Prop 61: Which Tony Soprano Bargaining Agent Do You Want?

Prop 61: Which Tony Soprano Bargaining Agent Do You Want?

Lawrence Abrams No Comments


Summary:   A YES vote  is a vote for an honest, but a narrow-minded Tony Soprano style of bargaining. A NO vote is for a dishonest, but open-minded Tony Soprano style bargaining.

California Proposition 61 — a.k.a. The Drug Price Initiative  —  forces managers of  government employee prescription drug plans to get more rebates from drug manufacturers.   YES ads feature Bernie Sanders and his anti-big business mantra.  NO ads feature Veterans lamenting the possibility that this measure will increase their prescription drug costs.

No one has analyzed this proposition starting with the idea that there are two sides to any deal.  You have to ask the question:  Rebates in return for what?

You have to start with bargaining styles to understand the problem Proposition 61 seeks to fix.    Lowering prescription drug prices is all about changing the bargaining style of plan managers.  

A YES vote says you want the style used by the Veterans Administration (VA).  A NO vote say you want to maintain the status quo and keep the bargaining style used by contracted pharmacy benefits managers (PBMs) such as CVS Caremark, UnitedHealthcare’s OptumRx, and Express Scripts.

To better understand the implications of California Proposition 61, we need only look to the pilot episode of the HBO hit series The Sopranos.   In that episode, Tony complains to his therapist Dr. Melfi about the stresses of being a “waste management consultant.”  

His job, for which he and his supporting crew are paid handsomely,  is to manage the competing interests of various sanitation companies wishing to win lucrative garbage contracts put out to bid by suburban New Jersey municipalities.

Tony has no real insights into the complexities of bid submission.  Tony’s sells himself as an effective gatekeeper, creating value by limiting access to lucrative markets.  He collects a tariff from those whom are allowed in and sends his nephew Christopher to exclude the rest.  

No wonder Tony is stressed.  Sanitation companies put Tony in a schizophrenic double bind “damn if you do, damn if you don’t” situation.  If Tony does limit competition to a single sanitation company, the favored earns excess profits while the excluded curse Tony.   If Tony does nothing, all the sanitation companies bid so aggressively against each other that no one profits and they all curse Tony.  Either way, someone is cursing Tony.

The Tony Sopranos of Prop 61 are VA administrators and PBMs.  These gatekeepers receive rebates from drug manufacturers in return for insuring limited competition from other patented brand drugs that are “therapeutic equivalents.”  

For example, there is fierce competition today among manufacturers of patented, but substitutable, combo drug therapies used to treat the Hepatitis C virus.  This includes pills from AbbieVie (Viekira Pak and Technivie),  Merck (Zepatier). and the more expensive, but more effective, treatments from Gilead Sciences (Solvadi and Harvoni).

Indeed, Harvoni is one of the most expensive drug therapies in the world with the list price of each pill at $1,125 and a total list price of $84,000 for a 12 week cure.

Plan administrators are able to slice off an estimated 30% to 60% of the list price in form of rebates in cases where there is competition among a few patented, but substitutable, brand drugs.

Indeed, over the past few years, a vicious cycle has emerged: drug  manufacturers raise list prices 15%, PBMs raise rebates demands 10%. Next year there is 20% increase in list prices coupled with a 15% raise in rebate demands, etc.   It is not clear who initiates and who responds here.  The villains might not be CEOs of drug companies like smirk-faced Martin Shkreli, but rebate-hungry CEOs of pharmacy benefit managers.

Prop 61 is about what version of Tony Soprano you want as a bargaining agent.

The vehicle for limiting competition is a list of drugs covered by the plan called a formulary.  The VA formulary is severely limited in terms of total drugs, but there are no copay tiers.  This highly restrictive formulary allows the VA to collect the largest rebates and the lowest net drug prices of any plan in the United States.

The PBM formulary lists many more drugs overall, but exerts secondary power over demand via copayment tiers, step therapy, and prior authorization.

Make no mistake.  Drug rebates are not volume-related price discounts.   If this were the case, then Medicare Part D drug plans with total enrollment of 70 Million enrollees would get higher rebates than the VA drug plan with 9 Million total enrollees.

The VA has a transparent business model.  VA employees earn a salary and only seek rebates in order to lower government costs.  But, unfortunately, the federal government historically has underfunded the VA.  Over the years, VA thinking has become narrowly focused on costs at the expense of quality of care for Veterans.  

A YES vote on Prop 61 is a vote for an honest, but a narrow-minded Tony Soprano seeking rebates for rebates sake,  with not enough weight given to consumer choice and quality of care.

A NO vote is for a secretive Tony Soprano pocketing rebates on the sly, but willing to pay higher prices for newer, more effective prescription drugs.  

We have no strong conviction either way.  

A YES vote is not good for Vets in the short run.  It will link California plans to VA prices and provide a disincentive for drug manufacturers to give big discounts to the VA.  But, ironically, a YES vote might be good for the Vets in the long run as it will call attention to the narrow-mindedness of VA administrators and force them to cover higher cost drugs that deliver better quality of care for Vets.

Our concern with Prop 61 is that it is tries to fix a problem by legislating outcomes rather than by legislating practices.  A YES vote legislates an outcome without any limits placed on the practices used to achieve mandated results. A NO vote preserves the status quo of PBMs as managers of state government employee drug plans.

We would have preferred that Proposition 61 mandate changes in the business model of any PBM that manages a state employee drug benefit plan.  This would include mandating a transparent fee-for-service business model with 100% pass-through of rebates  and no opaque “spread-margins”  earned on the resale of mail order generics.  

It would also mandate that enrollees have the option of obtaining 90-day prescriptions at local pharmacies as well as PBM-owned mail order operations.  Finally,  it would include outside review of PBM formulary choices.


Lawrence W. Abrams, Ph.D. has written over 20 papers on pharmacy benefit managers freely available at  He lives in N. Monterey County, California and can be contacted at


Who is Best at Negotiating Pharmaceutical Rebates?

Lawrence Abrams No Comments

The roll out of the new Medicare drug benefit program has renewed the debate about who is best at negotiating drug rebates with pharmaceutical manufacturers (“Pharma”).  Those who favor the Federal government point to statistics showing that Medicaid gets significantly better rebates than private sector entities called pharmacy benefit managers (“PBMs”).  

The purpose of this paper is to provide new insights into this question by viewing pharmaceutical rebates through bargaining theory. The first insight is that rebates are paid selectively so that averages of rebate rates across all brands are a poor measure of negotiating power.  PBMs’ ability to extract rebates from Pharma is much greater than previously realized when rebate averages are disaggregated.

The second insight derived from bargaining theory is that the rebate transaction is much more complex than the price theory conceptualization of rebates as volume discounts. Drug rebates are tariffs, or entrance fees, paid by Pharma to gatekeepers who promise access to markets with reduced competition.

Medicaid gets more than PBMs, but gives up more in terms of rights to impose co-payments, “prior authorization” restrictions and rights to switch on-patent brand prescriptions to lower cost therapeutic equivalents.  PBMs receive less than Medicaid, but they give up less. Based on the overall goal of cost containment, there is evidence that private sector PBMs do a better job at rebate negotiation than Medicaid.

The Variability of Pharmaceutical Rebates

Two recent studies provide new data on the variability of pharmaceutical rebates rates.  Disaggregating this data by classes of drugs demonstrates the weakness of using broad averages to measure rebate-negotiating power.  A recent letter from the Congressional Budget Office (CBO) provided an unprecedented breakdown of the often-quoted nineteen percent average rebate rate that Medicaid receives from Pharma.   

The Medicaid deal is as follows: in return for being placed on the Medicaid formulary and sheltered from prescription switching and other restrictions, a drug’s manufacturer must rebate the government the greater of 15.1 percent of its average manufacturer’s price (AMP) or the difference between the “best price” given to a private sector reseller and the 15.1 percent minimum.  

The CBO letter revealed that thirty-six percent of Medicaid brand drug spend received a “best price” rebate while sixty-four percent of brand drug spend received the minimum.  In addition, the CBO letter provided evidence of the value of a little known clause in the Medicaid deal that gave the government inflation protection.  The value of that clause amounted to a surprisingly large additional rebate of 11.7 percent of AMP in 2003.   

Based on the above data, it is possible to disaggregate the 19.6 percent basic Medicaid average into a 27.6 percent average paid on “best price” drugs and the 15.1 percent minimum paid on the rest.

In September of 2005, the Federal Trade Commission (FTC) released a long awaited study of potential conflicts of interest by independent PBMs.   The FTC obtained data on rebate receipts by drug for the “Big Three” independent PBMs—Caremark Rx, Medco Health Solutions, and Express Scripts. These three large PBMs manage about sixty percent of all outpatient prescriptions in the United States.

The FTC study confirmed that Pharma pays rebates only on a small portion of brand drugs. It does not pay on brand drugs with a monopoly position.  Nor does Pharma pay on brand drugs in aging therapeutic classes where most of the competing brands have lost patent protection.

The FTC also confirmed that Pharma negotiates brand rebate deals only with PBMs, and not retail drugstore chains like Walgreen and CVS. Size does not matter on the buy-side if an entity does not also have the power to affect the demand for brand drugs through discretion in formulary design and compliance.

On the other hand, it is generic drug manufacturers that negotiate volume discount deals with drugstores because only dispensing pharmacies have the power to choose from an array of suppliers of perfect substitutes.  

Unfortunately, the FTC failed, or was prohibited, from disclosing any detail about rebates rates by drug or therapeutic class.  However, it is possible to perform a rough disaggregation of the disclosure that the Big Three PBMs received an average of  $6.34 in rebates and data fees per on-patent drug in 2003.  

The FTC disclosed that data collection fees paid by Pharma amounted to three percent of wholesale acquisition costs.  Subtracting out these substantial fees, that some allege are masked rebates exempt from inclusion in Medicaid “best price” calculations, the estimate for the average rebate received per brand is $4.22.

The key to disaggregating this average was another disclosure that seventy-one percent of rebate receipts for each PBM were concentrated in the top twenty-five rebate receiving drugs.  Assuming that these highly rebatable brands represent about twenty percent of brand drug prescription volume, it is possible to decompose the $4.22 broad average into rebate components of $14.98 for the top rebate-receiving drugs and $1.53 for the rest.
For comparison purposes, Table 1 presents the conversion of rebate levels to rebate rates based on an assumed average wholesale cost (WAC) or AMP.  While the Big Three PBMs received on average 8.0 percent of AMP across all brands, they receive 22.7 percent of AMP on rebatable drugs.  This is comparable to the 27.6 percent that Medicaid receives as a “best price” rebate. Not too much should be made of differences as the ratio is sensitive to an assumed average for WAC and AMP.  


Overall, Medicaid receives more, but this is mostly due to the inflation factor and government’s unique ability to confiscate a 15.1 percent minimum from the all powerful (monopolists) and the all powerless (many competitors).

Disaggregation presents a completely different perspective on the rebate negotiation ability of the Big Three PBMs.   This ability is not something that they care to make transparent for strategic reasons. They also show no inclination to challenge the validity of using broad averages as measures of rebate negotiating ability.

There is much speculation over who actually triggers the Medicaid “best price”.  Some believe that the Big Three PBMs get the “best price” based on their sheer size and a business model bias that favors abstaining from switching of a rebatable brand drug to lower cost generic that garners no rebates.  

Others believe that HMOs with captive PBMs, like Kaiser Permanente, trigger the “best price”.  These HMOs know that their members are willing to sacrifice some freedom of choice for competitive premiums.  HMOs with captive PBM operations garner rebates through formulary design and compliance that advantages a single drug in a therapeutic class.

In contrast, the Big 3 PBMs tend not to play favorites, but extract rebates from competing manufacturers by promising each that they will abstain from disadvantageous restrictions and prescription switching.  This passivity allows other forms of competition like advertising and physician “detailing” to take over.

The Pharmaceutical Rebate Bargain

Price theory has been misapplied to the case of pharmaceutical rebates.  Rebates are not volume discounts.  They are not evidence of price discrimination based on elasticity of demand.  It may be incorrect to apply the analysis of “most favored nation” clauses to the Medicaid “best price” formula.

 Rebates are the result of a bargain over the surplus that is created in a market characterized by a bilateral oligopoly. Secrecy and credible threats are central to the negotiation of pharmaceutical rebates.  

There are several fundamental insights gained by viewing pharmaceutical rebates through bargaining theory.

First, the welfare implications of this deal are complex.  PBMs may not be the populist countervailing force conceptualized by John Kenneth Galbraith.  PBMs may be enabling and codependent, rather than countervailing.

The surplus that is being divided up here is not necessarily fixed.  It is possible that Pharma and PBMs are tacitly colluding to increase the surplus in an intermediate market at the expense of excluded competitors on the sell side and powerless downstream consumers on the buy side.    Evidence that PBMs and the government extract substantial rebates from Pharma is not sufficient proof that their actions improve consumer welfare.

Second, there are two sides to the rebate deal.  The question of who is the best rebate negotiator involves an evaluation of what is received relative to what is given up.  Private sector PBMs receive less that Medicaid, but they give up less in terms of rights to engage in therapeutic interchange, impose usage restrictions, and affect demand through co-payment differentials.

When the Medicaid deal was struck in 1990, generic drugs were not the competitive threat that they are today. In return for rebates, the government promised to place a brand drug on the Medicaid formulary and exempt it from any prescription switching and usage restrictions such “prior authorization”. In 1993, the deal was modified so that generic substitution—an off-patent brand switched to a generic equivalent—was allowed.  

 Companies paying Medicaid for formulary placement today are still protected from any type of therapeutic interchange—an on-patent brand switched to less costly generic that is a therapeutic equivalent. In addition,  “prior authorization” restrictions cannot be imposed at the national level, but remain a local option that several states have seized as a bargaining chip to extract supplemental rebates from Pharma.

A recent study by the Lewin Group evaluated the performance of different Medicaid plan managers on the basis of overall drug spend delivered, and not narrowly on net unit prices after rebates.

One set of plans—known as Medicaid fee-for-service (FFS)—are eligible for “best price” rebates, but must adhere to Medicaid guidelines limiting therapeutic interchange and usage restriction.  The other set of plans—known as Medicaid managed care organization (MCO)—are privately managed by PBMs and not eligible for Medicaid rebates. However, these PBMs have a lot more discretion in formulary design and compliance.

The Lewin Group study found that Medicaid FFS plans received rebates averaging fifteen percentage points higher than Medicaid MCO plans.  However, the discretion allowed by PBMs who managed Medicaid MCO plans enabled them to deliver a fifty-nine percent generic dispensing rate—the number of generic prescriptions divided by the sum of all prescriptions —compared to a fifty percent rate found for Medicaid FFS plans.

 Even more dramatic was difference in usage rates—number of prescriptions per member per month.  PBMs were able to deliver a usage rate that was fifteen to twenty percentage points lower than Medicaid FFS plans.   

Overall, the drug spend of privately managed plans was ten to fifteen percentage points lower than government run plans despite lagging in rebates received from Pharma.  

The results of this study clearly demonstrate the weakness of evaluating bargaining agents solely on the basis of rebate rates.  Based on overall goal of cost containment, this study provides evidence that private sector PBMs do a better job at rebate negotiation than Medicaid.

References and Further Reading

Beronja, Nancy et. al. 2003. Comparison of Medicaid Pharmacy Cost and Usage between Fee-for-Service and Capitated Settings.  Resource Paper prepared by the Lewin Group for the Center for Health Care Strategies, Inc.

Congressional Budget Office. 2005. The Rebate Medicaid Receives on Brand-Name Prescription Drugs.  Attachment to letter to Senator Charles Grassley dated June 22, 2005.

Federal Trade Commission. 2005. Pharmacy Benefit Managers: Ownership of Mail-Order Pharmacies.

Written: 12-1-2005

© Lawrence W. Abrams, 2005

Disclosures: I have not received any remuneration for this paper nor have I financial interest in any company cited in this working paper. I have a Ph.D. in Economics from Washington University in St. Louis and a B.A. in Economics from Amherst College. Other working papers on PBMs can be accessed at

Kabam: What Causes A Unicorn To Stop Skating To Where The Puck Is Going

Lawrence Abrams No Comments

The growth in the numbers of technology startups valued over $1 Billion, so-called unicorns, has abruptly stopped and even reversed.

In the last several months, a number of unicorns have seen their valuations marked down by mutual funds. This has been accompanied by a number of titillating articles about frivolous spending — Dropbox’s Chrome Panda sculpture — and debauchery — Zenefits’ sex in the stairwells — claimed to be endemic to high flying unicorns.

Unlike stories of fallen unicorns, this article is about a company that “officially” is still on all unicorn lists. It is about the mobile game company Kabam, elevated to unicorn status by its last funding round in August 2014 of $120 Million by the Chinese platform company Alibaba.

Kabam had early success at developing games based on movie IP licensed from major studios like Disney’s Marvel studio, Warner Bros., and Lionsgate.

Beginning in 2014, Kabam started timing new releases to coincide with the releases of mega-hit movie sequels like Fast and Furious and the Hunger Games. The results have been a disastrous string of five failures and one success.

Kabam Timeline of Hits and Misses

Kabam Timeline of Hits and Misses

What caused this unicorn to stumble?

There is an inspiring YouTube video of a Keynote address given by Kabam co-founder Holly Liu at a Women 2.0 Conference in 2014.

She talks about key moments in the early history of Kabam when the founders decided to “Go Big” in her words. By this, she meant building products based on a vision of where a market was going rather where the market was at. Today, we use a hockey metaphor of “skating to where the puck is going” not “skating to where it is”

Kabam’s Downfall: “Skating to Where the Puck Is” after 2013

Specifically, for the Kabam founders it was deciding in 2007 to port their games to Facebook via its newly created API in a year when the dominant access to games was through the PC browser.

Then again, at the height of game company success on Facebook in 2010, Kabam founders were anticipating Facebook’s closure of its game API and made the visionary decision to develop only for the mobile phone.

Silicon Valley VCs have a bias toward supporting founders opinions over professional managers when startups periodically face existential choices.

This is because founders have vision (“skate to where the puck is going”) and want to build long-lasting companies. They have a Facebook “move fast and break things” mindset that is risky, but can result in outsized payouts in the end.

Whereas professional managers prefer risk-averse choices (“skate to where the puck is” ) that look to be the fastest path to cashing out via a buyout or an IPO.

Kabam stopped making visionary choices in 2013. What had happened was the emergence of a “talk the talk” culture championed by hired professional managers that favored strategies geared toward short-term revenue goals followed by an IPO.

In 2013, Kabam’s revenue grew 100% that year, fueled in part by the explosion of mobile phone purchases. Kabam had 3 hit games with greater than $100 Million in annualized revenue.

CEO Kevin Chou talked to the press about timetables for an IPO. He even announced publicly early April of 2014 that revenue was forecasted to grow 80+% or more and be in the range of $550 — $650 Million.

The safe bet to achieving these short term goals was to release as many games with $100 M in annualized revenue as possible. And that is what Kabam did, with disastrous results.

Visionary game founders in 2013 would have seen that only a company with multiple chart-topping $1 Billion games could ever have a chance at an IPO.

They would have known that another mobile game company Machine Zone (now MZ) was doing the visionary thing by building a ultra-low latency many-to-many game platform based on Erlang and investing in dedicated servers with field programmable gate arrays.

Visionary founders at Kabam would have stopped doing more of the same, and would have started building a new platform. They would have shut off all talk of IPO, stopped giving the press explicit financial numbers and revenue forecasts, and told investors that revenue would plummet in 2014.

In our opinion, the source of Kabam short-sighted culture was non-engineering managers brought in run Kabam’s operations. COO Kent Wakeford, a lawyer and former AOL executive, has been the face of Kabam to the press in matters of deals. To his credit, he consistently deflected any questions dealing with IPO specifics.

The real source of Kabam’s culture of “talk the talk” was former SVP of Corporate Communications Steve Swasey. The idea for making annual explicit financial disclosures can directly be traced Swasey.

The height of Kabam’s arrogance occurred in December 2013 when Kabam announced that it bought the naming rights for the Cal-Berkeley’s football field for $18 Million paid over 15 years. This idea had to be initiated by Steve Swasey. But, to be fair, this symbol of arriveste had to be approved by Kabam’s Board of Directors and founders.

One can understand the desire of Kabam’s co-founders — all three UC-Berkeley grads — to give back to their alma mater. But, founders should wait years after their IPO to give cash for University buildings. For example, buildings on the the Bay Area campus of Stanford and Berkeley include no less than Gates, Allen, Moore, Varian, Hewlett, Packard, and Wozniak.

In our opinion, we do not think Kabam can recover. It is running out of cash. The IPO window is permanently closed to mobile game companies after the Zynga and King Digital IPO debacles. Kabam’s only hope for more funds is Alibaba, its prime investor to date.

The naming of the football field at UC-Berkeley in December 2013 looks to be Kabam’s symbolic “Kiss of Death.”

Former SVP of Corporate Communications Steve Swasey at Cal Football Field Naming

The Bancorp: Oversold Says Richard Thaler’s Behavioral Finance Fund

Lawrence Abrams No Comments


  • On September 29th, The Bancorp will hold a special meeting of stockholders to vote on a $74 Million secondary offering.
  • The terms and conditions are an insult to existing institutional investors and there is evidence that The Bancorp genuinely fears that a NO vote might win.
  • If a NO vote wins, the deciding votes will come from a hedge fund run by the famous behavioral finance theorist Richard Thaler.
  • If a NO vote wins, we predict that the stock will pop up 10% or more.

On September 29th, The Bancorp will hold a special meeting of stockholders to vote on a $74 Million secondary offering.

The terms and conditions are an insult to existing institutional investors and there is evidence that The Bancorp genuinely fears that a NO vote might win.

If a NO vote wins, the deciding votes will come from a hedge fund run by the famous behavioral financial theorist Richard Thaler.

If a NO vote wins, we predict that the stock will pop up 10% or more.

 In response to the subprime mortgage meltdown a decade ago, the US Congress passed the Dodd-Frank Act of 2009-2010 which, among other things, required FDIC-insured banks to maintain a Tier 1 leverage ratio (capital / average assets) greater that 5%.

This means that a relatively small (e.g. 5%-10%) mark down of a major asset class — whether it be loans outright or collateralized debt obligations — could wipe out a third or more of a bank’s capital. This would almost always cause a bank to fall below the Dodd-Frank standard for a “well-capitalized bank”.

Falling below the Dodd-Frank standard would trigger an existential crisis for the bank, forcing a merger or a private placement, often coupled with a massive shake-up of management and the board.

The Bancorp (NASDAQ:TBBK) has a two and a half years running history of erratic mark-to-market accounting of troubled commercial loans, followed by a series of moves to avoid falling below the Dodd-Frank standard for a “well-capitalized bank.”

We have documented The Bancorp’s problems in three previous articles for Seeking Alpha: The Bancorp: Bad Moon Rising (January 2015); The Bancorp: Continuing Problems with a Discontinued Operation (March 2015); and The Bancorp: Why the Continuing Delays in Filing Its 10-K(May 2015).

We have also published a recent accounting article called The Bancorp: A Test for Post-Enron GAAP that analyzes its late 2014 decision not to consolidate an LLC formed to buy the most troubled portion of its discontinued commercial loan portfolio.

Even though approved by its outside auditor Grant Thornton LLP, we believe that this decision is not in compliance with GAAP and have requested another review by the FDIC and the Federal Reserve Bank.

On July 28, 2016, The Bancorp announced a $31 Million loss for 2Q16, largely due to an unexpected $32 Million in loan mark downs / note write-offs associated with its discontinued commercial loan operation. The Bancorp’s balance sheet had been spared of any hits since the bank first announced the discontinuation of commercial lending operations on October 30, 2014.

During the Conference Call, one analyst quipped, “.. maybe you guys ripped the Band-Aid off this quarter..” and went on to say he was unsure whether these losses were a one-time event or the beginning of a more forthright examination of the valuations of these troubled loan portfolios.

The 2Q16 surprise loss and follow-up conference call sent The Bancorp’s stock down 14% the next day.

Two weeks later on August 8, 2016, The Bancorp announced a $74 Million private placement of new stock with two new investors accompanied by terms and conditions suggesting that the bank was desperate to get a deal done. In particular, the new stock was priced below market at $4.50 a share and the two new investors each were offered a board seat.

We wrote in an SA article that this private placement was a defensive move motivated by a desire to reverse a downward spiral toward the Dodd-Frank standard rather than a positive move to acquire more capital to support more loan-making activity.

We also speculated that the bank’s existing institutional investors would be angered by the terms and conditions because they had invested comparable amounts over the past few years at prices in the $10 to $20 a share range with no offers of board seats.

On August 26th, The Bancorp issued a DEF 14A Proxy notice of a special meeting of shareholders to vote on this secondary offering. The date set was September 29, 2016 at company headquarters in Wilmington, DE with stockholders on record at the end of the day on August 15, 2015 eligible to vote.

In order to hold this meeting, a quorum of ½ of total outstanding shares — 18.9 Million of 37.8 Million total shares on record — must be cast in person or sent in by proxy. At its December 2015 annual meeting, a total of 29 Million votes were cast for the slate of Board members up for re-election. Average tally per Board Member was 25 Million YES, and 4 Million NO.

We think that the total votes in the upcoming special election will exceed 30 Million with 15 Million NO votes needed to stop this secondary offering from going through. The secondary offering can be stopped if at least 6 of the largest institutional investors (see list below) vote NO.

We think the “tipping point” votes will come from its newest and largest institutional investor, the behavioral finance fund Fuller & Thaler Asset Management. (more on them later)

A NO vote would mean that The Bancorp would have to look elsewhere for additional capital to shore up its status as a well-capitalized bank. Another private placement with new investors seems unlikely. A merger with another bank, possibly forced by the FDIC and Federal Reserve Bank, would appear to be the only option left.

In sum, The Bancorp’s Management and the Board would face an existential crisis with a NO vote on September 29, 2016.

While majority NO votes going against Management recommendations are rare, nevertheless there is evidence that The Bancorp’s Management and Board genuinely fear that a NO vote might win.

The evidence for this is an unprecedented flurry of positive PR announcements issued by the bank during the past month. This includes token open market purchases of shares by Directors and Officers, a “cherry-picked” sale of loans from the discontinued portfolio, a inconsequential deal with a Fintech startup, culminating in a vague cost-reduction and layoff announcement:

8/17 — 10,000 shares bought in open market by Director Bradley.

8/24 — 26,000 shared bought in open market by Chief Administrative Officer Leto.

8/26 — a “cherry-picked” new $65 Million sale of discontinued loans to First Priority Bank.

8/29 — 1,000 shares bought in open market by Chief Operating Officer McFadden.

8/29 — 20,000 shares bought in open market by Director Kozlov.

9/9 — 2,000 shared bought in open market by Chief Operating Officer McFadden.

9/14 — deal to front online banking startup VARO Money.

9/15 — a cost-reduction plan with no specific headcount or reserves booked for severance.

There is also evidence that institutional investors have a heightened interest in the outcome of this special election. First, on the August 15th cutoff date to be eligible to vote, an unprecedented 1.9 Million shares were traded suggesting a large institutional investor really wanted in. (see chart below)


We are not sure, but the August 15th trading activity could have been based on inside information of the cutoff date, because we can find no prior public announcement of that August 15th date.

Second, a NASDAQ listing of The Bancorp’s institutional investors on record as of June 30, 2016 reveals an intriguing new, and now largest, investor. This new investor is Fuller & Thaler Asset Management– a hedge fund run by Richard Thaler, a University of Chicago professor now famous for theories on behavioral finance and “nudge”.

Thaler believes that behavioral economics can uncover cases where the “efficient-market” hypothesis is not working.

A Forbes article on Thaler’s investment strategy said that investing in companies with bad management accompanied by negative sentiment actually led to above average returns. The Bancorp would seem to be a perfect test for Thaler’s theories.

Thaler’s 2.2 Million share accumulation of The Bancorp stock during 2016 suggest that Thaler believe that negative sentiment has gone too far (led by us!) and that TBBK is in an oversold position.

The question is how will Thaler vote his 2.2 Million shares in the upcoming special election? And will the stock pop or drop with a majority NO vote? (We would love your take on these questions in the comments section.)

We think that Thaler will voting NO on the private placement. Also, we believe that the existential crisis caused by a NO vote will be overlooked by the stock market as it will be the first step in getting rid of bad management (fundamentally, the Chairman Daniel G. Cohen) and reversing the negative sentiment.

We predict that TBBK will pop 10% or more IF a NO vote wins. With Management and Board on the way out, the stock become a buy because its current price of $6.00+ a share is 15% below its current tangible book value of about $7.00 a share.

The Bancorp is not the only one facing an existential crisis here. As a financial analyst inclined toward exposing badly managed and overvalued companies, is our mission in life to create opportunities for outsized returns by behavioral finance investors like Richard Thaler?

The Bancorp: A Test for Post-Enron GAAP

Lawrence Abrams No Comments


Based on details presented below, we believe that The Bancorp is not in compliance with Post-Enron GAAP (specifically FASB 46R amended by SFAS 167, also know today as FASB ASC Topic 810-10) 


Generally accepted accounting principles (GAAP) relating to consolidation of subsidiaries have changed dramatically in response to the Enron scandal of the late 90s. Pre-Enron, GAAP for consolidation was specified in ARB No. 51. It said to the effect that an enterprise must consolidate all subsidiaries in which it had a controlling financial interest as defined quantitatively by a majority voting interest.

Between 1998 and 2001,  Enron’s CFO Jeffrey Fastow exploited that rule mercilessly by creating a number of minority equity interest LLCs  to buy Enron oil and gas assets that had not been fully marked down to market.  Enron did not consolidate these LLCs citing ARB No. 51.  

Nevermind if Enron had total power to direct the activity of the LLC with Fastow himself as managing director paid millions of dollars a year.  Nevermind if Enron had a majority financial interest when debt was considered due to loans from banks secretly secured by Enron common stock.  

Post-Enron in 2003, the Financial Accounting Standards Board (FASB) issued FIN 46R – an interpretation ARB No. 51. The simple majority interest rule was complete scraped.  

Instead, FASB said that an enterprise must consolidate a variable interest entity (VIE)  — variable shares of equity and debt   — when it had a controlling financial interest as defined quantitatively by the obligation to absorb the major share of losses or the right to receive the major share of benefits.

In 2009, FASB amended FIN 46R to take into account the valid criticism from lenders to VIEs who had to consolidate because they had a majority financial interest but absolute no power to direct the activities that affected the financials.

FASB 46R – amended by SFAS 167 (today called FASB ASC Topic 810-10) added a qualitative stipulation that a corporation must consolidate a VIE if it had most of the power to direct the activities as well as a majority interest in the resulting financial gains and losses.

Majority financial interest can be determined quantitatively and has been relatively easy to evaluate for compliance.   But, as PwC lamented in a bulletin, the qualitative question of who has the most decision-making power  “will require considerable judgment.”

The purpose of this paper is to review a late 2014 non-consolidation decision of The Bancorp (NASDAQ:TBBK),  a Philadelphia area bank regulated both by the FDIC and the Federal Reserve with a diversified loan portfolio, but also known for being one of largest issuers of reloadable prepaid debit and gift cards in the country.  

The non-consolidation decision has been reviewed and approved by its outside auditor Grant Thornton LLP.  

We are not sure if the FDIC or Federal Reserve has reviewed this particular non-consolidation decision.  However, the SEC is currently reviewing The Bancorp’s financials for the years 2010-4 in conjunction with the bank’s handling of mark-to-market accounting of the now discontinued commercial loan portfolio.  

The Bancorp case is important for two reasons, one general and one specific:

First, banks are highly leveraged entities (low capital / asset ratios) subject to strict mark-to-market accounting principles for their loan and asset portfolios.   In response to the subprime mortgage meltdown a decade ago, the US Congress passed the Dodd-Frank Act of 2009-2010 which, among other things, required  FDIC-insured banks to maintain a Tier 1 leverage ratio (capital / average assets) greater that 5%.

This means that a relatively small (e.g. 5%-10%) mark down of a major asset class — whether it be loans outright or collateralized debt obligations — could wipe out a third or more of a bank’s capital. This would almost always cause a bank to fall below the Dodd-Frank standard for a “well-capitalized bank”.

Falling below the Dodd-Frank standard would trigger an existential crisis for any bank, forcing a merger or a private placement, often coupled with a massive shake-up of management and the board.

Because of Dodd-Frank, the temptation is greater than ever for a bank to offload troubled assets not fully marked to market to a non-consolidated VIE. 

Second, The Bancorp in particular has a two and a half years running history of erratic mark-to-market accounting of troubled loans, followed by a series of moves to avoid falling below the Dodd-Frank standard.

In August, 2016, The Bancorp reversed a downward spiral toward the Dodd-Frank standard by securing an additional $74 Million in capital from two new investors with terms and conditions suggesting that the bank was desperate to get a deal done.

The Bancorp’s 2 ½ year history of dealing with its troubled loan portfolio has been documented by us in four previous articles for SeekingAlpha:  The Bancorp: Bad Moon Rising (January 2015); The Bancorp: Continuing Problems with a Discontinued Operation (March 2015); The Bancorp: Why the Continuing Delays in Filing Its 10-K (May 2015); and The Bancorp: Private Placement Needed to Shore Status as Well-Capitalized Bank (August 2016).

Finally, The Bancorp case study has an interesting human interest angle as there is a single mastermind behind the dealings and questionable accounting.  For Enron, it was CFO Jeffrey Fastow, “the smartest guy in the room”, who began his career at a big bank in the 1980s working in the nascent market for CDOs.

The Bancorp’s  “smartest guy in the room” with a history of  testing the limits of GAAP is its long-standing Chairman of the Board, Daniel G. Cohen.  The Bancorp was founded by his mother, the legendary Betsy Z. Cohen, but it is her son that controls the bank.

A majority of the bank’s Board has worked directly for Cohen or served on Boards of financial intermediaries he has created over the years.  This includes 6 of the 9 bank Board Members —  Chairman Daniel Cohen along with Beach, Bradley, Kozlov, Lamb, and McEntee III.  

In researching articles we have written about The Bancorp, we discovered that Cohen has been the CEO of a number of companies that create and trade CDOs, most of which imploded in the financial crisis of 2008-10.

The Bancorp Case

In its  3Q14 10-K, The Bancorp announced that it was discontinuing its $1.2 Billion commercial lending operation.  It set aside this portfolio on its balance sheet,  claimed it was marked-to-market, and that the bank was actively seeking buyers.  Since that announcement,  the bank has had considerable trouble selling off the most troubled segments to third-parties.  

As we have said in earlier papers, “fairly marked assets sell fairly quickly”.  A corollary is that failure to sell fairly marked assets is an indicator that the assets are not marked-to-market.

On the next to the last trading day of 2014 when most of us are making New Year’s plans, The Bancorp issued a terse 8-K saying it had made the first sale to a partnership called Walnut Street 2014-1 Issuer, LLC.  

Nine months later when it finally issued its 2014 10-K (another bank debacle detailed by us elsewhere), the bank revealed that it did not consolidate this LLC into its balance sheet despite the fact that the overwhelming proportion of the LLC’s financing came from the sale of notes back to The Bancorp itself.  

What caught our eye initially in early 2015 was NOT the financing structure.  That came out nine months later.  What caught our eye initially was the stark contrast in markdown between the sale portion and the remaining portion of the discontinued loan portfolio. (see table below) (click to enlarge)


We speculated in an January 2015 article The Bancorp: Bad Moon Rising that the remaining portion might not be fully “marked to market” and fairly valued.  Our speculation was validated 1 ½ years later in 2Q16  when the The Bancorp was forced by independent auditors to take an additional $32 Million in combined market-downs of the remaining portfolio on its books and write-offs of the notes received from the LLC to pay for the portfolio segment bought.

In electing not to consolidate, The Bancorp cited almost verbatim in Note H of its 2014 10-K (filed 9 months late), and in its 2015 10-K,  the criteria for consolidation specified in FASB 46R – Statement 167:

“(1) the power to direct the activities of the VIE that most significantly impact the VIE’s economic performance; and

(2) through its interests in the VIE, the obligation to absorb losses or the right to receive benefits from the VIE that could potentially be significant to the VIE.”

The table below is our presentation of the variable interests in the LLC as detailed in Note H of the bank’s 10-Ks: (click to enlarge)

The Bancorp VIE: Walnut Street 2014-1

The fact that bank waited until the day before New Year’s to disclose this sale in a terse 8-K plus the fact that the structure of the deal was so convoluted,  giving its partner 51% of the voting stock despite practically no “skin in the game”, alone suggests right from beginning that The Bancorp is testing the limits of Post-Enron GAAP.  

The Bancorp’s partner here  is Angelo, Gordon & Co (AG & Co.)  out of New York City.  According to its website, AG & Co. is a large $26 Billion manager of  “alternative investments” including commercial real estate mortgage-backed securities (CDOs).  

Legally speaking, AG & Co. is an unrelated, third party to The Bancorp and its the Chairman Daniel G. Cohen.  But, AG & Co. is listed as a “banner investor” of a firm that merged into Cohen’s latest concoction — a “blank check” IPO called Fintech Acquisition Corp, which we have written about in our paper Fintech Acquisition “Blank Check” IPO: Buzzy Name Fuzzy Aim.

Also, the founders of  AG & Co. — Michael Gordon and the late John M. Angelo — must have had direct meetings with Cohen over the years as both AG & Co. and various Cohen controlled companies —IFMI, Cohen & Co., Alesco Financial, Taberna Realty Finance, and RAIT Financial Trust  —  create and trade CDOs.

The fact that AG & Co has practically no “skin in the game” plus the fact that its founders had prior dealings with Cohen suggest that the bank’s sale to the LLC was barely an arm’s length sale to an unrelated third-party.

In Note H of its 10-K, the bank at least acknowledges that it has the most exposure to LLC losses:  “The Company’s maximum exposure to loss is equal to the balance of the Company’s loans, or $178.5 million.”

In terms of criteria (2) alone, the bank should have consolidated.  But what about criteria (1) above?

In Note H of its 10-K, the bank has nothing to say about who has the most power to make decisions that affect the performance of the LLC.  It just ends the note abruptly with this conclusion:  “The company is not the primary beneficiary, as it does not have the controlling financial interest in WS 2014 (the LLC)  and therefore does not consolidate.”

The purpose of the rest of the paper is provide evidence in support of our contention that it is high level executives at The Bancorp who make the key operating decisions that affect the LLCs financial performance and therefore The Bancorp should have consolidated.

Before we start, we just want to mention first that the very name for the LLC — Walnut Street 2014-1 Issuer, LLC. — marks its as The Bancorp’s venture, not some true partnership.

The Bancorp’s founder, Betsy Z. Cohen, the mother of Bancorp Chairman Daniel G. Cohen, was instrumental  reviving the Walnut Street area of downtown Philadelphia in the 1970s by making risky loans to startup restaurants in the area.  It is ironic that the same Walnut Street name that was associated with a civic-minded banker/mother in the 1970’s is now associated with a rule-bending banker/son now.

Officers and Directors

When trying to determine who controls the operations of an LLC, the usual place to start is a listing of the officers.  Unfortunately, but not unexpectedly,  Walnut Street LLC was formed in Delaware where such information is not publicly available.

Fortunately, we have found on-line a copy of the Purchase Agreement between The Bancorp and the LLC.  It yielded two names associated with the LLC.

The  LLC’s “Directing Holder”  is Jonathan Lieberman, head of AG & Co’s considerable commercial and real estate loan trading operations.  He is based in New York City.  One has to wonder how much time Lieberman puts into an LLC where AG & Co.’s investment is mere $16 Million, or less than .5%  of the Billions of real estate  investments he must be managing.

The LLC’s  “Designated Manager”  is Kenneth L. Tepper, head of Kildare Financial Group, an independent contractor that has been used by the FDIC to sort bankruptcy messes.  The initial address for the LLC was his office address in Gladwyne, PA.

It turns out Tepper has close ties to The Bancorp. According to a Bloomberg bio, Tepper has served as Managing Director of Financial Institutions Group at Cohen & Co, a firm founded by the family of Chairman Daniel G. Cohen.

Also, there is a 2012 article that says Tepper has worked on bankruptcy cases with Hersh Kozlov, a managing partner of the Philadelphia area law firm Duane Morris LLP.   It turns out that Hersh Kozlov has been a  Board Member of The Bancorp since 2014 and The Bancorp uses his law firm Duane Morris LLP.

In short, Kenneth L. Tepper was a front for The Bancorp when it set up the LLC in 2014.

Legal Activity

In trying to answer the question of who makes the key decisions that affect the LLCs financials, we start by asking what are the activities of this LLC that most significantly affects its performance?

The business of the LLC is managing an existing, troubled commercial loan portfolio already marked down 28% from principal. There is no need for loan officers to drum of new business,  get appraisals, or to create new loan documents.  

There is a need for servicing existing loans — posting remittances, checking certificates of insurance, sending out routine delinquency notices. etc. The Bancorp discloses in Note H of its 10-Ks that it has a contract to service the LLC’s loans.  But, servicing existing loans does not have material impact on financial performance.

The really important decisions of the LLC involve the handling of delinquent accounts.   This involves face-to-face meeting with borrowers who are mostly in the Philadelphia area.  It involves facilitating refinancing with other banks.  It involves directing lawyers to file documents in area courts to recover from borrowers who have defaulted on their loans.

Here is an a quantitative estimate of how many loans are involved in the LLC portfolio. The Bancorp’s CFO Paul Frenkiel gave some detail in a 2Q16 conference call regarding the concentration ratio in the discontinued operations portfolio.   By applying the same ratios to the LLC loan portfolio, (see below) we can get some idea of the number of large loans in the LLC portfolio: (click to enlarge)

The Bancorp: Walnut Street LLC Loan Portfolio

The core of the LLC activity is working with approximately 29 total customers, concentrating on about 5 customers with outstanding loans principals averaging $20 Million.  Losing one to default would be impactful. Losing two would be disastrous.

Below are links to two 2016 filings by lawyers on behalf of the LLC to recover from borrowers who have defaulted.  The total claims amount to $28.2 Million, or 14.6% of the total loan portfolio.  In both cases, the lawyers are based in the Philadelphia area and have close ties to The Bancorp.

In June 2016, a suburban Philadelphia paper reported a sheriff’s sale of a suburban shopping center where the owners were in default of loans held by the LLC. “According to a schedule of the Schuylkill County Sheriff’s Sale of Real Estate, the mall has been listed for sale based on a judgment of $27,428,876.”  This single default represented 13% of the LLC’s total portfolio.

The article mentioned that the LLC’s claim for damages was filed by Dana B. Klinges.

It turn out that Klinges is with the law firm Duane & Morris LLP. where Hersh Kozlov, a Board Member of  The Bancorp’s is a managing partner.

In May, 2016, a lawyer for the LLC filed in Pennsylvania court a plea to recover $822,053 in loan principal plus interest from owners of another Philadelphia area shopping center.  The lawyer was with the law firm  Spector, Gadon & Rosen P.C.

It turns out that  Spector, Gadon & Rosen P.C. was co-founded 35 years ago by Betsy Z. Cohen, founder of  The Bancorp and mother of Chairman Daniel G. Cohen.

Finally,  the LLC’s corporate attorney  — Dechert LLP — has close ties  to The Bancorp as Dechert LLP is listed as one of the Bancorp’s corporate attorneys and defended them in an investor lawsuit.

While we have evidence that all of these outside lawyers have close ties to The Bancorp, we have no hard evidence as who specifically gives them high-level direction.  Who do these lawyers discuss strategy with in face-to-face meetings in the Philadelphia area?  Who reviews their invoices? Who signs their checks?   

Based on court documents in connection with the shopping center case cited above, The Bancorp executive that lawyers report to is Daniel Sacho, current Executive Vice President of Commercial Lending and Real Estate.

The Bancorp’s Headquarters is in Wilmington, Delaware.  The Bancorp maintains a large office at 1818 Market Street, 28th Floor  in downtown Philadelphia. Of note, several other companies controlled by Daniel G. Cohen — Rait Financial Trust and Cohen Bros. & Company —  also maintain offices on the same 28th floor.  

A high level bank executive based in Wilmington at The Bancorp’s HQ is only 37 miles and a 40 minute ride by train or car away from their downtown Philadelphia office.

Finally, here is an example of an  assignment document transferring a loan from The Bancorp to the LLC.  The address used for the LLC was ℅ The Bancorp Bank, 712 Fifth Avenue 8th Floor, New York, NY 10019.  This is the same address used by Chairman Daniel G. Cohen for his Fintech Acquisition Corporation.

Accounting Activity

By selling a segment of its discontinued operation’s loan portfolio to an unconsolidated LLC, The Bancorp escaped rigorous, transparent, and periodic examination of mark-to-market GAAP for its troubled commercial loans.

But, those troubled loans were largely replaced on the bank’s balance sheet by $193.6 Million in notes issued by the LLC.  The Bancorp has chosen to label these notes an “investment in unconsolidated entity.”  While not subject to the same rigorous and periodic examination as direct loans, nevertheless this investment is subject to review as to value.

Normally, mark-to-market accounting of loan portfolios and investments are reviewed by a bank’s independent auditor, in this case, Grant Thornton LLP.  

However, on July 28, 2016 in its 2Q16 conference call, The Bancorp disclosed that it had engaged several independent auditors to review both the on-balance sheet portfolio and the off-balance sheet portfolio of the LLC.  Per their recommendation, the bank took a total of $32 Million in combined mark-downs of its on-balance sheet portfolio and write-off of its on-balance sheet investment in the LLC.

This surprised Wall Street and sent the bank’s stock down for a 14% one-day loss. This was the first time The Bancorp’s financials took a hit from its commercial loan operations since it declared it a discontinued operation nearly 2 years ago.

The bank must have known ahead of time that this disclosure would would cause  investors to worry about how close the bank was to the Dodd-Frank standard.  Two weeks later, on Monday August 8, 2016, The Bancorp announced a private placement of combined common and convertible preferred stock for a total gross consideration of $74 Million.

The Bancorp’s 2Q16 conference call revealed how deeply it was involved in its non-consolidated LLC.  Here is an exchange revealing that The Bancorp had hired  independent auditors for both portfolios and that, in particular, it had hired one independent auditor to work on both:

        William Wallace (Analyst, Raymond James & Assoc.)

         Okay. And do you have the same person or firm or company that’s valuing the value of those loans  versus the         ones that are in your discontinued ops.

        Paul Frenkiel (CFO, The Bancorp)

       We actually use multiple companies, but our primary loan review company, we have one loan review company         for discontinued ops and we have another one that also does work on that, but it is more specific to the one             that’s [doing] the investment in that [un]consolidated entity.


Investors eventually sense when a publicly-held company pushes GAAP to the limit. It’s stock price begins to fall long before any outside auditor or the SEC steps in to question its accounting publicly.  

The stock market has already punished The Bancorp for its handling of mark-to-market accounting and its painfully slow disposition of its discontinued commercial loan operations.  Between March, 2014 when it first announced an unexpected additional mark-down of its loan portfolio and June 12, 2016, the stock has fallen 69.3%  from $19.98 a share to $6.12 a share.

The Bancorp Stock Performance

Even though The Bancorp has moved a segment of its troubled loans off its balance sheet,  its balance sheet  eventually took a hit anyway.  Pressure from investors eventually forced the bank to accept an independent auditor’s recommendation to write-off a portion of the notes it took back from the LLC.

The problem is “eventually”  is not good enough.

In July, 2016, The Bancorp announced that it had settled a class action suit brought by investors who had lost $100+ Million during the past two year.  The settlement was for a paltry $17. 5 Million, of which the bank said that 100% was covered by insurance.

The Bancorp’s outside auditor Grant Thornton LLC needs to force the bank to explain in greater detail in its Note H why it believes it is in compliance with both criteria specified in  FASB 46R – Statement 167.  The SEC, FDIC, and the Federal Reserve need to review this case of non-consolidation.  

Allowing The Bancorp to get away with this non-consolidation sends a signal to banks that they can avoid falling below the Dodd-Frank standard by setting up blatantly convoluted VIE’s similar to Walnut Street 2014-1.