Trust But Verify
“A lean compromise is better than a fat lawsuit.” – George Herbert
Short sellers are a unique bunch. Mostly unloved by Wall Street investors, corporate executives, and government regulators alike, they spend their time sniffing out corporate malfeasance in the hopes of profiting from declining stock prices when the shenanigans are ultimately confirmed. Classic indicators of fraud involve accounting or governance red flags – Jim Chanos famously teaches an entire class at Yale on such red flags called A History of Financial Market Fraud: A Forensic Approach – but many short sellers also supplement with a few rather humorous rules of thumb.
Take the infamous “wig indicator” made popular on FinTwit by short seller Marc Cohodes. Under his theory, an executive willing to obfuscate their appearance through the use of a toupee might be willing to rug investors as well. Our personal favorite is the “hardhat indicator,” which states that any company whose CEO shows up on CNBC wearing safety gear over their business attire is likely an excellent short candidate.
Jokes aside, among the most damning indicators of fraud is a company’s refusal to dispel serious accusations when obvious and simple disclosures of otherwise harmless information would do so. For example, Tether, which issues and burns the crypto stablecoin USDT, has made various generalized claims about the assets that back USDT’s issuance while steadfastly avoiding submitting itself to a simple but rigorous audit by a reputable accounting firm. In contrast, Circle, which manages the stablecoin USDC, has revealed the assets backing its issuance down to the CUSIP numbers of the securities it holds. While questions remain for USDC (it too has yet to produce a full audit of its reserves), it has significantly quieted concern with its disclosure.
Like Tether, the owners of Grayscale Bitcoin Trust (GBTC) find themselves in a hole largely of their own digging. Operated as a subsidiary of Barry Silbert’s struggling Digital Currency Group (DCG), Grayscale has a simple mission: buy and hold Bitcoin on behalf of investors. Shares in the trust trade in the public stock market and initially did so at a significant premium to its net asset value (NAV), an entry comprised of the value of the Bitcoins it held. After a short tussle with the Securities and Exchange Commission (SEC) in 2014, the company unilaterally decided to halt redemptions, effectively converting GBTC into a closed-end fund. This was fine when Bitcoin prices were soaring and investor enthusiasm was high, but with collapsing Bitcoin prices and no ability to capture arbitrage profits, GBTC now trades at an incredible 48% discount to its NAV:
Grayscale claims to own more than 640,000 Bitcoins, and the whereabouts and security of those assets are of significant investor concern. At the current Bitcoin price of approximately $17,000, the market value of GBTC’s hoard is roughly $11 billion. The company asserts that its assets are safely held by Coinbase Custody Trust Company, LLC, a wholly-owned subsidiary of the popular trading platform Coinbase, which itself trades on the public stock market under the symbol COIN. Questions over the sanctity of GBTC’s assets began rumbling more than a year ago. Now, with Silbert’s DCG empire wobbling, recent actions by Grayscale are turning rumblings into a roar. In a statement meant to assuage investor concerns, the company instead substantially inflamed them when it invoked nonsensical and imaginary “security concerns” as cause to refuse the release of information that would permanently quell the rumors (emphasis added throughout):
“Coinbase Custody frequently performs on-chain validation as part of their custodian operations. Due to security concerns, we do not make such on-chain wallet information and confirmation data publicly available through a cryptographic Proof-of-Reserve, or other advanced cryptographic accounting procedure.”
The situation may soon be coming to a head. Last week, hedge fund Fir Tree Capital Management sued Grayscale in Delaware to pursue information rights available to shareholders of companies incorporated in the state. (This same hedge fund made headlines earlier this year when it announced taking a substantial short position on Tether.) With more than $3 billion of assets under management, Fir Tree is a formidable player with the necessary resources to bring significant pressure to Grayscale’s management. What is the nature of this lawsuit, and what are we watching for leading up to and resulting from its resolution? Let’s dig in.