Tesla private during market hours?

Mr. Musk stunned the markets and caused a 10% surge in Tesla’s stock price (and a trading halt) when he announced that he was considering taking Tesla private, meaning delisting Tesla from the Nasdaq and running it as a private company. Is the transaction genuine or is Mr. Musk just giving a bad time to the shorts?

There are two interesting pieces of securities laws at play here: Regulation Fair Disclosure (Regulation FD) and Rule 10b-5. It only makes sense to look at this from a US law perspective because Tesla is incorporated and listed in the United States. Regulation FD regulates how listed companies disclose important information while Rule 10b-5 is an anti-fraud provision for the purchase and sale of securities.

Quick disclaimer: this is post is not meant to be legal advice to you. If you are Tesla stockholder and you want to inquire about the legality of the announcement, please consult your own lawyer.

On Regulation FD

Scope

Regulation FD applies to all companies that have a class of securities registered under Section 12 of the Exchange Act or that are required to file reports under Section 15(d) of the Exchange Act (excluding certain investment companies, any foreign government or foreign private issuer).

Tesla is listed on the Nasdaq, which is a national securities exchange. Tesla’s shares are registered (the original registration statement S-1 can be found here).

Rule 100

Rule 100 of Regulation FD sets forth the basic rule regarding selective disclosure. Under this rule, whenever:

(1) an issuer, or person acting on its behalf (i.e. Mr. Musk, as CEO, is acting on behalf of Tesla, the issuer);

(2) discloses material nonpublic information (i.e. Mr. Musk’s tweet, stating that he is considering taking Tesla private at $420 a share, with funding secured, was non-public material information);

(3) to certain enumerated persons (in general, securities market professionals or holders of the issuer’s securities who may well trade on the basis of the information) (i.e. based on his twitter account, it seems that he has already locked the support of one or more investors. Those are probably sophisticated investors who could trade the stock. There may be brokers or advisors involved in this process who may have the ability to trade).

(4) the issuer must make public disclosure of that same information:

(a) simultaneously (for intentional disclosures), or

(b) promptly (for non-intentional disclosures). (i.e. Timing is a bit unclear here but it is likely that the disclosure was intentional as this was a private discussion with investors. For how long Musk has secured the backing of those investors is unclear, but presumably, it would have been a short amount of time. Alternatively, it is possible that his plans to take Tesla private leaked and he made the announcement as soon as possible).

The timing of the disclosure

The timing of the required public disclosure depends on whether the selective disclosure was intentional or unintentional. The company must make the public disclosure (i) simultaneously, in the case of intentional disclosures, or (ii) promptly afterward, in the case of unintentional disclosures. As previously stated, nothing indicates that the announcement was not made either simultaneously or at least promptly after the disclosure to certain enumerated persons such as securities market professionals or holders of the issuer’s securities.

What constitutes “material non-public information”?

Regulation FD applies to disclosures of “material non-public” information about the issuer or its securities. While the regulation does not define materiality but relies on existing case law, information is deemed material if there is a “substantial likelihood that a reasonable shareholder would consider it important” in making an investment decision. There must be a substantial likelihood that a fact “would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.” Information is nonpublic if it has not been disseminated in a manner making it available to investors generally. Here, there is no doubt that taking Tesla private would constitute material information.

Means of disclosure

The public disclosure may be made through an Exchange Act filing such as a Current Report on Form 8-K or through any method reasonably designed to effect broad, non-exclusionary distribution of the information. Here, there was no Form 8-k filing. Instead, Mr. Musk first tweeted at 9:48 am on 7 August 2018 and the link to a blog post “Taking Tesla Private” was tweeted on the Tesla twitter feed at 12:28 pm on 7 August 2018.

Are Twitter and/or Tesla’s website an appropriate alternative method of public disclosure?

Things get trickier here. The SEC recognizes alternative methods of public disclosure to give issuers the flexibility to choose another method or a combination of methods of disclosure that will achieve the goal of effecting broad, non-exclusionary distribution of information to the public (Rule 101(e)(2)). Therefore, failure to file a Form 8-k is not in itself a break of Regulation FD.

In the SEC release, acceptable methods of public disclosure include press releases distributed through a widely circulated news or wire service, announcements made through press conferences or conference calls that interested members of the public may attend or listen to, or by other electronic transmission. The public must be given adequate notice of the conference or call and the means for accessing it. The regulation does not prescribe a particular means and leaves the decision to the issuer to choose methods that are reasonably calculated to make effective, broad, and non-exclusionary public disclosure, given the particular circumstances of that issuer.

Interestingly, in the Proposing Release, the SEC stated that an issuer’s posting of new information on its own website would not by itself be considered a sufficient method of public disclosure. However, as technology evolves and more investors have Internet access, some issuers, whose websites are widely followed by the investment community, could use such a method. The SEC also states that “while the posting of information on an issuer’s website may not now, by itself, be a sufficient means of public disclosure”, the regulator agrees that the issuer’s website can be one important component of an effective disclosure method.

Announcing such non-public material information on social media is unusual but there is a precedent. In April 2013, the SEC agreed with Netflix CEO Hastings that disclosure over major open social media sites could constitute public disclosure – as long as investors have been altered to what social media will be used to disseminate the information. “One set of shareholders should not be able to get a jump on other shareholders just because the company is selectively disclosing important information,” George Canellos, then acting director of the SEC’s enforcement division said in a statement at the time. “Most social media are perfectly suitable methods for communicating with investors, but not if the access is restricted or if investors don’t know that’s where they need to turn to get the latest news.”

Furthermore, Mr. Musk’s tweet was well documented and distributed in multiple news outlets such as CNBC or Bloomberg. In conjunction with Tesla’s blog post, it seems likely that the information was properly disseminated.

One note of caution: the SEC cautioned “issuers that a deviation from their usual practices for making public disclosure may affect [the SEC’s] judgment as to whether the method they have chosen in a particular case was reasonable.” In short, an issuer’s methods of making disclosure in a particular case should be judged with respect to what is “reasonably designed” to effect broad, non-exclusionary distribution in light of all relevant facts and circumstances. There could be some doubts here as no such announcement has ever been made on Twitter. But then, such announcement – being unique in its nature, i.e. the delisting of a company – has never been made in the history of the company either.

On Rule 10b-5 of the Securities Exchange Act of 1934

Rule 10b-5 is meant to prevent acts of fraud or deceit in relation to the purchase or sale of securities. This rule is frequently used in insider trading cases.

Rule 10b-5: definition

“Rule 10b-5: Employment of Manipulative and Deceptive Practices”:

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,

(a) To employ any device, scheme, or artifice to defraud,

(b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or

(c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person,

in connection with the purchase or sale of any security.”

For a claim to be successful, a plaintiff will have to show (i) deception or manipulation (through false or misleading statements for instance), (ii) materiality (of the misleading statement, meaning this would have impacted the decision to buy or sell the security), (iii) causality (the deception must be the reason you decided to buy or sell the security) and (iv) scienter (there must have been an intent by the other party to deceive you).

If any portion of Elon Musk’s tweet is untrue or even misleading, then Mr. Musk would be in violation of Rule 10b-5. From his tweet, it is unclear what “funding secured” means. And this is by far the biggest point. What does it mean? Is this a handshake agreement or is there a signed commitment letter? There are already reports that the SEC requested further information from Tesla. If this proved to be untrue or misleading, Tesla would soon be dogged with lawsuits.

How the Government murdered the buy-to-let market in London and the rest of the UK

The English Investor

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How the Government murdered the buy-to-let market in London and the rest of the UK

I don’t own a home yet in London. Like many millennials, I am saving enough cash to build a substantial down payment. My target is 25% of the house price, plus 5-7% for unforeseen expenses. Long story short, it takes time and discipline is key.

As an EU national, I’m quite sensitive to Brexit-related developments. I don’t plan to leave the UK (I love it here) but I’m still keeping an eye on the negotiations (or lack of) to assess any potential impact on my investments. For instance, we now know that the decision to leave the EU is a significant factor in the slowdown in London real estate prices. London house prices are a lot more sensitive to Brexit due to the number of EU citizens working and living in the capital. Even a slowdown in the number of EU citizens arriving in London is likely to weaken the demand for London homes. This is not simply due to a quantitative factor such as the number of people arriving and leaving. There also is a qualitative dimension: many EU citizens occupy high-paying jobs in the City requiring specific skill sets in finance but also the ability to speak multiple languages to cater to clients’ needs across the continent.

For those reasons, I am in no rush to splash a large amount of cash on an overpriced 2 bedroom + apartment in London. I first want to see if this slowdown will materialize itself in something bigger.

Having said that, it still hurts to lose money every day in a low-yielding saving account with inflation surging due to the continued weakness of the pound. I, therefore, thought about buying a studio or small one bedroom and rent it, whether in London or further north. I had two reasons: 1) I hoped the returns would be better than what I’m getting from my savings account and 2) the investment would have acted as a hedge, meaning that if house prices were to suddenly surge after an agreement was found with the EU, then I would have effectively bought the dip. I, therefore, looked into various metrics (such as regional house prices, downpayment requirements, taxes or expense deductibility to name a few) to see if this could be a worthwhile investment.

My conclusion is that a buy-to-let real estate investment is one of the less yielding and tax effective investments, especially for a millennial landlord who does not own his main residence in the United Kingdom. Here are my reasons supporting this conclusion.

Reason #1: Banks will refuse to lend you if you don’t already own your main home

This is self-explanatory: most banks will refuse to extend to you a buy-to-let mortgage if you don’t already own your main home. For instance, HSBC, which is the bank I use the most, was quite explicit on this: I had to show that I either owned a home in the UK or that I owned a piece of property abroad, with supporting documentation at hand and relevant certified translations, if required. I discussed this with a few of my friends and they ran into similar issues with their respective banks (Barclays, Natwest etc). I did not hire a broker to source a better deal. I suspect he would have found a deal, although at a significant premium in terms of interest rates.

I’m not sure I really follow the banks’ rationale here. I guess the assumption is that if you already own a piece of property, your net worth is higher and the risk of default on the buy-to-let mortgage is lower. This reasoning only holds if your main home is fully paid off (or close to being fully paid off). This may not, however, be true and you could already be significantly leveraged and have a huge portion of your mortgage to pay off. This leads to odd results: the potential investor with no debt is not allowed to have a buy-to-let investment but the already over-leveraged homeowner is eligible.

Besides, the bank will secure the mortgage with a lien on the buy-to-let property and will carry other due diligence checks. It is a bit of an odd standard to me, and I’m not sure I find it entirely fair either.

Reason #2: Buy-to-let investors are losing tax relief on their buy-to-let mortgage costs

Buy-to-let investors borrow to benefit from leverage. In practice, this means taking a mortgage and paying back interest to the bank. Once the property is purchased, the tenant moves in and pays rent, which is taxable income.

Historically, buy-to-let investors had a significant advantage over people who would purchase a property as their main home: they could offset their mortgage interest payments against the income earned from their rental property. First, you collected the rent. Second, you deducted the interest payments and other expenses incurred throughout the year. Third, you would pay tax on your net rental income (and not on your gross rental income). By doing so, the amount of taxable income would be significantly reduced, which meant less taxes due to HMRC.

Since April 2017, the tax relief available to landlords of residential properties is greatly reduced and will eventually be restricted to the basic rate of income tax, which is 20%. Essentially, you can no longer reduce your rental income (and tax bill) by deducting all mortgage interest payments. Instead, landlords are given a tax credit of 20% on their gross rental income. And as you can imagine, to landlords, especially those on interest-only mortgages, a 20% tax credit does not even come close to the ability to offset all financing costs against the rental income.

The changes are so bad that the government decided to phase in the application of the new regime so that the pain to landlords would be spread over 4 years. The phase-in regime is:

In the 2017-18 tax year, 75% of your pre-2017 mortgage tax relief can be claimed;
In the 2018-19 tax year, 50% of your pre-2017 mortgage tax relief can be claimed;
In the 2019-20 tax year, 25% of your pre-2017 mortgage tax relief can be claimed.

The changes hit higher rate and additional rate taxpayers the most because they don’t get all the tax back on their mortgage repayments. The tax credit only refunds tax at the basic 20% tax rate instead of the 40% or 45% tax rate to which they are subject.

Below is a table showing what to expect:

In my opinion, this is one of the biggest killers in the buy-to-let market. Newspapers consistently report that buy-to-let investors are now nowhere to be found and I suspect the changes to tax relief on financing costs is the primary reason. As the effect is phased in, I would expect landlords to slowly realize what is going on when they fill out their self-assessment. I believe that we will see an avalanche of studios and 1 bedroom apartments on the market in a few months’ time when landlords notice the higher tax payments and realize that they are no longer making any money (or not in sufficient amounts to be bothered to deal with tenants and real estate agencies).

Reason #3: Buy-to-let investors must pay an extra 3% of stamp duty

Since April 2016, individuals and companies need to pay an extra 3% of stamp duty if they buy an additional residential property in England or Northern Ireland. The surcharge applies even if the property you own is outside the UK. Buy-to-let investors often already own their homes and/or have multiple buy-to-let properties. They are therefore hit by the 3% surcharge. Below is a comparison of the existing stamp duty rates against the higher rate:

As an example, buying a second property worth £300,000 means that you are paying an additional £9,000 just with the extra 3% stamp duty surcharge. This is an addition to £5,000 for the regular stamp duty, bringing the total amount to a pricey £11,000.

One option to mitigate this surcharge is to incorporate a company and purchase the property through the company. This is one solution. However, there are costs also to running a proper company. From book-keeping requirements to company house filings, be ready to do a lot more work. In my view, this solution is only worth considering if you have a significant property portfolio. If you are buying a studio, I don’t think it’s worth the hassle.

Reason #4: Buy-to-let investors are subject to tougher lending criteria

The Bank of England recently rolled out strict new affordability tests. Buy-to-let investors must now pass new affordability assessments based on hypothetical “stress rates” of 5.5% for five years, regardless of the actual interest rate locked in by the borrower. Lenders have also moved to require rental income to cover 125% to 145% of mortgage costs (the rate may vary based on your tax band and lenders’ practices). Those stricter lending criteria also take into account the reduced tax relief now available to buy to let investors.

When I ran a few simulations with my HSBC counselor, this meant that my down payment had to be between 40% and 50% of the house price. Without a significant upfront down payment to reduce future mortgage payments, rental income is unlikely to be sufficient to cover the required 125% or 145% of mortgage costs. Sure, this reduces the risk of the investment because interest payments are lower as you are borrowing less. But I did not find those arguments to be very compelling and I thought the opportunity cost was too high.

Once again, first-time buy-to-let investors are the ones likely to be the most penalized. Other investors with larger real estate portfolios should be able to juggle the changes, especially if some of their properties are already fully paid off.

Reason #5: New energy efficiency measures are being introduced

Landlords must also now comply with new energy regulations. New tenancies or renewed tenancy contracts must now carry at least an E rating on the Energy Performance Certificate. Non-compliance can lead to a fine of up to £4,000.

This means that landlords may have to upgrade their properties to make them more energy efficient. I suspect some of those expenses may, however, be deducted and therefore reduce taxable income. Still, this is an outgoing expense that will impair cash flow, in addition to the hassle of dealing with contractors and tenant while the upgrade is carried out.

Key takeaways:

Focus on buying your main home first. Owning property through buy-to-let investments should come after as tax and regulatory changes make it too expensive.
Buy-to-let investments are still interesting for long-term investors whose portfolio have reached a critical mass to navigate the changes.
Incorporating a company will help mitigate some of those issues but the solution is not very practical.

Three lessons from Facebook’s 20% crash

Stocks
YOLO

The English Investor

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Facebook is a company for which I might have a bit of a love/hate relationship. Like the other 2.23 billion users as of the time of this writing, I spent a very large amount of time (see that understatement?) on the platform. This was especially true when I was in college and even grad school. At the beginning at least, the platform was incredibly effective at connecting classmates and sharing pictures or events. It was new, cooler than Myspace, and I loved it. Over time, the product had some iterations, and most of them were good (despite the traditional grandstanding of every user when Facebook introduced a minor design change).

Today I am no longer on Facebook. It is not because of the Russians and it has little to do when how my data is being used to target me with relevant ads (the data might not be sold technically, but let’s say it is sort of “leased” to businesses. It definitely has to be shared at some point with third parties so that third parties can tailor the ads based on your profile – let’s not be naïve here).

The real reason I left was that my newsfeed had turned into an endless stream of auto-playing videos. Most of those were either ads or BuzzFeed like videos. Meanwhile, my friends were no longer sharing content and had become passive consumers on the platform. I found that I had more time to myself as a result, although I lost touch with some friends with whom I could only connect through the platform.

While I no longer log in to Facebook, I have kept a close eye on its stock price and I did not miss the nearly 20% drop that we all witnessed last Thursday. The drop was the biggest single-day market capitalization wipe-out in US history: $120 billion, gone. I always thought that I was one of the outliers (with a few other friends) for leaving the social network but based on comments made by David Wehner, Chief Financial Officer of Facebook, it looks that this is becoming a trend in Europe. Indeed, in prepared remarks during the Q2 conference call, David Wehner noted that monthly active users and daily active users in Europe “were both down slightly quarter-over-quarter.” Is this the beginning of something bigger?

Beyond the large drop in market capitalization, here are a few things that are noteworthy.

Lesson #1 – Facebook was a crowded trade and we are back at the stock price of early May 2018. So not that long ago.

Facebook’s stock price closed at $217.5 on 25 July 2018 and closed at $176.26 on 26 July 2018. That is a massive drop. If you don’t believe me, please check out the chart below:

Facebook’s stock price for the week 23 to 28 July 2018.

If you held shares, your holdings lost approximately 20% of their value. If you held options expiring a month out, those have probably expired worthless, or are about to. That should be a 90% to 100% loss of the value of your holdings. Sure, it also depends when you bought it. Here, I am assuming that you bought in during the month of July to play Facebook’s earnings.

A lot of newspapers and websites covered the drop extensively. They commented at length on the reasons for the drop. They also pointed out how much of a hit Mark Zuckerberg’s net worth took (the estimate is $16 billion dollars if you wondered). Few, however, looked back at the stock price.

The chart below shows the progression of Facebook’s stock price in the last 6 months.

A six-month view of Facebook’s stock price

Even after this 20% drop, Facebook’s stock price is back at the levels it used to be early May, which was less than three months ago. Hindsight makes everything easy so I am not trying to tell you that I knew that it would drop. Instead, we now know that the stock price is still above the levels where it hovered during the Cambridge Analytica meltdown. It is fair to say that any stock that grows up by 20% in less than three months may turn out to be a crowded trade – short of some game-changing announcement. If you bought during the April dip, you actually still haven’t lost any money. Sure you lost some unrealized gains, but that’s still a gain. If you were playing options and held through earnings, that’s another story.

In the end, the market brutally corrected itself. The assumption was that Facebook would grow forever. The Q2 results showed that this may not be true. It is bad but it is not the end of the world. And as it turns out, you may not have lost any cash depending on when you got in the stock.

Put things into perspective. On May 14, 2012, Facebook’s stock price was at $38.32. This trade has been incredibly good to long-term investors.

Lesson #2 – If playing options, only put money you are ready to lose

Here, I am distinguishing between options and common stock (shares). The nature of shares is such that you can hold forever (or until the company goes bankrupt). If you believe that Facebook will be back at $200 by the end of the year: don’t sell. If you have cash left, buy the dip. To be clear, I am not advising you to double down. In fact, I would sit this one out until the end of the summer and wait for the dust to settle. You may not buy at the bottom but it is still a better option than trying to catch a falling knife.

With options, there are other variables at play such as volatility and theta. The point is that you cannot hold forever. If you hold long enough, you will suffer from decay. If you buy just before earnings, watch out for that IV crush. If at expiration, the stock price is below the strike price, your options are worth nothing. If they are above the strike price, then good, they are worth something. But then you might get assigned those shares so watch out for that margin call if you don’t have enough available cash in your brokerage account. Still following?

As options are incredibly riskier, you should only buy options with money you are ready to lose. If you don’t have any YOLO money to waste, at least make sure that the expiration date is a couple of months out at least. This will reduce the immediate (negative) side effects of theta.

Lesson #3 – It is incredibly hard to go against sentiment, even for a crowded trade.

Sentiment could be translated as the atmosphere surrounding a stock. A positive sentiment – also known as momentum – tends to result in a higher stock price. In other words, rising stock prices mean that there is a bullish sentiment. In the end, market sentiment can be viewed as the tone of the market.

There are entire strategies built around “market sentiment” and “momentum investing.” I put those two in the same basket but many people will disagree. Momentum strategy, for instance, aims at capitalizing on the continuance of existing market trends.

One “sentiment indicator” is volume. If there is higher than average volume, then one can conclude that there is strong interest in a given stock. If the stock goes up over an extended timeframe, then there is a trend that the sentiment is bullish.

Another indicator that I personally like is Reddit or another similar online forum. People tend to be very honest about their opinions behind the anonymity of a randomly selected username. They will give you their unfiltered view on anything, and this includes stocks. Sometimes, they may even upload a screenshot of their positions.

A couple of days before the Facebook earnings call, I was browsing certain chat rooms and threads on Reddit. The vast majority of people were long because they were hoping for a repeat of the Q1 results, where Facebook posted strong results in the midst of the Cambridge Analytica debacle. I assume the reasoning was somewhat along the lines of: “Facebook’s growth was strong when the press and politicians were beating down the company, things have calmed down since, nothing stands in the way of a strong Q2.”

I remember being surprised by the tone. It was not “Facebook may do well”, but “Facebook will crush again.” This was a reasonable hypothesis given the track record of the stock and the company. But it still made me uncomfortable. So I decided to throw $181 in a put option expiring on 27 July:

The definition of a YOLO

I bought one put option contract (100 shares) for $181 dollars. A day later, I sold the same contract for $2,920. That’s a 1,500% increase. Not bad for barely a day of work.

I would love to tell you that it was all planned. That I studied Facebook’s financials for hours. That I spoke to users about how often they used the product. That I found metrics online on how often the site was being pinged every day by region. That I had anticipated the GDPR effect before anyone else.

Of course, none of this is true. It was mostly luck. In fact, I was convinced that I would lose that money. Even losing such a small amount annoyed me as everybody else was convinced that Facebook would outperform and it seemed a sure trade. The only two reasons I still placed that bet (no other name to call this trade) was (1) the chatter pointed to a crowded trade and (2) this was also an imperfect hedge against my MU call options (which are not doing so well at the time of this writing).

This contrarian trade paid off, and of course, I wished I had put my entire net worth in retrospect. But sometimes, it’s good to just be content. If you have a hunch that something is not right but cannot prove it, put a sum that you are ready to lose. You will very likely lose your money but at least you won’t have any regrets. And if you are right, the returns are generally very (very) high.

Key takeaways:

For long-term passive investors, that 20% drop was not that bad;
If you play options, (i) only invest money you can lose and (ii) make sure that the expiry is a couple of months out;
Contrarian trades are the most profitable but are hard to find: invest a small amount at the beginning and avoid the regrets.

How to deal with delays, cancelled flights and compensation

Legal
Travel

The English Investor

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How to deal with delays, cancelled flights and compensation

August tends to be the month where everybody goes on vacation. From experience, this tends to be especially true for investment bankers, traders, and lawyers because financial markets are a bit slower. Or more accurately, financial markets are slower because nobody is at the trading desks.

With a historically low pound and an incredibly warm weather across the United Kingdom, you would be wise to spend your vacation in Scotland or Brighton. However, who can resist the French Riviera or Ibiza? I am also guilty, as I will be flying to South America in August for a wedding. If you cannot resist temptation (or can’t miss a wedding), you are likely to fly to your end destination, and possibly encounter delays or cancellations along the way.

It is important to know your rights when a flight is delayed or canceled. First, there is nothing more stressful than the sense of uncertainty that comes with not knowing whether your plane will take off and your holidays be ruined. If you know your rights, you can map a course of action to mitigate the damage. It will not remove the stress and disappointment but at least you might not end up completely out of pocket.

Under EU Regulation 261/2004, you may be entitled to up to €600 in compensation when your flight lands more than three hours late. For canceled flights, you have the fly to your destination on another flight with the same airline or receive a full refund if you end up not flying. Of course, some airlines will still come up with false pretenses or excuses to avoid compensating passengers. Personally, it has been unclear if this was due to poor staff training or genuine incompetence. In any event, let’s turn to the fine print to make sure you get what you are entitled to.

Who is eligible?

This right of compensations is rooted in EU law and essentially meant to cover EU airspace or EU carriers. Article 3 of Regulation 261/2004 states that the following passengers are eligible:

passengers departing from an airport located in the territory of a Member State to which the Treaty [the Regulation] applies;
passengers departing from an airport located in a third country to an airport situated in the territory of a Member State [EU country] to which the Treaty applies unless they received benefits or compensation and were given assistance in that third country if the operating air carrier of the flight concerned is a Community carrier.

Below is a cheat sheet of what the above means:

As you are probably flying from the UK, this means that you are eligible (at least until March 2019 – then you might want to fly with EU carriers).

What can you claim?

If your flight is canceled

If your flight is canceled, you have the right to be reimbursed within seven days, re-routed on another flight to the same final destination at the earliest opportunity or return to your original point of departure at the earliest opportunity.

In a city or region is served by several airports, if an air carrier offers a passenger a flight to an airport alternative to that for which the booking was made, then the air carrier must bear the cost of transferring the passenger from that alternative airport either to the airport of the booking or to another close-by destination agreed with the passenger. Therefore, if you were supposed to land at Gatwick airport but instead you landed at Southend airport, then you are entitled to free transportation to go to Gatwick, or another close by location agreed with the airline. This could be your home, especially if you live close by Gatwick or Southend.

In addition, you also have the right to assistance. This includes meals and refreshments, hotel accommodation if you need to stay overnight and transport between the airport and place of accommodation. You are also entitled to two phone calls, telex (who uses that?), fax messages or emails.

Finally, if you are informed of the cancellation of your flight less than two weeks before the scheduled time of departure, you are also entitled to compensation:

€250 for all flights of 1 500 kilometers or less;
€400 for all EU flights of more than 1 500 kilometers, and for all other flights between 1 500 and 3 500 kilometers;
€600 for all other flights not covered in (a) and (b).

If you are offered re-routing to your final destination, compensation levels may be reduced depending on the delay incurred. Compensation would be reduced by 50% if your delay was less than:

Two hours, in respect of all flights of 1 500 kilometers or less;
Three hours, in respect of all EU flights of more than 1 500 kilometers and for all other flights between 1 500 and 3 500 kilometers; or
Four hours, in respect of all flights, not falling under (a) or (b).

Don’t get me wrong. I’m not saying that a Coke and €400 will turn you into a very happy person after discovering that your flight got canceled. At least, you are getting something for your hassle.

If your flight is delayed

In my view, a delayed flight is where things get interesting. With cancellation, you are trying to salvage what you can. With a delayed flight, you are still suffering an inconvenience but at least you are getting to your destination and you are making bank at the same time if the delay is significant.

Under Regulation 261/2004, you were historically only entitled to the right to assistance (as described above) and, if your flight was delayed for at least five hours, reimbursement for the unused part of the journey or a return flight (whichever is relevant). Let’s note that this isn’t great compensation: you could be delayed over 5 hours, still use the same aircraft and route on that same day, and get nothing because you made it home just fine as expected. You would only get reimbursed if you decided not to fly (maybe if you had found a quicker flight with another airline – unlikely). I’m eager to hear your opinion on this. If you think I’m reading this wrong, do let me know.

You can see that a strict reading of the Regulation does not offer that much protection. It’s a nice to have, but hardly anything ground-breaking.

Five years after the issuance of the Regulation, things started to change with the European Court of Justice (ECJ). The 2009 case of Christopher Sturgeon and Others v Condor Flugdienst GmbH and Stefan Bock and Cornelia Lepuschitz v Air France SA (the “Sturgeon Ruling”) proved to be pivotal. The Court determined that the compensation rules should not just apply to canceled flights and cases of denied boarding, but also to delayed flights. Paragraph 61 of the ruling here is clear:

“In those circumstances, the Court finds that passengers whose flights are delayed may rely on the right to Compensation laid down in Article 7 of Regulation No 261/2004 where they suffer, on account of such flights, a loss of time equal to or in excess of three hours, that is to say when they reach their final destination three hours or more after the arrival time originally scheduled by the air carrier.”

The reasoning of the Court made sense. The Regulation allows for compensation for passengers who are delayed as a result of being re-routed. However, passengers whose flights are delayed (without being re-routed) do not acquire any right to compensation and therefore are treated less favorable even though, depending on the circumstances, they suffer a similar loss of time, of three hours or more, in the course of their journey.

To resolve this difference in treatment of passengers, the Court found that passengers also acquired a right to compensation when their flight was delayed.

Since the Sturgeon Ruling, we now have the following compensation levels for delayed flights:

Claims can usually be submitted through the airline’s website. Low-cost airlines such as Easyjet and Ryanair regularly deal with such claims and will guide you throughout the process. Make sure you keep a record of your flight number, the number of hours you were delayed and the reason for the delay. If you believe you have a legitimate claim, and that such claim was rejected by the airline, you can escalate the matter.

Airlines tend to take their time when it comes to dealing with compensation claims. This is often a combination of staff shortage and high volumes of claims due to multiple delayed flights. If you believe that you are entitled to compensation, claim promptly. First, the clock starts ticking for the airline to respond. Second, the details of the flights, distances, delay, and nature of the delay will still be fresh in your memory.

The catch: extraordinary circumstances

Claims will only be successful if the delay or the cancellation is the airline’s fault. This means that airlines are under no obligation to compensate for delays or cancellations that are due to unforeseen or extraordinary circumstances. As the Court pointed out, “a delay does not, however, entitle passengers to compensation if the air carrier can prove that the long delay was caused by extraordinary circumstances which could not have been avoided even if all reasonable measures had been taken, namely circumstances beyond the actual control of the air carrier.”

The Regulation does not define precisely what the term “extraordinary circumstances” and the Court only offered limited guidance in this respect. The Civil Aviation Authority lists the following events as extraordinary circumstances on its website:

Acts of terrorism or sabotage;
Political or civil unrest;
Security risks
Strikes (unrelated to the airline such as airport staff, ground handlers, or air traffic control);
Weather conditions incompatible with the safe operation of the flight; and
Hidden manufacturing defects (a manufacturer recall that grounds a fleet of aircraft).

On the other hand, anything related to technical or maintenance issues unrelated to manufacturing defects, strikes from the airline’s staff and overbooking will, for example, give rise to the right to compensation. As a rule of thumb, if you are unsure of your claim, you have nothing to lose by submitting it. You never know, it might all work out.

Readers who have recently traveled to the south of France, Italy, and Spain are likely to have been hit by the French air traffic control strikes. I was flying on an Easyjet flight from Nice to London towards the end of June and our flight was delayed. As the delay was less than three hours, I was not entitled to any compensation. I still got refreshments as we were over two hours late. But even if my flight had been delayed for more than three hours, I would not have been entitled to compensation because air traffic strikes are considered extraordinary circumstances. The “extraordinary” nature here is really debatable when the said strikes have been going on for months now… Airlines such as Easyjet, Ryanair, and IAG (the parent company of British Airways) all filed complaints with the European Commission over the French air traffic controllers’ walk-outs and strikes. Their claim is that France’s inability to resolve the strikes amounts to a breach of the principle of free movement within the European Union. This should prove to be an interesting case and we will keep an eye on those developments.

Key takeaways:

You are entitled to compensation for delays of at least three hours and cancellations;
Claim promptly as airlines tend to take their time to settle claims;
Delays due to extraordinary circumstances will not be compensated.

Why you are probably also paying 60% of tax on your income

Taxes

The English Investor

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Why you are probably also paying 60% of tax on your income

Let’s turn our attention to income tax brackets (or bands). It is generally a good idea to know how much income tax you are paying. Three reasons come to mind. First, you know how much net income you have left to save but also to invest. That’s crucial if you want to take control of your personal finances. Budgeting based on gross income can be perilous because gross income is usually not the amount available for you to spend and may lead you to overestimate the available cash at your disposal for any given month. Taxes but also social contributions and other potential deductions (made by your employer for instance) might affect your take-home pay. Second, government spending becomes more interesting. When you know how much the government is taking, this might spur a sudden interest to see how your money is being spent. If you disagree with how the government spends, then you have a ballot box to complain. This might be a bit idealistic but if it even works for a fraction of the population, then that’s a win for democracy. Third, the tax bracket you fall into is also a helpful indication of how the government views you: the higher the tax bracket, the more income you are supposed to have, the richer you are in the eyes of the government and society.

In the United Kingdom (Scotland excluded), as of the time of this post, we have the following income tax bands:

Source: https://www.gov.uk/income-tax-rates

For the sake of completeness, below are the tax bands for Scotland, which recently reformed the rates for various levels of taxable income:

Source: https://www.gov.uk/scottish-rate-income-tax

For the sake of simplicity, we will mostly focus on the UK tax bands, therefore excluding Scotland. The principles we discuss are however generally applicable to Scotland (absolute numbers may vary due to different tax rates).

Turning our attention to the UK tax bands, everything is quite self-explanatory if you make less than £100,000. For instance, if you make £35,000 a year, we have the following breakdown: the first £11,850 are untaxed, and between £11,851 and £35,000, the portion of your income is taxed at a rate of 20%. As described in the table above, the first £11,850 are untaxed: this is your personal allowance, meaning the amount the government allows you to keep without contributing to society. Not that paying taxes is the only way to contribute.

The more income you make, the highest the rate at which your additional income is taxed. This is essentially how progressive tax systems are supposed to work (this alone is a debate for another time). This principle of progressivity applies virtually everywhere, and especially in western economies.

However, in the United Kingdom, there is a catch. If your income exceeds £100,000, then your personal allowance – the income amount that is not taxed – diminishes. For people earning more than £100,000, the personal allowance of £11,850 is reduced by £1 for every £2 earned. Therefore, when someone makes over £123,700, then there is no personal allowance and one is taxed from the first pound earned.

According to HMRC, if you withdraw the personal allowance in full, the following income tax bands apply in Scotland and the rest of the United Kingdom:

Source: https://www.gov.uk/government/publications/rates-and-allowances-income-tax/income-tax-rates-and-allowances-current-and-past#tax-rates-and-bands

Excluding Scotland, the figures presented by HMRC are essentially a subtraction of the upper bound of a tax band minus the full amount of the personal allowance. For instance, for the higher rate in the UK (excluding Scotland), we have: 43,430 – 11,850 = 31,580.

This is definitely one way to look at it and the math does seem to check out. I, however, think this is misleading as it implies that the effective marginal tax rate is not increased, i.e. 40% or 45% would remain applicable because the underlying amount of taxable income is no longer the same.

In reality, the tapering of the allowance increases the marginal tax rate by approximately 20% because you are reducing the allowance by £1 for every £2 earned over £100,000. In other words, the tapering effectively adds 20p of tax on every pound earned over £100,000. This is in addition to the 40% tax rate that is applicable for income over £100,000 but under £150,000. Therefore, the marginal tax rate in the United Kingdom (excluding Scotland) is effectively 60% for the portion of the income subject to the tapering of the personal allowance as tax is now payable on previously tax-free income. We are far from the 40% tax rate, which is supposed to apply to income over £100,000 and under £150,000.

Not only this surpasses the 45% additional rate applicable to income over £150,000 but it also seems to top any income tax rate in Europe. Through a combination of local and national taxes, Sweden may reach close to 60%. France also amounts for a very high rate when one takes into social security contributions or special contributions on income over 250,000 euros.

Arguably, a 60% marginal tax rate dents the progressivity of the UK tax system. The tax rate is supposed to increase as the taxable amount increases. Here, a taxpayer will pay 60% on a portion of its income under £150,000 and then 45% on the income earned over £150,000. In my humble view, this is an anomaly. HM Treasury is unlikely to act as this would substantially reduce the amount of taxes collected.

Is there a way not to pay 60% on income over £100,000?

The most common piece of advice I hear is to sacrifice cash in one form another. The idea is to trade cash for non-taxable benefits (for example) so that the taxable income is brought back closer to £100,000 – where the tapering starts to bite – or even under £100,000. This is seen as a win-win scenario as your total remuneration remains the same but your taxable income decreases (and so is the portion of your income subject to the de facto 60% tax rate).

Subject to one exception, I don’t find this solution particularly enticing for two reasons. First, most benefits provided by the employer such as health and dental insurance are taxed. As those benefits are taxed, there is, in reality, no rebate of the personal allowance. Second, sacrificing cash disincentives the employee to make more money: you are trying to avoid the threshold by taking a step back – reducing your taxable income. A better option is to simply try to make more as quickly as possible to overcome the tapering of the allowance. Granted, this is not easy, especially in a country where pay rises have been sluggish. But it is really the only effective way long-term: pay the 60% effective tax rate and then make more to reach the 40% or 45% tax rate once you have overcome the full effects of the tapering of your personal allowance. It is difficult but not impossible. Gig economy and passive income streams are making it easier to generate additional sources of income that will allow you to get over the tapering of your personal allowance.

I mentioned earlier one exception where I think sacrificing cash makes sense, and that is pension contributions. Unless you are subject to the pension contribution tapering (another type of tapering to be discussed later), it makes sense to maximize pension contributions, especially if those are matched by your employer. Subject to your pension allowances, you would get tax relief at the full rate. Although recent reforms significantly curtailed the effectiveness of pension contributions for high earners, it remains one of the rare available ways to improve your tax position.

Key takeaways from this post:

Due to the withdrawal of the personal allowance, you are paying a 60% tax rate on a portion of your taxable income over £100,000
Pension contributions are most likely the only effective way to mitigate the effects in the long term;
Sacrificing your salary only makes it so far, at some point you simply need to earn more to overcome the tapering as quickly (and painlessly) as possible.