Sting Operation Could Be Tip of Iceberg
August 16, 2002 09:10 PM ET
By Toni Clarke
NEW YORK (Reuters) - A two-year federal sting operation led to a mass indictment this week of 58 stockbrokers and corporate executives on charges of stock fraud and money-laundering.
It's just the tip of the iceberg, lawyers say.
One of the most prominent figures caught in what investigators call the "Bermuda Short" operation was Mark Valentine, the suspended chairman of Canadian brokerage Thomson Kernaghan & Co. Ltd., according to FBI officials.
The arrest of Valentine, who was detained in Frankfurt on Wednesday, could help unravel other stock manipulation schemes, say lawyers for companies that claim to have been victimized.
Valentine's lawyer, Joe Groia, was not immediately available for comment on Friday.
In federal indictments unsealed on Thursday, investigators claim that Valentine and a Bermuda-based financial firm conspired to manipulate the shares of three companies -- JagNotes.Com, Softsquad Software Ltd. and C Me Run Corp. Kernaghan was not immediately available for comment.
Valentine's company is one of dozens of brokerages -- many based offshore -- that have stripped or ruined small U.S. companies in fraudulent funding schemes, possibly helped by venerable Wall Street firms, according to lawyers of the affected companies.
"Our mission is to find the real beneficial owners behind these offshore companies, to find the banks behind them and the brokers through which they trade," said James W. Christian, a Houston lawyer representing a growing number of companies that claim to have been hurt in the schemes.
Christian is partnering with John O'Quinn, the Houston attorney who won billions of dollars for clients in breast implant and tobacco suits.
The frauds allegedly center around a funding mechanism known as "death spiral financing" in which an investor or group of investors approach a company with limited access to cash and offer to invest in return for convertible preferred debt.
Unlike typical convertibles, which convert into a specific number of common shares, the death spiral preferred debt converts into a set dollar amount of common stock. If the price of the common stock declines, the convertible holder is entitled to more shares.
The victimized companies see their stock plummet right after the investment, as the convertible holders begin short-selling the common stock, the plaintiffs say. Short sellers sell borrowed stock on the bet the price will fall. If it does, they buy back the stock at the cheaper price and pocket the difference.
As the stock of the target company plummets, the unscrupulous investors convert their preferred debt into common shares, diluting the value of existing shareholders almost out of existence, the plaintiffs' lawyers say.
A wide range of Wall Street firms sold shares they could not deliver on behalf of such investors, the plaintiffs' lawyers say. Short-selling in itself isn't illegal. But it is illegal if the certificates are never delivered, or if there is no intention to cover the sales -- something known as "naked" short selling. That, plaintiffs say, is exactly what happened.
"In our opinion, the brokers are going to get slaughtered," said Christian. "We've identified 50 that make sizable money from it. The same guys are doing this every day."
Thomson Kernaghan is one of dozens of brokerages that are named in civil suits filed by O'Quinn's group. The group has filed lawsuits on behalf of five companies, most of which trade on the over-the-counter Bulletin board, and it's preparing to file another seven, Christian said.
JagNotes, subsequently renamed Jag Media Holdings Inc., is one of the companies O'Quinn's group is representing in a civil suit. Among the defendants named in the Jag suit are well-known Wall Street firms like Banc of America Securities, Bear Stearns Cos. and CIBC World Markets Inc, as well as dozens of others.
Representatives from Bear Stearns, CIBC and Banc of America Securities were not available for comment.
The practice of naked short selling became evident when Jag began issuing a new class of shares to stockholders in return for their old certificates, plaintiffs lawyers say. More shares had been sold than could be accounted for by the number of certificates held.
"Many brokerage houses have large gaps in their beneficial holder lists," the Jag complaint alleges. "In many instances there is no certificate to match many trades held by brokerage firms and back office people who are settling the trades."
John Finnerty, principal at Analysis Group Economics, a consulting firm that has been analyzing the trading into some of the victimized companies, said it is clear that short selling accounted for a large part of the decline in the targeted companies' shares, though it is unclear who was behind the selling.
"We could not identify any fundamental or market related reasons that would account for the stocks being driven down as much and as fast as they were," Finnerty said.
A lawsuit filed by O'Quinn on behalf of Internet Law Library, now called ITIS, lists numerous companies whose shares declined precipitously after being touched by Kernaghan and others.
According to Christian, hundreds of companies have been hurt by groups with very similar modus operandi. An examination of filings made with the Securities and Exchange Commission indicate that the same group of names -- often investment entities based offshore -- come up time and again in connection with companies that, having accepted money from these groups, see their stock plunge to near-zero.
Desperate start-up companies, often without much business savvy, are eager to believe the groups' pitch. The investors often request warrants to buy shares at a higher price, implying they have an interest in seeing the company succeed. But the warrants are almost never exercised because the stock price heads south after the ink is dry on the financing.
"The most compelling fact in all these cases is the repetitive pattern of abuse by these companies," Christian said. "Everyone who goes into operating room No. 1 dies. That's what will get us punitive damages."
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