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In the wake of the dramatic resignation of Overstock's (OSTK) CEO Patrick Byrne in the middle of the trading day on August 22nd, and his extraordinary public comments regarding Russian spies and the FBI, many investors were left scratching their heads. Some were skeptical that Byrne's statements regarding Russian spies and the deep state were the real reason behind his unusual resignation. Some investors have speculated that the resignation may instead indicate that a serious SEC enforcement action could be forthcoming. In this article I discuss what we know about the status of the SEC investigation and speculate a little on what might happen now.
Public Disclosures And Interviews
The following is the most current disclosure regarding the SEC investigation. The Overstock 10-Q filed on August 8, 2019 discloses:
In February 2018, the Division of Enforcement of the SEC informed tZERO and subsequently informed us that it is conducting an investigation and requested that we and tZERO voluntarily provide certain information and documents related to tZERO and the tZERO security token offering in connection with its investigation. In December of 2018, we received a follow-up request from the SEC relating to its investigation. We are cooperating fully with the SEC in connection with its investigation.
We also have a recent interview from Interim CEO Jonathan Johnson from September 4, 2019. From the interview:
Johnson said that the SEC's enforcement division hasn't asked the company for information since December 2018, and that he recently met with the enforcement staff to put an end to the inquiry.
Johnson continued regarding a "Wells notice":
The longtime Overstock board member [Johnson] said that neither the company nor any past or present executive has received a "Wells notice" from the SEC enforcement staff. A Wells notice is a document the SEC sends to people or firms when it is planning probable legal action for violating federal securities laws.
"We haven't had requests for information for almost a year," Johnson told Fox Business. "We have spent a king's ransom to process their requests for information to put this to bed." Johnson believes that based on conversations he recently had with the commission the state of the investigation is "almost dormant".
To pound these points home further, TZero CEO Saum Noursalehi released an investor letter on September 6, 2019. First he makes clear that the company's interactions with the SEC had nothing to do with Byrne's resignation. Then he clarified that the company is engaged in two separate interactions with the SEC. The first relates to its broker dealer business and Overstock's capital markets technologies. The second interaction relates to the SEC investigation. Noursalehi writes:
The second set of interactions pertains to an SEC request for additional information related to the tZERO security token offering, which we received in February of 2018. This inquiry came at a time when many issuers of token offerings were also contacted. We provided all of the requested information to the SEC earlier this year and have not received any formal follow-up requests from them since December of 2018.
The Facts We Know
From these sources we can lay down a couple key facts. First, the investigation is being conducted by the Division of Enforcement, which is the enforcement arm of the SEC. This is not a routine investigation or review, which are conducted by other divisions within the SEC.
Second, we know that the SEC most recently made a request for documents in December 2018. From Noursalehi's investor letter, we also know that the company responded to the requested information "earlier this year". Johnson was a bit hyperbolic when he said the company hasn't had any requests from the SEC for "almost a year". Given that the company spent a "king's ransom" (Johnson's words) responding to the information request, we can assume it took them a few months to assemble the documents. It's possible they supplied the documents to the SEC in February. So the relevant period is really the approximately six months since the company responded to the information request, not the "almost a year" time period Johnson uses. Factor in a period for the SEC to review the materials, potentially delayed by the government shutdown and resulting backlog early this year, and a time period necessary for the SEC to determine any enforcement action strategy, and Johnson's conclusion that the investigation is "almost dormant" appears premature.
Third, we know something about the size of the investigation. While the company doesn't disclose the absolute amount of legal fees, Bryne called the SEC's document request "enormous" in the second quarter conference call and stated that he thought the company had spent "$10 million to $13 million or something" in responding to the request. Johnson called the expenditure a "king's ransom". I think this level of expense indicates that the investigation was serious and extensive, and the documents produced were extensive and voluminous.
Finally, we know that the SEC was looking at TZero and the TZero security offering.
What Is The SEC Looking At?
What is the SEC looking at regarding the TZero security offering? For this, we have to travel back in time to the halcyon days of late 2017 to early 2018. It was then that Overstock, a company that for decades had been starved of capital while their competitors were being rewarded for growth and losses, found itself in the middle of the blockchain mania. Its stock had jumped from around $15 to $20 pre-mania to $90 at its peak in early 2018.
It was in this environment that Overstock launched the TZero tokens, which were meant to entitle the holder to receive a share of any dividends declared by the TZero board, which were to equal 10% of TZero's adjusted revenue (with revenue actually being defined as gross profit (with some further adjustments)). In addition, the offering memorandum noted that the company intended (though was not required to) to offer additional benefits to holders of the tokens, such as discounts on TZero services or membership in the overstock.com Club O program. In initial discussions of the token offering, the company had discussed potentially offering up to $500 million of the tokens (the final amount sold was $82 million). For a company that had been starved of capital for so long, this was a wonderful opportunity to raise an enormous amount of capital while, amazingly, not giving up any actual equity or voting interest or even any real contractual rights at all. Combine this amazing opportunity to raise capital with Byrne's reputation for brash and freewheeling comments, and you have the makings of a failed offering.
So what exactly might the SEC be looking at? Here are some of my ideas (which of course are just pure speculation by the author):
1. General Hype By The Company. There is a long list of examples of Byrne hyping the token offering. I wrote about many of them at the time in these articles. I think the most significant items the SEC might be looking at here are:
- After the December 18, 2017 launch of the token offering, Byrne said in an interview that the company was overwhelmed with demand. He says that they would have sold $300 million in tokens by January 5, 2018 if it weren't for the "friction" of confirming investors' accredited status. This as it turns out was almost certainly false. Byrne said at the time: "I think based on phone calls that could have had $300 million by 10:30 the next morning. There's a lot of demand for this, is my point." Now perhaps the company can defend this as a mere statement of belief at the time. But statements of belief have to be reasonable and not misleading.
- While the offering was active, Byrne actively conditioned the market with estimates of the value of TZero. In this article he said that "people are telling me that's a business they think has a $3 billion or $4 billion value." In the offering documents the company discloses that it engaged an independent third party to perform a valuation of TZero. As a result of the valuation analysis, the company disclosed that it believed TZero had an approximate value of between $222.8 million and $395.6 million. The company did not disclose who performed the valuation, the methodology or what the results of the valuation were. It only disclosed what the company believed itself to be worth based on the analysis. Query how any valuation could have been assigned to a company that was still at the idea phase with almost no functioning products or revenues. Now of course there is nothing wrong with selling securities of early stage companies. But for the company to assign a value to itself and present that valuation as being in some way expertized is an entirely different matter. The SEC may have been digging into this.
2. Potentially Misleading Statements Regarding TZero Product Capability. At the time of the token offering, TZero was very much still just a concept. It did not have the ability to trade tokens and, in fact, had not even begun development of such a system at the time of the offering. The SEC may be questioning whether investors were misled into believing that the product was more advanced than it was. Similarly, management spent a significant portion of its time on conference calls talking about TZero's digital locate receipt functionality for short selling but gave no actual numbers regarding usage. It's unclear whether there was any usage of the product at the time.
3. Coercive Measures. The company used various mechanics that could be considered coercive to increase demand for the token offering. The most significant was the tactic that the first $10 million purchased in the ICO would receive a 100% bonus, the next $40 million would receive a 50% bonus and the following $50 million would receive a 25% bonus. While it is unclear whether these bonuses were part of the final closing, they offered an incentive to get in early and built hype for the offering. I imagine the SEC is not used to seeing such mechanics very often.
4. Potentially Misleading Statements Regarding GSR Capital Transaction. In August 2018, the company disclosed that it had entered into a term sheet agreement with GSR Capital for GSR Capital to invest $30 million into TZero tokens and up to $375 million into TZero and Overstock equity. Aguably, the agreement was described by management as essentially a done deal, when in reality it was subject to significant documentation, further negotiation, foreign exchange controls and other risks. GSR Capital (and later Makara) ended up investing $5 million in 2019 to clear itself of any further obligation to Overstock. Johnson said in the Fox Business interview, "'We disclosed what they initially said', Johnson said of the investors' interest adding that the company didn't intentionally mislead anyone." While I sympathize with the company on this point, it is another example of the company presenting an overoptimistic and misleading picture of reality.
My guess is that the SEC may be/have been looking at some of these issues. There may be others as well.
We know from the Johnson interview that the company has not received a Wells notice regarding the investigation, which would indicate that the SEC intends to pursue an enforcement action imminently. You can read more about Wells notices and SEC procedures here. However, SEC investigations often take between six months and a year (see here), or even longer, and it has only been around six months since the company responded to the SEC's document request, so I don't think the fact that the company hasn't received a Wells notice at this point necessarily means much of anything. A better sense of what the SEC is thinking would have come at the in-person meeting that Johnson said he had with staff in late June.
What we know is that the SEC enforcement division was conducting a significant investigation of the TZero ICO. Byrne called it "enormous". The company paid (perhaps) $10 million to $13 million responding to it, but in any event a "king's ransom". That very high level of legal expense indicates that the company was responding to an extensive document request. I have outlined some of the issues the SEC may have been looking at, and of course there may be others.
While the Overstock ICO may seem tame in comparison to the rampant fraud in other ICOs that were active at the time, the SEC may have examined Overstock more closely simply because it is a public company with SEC-registered equity traded on the Nasdaq. It should be held to a somewhat higher standard than the fraudulent ICOs that were being pumped on Facebook at the time.
New Interim CEO Johnson is eager to take on the new leadership role. He has even purchased 2,000 shares on the open market, a welcome change from the much larger and very frequent stock sales he has been making for years. In his eagerness to seize the opportunity to eventually shed the "Interim" title, he may have been a little aggressive or overoptimistic in declaring the SEC investigation "almost dormant". What does "almost dormant" even mean? It reminds one of the old saying, "you can't be a little bit pregnant".
The SEC (of course) may decide not to pursue an enforcement action here. But given what we know about the company's actions during the ICO, along with what we know about the cost of company in responding to the investigation, the timing of the company's response and management's statements regarding the investigation, I don't think the case is quite closed yet.
As an aside, I do not personally believe that Byrne's resignation was directly related to the SEC investigation. Byrne has demonstrated again and again that he marches to the beat of his own drum. This is a man who was once arrested for carrying a handgun on an airplane. Let's just say I believe he believes what he says.
An enforcement action by the SEC could give token holders a right of rescission with respect to their tokens, which would allow them to put the tokens back to Overstock for their original $10 purchase price. Together with associated SEC penalties and further legal fees, this could cost the company over $100 million ($82 million in sold tokens plus any associated penalties and legal fees). This would require the company to raise additional capital, which it may not be able to do. Conversely, a closed investigation would lead to a relief rally in the stock, although potentially that has now been priced in over the last two trading sessions after Johnson told the market that the investigation was "almost dormant" and the stock rose from $15 to $17. As a final aside, I would add that management's assertion that the pending SEC investigation hampered their ability to sell the retail business makes no sense at all. A buyer would have no concern or care about that after acquiring those assets.
Disclosure: I am/we are short OSTK. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.