In $440 Million Trading Error, Upside of Wall St. Failures

The near implosion of the Knight Capital Group on an accidental $440 million trading loss may make many feel that Wall Street firms are on automatic self-destruct with the timer set to go off fairly soon.

The truth may instead be that the finance industry not only has fewer missteps than the rest of corporate America, but that sometimes failure is a good thing.

The wunderkinds at Knight Capital certainly did seem to blow up the joint. The market maker's trading program ran amok over the course of 45 minutes last Wednesday morning, leading to $440 million in losses. At best, this was an unintentional programming malfunction, but whatever the cause, it was a stupendous error that necessitated a rescue of the firm on Monday by a group of investors.

And the Knight Capital debacle follows a long list of Wall Street failures. In the last few years, Lehman Brothers, Bear Stearns and MF Global have destroyed themselves. Before that, Drexel Burnham Lambert filed f or bankruptcy in 1990, Barings in 1995, Long-Term Capital Management in 1998, Refco in 2005 and Amaranth Advisors in 2006. In the late 1980s and early 1990s, the savings and loan scandal resulted in a spate of bank liquidations. In the 1970s, there was the implosion of the Wall Street financial institution Goodbody & Company, and in the decade before, the failure of Ira Haupt & Company.

While you may look at horror when you see this record, Wall Street is actually better than average in the failure department these days.

Look at corporate landmarks like Eastman Kodak and American Airlines, which are now in bankruptcy. Last year, 86 publicly traded companies went bankrupt, according to bankruptcydata.com, with an average filing size of $1.2 billion. Only 4.7 percent of these companies were in finance or banking. Since 2000, 1,768 public companies have filed for bankruptcy, but only about 6 percent have been financial and banking companies.

Putting this in pe rspective, about 15 percent of the Standard & Poor's 500-stock index is made up of financial companies. Financial and banking companies appear to have a lower rate of failure than the rest of corporate America.

Even so, this doesn't mean that failure is bad. Failure is a necessary component of the creative destruction that the Austrian economist Joseph Schumpeter wrote about.

Schumpeter's theories have been extrapolated by free-market advocates into an explanation of how dynamic, capitalistic economies renew themselves through failure.

Normally, Americans take this failure as the price to pay for a successful capitalist system. The nation does not seem terribly upset about the fall of Kodak, or before it, Polaroid. These companies failed to adapt and change, and if you buy into creative destruction, they were eclipsed by swifter, faster companies like Shutterfly and Instagram.

Obviously, these events are terrible for the employees and communities invo lved, but you don't see this bring new cries for regulation to prevent Kodak from going under.

The question is whether creative destruction is different on Wall Street, and if so, can we even stop it.

Creative destruction certainly hasn't gone away. In recent years, we've seen the creation of boutique investment banks like Moelis & Company and Evercore. Hedge funds have gradually captured significant trading volume from the investment banks. Knight Capital itself was a symbol of the rise of the market makers, which compete with the exchanges for trading business.

These newer entrants counteract what has been the huge consolidation in the investment banking industry over the last 40 years. Investment banks swallowed each other only to be subsequently acquired by big commercial bank holding companies. Lehman Brothers, for example, was an agglomeration of a number of storied banks like Kuhn Loeb, E. F. Hutton and Shearson/American Express. Lehman's remnants ar e now part of Barclays and Nomura.

In other words, Wall Street is continuously evolving. In such a place, failure, as it does everywhere in corporate America, must occur. This is the way weak players are discarded so stronger players can survive and provide better and more stable services.

In this system, the dumb must also go. In the case of Knight Capital, regulators appeared to agree, declining to make any exceptions for the firm.

The difference is that finance is about risk, and when financial companies collapse, it can happen quickly, with extensive harm to others. When a bookstore chain goes bankrupt, people are inconvenienced and there are losses, but the losses are mostly containable.

In finance, however, the collapse of a single firm can jeopardize the system, and as with Knight Capital's teetering on the brink last week, it can happen very quickly. We're all understandably on edge about that because of the financial crisis.

The chairwo man of the Securities and Exchange Commission, Mary L. Schapiro, said before the rescue that a failure of Knight would be “unacceptable.” There is also public hand-wringing by commentators that we need to go after computerized trading.

It may well be that we need more regulation of computer trading, but we also have to realize that failure will happen with financial firms, and that this is part of the weeding out. It's not just acceptable, but desirable.

Firms that can't manage their risk should be replaced by firms that can. If we instead regulate these firms so they take no risk, finance will dry up. The existence of a financial system is a trade-off for the benefits that finance can provide. And yes, there are benefits, like credit and financing for a $15 trillion economy.

The trick is to strike the right balance. That is actually what the much-criticized Dodd-Frank Act does - allowing firms to take risk but tempering that risk-taking with regulatory oversight. Dodd-Frank also creates a new insolvency system for banks that pose systemic risk to manage the inevitable failure.

But Dodd-Frank's insolvency net would not have activated for Knight because it wasn't systemically important. Instead, the normal system worked to minimize the impact of Knight's losses and absorb it. In other words, the near failure of Knight was a success for Wall Street, showing that it can manage the inevitable collapse.

All told, it may be that new rules are needed in light of Knight, but it should also be recognized that we can't just regulate failure away without eliminating risk, too. And we can't have a financial system without both.

Steven M. Davidoff, writing as The Deal Professor, is a commentator for DealBook on the world of mergers and acquisitions.

Federal Judge Grudgingly Approves Morgan Stanley Price-Fixing Case

Over objections from consumer groups and New York officials, a federal judge on Tuesday approved a $4.8 million settlement between the Justice Department and Morgan Stanley over allegations of price fixing in the electricity market.

Yet even as he signed off on the settlement, Judge William H. Pauley III of Federal District Court in Manhattan expressed “misgivings” about the deal, saying the dollar amount was too low.

“Given the government's stark allegations of manipulative conduct against Morgan Stanley, disgorgement of $4.8 million is a relatively mild sanction,” Judge Pauley wrote. “There is a risk that a large financial services firm like Morgan Stanley could view such a modest penalty as merely the cost of doing business.”

The judge said he agreed to the settlement out of deference to government's arms-length negotiations with Morgan Stanley. In his ruling, Judge Pauley cited a recent decision by a federal appeals court that criticized a nother federal judge, Jed S. Rakoff. The appeals court suggested that Judge Rakoff might have overstepped his authority when he rejected a contentious settlement between the government and Citigroup.

The Morgan Stanley case was the first attempt by the Justice Department to penalize a bank over using derivatives to help clients allegedly violate federal antitrust laws. Morgan Stanley, the government said, aided the efforts of KeySpan Corporation, a major utility company in New York, to manipulate electricity prices.

In 2006, the bank entered into a complex swap agreement with KeySpan that gave the company a stake in the profits of its competitor Astoria Generating Company Acquisitions. Morgan Stanley also represented Astoria in the transaction.

The government said that the deal allowed KeySpan to push up the price of electricity in New York, costing consumers about $300 million. Morgan Stanley made $21.6 million in revenue in serving as an intermediary in t he deal.

Morgan Stanley settled the allegations with a $4.8 million payment to the federal government without admitting any wrongdoing. In 2010, KeySpan, which is owned by the British energy company National Grid, paid $12 million to resolve its role in the case, also without admitting any wrongdoing.

Late last year, after the government solicited public comments on the settlement, the AARP, an association of middle-aged persons and older Americans, filed a complaint that the deal was too lenient and Morgan Stanley should be forced to disgorge all of its revenue from the transaction.

The AARP also objected, saying that Morgan Stanley did not have to admit that it violated the law. In addition, the payment will go to the United States Treasury and not to utility customers.

“Future wrongdoers can try the gambit again and need be concerned only about trivial civil sanctions,” said the AARP.

A Morgan Stanley spokeswoman declined to comment. A Ju stice Department spokeswoman did not immediately respond to a request for comment.

Michael Gianaris, a New York state senator, had sent a letter to the court opposing the settlement. On Tuesday, Mr. Gianaris said he was extremely disappointed with the judge's ruling.

“This does nothing to achieve justice for aggrieved consumers,” Mr. Gianaris said. “And by allowing Morgan Stanley to reap more than $16 million in profit despite their misdeeds, it does even less to deter other banks from engaging in the exact same scheme in the future.”

US v Morgan Stanley

In \'Squawk Box\' Case, a Delicate Line for Prosecutors

An appeals court ruling that reversed the convictions of six brokers and traders for misusing brokerage firm “squawk boxes” was a setback for the Justice Department.

The court, which found that prosecutors violated a central tenet of due process, went so far as to question whether the government should try again to convict the defendants and called the violation “entirely preventable.” This is only the latest case in which the government failed to turn over important information and raises questions about whether prosecutors can abide by the rules.

The squawk box case involved brokers from Merrill Lynch, Lehman Brothers, and Smith Barney who allowed traders from A.B. Watley, a day-trading firm, to listen to the firm's in-house broadcasts that included pending client orders to buy or sell large blocks of stock. The Watley traders used information gleaned from the conversations to trade ahead of the execution of the customer orders, a practice known as â €œfrontrunning.”

Last week, in United States v. Mahaffy, the United States Court of Appeals for the Second Circuit ruled that the Justice Department had violated the defendants' rights after it withheld material that the government had in its files that could be helpful to the defense.

The obligation to turn over what is known as “Brady material” stems from the Supreme Court's seminal decision in Brady v. Maryland, which found that it violated a defendant's due process right for the government to withhold from the defense critical evidence.

In the squawk box case, the government originally charged the defendants with multiple counts of securities fraud, witness tampering and conspiracy. The first trial ended with an acquittal on almost all the charges for most defendants, but the jury was unable to reach a verdict on one count of conspiracy to commit securities fraud.

Prosecutors decided to retry the conspiracy count on the theory that letting the Watley traders listen to the squawk boxes defrauded the firms through the improper disclosure of confidential information about customer orders. The defense argued that information broadcast on the squawk boxes was not confidential, and therefore disclosing it did not deprive the firms of any property.

The jury convicted the defendants after the retrial, based in part on the testimony of witnesses from the brokerage firms who said that customer order information was in fact confidential.

The appeals court, however, overturned the convictions because the prosecutors did not provide the defense with transcripts from the Securities and Exchange Commission investigation of the Watley trading operation. In those transcripts, other witnesses from the brokerage firms testified that order information transmitted over the squawk boxes was “sensitive” but not considered confidential. The transcripts only came to light after the second criminal trial when the S.E. C. turned them over to the defendants as part of the discovery in its civil enforcement case.

The transcripts would not necessarily have resulted in an acquittal in the criminal case, but it certainly would have been helpful to the defense in cross-examining witnesses who claimed the customer order information was “confidential.” If nothing else, it could have undermined the government's argument that the order information constituted valuable property, a key element to prove the securities fraud conspiracy.

The failure to disclose the information is mystifying because an S.E.C. lawyer assigned to help on the criminal case even cautioned the other prosecutors that at least one transcript contained Brady material.

But the prosecutors in the second case decided not to revisit decisions made by other prosecutors before the first trial, apparently never reviewing the materials gathered by the S.E.C. to determine whether they contained exculpatory evidence.

There is no clear test for when evidence rises to the level of being “exculpatory,” thereby requiring the government to disclose it to the defense.

In a street crime case, it is often easier to determine what is helpful to the defendant. In Brady v. Maryland, for example, the prosecution withheld a co-defendant's statement that he had killed the victim, information crucial in deciding whether to impose the death penalty.

In a white-collar crime case, the major issues are more likely to revolve around fuzzier issues like a defendant's intent and the legal meaning of particular terms, such as “confidential.”

What is exculpatory rarely leaps off the page, unlike direct information on the identity of a murderer or robber. Therefore, prosecutors in white-collar cases have to be much more careful in assessing what evidence has to be turned over.

The label “prosecutorial misconduct” is often assigned to cases involving violations of the Brady disclosure obligation because the decision on whether information is exculpatory is made initially by the prosecutor, not the judge. Unlike in civil cases, which involve broad discovery, federal criminal cases allow much more limited discovery by the defendant, so there is a greater chance that information the defense considers important might not come to light before trial.

One of the most prominent cases involving a Brady violation involved former United States Senator Ted Stevens of Alaska, whose conviction was overturned and the charges dismissed because of government misconduct. A 672-page report on the case excoriated prosecutors for repeated Brady violations.

After the report about Mr. Stevens's case, a bill was introduced in the Senate called the Fairness in Disclosure of Evidence Act, which would require prosecutors to turn over all evidence that “may reasonably appear to be favorable to the defendant.” This standard is much broader than the current requirement under the Brady case, which is limited to material evidence that goes to a defendant's guilt or punishment.

Not surprising, the Justice Department opposes the legislation. The deputy United States attorney general, James M. Cole, testified at a Senate Judiciary Committee hearing in June that the problems in the Stevens case “does not suggest a systemic problem warranting a significant departure from longstanding criminal justice practices.”

Unfortunately, the squawk box case is another example of the failure of federal prosecutors to adhere to their obligation to disclose information when it was sitting right in front of them. Although there may not be a “systemic problem,” that is little solace to individuals facing the prospect of criminal prosecution without the tools to adequately defend themselves.

Peter J. Henning, who writes White Collar Watch for DealBook, is a professor at Wayne State University L aw School.

Jefferies Raises Questions About Schulze\'s Best Buy Holdings

As part of his audacious takeover proposal for Best Buy, the company he founded decades ago, Richard Schulze said that he would contribute about $1 billion of his holdings into a leveraged buyout offer.

But Daniel Binder, an analyst with the Jefferies Group, wondered why he wasn't rolling in more of his shares.

Here's what Mr. Schulze wrote in his letter to the retailer's board on Monday: “The transaction would be financed through a combination of investments from private equity firms, my equity investment of approximately $1 billion, and debt financing.” According to regulatory filings, he owns a 20.1 percent stake, or about 68.9 million shares.

In a research note on Tuesday, Mr. Binder wrote that, assuming the midpoint of Mr. Schulze's $24-to-$26 price range, the Best Buy founder would still have a little more than $700 million in stock available. The analyst writes that there are a couple of different musings:

• Mr. Schulze doesn't believe in his strategic plan, which doesn't make sense given the energy and expense he has apparently devoted.
• He is protecting his downside by holding onto the additional shares.
• Mr. Schulze has been asked to reduce his stock holdings by prospective partners who want to ensure that he has a minority stake in a newly private Best Buy.

Mr. Binder elaborates on the final possibility thusly:

In a deal that would require an estimated $4 billion of equity, his $1 billion would give him 25% equity versus his current 20%. Rolling over all his equity would probably put him closer to a 44% holder.

The truth may be more prosaic. A person briefed on Mr. Schulze's plans said that the $1 billion figure is preliminary, and that he is willing to contribute all of his holdings if necessary.

Knight of the Living Dread

The devil we don't know is lurking in the financial system.

At the start of last week, Knight Capital Group was a battle-tested trading firm whose electronic trading systems had performed steadfastly through several crises since the late 1990s. Unlike Lehman Brothers, it was not the sort of firm that took on too much debt to buy assets that could later collapse in value. Knight's business model was to match buyers and sellers of stocks more quickly and skillfully than its rivals, hardly a business that is associated with firm-destroying risk. Yet seemingly out of nowhere, Knight made a huge amount of trades last Wednesday that ended up saddling the firm with $440 million of losses and forcing it into a financially punitive rescue that was sealed on Monday.

The episode tests the limits of what a market can possibly know. And that's why it's uniquely unnerving.

Nearly all trades boil down to a disagreement between buyers and sellers over how much a company or security is worth. In a healthy market, investors feel they have ways to deepen their understanding of what constitutes the value of a share or bond. They dive into balance sheets. They quiz management. Investors spend a lot of time debating their theses. That back and forth is what markets thrive on. Even in the biggest manias, like the mortgage bubble of the last decade, there were skeptics, armed with data. Hedge funds had enough information to bet against subprime securities. Investors went public with criticisms of Lehman and other shaky banks, using the firms' own financial statements against them. In the aftermath of the crisis, banks were quickly targeted if they had troublesome positions. MF Global's European trades helped deplete confidence in the firm.

But Knight had almost no red flags. Its balance sheet doesn't show big build-ups of assets of potentially dubious value. Its income statement is plain compared with those put out by much bigger Wall Street firms. The market even appeared to give Knight some credit for that. At the end of June, the company's stock market value was three-fourths of its net worth, as measured by its balance sheet. That's hardly outstanding, given that investors usually give a company a value above its net worth if they like its prospects. But it was much better than Morgan Stanley, a much larger, more complex firm, which was then trading at half its net worth.

Of course, algorithmic trading, Knight's core business, had plenty of critics. Recent incidents showed that it could be precarious for practitioners. But could outsiders ever have known that such trading had the potential to land a firm with crushing losses in a matter minutes? Knight's filings hardly quantified that risk. In its last annual report, the firm merely said that a major system failure might lead to “potentially costly incidents” or “substantial financial losses.”

The likely truth of the matter is that Knight had no idea how much it could lose if its trading went awry. How could it? Predicting the losses from a rogue algorithm is like predicting the losses from a tornado that turns into a hurricane. In fact, it's not even clear if it was the technology in isolation. In a filing with the Securities and Exchange Commission on Monday, Knight said there may have been a human element. The filing stated, “the company experienced a human error and/or a technology malfunction related to its installation of trading software.”

Knight's failures were perhaps worse than those of banks that allow human traders to get out of hand. Though JPMorgan Chase announced big trading losses on derivatives in May, several media reports had previously noted the souring positions, which had taken months to amass. Knight's losses stemmed from positions that came about in minutes.

No doubt, bank executives will say that the way to prevent the Knight-type debacles is to improve “risk manag ement,” the industry term used for firms' efforts to assess how much they could lose under different scenarios. But in a piece of research that enraged Wall Street earlier this year, Moody's Investors Service said, “there are no financial ratios to measure the effectiveness of risk management.” In other words, outsiders have no sure way of knowing which banks are good at policing their own risks.

Looking at Knight, regulators will likely argue that banks have built up hefty loss buffers since that crisis that will be able to absorb surprise losses. But that cushion, called capital, is calculated using a relatively static approach using a known amount of assets. Capital gets overwhelmed if, like Knight, a bank acquires a huge amount of additional assets in a matter of minutes.

The hope is that the Knight debacle was a freak accident. But, in today's market, how could we ever know?

Gensler Calls for a New Rate Benchmark

AMERICANS who save for the future, use credit cards or borrow money for tuition, cars and homes deserve assurance that the interest rates on their are set in a reliable and honest way.

That's why the revelation that the British bank attempted to manipulate the , or Libor - one of the benchmark rates used to determine the cost of borrowing around the world - is so disturbing. But the Barclays case isn't only about misconduct by large financial institutions. It also raises questions about the reliability and accuracy of these key interest rates, which are largely determined by the private sector, without significant government oversight.

When you save money in a money market fund or short-term bond fund, or take out a mortgage or a small-business loan, the rate you receive or pay is often based, directly or indirectly, on Libor. It's the reference rate for nearly half of adjustable-rate mortgages in the United States; for about 70 percent of the American futures market; and for a majority of the American swaps market, where businesses hedge risks from changes in interest rates.

Libor is supposed to be the average rate at which the largest banks honestly believe they can borrow from one another unsecured (that is, without posting collateral). Libor was set up in the 1980s when banks regularly made loans to other banks on that basis.

However, the number of banks willing to lend to one another on such terms has been sharply reduced because of economic turmoil, including the 2008 global financial crisis, the that began in 2010, and the downgrading of large banks' credit ratings this year.

Banks have shifted toward secured borrowing and, on occasion, borrowing from central banks like the Federal Reserve and the European Central Bank. As Mervyn King, the governor of the Bank of England, said of Libor in 2008: “It is, in many ways, the rate at which banks do not lend to each other.”

These changes in the markets raise questions about the integrity of this important benchmark.

First, why is Libor so different from another benchmark interest rate for borrowing in United States dollars - Euribor, or euro interbank offered rate? Both rates are calculated on the basis of banks' answers to roughly the same question. For Libor, a bank is asked at what rate it thinks it can borrow, while for Euribor, a bank is asked at what rate it thinks other banks are able to borrow. And yet the Euribor for dollar borrowings is about twice as high as the comparable Libor.

Second, why have Libor and other benchmark rates typically not been aligned, since 2008, with the borrowing rates that would be implied by foreign exchange markets? A long-established financial theory known as interest rate parity says that the difference in interest rates between two countries should be roughly in line with the expected change in exchange rates between the countries' currencies. (If it isn't, that opens an opportunity for arbitrage, the practice of taking advantage of price differences.)

Until 2007, as the theory predicted, the difference between the borrowing rate in one currency and the lending rate in another could typically be derived from foreign currency exchange rates. In the last few years, that hasn't been the case, and this divergence between theory and practice has yet to be adequately explained.

Third, why is the volatility of -denominated Libor so much lower than the volatility of other short-term credit market rates? Just like stocks and bonds, short-term interest rates experience a certain volatility. But Libor has less severe swings than comparable rates.

In addition, the variation in rates that some banks submit to the British Bankers' Association - the private group that oversees Libor - don't seem to match the variation in the rates for their (financial instruments that are similar to insurance and are one measure of a bank's credit risk). There have been times when the swap rates have widened for particular banks (suggesting a growing credit risk) even as their Libor submissions have remained stable (suggesting that the banks' borrowing costs haven't changed).

Anyone saving or borrowing for the future has a real stake in the integrity of Libor and in the answers to these questions.

When the Commodity Futures Trading Commission, which oversees derivatives markets, began looking into interest-rate setting in 2008, we were guided not only by questions about the decline of actual unsecured lending among banks, the supposed basis of Libor, but also by our founding statute, the Commodity Exchange Act. The law prohibits attempts to manipulate and falsely report information that tends to affect the price of a commodity - including interest rates like Libor.

Markets work best when benchmark rates are based on observable transactions. The public is shortchanged if Libor, the emperor of rates, is not clothed in such transactions.

One solution might be to use other benchmark rates - like the overnight index swaps rate, which is tied to the rate at which banks lend to one another overnight - that are based on real transactions. There are also benchmark rates based on actual short-term secured financings (loans in which collateral is pledged) between banks and other financial institutions.

For any new or revised benchmark to be broadly accepted by the financial markets, borrowers, lenders and hedgers who rely on Libor would benefit from a process for an orderly transition.

The Barclays case demonstrates that Libor has become more vulnerable to misconduct. It's time for a new or revised benchmark - an emperor clothed in actual, observable market transactions - to restore the confidence of Americans that the rates at which they borrow and lend money are set honestly and transparently.

Minnesota Minefield for a Best Buy Deal

Before Richard Schulze can acquire and turn around Best Buy, he needs to come to terms with the State of Minnesota.

Mr. Schulze is the founder and owner of 20 percent of Minnesota-based Best Buy. On Monday, he went public with a proposal to acquire Best Buy from $24 to $26 a share in cash.

Mr. Schulze likely announced his bid to force the Best Buy board into considering a deal, but there's another strategic reason for this announcement.

Minnesotans, famous for their niceness, don't seem to like hostile takeovers very much. The state has adopted some of the stricter antitakeover laws in the country.

Mr. Schulze's letter was clearly aimed at addressing the problem he confronts from one of these statutes, the Minnesota business combination act, which is adopted word-for-word in the company's certificate of incorporation.

The business combination act requires that a:

public corporation may not engage in any business combination. . . . with, any interested shareholder of [Best Buy] or any affiliate or associate of the interested shareholder for a period of four years following the interested shareholder's share acquisition date unless the business combination or the acquisition of shares made by the interested shareholder on the interested shareholder's share acquisition date is approved before . . . . prior to the interested shareholder's becoming an interested shareholder on the share acquisition date. . .

An interested shareholder is a shareholder who owns 10 percent or more of the company. The share acquisition date is the first date that the interested shareholder exceeds this amount.

This statute is quite strict. It means that before any person can acquire 10 percent or more of Best Buy, the acquisition must be approved by a committee of disinterested directors. If the approval is not obtained before the threshold is passed, then the acquirer has to wait four years to squeeze out the remaining shareholders.

Compare this with Delaware's business combination statute, which applies only to shareholders who acquire 15 percent or more of the company and requires a wait of only three years. Even thereafter, the acquirer can still squeeze out the minority shareholders by obtaining a 66.66 percent vote of the outstanding voting stock that is not owned by the interested stockholder.

Mr. Schulze has held his 20 percent interest long enough so that the four-year period wouldn't apply, but this statute would ordinarily require him to obtain approval to acquire even one more share. The banks will want Mr. Schulze and his partners to gain approval to acquire the company before they will agree to billions in financing, meaning that any acquisition is impossible if this statute applies.

In truth, this is not such a problem, since Mr. Schulze really can't acquire additional shares of Best Buy without the board's approval anyway because the board can just adopt a poison pill to prevent this. Instead, Mr. Schulze is trying to push the board into a friendly deal and get any necessary approval under Minnesota's antitakeover statutes.

But the real problem is a quirk in the business combination statute. Once Mr. Schulze takes on a partner to bid for Best Buy, the partner will be deemed part of a new group of interested shareholders. This sets off application of the business combination statute and the four-year waiting period.

The consequence is that Mr. Schulze can't make any arrangements with partners until the board approves. Otherwise, he and his partners will be effectively barred from acquiring Best Buy for four years. And because the statute is broadly worded as to what constitutes a partnership, Mr. Schulze really can't have more than preliminary talks with partners or he risks activating the statute.

But it appears that the Best Buy board is hesitant to allow him to arrange such par tnerships.
The Minnesota business combination statute provides Mr. Schulze some help to push the issue. Now that Mr. Schulze has announced his proposal, the law requires the board to form an independent committee of disinterested directors to consider the offer and make a decision within 30 days. By putting forth even this highly conditional proposal, Mr. Schulze has set the clock ticking.

But again, Minnesota law works against Mr. Shulze. In Minnesota, companies are not required to sell to the highest bidder. Instead, boards can choose to “consider the interests of the corporation's employees, customers, suppliers, and creditors, the economy of the state and nation, community and societal considerations, and the long-term as well as short-term interests of the corporation and its shareholders including the possibility that these interests may be best served by the continued independence of the corporation.”

This legal standard provides the board su bstantial leeway to not only pick the buyer but to decide not to sell because of a variety of reasons, including perhaps the leverage that Mr. Schulze may put on the corporation and the employee cuts it may bring.

So what comes next? Well, the board of independent directors has a tough decision. Since the board really holds the cards, it may just say no, but the it may just allow him to speak to his partners without further addressing the offer. To not do so may make the board seem recalcitrant, and it doesn't tie the board to any sale decision anyway.

Thereafter, Mr. Schulze would have to come through with a firm offer. Right now, his financing is not secure. Instead, Mr. Schulze's financial adviser, Credit Suisse, has issued a “highly confident” letter.

Such a letter is a relic from the 1980s, when banks refused to commit to risky financing, Michael Milken and Drexel Burnham would step in to say that while a commitment was not forthcoming, the ba nk was highly confident it could raise the money. But that doesn't mean financing is certain or even that there is a contractual obligation to provide financing. (In Mr. Schulze's defense, he is not likely to have signed a commitment letter anyway at this stage because it would have cost him too much in fees.)

Mr. Schulze will still not only have to arrange financing but persuade a private equity partner to help him buy this struggling company. It's not the easiest feat in the world in this market, and it may be yet another reason why the Best Buy board is hesitant to let him pursue what may be an errant chase.

Steven M. Davidoff, writing as The Deal Professor, is a commentator for DealBook on the world of mergers and acquisitions.

Shares of Standard Chartered Slide Amid Money Laundering Inquiry

LONDON â€" Shares of Standard Chartered tumbled on Tuesday as investors reacted to accusations that the British bank schemed with the Iranian government for nearly a decade to launder $250 billion.

In morning trading in London, Standard Chartered's stock fell by almost 24 percent as analysts estimated that the firm may have to pay around $5.5 billion in costs related to the money laundering case. It was the sharpest one-day decline in the bank's shares since at least 1988, according to Bloomberg data.

The news comes at a difficult time for British banks.

Barclays agreed to a $450 million settlement with American and British officials in June after some of its traders and senior executives were found to have alter the London interbank offered rate, or Libor, for financial gain.

Rival HSBC also apologized last month for not cracking down soon enough on money-laundering activities in America. David Bagley, the head of compliance for the British bank s ince 2002, resigned because of the scandal.

Standard Chartered, which relies on operations in fast-growing emerging markets for the majority of its profits, had side-stepped many of the problems facing European financial institutions, including a fall in trading activity related to Europe's debt crisis.

Yet its reputation now stands to be tarnished after having been ensnared in a case that New York's top banking regulator said had left the United States financial system vulnerable to terrorists and corrupt regimes.

The New York regulator accused the bank of masking more than 60,000 transactions for Iranian banks and corporations, as the firm pocketed millions of dollars in fees.

Senior management at the 150-year-old bank used its New York branch “as a front for prohibited dealings with Iran - dealings that indisputably helped sustain a global threat to peace and stability,” according to a regulatory order sent to the bank.

In response, the British bank said it “strongly rejects the position and portrayal of facts” by the New York State Department of Financial Services.

Fines connected to the money laundering case my cost Standard Chartered around $1.5 billion, according to Cormac Leech, banking analyst with Liberum Capital in London.

The firm could lose an additional $1 billion from a cutback in operations connected to Iran, as well as $3 billion in market value if some of the bank's senior executives, including chief executive Peter Sands, are forced to resign over the scandal, Mr. Leech added.

Along with the financial penalties, Standard Chartered may also have its New York banking license revoked because of the activities. Analysts say that prospect remains unlikely, as United States authorities have focused their attention on monetary fines for the British bank.

Unlike other European financial giants that have suffered from a downturn in trading activity, Standard Chartered repo rted an 11.3 percent rise in net profit in the first half of the year, to $2.86 billion.

Before the money laundering accusations were made public, shares in the firm have outperformed other financial institutions. Over the last 12 months, Standard Chartered's stock has risen 10.4 percent compared with a 12.8 percent drop in the Stoxx Europe 600 Banks index.

Why Are Investors Fleeing Equities? Hint: It\'s Not the Computers

Let's stop with the excuses.

You've no doubt been reading a lot about a “crisis of confidence” on Wall Street in recent days after software problems at a big trading firm that sent the stock market, briefly, into a tizzy.

Everyone is pointing fingers at the errant trades at the Knight Capital Group - suggesting, in the words of Arthur Levitt, that these malfunctions “have scared the hell out of investors.” The problems at the firm were immediately lumped together with Facebook's glitch-filled initial public offering, the flash crash of 2010 and the rescinded public offering of BATS Global Markets, among others.

Apparently - if the experts are to be believed - these computer errors are the reason “investors are fleeing the markets like never before,” Dennis Kelleher, president of Better Markets, told The Los Angeles Times. Dozens of articles about the trading blunder included some form of that contention, using statistics showing that $130 bill ion or more had been withdrawn from mutual funds over the last year or so.

Let me offer a more straightforward explanation of why investors have left the stock market: it has been a losing proposition. An entire generation of investors hasn't made a buck.
“The cult of equity is dying,” Bill Gross, the founder of Pimco, wrote in his monthly letter last week.

“Like a once bright green aspen turning to subtle shades of yellow then red in the Colorado fall, investors' impressions of ‘stocks for the long run' or any run have mellowed as well,” Mr. Gross wrote. His letter came after he had sent a Twitter post that read: “Boomers can't take risk. Gen X and Y believe in Facebook but not its stock. Gen Z has no money.”

(Mr. Gross, who manages the largest bond fund in the world, started a stock fund several years ago, too, so he has a vested interest in seeing stocks succeed for his clients.)
This is not to say that Knight Capital's software d ebacle is helping instill confidence in investors. But it's doubtful it would make a Top 10 list of reasons for investors to flee.

So why are so many investors sitting on their hands? The unemployment crisis, the European debt crisis and the looming fiscal-cliff crisis, to name just a few reasons. Economic growth is slowing, not just in the United States but in China, too.

Those are the same reasons that chief executives and boards of American companies are sitting on $2 trillion in cash and not investing in their own businesses. They are scared, rightly or wrongly, about the future. (It should be noted that some of the most skilled investors, including Warren Buffett, contend that when everyone's scared, that's usually a good time to invest. Mr. Buffett famously advised that investors “should try to be fearful when others are greedy and greedy only when others are fearful.” But it doesn't seem like that advice is being followed.)

Even the hedge fund t itan Louis M. Bacon has been so humbled by the stock market that he returned $2 billion to his investors last week rather than risk losing it.

None of these fundamental issues have anything to do with a computer that ran amok or a trade order mistakenly entered by a fat finger.

Blaming computers is not a new phenomenon. In 1988, months after the 1987 crash, The New York Times explained that small investors shared a “fear of being whip-sawed by program trading.”

“I think everybody is concerned about the flight of the small investor - the S.E.C., the exchanges, everyone,” Howard L. Kramer, assistant director of the Securities and Exchange Commission's division of market regulation, said in another article, also in 1988.

Here are the numbers: About $171 billion has flowed out of mutual funds over the last year, according to the Investment Company Institute, which tracks mutual fund data. Where has all that money gone?

Bonds. About $208 bi llion has flowed into the bond market over the same period, according to numbers from the I.C.I.

The fact that so few long-term investors are in the stock market has only worsened the volatility, since it often seems as if the only people who are trading stocks are the professionals.

Which brings us back to the “crisis of confidence.” This does exist among investors, but they are not focused on how computers are making the markets go haywire. Rather, they are concerned about the future of the economy and, yes, trust.

Individuals are worried that it's hard to make the right bet and worried that the market is rigged against them. Much of this is an outgrowth of woes of Wall Street's own making, like insider trading cases or market manipulation scandals. Those situations are partly why individual investors don't believe they stand a chance against the professionals.
Consider this: Of 878 students at 18 high schools across 11 different states surveyed by the Financial Literacy Group, three-quarters of them said they agreed with this statement: “The stock market is rigged mostly to benefit greedy Wall Street bankers.”

So for now, it seems, trading firms don't just need to throw out their electronic trading systems or bring in more regulators to oversee their stock executions. They need the country to get a shot in the arm to address its economic problems, and they need the public to have faith in the long term.

Instead of pointing the blame at one incident or another, look at the fundamentals.

Best Buy Founder Makes Bid for a Takeover

Best Buy has been troubled by declining sales and growing competition from the likes of Wal-Mart Stores and Amazon.com.

Now, with a preliminary takeover proposal from the company's founder, many are considering whether it has more of a future with executives who led it in the past.

Richard M. Schulze, who founded the company with a single audio equipment store in 1966, announced on Monday a proposal that would give the company a market value of $8.8 billion. Mr. Schulze, 71, who is Best Buy's biggest shareholder with a 20 percent stake, is betting that he and a handful of longtime lieutenants can breathe new life into the company.

Yet investors and analysts were immediately skeptical about his ability to cobble together the huge sums of money that would be needed to take the chain private.

And they questioned how anyone could turn around a company that has steadily declined over the last several years amid a newer generation of retailers competing b oth online and in brick-and-mortar outlets. Best Buy reported a loss of $1.2 billion for its last fiscal year.

Mr. Schulze wrote in a letter to the company's board that he has been in discussions with private equity firms and former executives over the outlines of a potential deal. He is seeking access to the company's books. Under the laws of Minnesota, where the retailer is based, Mr. Schulze must also win its permission to form the takeover consortium.

Under the terms of his proposal, he would pay $24 to $26 a share - up to 47 percent higher than the company's closing price on Friday. He would roll as much as $1 billion worth of his shares into a takeover.

“After assessing all of my options, it is my strong belief that Best Buy's best chance for renewed success is to implement with urgency the necessary changes as a private company,” he wrote in Monday's letter. “This proposal represents a unique win-win opportunity for everyone involved.”

Such a transaction would be difficult enough in terms of amassing the required equity and debt financing. But beyond the financial challenges, Mr. Schulze would face a daunting competitive landscape.

While he and two former Best Buy executives that he plans to involve in the deal, Brad Anderson and Allen Lenzmeier, helped turn the company into a seemingly omnipresent big-box retailer, analysts say that the current predicament may be beyond their solving.

“They both did a strong job while at the company, but we would be a bit skeptical that they would be able to come in and drive this turnaround,” David Strasser, an analyst with Janney Capital Markets, wrote in a note to clients. “So much has changed in the few years since they left the business, that the learning curve could prove to be steep.”

Mr. Schulze has outlined few specifics, though people briefed on his plans said that he disagrees with the current management's efforts to shrink the compan y sharply. And he and his proposed management team have expressed frustration at what they see as an erosion of the company's culture.

What he may pursue is some extra focus on online sales and retail formats that would appeal to specific segments of consumers as part of an effort to compete with Apple's highly successful physical stores.

Best Buy said in a statement that it will review Mr. Schulze's proposal - which it called “highly conditional” - and respond in due course. But the retailer's interim chief executive, George Mikan, who is known as Mike, has said that he will announce the company's own turnaround strategy in a matter of weeks. The company is searching for a permanent chief.

Known as a hands-on manager, Mr. Schulze stepped down as chief executive in 2002 and remained on the company's board until June. He stepped down after Best Buy disclosed in May that Brian J. Dunn, who had resigned as chief executive just a month before, had “violat ed company policy by engaging in an extremely close personal relationship with a female employee that negatively impacted the work environment.”

Mr. Schulze had found out about the relationship last December and confronted Mr. Dunn, though did not inform the board, which learned about it only in mid-March. At the time of the board's report, Mr. Schulze said that he planned to resign as chairman, but remain a director until next year.

In June, he changed his mind, announcing his imminent departure and plans to explore options for his 20 percent stake. The move prompted many investors to wonder if the company founder would make a move to eventually take the company private.

Since then, he has been working with Credit Suisse and the law firm Shearman & Sterling on a proposal.

Mr. Schulze began meeting with former Best Buy executives shortly before announcing his departure from the board, according to people briefed on the matter. He had breakfast with Mr. Lenzmeier, a former president of the company, several weeks ago to complain about the current management team. Later that afternoon, he called Mr. Anderson, who replaced him as chief executive in 2002. Mr. Schulze also began reaching out to what he described in Monday's letter as several “premier private equity firms” with retailing experience.

He has expressed frustration about what he said was a lack of urgency on Best Buy's part, according to people briefed on the matter. The tipping point came this past weekend, when the company's board asked for about three weeks to respond to his takeover proposal. But he did not disclose his proposed price range until Monday.

Such a deal would likely require garnering some $2 billion in equity financing, which would likely come from one or two leveraged buyout firms, according to one of the people briefed on the matter. It would also require raising some $7 billion in debt to cover the rest of the purchase price.

Best Buy is rated at Baa2 by Moody's Investors Service, two levels above junk status. And it already has about $1.7 billion worth of debt on its books.

Colin McGranahan, an analyst at Sanford C. Bernstein, wrote in a note to investors that the heavier debt load would expose the company to much more risk. Vendors, for instance, often decline “to extend terms to struggling retailers when cash flow comes under pressure,” he wrote.

But in his letter to the board, Mr. Schulze wrote that his advisers at Credit Suisse were “highly confident” that they can secure the financing.

Investors seem less sure. While shares of Best Buy jumped 13.3 percent on Monday, they remain well below the $24 to $26 proposed price range, suggesting significant doubt that a deal will be done.

“It will be very hard for him to take it private,” said David J. Simon, the chief executive of Twin Capital Management, a hedge fund that holds a short position in Best Buy a nd increased the size of that bet against the company's stock on Monday. Noting that Mr. Schulze left in June, he asked, “what could he do now that's different that he didn't realize” then?

Knight Capital Skirts Collapse as Investors Offer Lifeline

When Thomas M. Joyce arrived at Knight Capital's Jersey City offices on Sunday, the fate of his company and the legacy of his long Wall Street career were in jeopardy. His lawyers were preparing a potential bankruptcy filing throughout the day, according to people briefed on the matter, and the company's last hope rested with an eclectic group of investors.

But by 9 p.m., when Mr. Joyce departed for home while lawyers reached a deal over a meal of Chinese food, the crisis was largely contained. The Knight Capital Group, the company that Mr. Joyce nurtured into one of the most powerful brokerage firms on Wall Street, had just survived the most harrowing week in its 17-year history.

Hobbled by recent knee surgery and haggard from several sleepless nights, Mr. Joyce on Monday announced that Knight Capital had struck a $400 million deal with the group of investors, staving off collapse after a devastating trading mishap.

The rescue package, which was assemble d and led by the Jefferies Group, includes investments from TD Ameritrade and the Blackstone Group. Getco, a high-speed trading firm, and the investment bank Stifel, Nicolaus & Company, also invested.

The group appears poised to cash in on the deal. The investors are afforded the right to buy more than 260 million shares, or 73 percent of the firm, at $1.50 a piece. Before the trading blunder, the firm's shares traded above $10.

Under the terms of the deal, Knight will also expand its board by adding three new members from the investor group. Jefferies, which led the group with a $125 million investment, will take one seat.

“The array of participants in this capital infusion underscores Knight's critical role in the capital markets,” Mr. Joyce, the firm's chairman and chief executive, said on Monday.

The lifeline capped a rapid recovery for a firm that, just days ago, was on the brink of collapse.

On Wednesday, Knight Capital sustained a $44 0 million trading loss stemming from a technology error that generated erroneous orders to buy shares of major stocks. The orders affected the shares of 148 companies, including Ford Motor, RadioShack and American Airlines, sending the markets into upheaval.

Despite the embarrassing setback, investors saw plenty of potential in Knight, a sharp contrast from times when other Wall Street firms - like Lehman Brothers and more recently, MF Global - faced extinction.

Knight, stumbling at a healthier time for the financial industry, had more choices. Mr. Joyce fielded about 100 phone calls from potential buyers, who coveted Knight's giant presence in the profitable electronic trading game. In the first half of the year, Knight accounted for 11 percent of all stock trading in the United States.

Still, the firm faces significant challenges. A company built on the strength of its technological prowess, Knight suffered a major electronic mishap that rattled investor confidence.

And the deal comes at a cost as it will significantly dilute existing shareholders of the company. Shares of Knight Capital fell more than 24 percent on Monday.

Most of the losses will be borne by mutual funds that owned 54 percent of Knight's outstanding shares before the trading errors, according to data from Morningstar. Fidelity and its mutual funds were the largest owners of Knight shares, holding 15 percent of the company, the fund manager reported in its most recent filings.

But the individual who has lost the most money since the problems last Wednesday may be Mr. Joyce. A longtime trader who rose to prominence at Merrill Lynch and at the Sanford C. Bernstein & Company, his 1.2 million shares dropped in value by about $9 million from last Wednesday to Monday.

Knight Capital also faces heavy regulatory scrutiny. The Securities and Exchange Commission is examining potential legal violations as it pieces together the firm's missteps.< /p>

The New York Stock Exchange said on Monday it “temporarily” reassigned the firm's market-making responsibilities for more than 600 securities to Getco, the trading firm that also invested in Knight. Market makers buy and sell securities on behalf of clients.

The problems for Knight Capital began on Wednesday when the New York Stock Exchange's opening bell rang. The Exchange opened a new trading platform - and Knight had tweaked its computer coding to push itself onto the system then.

But when Knight's new system went live, the firm “experienced a human error and/or a technology malfunction,” the firm explained in a regulatory filing on Monday.

Chaos ensued. The error caused Knight to place unauthorized offers to buy and sell shares of big American companies, driving up the volume of trading and causing a stir among traders.

Mr. Joyce, who had knee surgery that week, went into work on crutches.

Knight later had to sell the stocks th at it accidentally bought, prompting the $440 million loss. The loss would drain Knight's capital cushion and cause “liquidity pressures,” the firm said in the filing.

The firm also consulted restructuring lawyers at Kirkland & Ellis on a potential Chapter 11 filing, according to people with direct knowledge of the matter who did not want to be identified because the negotiations were not public. The lawyers worked on the filing until about 4 a.m. on Monday, when a deal was mostly done.

As the firm's health soured, the S.E.C. kept a closer watch. The agency dispatched officials to the firm's Jersey City offices. In the agency's Washington headquarters, senior officials worked through the night in offices without air-conditioning to monitor the firm's liquidity position. The office's air-conditioning bad been programmed to shut off before midnight as an energy-saving measure.

But events soon turned in the firm's favor. Knight secured emergency short-term financing that allowed it to operate on Friday. Some of the firm's biggest customers, including Scottrade, said they had resumed doing business with Knight.

Investor interest was heating up, too. Citadel, a big hedge fund and trading firm, was interested in buying portions of the company. Jefferies was aiming to build a coalition of investors. By Friday night, Knight aligned with Jefferies, accelerating negotiations into the weekend.

Jefferies, which signed a document outlining the terms of the deal on Saturday night, had little trouble recruiting other investors. TD Ameritrade, the online brokerage house, ramped up its interest on Saturday after concluding the terms of the deal were reasonable, according to the people briefed on the matter.

One of the last to join was Blackstone, though it was well aware of Knight's business. The private equity company first approached Knight about a potential takeover just months ago, a person briefed on the matter said. Blackstone's chief financial officer, Laurence Tosi, knew Mr. Joyce from their days together at Merrill Lynch.

On Sunday, the deal teams were split into various locations. Some investors, including TD Ameritrade, remained with Mr. Joyce in Jersey City poring over Knight's documents. Others huddled at the Manhattan offices of White & Case, the law firm representing Jefferies in the deal.

In the evening hours, a deal looked promising. While firms typically need a shareholder vote to bless such a deal, the exchange allowed Knight to proceed because the firm's survival was at stake. The S.E.C. was monitoring Knight's compliance with capital rules. Robert W. Cook, the head of the agency's division of trading and markets, spent his birthday on Sunday tracking the final stages of the deal.

By 9 p.m., when Mr. Joyce left his offices, the deal was all but signed.

Jefferies would invest $125 million, Blackstone and Getco would spend $87.5 million and TD Amerit rade contributed $40 million. The payments came in waves over the next several hours, with the last few dollars rolling in just before the trading opened on Monday morning.