Monthly Archives: October 2013

The Athlete Stock Exchange Part II: The Duties of Athletes to Shareholders

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by Kyle Ohlenschlaeger

Nima Tahmassebi recently wrote on this blog an interesting post on a recent deal between Houston Texan’s running back Arian Foster and Fantex Brokerage Services, in which Fantex will be selling a 20% equity share in Mr. Foster’s future income. This was an excellent post that highlights some of the risks and rewards that are associated with an investment in Mr. Foster. It gave me pause, however, to consider the ramifications this deal may have on Mr. Foster’s future life and business decisions.

First, the initial public offering of these shares are undoubtedly the purchase and sale of a security, as shareholders will be making an investment of money in a common enterprise with an expectation of profits arising solely from the efforts of others, namely Mr. Foster. In general, corporate officers and directors owe both a duty of loyalty and a duty of care to their shareholders. Mr. Foster would undoubtedly fall under the broad scope of these requirements, as he will most likely be viewed as a corporate officer because of his discretion in determining his future earnings. The main concern going forward then, would be Mr. Foster’s duty to act in the best interests of the corporation.

Generally, decisions by corporate officers fall under the business judgment rule, a safe harbor for decision-makers that takes into account the fact that corporate officers know what is best for a corporation. As a result of this rule, corporate officers are not always required to take the best financial deal available at a certain time if there are other factors that could make the deal better in the long run. However, another principle rule is that officers cannot take a deal solely for the reason that it benefits them in a personal capacity while causing detriment to the shareholders.

This is the problem I see with Mr. Foster’s contract with Fantex. For those of us who pay attention to professional sports contracts, we know that money is not always the deciding factor for a player and whether or not they will sign with a particular team. For example, in July of 2010, basketball phenom Lebron James decided to sign with the Miami Heat despite the fact that the Cleveland Cavaliers were offering him significantly more money. This is because he felt the prospects of winning championships with Miami were higher than with Cleveland. This decision would probably fall under the business judgment rule because Lebron could foresee higher future earning potential if he won a championship based on larger endorsement deals.

However, another recent example is more troublesome. In December of 2003, baseball pitcher Andy Pettitte signed with the Houston Astros despite leaving about $7.5 million on the table by way of an offer by the New York Yankees. This decision came down to the fact that Mr. Pettitte’s home and family were located in Houston, and he wanted to be closer to them. This decision is much harder to justify under the business judgment rule, as there were lower prospects of winning a championship, as well as lower prospects of gaining new endorsement contract, as Houston is a much smaller market than New York.

Arian Foster currently lives in Houston with his wife, Romina, 4-year old daughter Zeniah, and 4-month old son Khyro. He is currently signed with the Texans through 2016, and will become a free agent following that season. It is safe to say that by that time he will have pretty strong ties to the Houston area. What happens however, if the Texans at that time offer him a significantly lower contract than another team, say the New England Patriots, located in Boston, Massachusetts. If Mr. Foster wants to take the contract with the Texans to stay close to his home, will he be violating his duties to his shareholders? To take this a step further, what if Mr. Foster wants to retire from the game and spend time with his children? Is that option taken away because he is required to maximize value for his shareholders?

These are all interesting questions as we enter the world of players being treated as assets. Further, I am sure there are things that can be done within the prospectus offering shares in Mr. Foster that will mitigate some of these future risks. But it still begs the question, is Arian Foster allowed to make decisions that benefit him personally but may have a detrimental effect on his shareholders?

The Athlete Stock Exchange: Can Big Time Players Make Stocks That Pay?

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By Nima Tahmassebi

If you’ve ever played fantasy sports, you understand the risk that comes with picking a player with a high round draft pick. Whether they succumb to injury, enter early retirement, or find themselves entangled in off-the-field issues, real threats can plague an athlete’s career at any given moment. Last Thursday, Fantex Brokerage Services announced a plan that could transform professional athletes into real life investment opportunities; a move that could turn potential threats to your fantasy football team into a serious risk to your investment portfolio.

Fantex is set to pay Houston Texans Pro Bowl running back Arian Foster $10 million for a 20% stake in his future income. This equity share includes Foster’s current and future contracts, endorsements, and other related business revenue. With this move, Fantex is now the first registered trading platform to let its investors buy and sell stock linked to the value and performance of a professional athlete. If Fantex and other brokerage services are able to generate a similar interest from other athletes, this move may be the first step in what could be a new investment medium centered on investing stock in professional athletes.

For a majority of professional athletes, the only thing certain in sports is guaranteed money. As a result, the idea of getting paid upfront may be too good of an offer for some players to pass up. Firms will not only pay these athletes for their current performance and future potential, but will also protect their investment by building and marketing their athlete’s brand image. Players who choose to take part in this deal may not realize how much money they’re potentially parting ways with if they’re successful both on and off the field. However, this agreement also provides them with an opportunity to hedge the risk on their playing careers, as the fifth-year running back Foster has done here.  Moreover, this unique opportunity presents a serious risk to an athlete’s privacy. Now that Foster is a publicly traded entity, his medical history, criminal history, and personal life are available on public record in a lengthy prospectus.

Potential investors also face unique risks and strategies with this new concept. The idea of investing in an NFL player, let alone a majority of professional athletes, is extremely high-risk. With a variety of factors contributing to expectedly short career spans, an investment linked to the career of a professional athlete could be highly volatile and should only be considered by those who can afford the loss of their entire investment. Those who can afford the risk, however, have multiple investment strategies to choose from. One could choose to make an investment early in a player’s career with the goal of eventually getting a percentage of a big contract. Another strategy may be to purchase stock in players who will continue to capitalize on their brand image long after their playing days. Creative investors may even look to short sell the stock of certain players with the hopes of turning a profit from the predicted decline in value.

Whether or not Fantex’s deal with Foster leads to a new world of investment opportunities, this is an exciting new twist in the world of securities. Professional athletes are a high risk, highly volatile investment; however, for to those willing to take the gamble, this could be the kind of endeavor that someday makes fantasy football look like child’s play.

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Technology for Automated Trading at its Finest…for Failure

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By Renee Kramer

On October 16, 2013, the Securities and Exchange Commission (SEC) announced that Knight Capital Americas LLC (“Knight Capital”) has agreed to pay $12 million to settle charges that it violated the agency’s market access rule in connection with the firm’s Aug. 1, 2012 trading incident that disrupted markets. (Knight Capital was formerly a subsidiary of Knight Capital Group and, as of July 2013, is now a subsidiary of KCG Holdings, Inc. Knight Capital Group’s biggest business was in market-making of U.S. equities for retail brokerages and it was known on Wall Street as the biggest trading firm.)

The SEC’s market access rule, or Exchange Act Rule 15c3-5, applies to broker-dealers with market access to an exchange or alternative trading system (“ATS”), as well as to broker-dealers that provide customers or other persons with that same market access. The SEC adopted the rule in 2010 because of the potential that firms were not properly managing placement of orders and thereby exposing customers to financial, regulatory and other risks associated with those order placements. The rule specifically prohibits broker-dealers from providing customers with “unfiltered” or “naked” access to an exchange or ATS. It requires firms to put in place risk management controls and supervisory procedures to help prevent erroneous orders, ensure compliance with regulatory requirements, and enforce pre-set credit or capital thresholds.

On the morning of Aug. 1, 2012, Knight Capital sent out a wave of more than 4 million accidental stock orders that resounded through the market and led to a $460 million loss for the firm.  Knight Capital maintains an automated routing system for its equity orders, known as SMARS. While processing 212 small retail orders placed by Knight Capital’s customers, SMARS routed millions of orders into the market over a 45-minute period and acquired over 4 million executions in 154 stocks for more than 397 million shares. By the time that Knight Capital ceased the orders, Knight had assumed a net long position in 80 stocks of approximately $3.5 billion and a net short position in 74 stocks of approximately $3.15 billion. After the incident, Knight Capital nearly went bankrupt as its stock price fell about 75% in two days and set off an investigation by the SEC.

The SEC explained that Knight Capital made two critical technology missteps that led to the trading incident on Aug. 1, 2012. Knight Capital moved a section of computer code in 2005 to an earlier point in the code sequence in an automated equity router, rendering a function of the router defective. Knight left it in the router, even though it had no use. In late July 2012 when preparing for participation in the NYSE’s new Retail Liquidity Program, Knight Capital incorrectly used new code in the same router. As a result, certain orders eligible for the NYSE’s program triggered the defective function in Knight Capital’s router, which was then unable to recognize when orders had been filled. Apparently, on the morning of Aug. 1, 2012, 97 automated emails were sent to a group of Knight Capital personnel that identified an error before the markets opened but Knight Capital did act upon them.

The SEC’s investigation found that the firm did not adequately safeguard market access in the disruptive trading incident, nor did the firm sufficiently review its controls. The SEC’s order requires Knight Capital to pay a $12 million penalty and retain an independent consultant to conduct a comprehensive review of the firm’s controls and procedures to ensure compliance with the market access rule. Without admitting or denying the findings, Knight Capital consented to the SEC’s order, which censures the firm and requires it to cease and desist from committing or causing these violations.

For a copy of the SEC’s order please see: SEC Order – Knight Capital

Broker Recruiting Practices Revealed: Firms May Soon Have to Disclose Bonus Packages

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By Bernadette Sadeek

If firms want to recruit high-producing brokers, they may soon be required to disclose their bonus incentive packages to customers. On September 19, 2013, the Financial Industry Regulatory Authority (FINRA) Board of Directors approved a proposal to require disclosures of conflicts of interest relating to recruitment compensation packages incentivizing brokers to move to a new firm. The proposal is now being considered by the Securities and Exchange Commission (SEC) for final review and approval. The SEC staff may request changes or amendments to the rule proposal.

There are two main components of the proposed rule. The first is a disclosure requirement, obligating “recruiting firm[s] to make important disclosures to a registered representative’s former customer who is contacted about following the representative to the recruiting firm or who decides to transfer assets to the new firm.” Firms would have to disclose any upfront payments (e.g. guaranteed bonuses and loans) and potential future payments (e.g. compensation contingent upon satisfying performance criteria or special payments not ordinarily provided to similarly situated representatives) and the basis for receiving the potential future payments. The disclosure would be required if the broker’s compensation package exceeds $100,001. However, the amount of compensation would only be required to be divulged in ranges, i.e. $100,000–$500,000, not the precise dollar amount. Lastly, because switching firms could be costly to investors, firms would also have to disclose the costs that would “accrue if a customer decides to transfer assets to a new firm” as well as the fact that “certain assets may not be transferrable.”

FINRA states that the purpose for requiring these disclosures is to allow the customer to make an informed decision about the implications of following the broker to the new firm. Many firms offer significant financial incentives to recruit brokers to join their firms and to transfer their book of business to the new firm. A typical compensation package is paid upfront to the broker in the form of a 10-year forgivable loan. The compensation package is usually based on the broker’s 12-month gross production or revenue produced in fees and commissions during the past year at the broker’s old firm. Other factors that may influence a broker’s bonus package include the firm from which the broker is transferring, the broker’s book of business, and the broker’s years of service and experience. The offer is typically an irresistible financial package, sometimes reaching up to several million dollars and exceeding three times a broker’s annual production. At some firms, the compensation package will include a combination of a forgivable loan and an annual bonus that equals the annual installment due on the loan at the time the loan payment is due. As part of this package, each year, the broker is expected to meet or exceed a sales goal in order to be “forgiven” for a portion of the loan.  If the broker fails to meet the sales goal, the broker is obligated to pay installments on the loan, plus interest.  Consequently, brokers may feel pressured to sell securities as high levels, or worse, engage in conduct that may violate obligations to investors (i.e. recommending unsuitable investment products or churning customer accounts), in order to generate enough fees and commissions to meet the firm’s expectations.

Meanwhile, an unassuming customer would be completely oblivious that this arrangement creates a significant conflict of interest. While the broker is bound by the duty to recommend and operate in the customers’ best interest, the bonus packages incentivize brokers to generate more costs to the customer. Therefore, the disclosures are intended to provide transparency and to protect customers from the conflict that arises when the customer follows the broker to a new firm. Customers would be able to make a fully informed decision to follow the broker to a new firm and understand the costs and other implications associated with transferring his or her account.

The second component of the proposed rule is a reporting obligation—requiring a “recruiting firm to report to FINRA when a representative is expected to receive [either] an increase in total compensation over the prior year of 25 percent or $100,000, whichever is greater, in connection with the transfer to that firm.” FINRA would use this information to compile an industry-wide risk-based examination of compensation packages as it relates to sales abuses.

Some firms who oppose the rule warn the proposed rule is anti-competitive in nature because it would limit compensation and discourage brokers from seeking new employment at another firm. However, the problem of broker sales abuse due to pressures associated with the recruiting practices of the industry has persisted for many years. This proposed rule is a step towards preventing such abuses relating to conflicts of interests between firms, brokers, and their customers.

To view a short video detailing this report, please see the FINRA Regulation Guidance Video