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No Basis for Trust 2

The author is not an attorney and this post should not be construed as legal advice. 

The grand dream of printing money from thin air remains alive and well in crypto.

As it gradually dawns on promoters that selling unregistered securities to retail investors is against the law, attention has pivoted to maintaining access to trading venues. Secondary market trading is essential because it provides the mechanism for coin offering participants to have an expectation of profits from greater fools. The market seems to have wised up to the fact that most coin offerings were just fundraising schemes for issuers without the quaint norm of “repayment,” but between “initial exchange offerings” and “stablecoins” the idea of the moment is to raise money for an exchange or for a refundable token to be used on one. (This is darkly efficient, as it provides hard currency for the venue’s immediate use rather than requiring it to wait for the speculator first to lose the deposit gambling).

Cryptocurrency exchanges have developed a nasty habit of losing their private keys, customer funds, and access to the banking system. In the US, there may come a day when operating an unregistered broker-dealer stops passing muster with a reckless minority of the securities bar or authorities act to enforce laws against selling securities without registration. In the meantime, stablecoins have gained momentum as a solution to these potential access barriers, creating a transferable on- and off-ramp to even the most untrustworthy cryptocurrency exchange without the unwanted regulatory limitations of handling fiat currency. From the standpoint of the promoter, if redemption of a purportedly redeemable stablecoin can be discouraged or prevented altogether, so much the better: The hapless user has no choice but to buy other digital assets, driving up their price. (A good explanation of how this might work is posited in a Twitter thread here).

Stablecoins look like securities to me.

With stablecoins popping up right and left, some of the more prominent projects have begun to attract scrutiny. Observers including members of the defense bar and Valerie Szczepanik of the SEC have recently observed that stablecoins can resemble investment contracts. A coin that promises redemption, especially when sold at a discount, looks awfully similar to a zero-coupon bond to me. It is a contractual obligation of the issuer to repay a fixed amount of principal on demand. How is that not a security? In my view, the Howey prongs are satisfied because there is clearly an 1) investment of money in a 2) common enterprise (the issuer, which provides custodial services and a peg algorithm) with 3) an expectation of profits (whether from the reversion of the discount or the facilitation of trade in other securities or commodities, especially those provided by an affiliate of the coin issuer) which 4) come from the efforts of others (the coin issuer’s redemption activities or its affiliate’s operation of an exchange or brokerage business).

Some well-known stablecoins that appear to fit this model include:

Tether  — the Bitfinex affiliate, which restricts redemptions and faces credible fraud allegations, recently admitted publicly for the first time that its purported backing is not based on fiat currency. Tether is widely believed to be a transmission mechanism for cryptocurrency market manipulation. It can be bought and sold (even borrowed and sold short), just like a fixed income security.

Basis — recognizing that its token would be deemed a security under US law, Basis shut down late last year.

Gemini Dollar — GUSD caused controversy by selling its token at a discount to market makers, only to refuse to honor their entirely predictable redemption requests. Purchasing GUSD at a discount to $1.00 created an immediate expectation of profits, were Gemini to honor a redemption demand at par value.

What about TrueUSD and the TrustToken platform?

Though all stablecoins are worthy of criticism, I want to spend the remainder of this post picking on TrueUSD because they introduce a novel and, in my opinion, entirely incorrect legal analysis into the debate. Like the misguided concept of “utility tokens” that encouraged startups to engage in unregistered securities offerings based on minority legal views, publicizing incorrect legal claims throws sand in the air and can give cover to bad actors looking to take advantage of retail investors. TrueUSD deserves credit for registering as a money services business and attempting to address some of the issues with schemes like Tether. TrueUSD purports to hold audited fiat collateral in escrow and require KYC and AML checks on purchasers of its token. Though commendable, these efforts do not save the token from its potential status as a security. Whether or not coinholder funds are escrowed or held by a regulated trust is a red herring. Stablecoins that promise a right of repayment are ultimately liabilities of the coin’s issuer — if they are not securities, those liabilities at a minimum resemble demand deposits that may require a banking license.

As I was drafting this post, TrueUSD announced an alarming new partnership with Cred, an apparent unregistered finance lender that is “not a bank” but is making or intends to make deposit-funded commercial loans. Cred is itself a token issuer, which claims to have raised $26 million in an unregistered securities offering (more popularly known as an “ICO”) of its LBA token in 2018. The partnership creates an expectation for TrueUSD purchasers that the efforts of Cred will provide TrueUSD holders with the potential to profit from 8% annual interest.

I believe TrueUSD should file a registration statement and offer the token only in compliance with the securities laws, which would, in turn, limit its use to trading venues that also properly registered with the SEC. The current list of exchanges that trade TrueUSD does not include any such venue.

In its published FAQ, TrueUSD states:

“Will TrueUSD tokens be classified as securities?

Our legal counsel has provided a memorandum that TrueUSD tokens are not securities. They are more akin to deposit & safekeeping receipts, which the SEC has previously analyzed and recommended no enforcement actions for their use (see 40 Fed. Reg. 1695 et. seq).”

TrustToken’s legal counsel Michael Bland did not respond to a LinkedIn message requesting a copy of the memo. Let’s look more closely at 40 Fed. Reg. 1695 et. seq..

The citation is to interpretative guidance issued by the SEC in December 1974 along with three no-action letters provided to sponsors of gold-backed investment offerings. When restrictions on private ownership of bullion were lifted, issuers sought to meet demand for gold and address storage constraints by buying bullion and selling deposit receipts to investors. The SEC determined that X, Y, and Z, respectively a bank, commodity dealer, and registered broker-dealer, could sell receipts to investors without registering an offering under the Securities Act of 1933. The analysis concluded with language consistent with recent SEC commentary regarding coin offerings: “The arrangements described in the foregoing no-action letters are only three of a number of proposals for the public offering and sale of gold which have been brought to the attention of the Commission. Some of these appear to involve the offering of a security and others do not. This would depend upon all the facts of a particular case, and variations in the facts of such cases may lead to different results.”

So, is TrueUSD distinguishable from the non-security gold offerings granted no-action relief in the 1970s?

Facially, TrueUSD is the opposite of a deposit receipt created due to demand for underlying gold bullion — demand for a stablecoin is driven not by demand for underlying dollars, but instead by a desire to avoid using dollars on a cryptocurrency exchange that is untethered to the financial system. There are other major differences. In granting no-action relief, the SEC highlighted certain facts that the gold bullion issuers had in common (emphasis added):

(1) It does not appear that, in the gold investment program described in these letters, the economic benefits to the purchaser are to be derived from the managerial efforts of the seller, promoter, or a third party

(2) It does not appear that the services to be offered In connection with these offers to sell gold rise to the level of being those essential managerial efforts upon which the purchaser must rely in order to make a profit from his purchase. In this regard:

a. The purchaser will pay full value in cash for the gold purchased and purchases will not be made on margin.

b. The depository arrangement is limited to the storage of the gold with a reputable storage facility, insurance against loss or theft from the storage facility, and the issuance of a document which would evidence, the right of the purchaser, or his successors and assigns to take possession of the gold; and

c. Neither X, Y, Z, nor anyone acting on their behalf has any obligation to repurchase the gold or ownership documents from the purchaser, nor to sell such gold or ownership documents for the purchaser’s account; but they may repurchase the gold at the then prevailing market price.

TrueUSD, like other stablecoins, is immediately distinguishable from the gold bullion deposit receipts described in 2(c) because of its redemption mechanism. The company variously notes that it has an obligation to repurchase and even notes the possibility of profiting from that service: “Since traders can always trade TrueUSD for the equivalent USD on, there will be an incentive to buy or sell mispriced TrueUSD on exchanges and convert on” (FAQ) and “TrueUSD holders can purchase or redeem TrueUSDs for US Dollars held in escrow accounts managed by our fiduciary network through the Platform. The Platform is intended only to facilitate such purchases and redemptions” (Terms).

Unlike the gold bullion receipts, TrueUSD is intended as a negotiable instrument to be traded on a secondary market, and the economic benefits to the purchaser arise in part from the managerial efforts of the seller, including its efforts to list the coin on various exchanges. The efforts by the exchanges to list and promote the token further distinguish TrueUSD from the receipts described in (1) above. Furthermore, Letter 2 even goes so far as to state, “Receipts would be in non-negotiable form for the protection of purchasers.” Receipts could only be transferred or assigned through Y with a signature guarantee. Plainly, the SEC was already alive in 1974 to the possibility that a freely tradable instrument would raise investor protection concerns contemplated by the securities laws.

Legal inaction

The TrueUSD website currently states, “The TrueUSD team has developed a legal framework for collateralized cryptocurrencies in collaboration with WilmerHale and White & Case.” An earlier version of the site referenced elsewhere stated, “TrueCoin has developed a legal framework for collateralized cryptocurrencies in collaboration with Cooley and Arnold & Porter.” I’m not sure which of these firms actually developed the supposed legal opinion that TrueUSD is entitled to rely on the SEC’s 1974 no-action letters concerning gold bullion deposit receipts. Nor is it clear which of them intended to lend their reputations to the project by virtue of providing legal advice in some other context. The attorneys of WilmerHale, White & Case, Cooley, and Arnold & Porter all have significantly more experience and knowledge of the federal securities laws than I do, so perhaps I’m missing something. A plain reading of the no-action letters, however, does not appear to provide the type of relief upon which the company purports to rely.

More importantly, TrueUSD and its legal advisors, like so much of the cryptocurrency industry, evince a level of contempt for regulation that perplexes me. Technological innovation need not require open conflict with existing regulation: The SEC has repeatedly indicated that it wants to hear from companies in the industry. Why hasn’t TrueUSD requested no-action relief of its own?

Attorneys often advise clients to rely upon no-action letters and guidance when there is a clear similarity in the fact pattern. It takes a tortured reading of such authority to see that here. Where there is doubt regarding the application of securities laws to a new business venture, attorneys may make a risk-based assessment of the costs of non-compliance and likelihood of enforcement. The normal course by conservative, risk-averse legal counsel would be to request a no-action letter from the SEC when there’s uncertainty about a proposed business. Announcing to the world you’re relying on inapposite guidance falls on the other extreme of that spectrum.

A note on Cable Car’s Blog

You may be forgiven for wondering why this site has hosted no new blog posts for more than a year, and now all of a sudden it’s a priority to write dry legal analysis of a cryptocurrency scheme that may well disappear on its own. Other than short sales of public companies that claim to be developing blockchain-related projects, Cable Car does not even invest in crypto. My interest in the sector has been motivated by broader concerns regarding investor protection and securities regulation.

With the launch of The Funicular Fund, LP last year and the firm’s transition away from managing separate accounts, I had administrative priorities that took precedence over this soapbox. What thoughts I’ve wanted to share publicly have been diverted to Cable Car’s letters, public comments, and the instant gratification of Twitter’s echo chamber.  However, the purpose of this blog remains to share opinions with the investment community that do not fit neatly into another forum. I’ll continue to do that when I get the chance! Feedback remains very much appreciated. As before, no content on this blog should be considered investment advice or an offer of securities. It is certainly not legal advice, either.

2018 Letters

Cable Car published its Spring 2018 letter earlier this year. The Summer 2018 letter sent to clients today references a private securities offering and is available along with further details upon request.

Cable Car is no longer soliciting separate account clients and is in the process of converting to a hedge fund.

Please view important disclosures regarding performance reporting.


Don’t buy Bitcoin. 3

Clearly, what the Internet needs right now is another opinion on Bitcoin (no position).

On the other hand, gentleman, what if we gave a war and EVERYBODY came?

Gary Larson, The Far Side (1982)

With hundreds of newly formed funds, commentators proclaiming the birth of a new asset class, and the general public beginning to take notice of the world’s largest confidence game, it is a fait accompli at this point that huge sums of capital will be allocated to cryptocurrency. That is unfortunate. Generally lost in today’s breathless predictions that a proportion of the world’s wealth will flow into cryptocurrencies, especially Bitcoin, is any reasoned discussion of whether it should.

Aside from some excitement about the potential applications of distributed ledger technology, which are legitimate if somewhat overhyped, there appears to be widespread acceptance that the bulk of these allocation decisions are circular. Capital is flowing into the sector primarily because prices are rising. In turn, prices are rising because of the anticipated inflow of capital. Indeed, many cryptocurrencies are deliberately structured to increase in price as their use increases, a virtuous cycle that proponents hope will reflexively result in increased acceptance. They are not incorrect, which is all the more reason we should hope they do not succeed.

Advocates of Bitcoin correctly hypothesize that the price of Bitcoin must be stratospheric if even one percent of global savings were allocated to it. Yet who in their right mind actually thinks that would be a good idea? Bitcoin’s defining characteristic is extra-legality, and its primary function is to enable transactions that are impossible within a regulated system. Whatever you think of its technological usefulness or lack thereof today, Bitcoin has indisputably been the leading new payment tool of criminals for the past few years. Whether that seems more like a feature or a bug to you, it has resulted in a distribution of resources concentrated in the hands of money launderers, offshore tax evaders, drug dealers, and various other people who have no business managing the world’s money supply. To top it off, the largest holdings are controlled by an anonymous cadre of individuals so mysterious that there is half-joking speculation that its pseudonymous creator could be Kim Jong-un, Vladimir Putin, or various other unsavories. Surely, enormously enriching this group of people is not a desirable outcome. Other digital currencies suffer from the same problem; widespread adoption represents an extraordinary redistribution of wealth to private hands, who are in many cases some of the worst elements of society.

By now, it has been widely demonstrated that the price of Bitcoin, much like a low-float stock, is being actively manipulated through wash trading, abusive margin policies on offshore exchanges, and frequently outright theft. Bitfinex, an exchange in Hong Kong which has had its access to the banking system rescinded and bears hallmarks of a Ponzi scheme, has been a key contributor to the rise. Credible allegations suggest that over $800 million of purported transaction volume on the exchange, which is unlicensed, has resulted from the creation out of thin air of a pseudo-dollar equivalent called Tether, issued by a Bitfinex affiliate. A substantial proportion of the price increase in Bitcoin this year may be attributable to transmission effects from Bitfinex. Critics of Tether question whether dollars actually back the issuance of Tethers, as the company claims, but this may be the wrong question to ask. From appearances, Tether’s liabilities are not so much end-user claims on it as they are claims on Bitfinex that represent customer deposits, never to be recovered. Like most bucket shops with aggressive margin policies, Bitfinex can be expected to convert its customer balances to owned capital over time. The new Tethers being created may well represent Bitfinex’s historical and anticipated takings from its customers. Perhaps you feel little sympathy for gamblers, but it’s the less educated and the desperate who most often end up left holding the bag. Buying Bitcoin today and contributing to its price increase directly facilitates the continuation of an inequitable wealth transfer.

With that backdrop, I don’t see how any responsible fiduciary can argue with a straight face that Bitcoin is an acceptable part of a customer’s portfolio. The introduction of regulated, exchange-traded futures next week promises to make it easy for many more institutions to trade Bitcoin, or something like it, and there is so much volatility that there are sure to be profitable trading opportunities as a result. No doubt it is futile to suggest that any member of the financial industry ought to deliberately avoid an opportunity to profit due to ethical concerns. But curmudgeon that I am, I think the better course of action is not to participate.

Certainly one would be foolish to short Bitcoin outright, given how demonstrably easy it is to manipulate the price to almost any level. Perhaps investing one percent of the world’s wealth in put premiums is a more reasonable course of action. Otherwise, what if we gave a war and nobody came?

FX Antitrust Litigation Settlement 1

Disclosure: Cable Car is party to a referral agreement described below. Long RTRX.

As mentioned frequently over the past few years, Cable Car is a long-time shareholder of Retrophin (RTRX). Following events in 2014 that are well known, RTRX reached a modest settlement in a shareholder derivative action last year. Claims were due last June, and 15 months later, in October of this year, a few Cable Car clients from 2014 finally received a distribution from the settlement fund. After proration, the recovery was less than $0.02 per share held at the time, but it was better than nothing!

At three years from event to disbursement, the RTRX settlement was relatively quick by the standards of securities litigation. However, there was still a great deal of paperwork and effort involved in securing even such a modest recovery. As a result, I took more than passing interest in a recent solicitation from a claims recovery service offering to file similar claims on my behalf. To be frank, it wasn’t really a great use of time to file the RTRX claim. I was also intrigued because claims recovery services have an appealing business model: in exchange for dealing with the headache of filing and managing long-duration litigation claims, the service works entirely on contingency, retaining a percentage of the eventual recovery (usually 25%). That seems like a mutually beneficial proposition, especially for smaller claims. The firm that reached out to me is a public company subsidiary, and I was interested to learn more about the approach.

The most significant opportunity at the moment is a $2.3 billion antitrust settlement regarding foreign exchange rate-fixing allegations against 15 major investments banks covering expansive conduct from 2003-2015. Cable Car did not have significant activity that qualifies, but I did go through the exercise of submitting a claim for a handful of personal futures trades from 2009-10, just to see how the process works. Sure enough, it was a lot of paperwork for a claim that will most likely result in only a $15 de minimis recovery, so I can see the appeal of working with a third party.

Most large investment firms are likely to have had at least some transactions covered by the settlement. To my readers who manage investment firms or work at funds: you should look into this or mention it to your CFO. If you traded any foreign exchange derivatives or spot whatsoever (whether OTC directly with the defendants, on-exchange, or through an ECN) from 2003-2015, you are likely to have eligibility to file a claim, which could be significant.

To learn more and file a claim yourself, visit

If this is the kind of thing you don’t want to bother with, there is also the option of engaging a third party to do it for you. When I spoke to the claims recovery service, they offered a referral fee for introductions from my network. If we already know one another and it’s something that might be of interest to you, let me know and I’d be happy to introduce you. To reiterate, you can and should file a claim yourself if you are eligible. However, if you prefer to have assistance, this post is just to somewhat sheepishly say that I’m willing to accept a modest referral fee to introduce you to someone who can help.


Disclosure: No position in EXAS.

Remember Exact Sciences?

In 2015, I argued unsuccessfully in a series of public comments and an oral presentation that the proposed Medicare reimbursement rate for the company’s Cologuard test was too high. While Cable Car’s investment positioning at the time was validated by a subsequent advisory panel decision, the public policy outcome was not what I had hoped for. I believed then and continue to believe that the company cleverly exploited technicalities in the process for establishing new codes on the Clinical Lab Fee Schedule to receive a payment rate far exceeding the level that would be cost-effective in population screening.

The rate-setting process was reformed by a rulemaking mandated by the Protecting Access to Medicare Act (PAMA), which with effect from January 1, 2018 is supposed to establish market-based reimbursement rates. PAMA was intended to reduce costs to Medicare by basing future reimbursement amounts on the rates determined by commercial payors. At least in theory, commercial payors can conduct thorough cost-effectiveness analyses and determine payments through competitive forces in the marketplace. In practice, there are issues with this approach as well. During the draft rulemaking, Cable Car submitted a public comment noting that for some tests, like Cologuard, the price in the commercial population and the price for the Medicare population really should not be the same. Unfortunately, CMS received over 1,300 comments on the proposed rulemaking and did not specifically address this concern.

Disappointingly, it now appears that an additional loophole in the data collections process under PAMA will enable Cologuard to receive another 3 years of above-market reimbursement. Thanks to a provision in the final rule inserted after comments from the lab industry, the definition of “applicable information” used to determine reimbursement rates excludes any test where the company appealed a reimbursement rate from a commercial payor. EXAS appears to have challenged a significant proportion of its test volume during the relevant period, delaying payment outside the collection window and enabling the company to report only favorable reimbursement rates.

During the relevant time period, EXAS had an average commercial reimbursement rate I estimate from its financial filings at about $321 per test. Yet based on the interquartile range and weighted median data published by CMS, more than 75% of the test volume submitted under PAMA was reimbursed at or above $508.87. I believe the company’s policy at the time was to appeal virtually every commercial reimbursement that came in significantly below the Medicare rate. Even when those payment decisions were resolved in the payor’s favor, they were excluded from the data submitted under PAMA.

PAMA imposes stiff civil monetary penalties for misrepresentations and omissions by reporting laboratories, and importantly I’m not suggesting that EXAS knowingly misrepresented the commercial reimbursement for Cologuard. Instead, it appears they once again took advantage of the rules as written. They made a great return on investment for their 2016 lobbying spend.

Although past experience suggests it will have limited impact on policy, I have written another public comment to CMS to shine light on this situation, primarily in hopes of improving the PAMA data collection process in the future and ensuring that data was accurately collected this time. Exact Sciences CFO Jeff Elliot was kind enough to give me time last week, but provided the following statement:

Exact Sciences disagrees with the assumptions and assertions in your comment letter, and we noted multiple factual inaccuracies. While we would encourage you to check your facts and your analysis further before submitting your letter, we don’t intend to respond on a point-by-point basis.

I have made every attempt to avoid factual inaccuracies and will gladly make corrections if requested.

Although EXAS is trading near all-time highs, I have not held a short position for more than two years. There was some public discussion of the likely impact of PAMA earlier this year which briefly excited some short sellers. I take no pleasure in having known better.

PDF icon Read the public comment

Dirty Water 5

Disclosure: Short Cadiz (CDZI). This post expresses personal opinion about the company’s political strategy. It is not an investment thesis. Cable Car has no relationship with any of the individuals mentioned herein.

When a public company attacks a short seller, buyer beware.

After years of litigation and bureaucratic wrangling, management’s mounting frustration with the drawn-out approval process for the Cadiz water project is understandable. Proponents of the company’s increasingly long-shot project must have been upset by the October 2015 Bureau of Land Management (BLM) decision preventing it from using an obscure loophole to sidestep a federal environmental review.

Under the circumstances, Cadiz’ aggressive and expensive political response could be forgivable. However, the company’s August 2016 decision to engage in a coordinated smear campaign against an investor and a junior BLM staffer was unfair. The company’s disappointment at political setbacks does not justify public character assassination, nor does Cadiz advance its cause by making unfounded accusations.

Through a FOIA request, Cadiz obtained a series of emails between a BLM employee and Thomas McGannon, a partner at an investment adviser researching the water project. Cadiz issued a press release claiming the emails revealed the BLM decision “lacked objectivity” and provided the documents to the Wall Street Journal, peddling a thoroughly biased interpretation that accused the BLM and Mr. McGannon of impropriety. Perhaps swayed by its own political preferences (Senator Diane Feinstein, D-CA, is the lead opponent of the Cadiz project), the Journal published an unconscionable editorial, “The Pipeline and the Short Seller,” that unjustifiably accused Mr. McGannon of insider trading. The editorial noted that Cadiz provided the emails to the author, and Cadiz quickly amplified the editorial with another press release.

Call for retraction

Investors more accustomed to the investigative journalism the Journal is known for should be offended by the use of its mouthpiece for a company with a history of stock promotion at the expense of the reputation of a member of the investment community. I believe the Wall Street Journal owes Mr. McGannon an apology and retraction for its arguably defamatory editorial. The editorial falsely stated that “one Cadiz investor had inside information that could have allowed him to make a killing” and that the BLM “shared non-public information” with him.

In my opinion, the information exchanged in the emails was neither material nor non-public. Parts of the exchange sought informal views on whether proposed project modifications would be subject to BLM jurisdiction, not any indication of how the BLM might rule on an alternative. The rest concerned primarily procedural updates on the timing of BLM deliberations, not any indication of the likely outcome.

Administrative process timelines are a matter of public record. While agencies have FOIA procedures for releasing more extensive material including internal documents, which are also public information, it is entirely proper for government employees to share quotidian process updates with any member of the public who calls or writes to ask. Investors routinely interact with government agencies in this manner. Furthermore, there is nothing wrong with requesting information that an agency can choose not to release. Erik Pignata, the BLM employee with whom Mr. McGannon corresponded, made clear in one email that he could share only scheduling details, not the outcome of internal BLM discussions.

The Journal also makes hay of the time elapsed between emails and the fact that Mr. McGannon and Mr. Pignata also spoke on the phone. This amounts to an entirely unsubstantiated suggestion that the BLM FOIA office broke the law by failing to release relevant records. There is nothing in the FOIA response that suggests any emails are missing. And while it is theoretically possible that a phone conversation could have revealed non-public information, there is no evidence whatsoever for such an inflammatory suggestion.

According to Cadiz, the company’s requests for status updates from the BLM went unanswered. If their correspondence was also directed to Mr. Pignata and if he did not provide timeline details to Cadiz, he erred in not being equally responsive. Yet despite Mr. McGannon’s expression of opinions, there is nothing in the messages that indicates any substantive bias against the project from Mr. Pignata or his superiors at the BLM. Only a single comment from Mr. Pignata, after the decision was announced, implied that one controversial aspect of the local environmental review might have been “shady.”

The editorial was published in August, but I’m just now writing about it because it took time to receive a reply to my own FOIA request. I obtained the same series of emails by requesting the response provided to Cadiz. I am publishing that response in full here, as the Journal might have done instead of selectively quoting out of context. In my view, Mr. McGannon is at most guilty of being a bit overeager and irritating in his persistence, but you can be the judge of that for yourself:

PDF icon Read the emails

Why wade in?

Character is everything in the investment management industry. Even the whiff of impropriety, no matter how unfounded an accusation of wrongdoing, has been known to damage careers, prompting job losses and even investor redemptions. Publicly accusing an investor of misappropriating private information is particularly invidious, as it plays to popular misconceptions about what actually constitutes criminal insider trading. The reputational damage is done by the mere suggestion of cheating. The Journal editorial would implicitly criminalize a great deal of routine due diligence.

While I am wary of criticizing a company as litigious as Cadiz, I feel strongly that the public shaming of a fellow investor is unjust. I regularly seek public information from government agencies, as do my peers in investment research and investigative journalism. That is not wrong, and it should not be portrayed as being somehow insidious. Irrespective of the ultimate approval status of the Cadiz water project and Cable Car’s investment outcome, Cadiz sets a dangerous precedent.

As if the risks of short selling were not high enough, Cadiz has introduced the added possibility of the news media and even Congress (see below) being enlisted in a campaign of reputational damage against critics. Based solely on the project economics and its history, a large number of short sellers have independently reached the same conclusions as the Pump Stopper article cited by Mr. McGannon in one of his emails. The Pump Stopper article mentions unsuccessful attempts by the author to contact Cadiz as well as FOIA requests, which are publicly available. These imply that Cadiz was able to determine the identity of the article’s author, strongly suggesting that the campaign against Mr. McGannon was retaliatory in nature. The Journal should have known better than to get involved.

I have never knowingly interacted with Mr. McGannon, and I do not know if he was the source of the anonymous report. I know nothing of his character. However, I think it manifestly unfair for an individual’s reputation to be tarnished in this manner.

Cadiz protests too much

What passes for acceptable mudslinging in the corridors of Washington can be more damaging to non-politicians. Perhaps the reason for the company’s willingness to attack the BLM and a third-party investor is that Cadiz and its legal counsel/part-time CEO, Scott Slater, are no strangers to lobbying and backroom politics.

Mr. Slater is a shareholder of the law firm of Brownstein Hyatt Farber Schreck LLP (BHFS), which has been the company’s primary legal services provider since he joined as General Counsel in 2008. BHFS has a large corporate and government relations practice that includes significant lobbying work. The firm also operates a political action committee funded by shareholders of the firm, BHFS-E, PC PAC. The PAC makes about $400,000 of bipartisan contributions per election cycle.

Although Mr. Slater became CEO in 2013, he remains employed by BHFS and free to provide other services for them while collecting a $300,000 annual salary from Cadiz. On top of Mr. Slater’s salary, Cadiz pays an additional $300,000 annual retainer to BHFS for legal services relating to the project.

The retainer is a minimum commitment; the actual fees paid to BHFS by Cadiz have not been disclosed in aggregate but are considerably higher. For example, federal filings show Cadiz makes a $110,000 quarterly payment to BHFS for lobbying representation alone, while BHFS has simultaneously represented the company in various legal challenges to the project. Cadiz lobbying payments to BHFS began in Q4 2010 and have ranged from $400,000-440,000 every year since. In total, CDZI shareholders have compensated BHFS at least $2.4 million through June 2016 just for representation in Washington, although in five quarters the disclosures indicated that BHFS was compensated despite performing no lobbying activity.

What’s more, BHFS is eligible to receive incentive compensation based on project approval milestones. The firm has already earned three incentive awards since 2009, a total of 259,312 shares worth over $1.8 million at current market prices. They are eligible to receive a further 200,000 shares worth over $1.4 million upon achievement of additional milestones.

Mr. Slater’s unique employment situation makes BHFS a related party to Cadiz, a status that has been omitted from the related party disclosures in the company’s annual reports and proxy filings. Curiously, it was not until the second quarter 10-Q filed on August 8, 2016 that the company explicitly acknowledged BHFS as a related party in an SEC filing. I will leave it to securities lawyers to debate whether item 404(a) of regulation S-K provided a sufficient exemption from disclosing the total payments to BHFS.

CDZI, a company with only 10 full-time equivalent employees, spent $12.6 million on general and administrative expenses excluding stock-based compensation in 2015 and $9.0 million in 2014. Shareholders ought to know just how much of that went to Mr. Slater’s law firm.

Statement on apparent bias

Readers familiar with CDZI will have noticed that I have not yet mentioned the letters sent by Jason Chaffetz (R-UT) of the House of Representatives Oversight and Government Reform Committee to the BLM and Whetstone Capital. Partly that is because the committee’s activities appear to be rather more focused at the moment on another manufactured government email controversy and are unlikely to go anywhere. Yet the letters present the same concerns as the Cadiz press releases and Journal editorial. They also raise the separate question of why a Congressional committee would so readily adopt a financially interested company’s misleading insinuations of wrongdoing when describing innocuous correspondence.

It is probably only a coincidence that Representative Chaffetz has received 3 donations totaling $5,000 from BHFS-E, PC PAC. Cynthia Lummis (R-WY), his co-signer, received $1,000 from the PAC in 2013.

According to Federal Election Commission records, Mr. Slater has been an unusually prolific donor to politicians. He has given at least $78,977 of his personal funds to political committees and candidates for federal elective office, including $26,817 through the BHFS-E, PC PAC. I do not wish to insinuate that there has been any explicit quid pro quo from politicians in response to Mr. Slater’s or the PAC’s donations. Nevertheless, political contributions are a potential source of bias. The significant flow funds from CDZI investors to BHFS makes their political action activities important to consider as well.

Cadiz has focused its lobbying efforts during the current session on trying to insert an appropriations rider that would nullify the BLM decision. These efforts were primarily oriented toward Department of Interior appropriations legislation, which eventually passed the House but has been deferred to the lame-duck session by the most recent continuing resolution. I believe the language is highly unlikely to become law due to Senator Feinstein’s continuing opposition.

Interestingly, Cadiz’ second quarter lobbying disclosure form for BHFS added a new category of lobbying activities relating to the “Senate FAA authorization bill and amendments.” Obviously, the FAA reauthorization bill had nothing to do with water in the California desert, but BHFS evidently tried unsuccessfully to add a rider to that legislation sometime during the second quarter.

The Senate version of the bill was sponsored by John Thune (R-SD), Chair of the Commerce, Science, and Transportation committee. Mr. Slater donated $1,000 to Senator Thune on June 1, 2016, his first and only donation to the Senator. BHFS had not supported him since 2010. Senator Gary Peters (D-MI), a junior member of the committee who had not received any money from BHFS since 2011, made headlines in March for inserting other unrelated amendments into the legislation. On May 15, 2016, Mr. Slater donated $1,000 to Senator Peters. Neither senator faces a competitive reelection contest at the moment, giving Mr. Slater’s donations the appearance of an overt attempt to gain influence during concomitant lobbying efforts sponsored by his company.

Cadiz has also tried to win support from California’s federal Congressional delegation. Tim Sheehan, Cadiz CFO, supported Wendy’s Greuel’s unsuccessful House bid in 2014. Richard Stoddard, former CEO, donated to John Tavaglione’s ill-fated 2012 bid. Tavaglione is a Riverside county supervisor who has supported the project publicly. Both candidates for Barbara Boxer’s Senate seat this year have received contributions from either Mr. Slater or Keith Brackpool, Cadiz’ board chairman. To be fair, receipt of donations does not guarantee preferential treatment; even Senator Feinstein received $4,500 from the BHFS-E, PC PAC in 2012 (though nothing since).

In all, 19 current and former representatives are listed by the company on its most recent project support list. No doubt Cadiz has also supported local officials on the list as well, but since FEC data is more readily available, consider just the listed federal supporters of the Cadiz water project. At least 10 of these representatives have accepted money from Cadiz insiders through the second quarter of 2016:

Cumulative contributions from Cadiz insiders to stated supporters of Cadiz water project

Representative District Status BHFS-E, PC PAC Slater Other CDZI Executives Total
Jim Costa D-Fresno in office - 7,400 32,200 $39,600
Duncan Hunter R-El Cajon in office 5,500 - - 5,500
Darrell Issa R-Vista in office 4,000 - - 4,000
Ed Royce R-Hacienda Heights in office 4,000 - - 4,000
Ken Calvert R-Corona in office 2,500 500 500 3,500
Paul Cook R-Yucca Valley in office - 2,000 1,000 3,000
Linda Sanchez D-Cerritos in office 1,000 - - 1,000
Loretta Sanchez D-Santa Ana in office - 1,000 - 1,000
Gary Miller R-Redlands retired - 1,000 - 1,000
Doug LaMalfa R-Auburn in office 500 - - 500
Tony Cardenas D-Panorama City in office - - - -
Tom McClintock R-Roseville in office - - - -
Scott Peters D-San Diego in office - - - -
Collin Peterson D-Minnesota in office - - - -
Dana Rohrbacher R-Huntington Beach in office - - - -
Norma Torres D-Ontario in office - - - -
Mimi Walters R-Laguna Niguel in office - - - -
John Campbell R-Irvine retired - - - -
Gloria Negrete-McLeod D-Ontario retired - - - -
Totals $17,500 $11,900 $33,700 $63,100

In the company’s words, apparently now a “palpable dark cloud” hovers over the Congressional decision-making process.