MARKET WATCH
It Still Pays to See Who Did the Research
By GRETCHEN MORGENSON
HE nation's securities regulators, in their settlement with the biggest Wall Street firms, have finally come up with a series of rules that they think will keep research by brokerage firms honest, fair and independent. But investors should remember that relying on what looks like independent research can still be dangerous.
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Consider the case of Prepaid Legal Services, a company that sells legal-services plans to consumers. The company, whose shares are up 22 percent this year, is the subject of a heated battle between short-sellers, who think its business model is flawed, and true believers who own its stock.
Last month, Gotham Partners, a hedge fund in New York and a Prepaid believer, jumped into the fray when David Berkowitz, a Gotham principal, completed an extensive analysis of Prepaid. He concluded that the company has a fair value between $32 and $67 a share. The shares closed on Friday at $26.80.
Mr. Berkowitz published the report, "A Recommendation for Prepaid Legal Services," on Gotham's Web site on Nov. 20; two days later, a summary appeared on the Business Wire, which disseminates information to news organizations. The report said Gotham owns "over a million shares" of Prepaid.
Much of the report tries to refute the case against Prepaid that has been made publicly by short-sellers. It filled a research void because only one analyst, at a small brokerage firm in Boston, follows the company. The stock rose 14.8 percent in the week after the report came out.
Mr. Berkowitz said that Gotham has owned Prepaid shares for over a year and that he began his report in September after becoming frustrated with negative coverage of the company on TheStreet.com, a financial news Web site. Mr. Berkowitz decided to write his upbeat views on Prepaid for posting on his own site as well as TheStreet.com after talking to an executive there. He said he called Prepaid executives to see if they thought a report from Gotham "would be a good idea." They did, and he took up his pencil. The stock was trading near $17, he said, but by the time he completed his report, it had risen to around $25.
The week before the report's release, intriguing trading patterns emerged in Prepaid call options, securities bought by investors who think the underlying stock will rise. Options with a strike price of $22.50 that were due to expire on Nov. 15 jumped from 10 cents per contract on Nov. 11 to $2.20 four days later. Volume surged from 398 contracts during the week ending Nov. 8 to 2,759 contracts the week the options expired.
By Dec. 4, two weeks after the Gotham report appeared, Prepaid's stock had risen to $28. That day, Randy Harp, Prepaid's chief operating officer, announced that he was selling 55,000 shares of company stock to repay $1.3 million in personal loans, most of which were from the company and backed by Prepaid shares. Some of Mr. Harp's loan was used to buy Prepaid stock last April, through an option exercise. He has 26,000 shares left.
Did Mr. Berkowitz know at the time he was writing his report that Mr. Harp was set to sell a big Prepaid stake? He said that he did not, but that the sale did not worry him.
Prepaid's shares have drifted lower since Mr. Harp sold. And even though the Gotham report, suggesting the value of $32 to $67 a share, remains on its Web site, the hedge fund has been selling, too. In the past two weeks, Gotham has sold more than 200,000 shares, almost one-quarter of its stake, at prices between $27 and $30.
Mr. Berkowitz would not confirm or deny that Gotham was selling Prepaid shares. But when asked whether it was fair to investors to be selling stock even as his "recommendation" remained in the public domain, he said he felt no obligation to note his sales publicly.
Some things never change. |
