Selling short-selling short
Paul Kedrosky
Financial Post
Tuesday, March 25, 2003
'Our shareholders can't obtain stock certificates." That plaintive headline from Nutek Inc. briefly flashed across newswires yesterday.
Were Nutek shareholders barred from brokerage offices? Or had they fallen and not been able to get up? And why does Nutek care that its shareholders can't get their stock certificates? More importantly, who worries about stock certificates these days anyway?
In answering those questions we enter the Spy-vs.-Spy struggle between short-sellers and penny stocks, a place where things rarely happen for the reasons given.
Nutek says in its press release that 24 of its shareholders, representing 4,524,943 shares, are not being given stock certificates by their brokerage firms. According to Nutek, the offending companies are a who's who of the major brokers, including E*Trade, Ameritrade, TD Securities, and Charles Schwab. So with these brokerage firms being understandably intransigent about delivering millions of paper certificates, Nutek announced this morning that it had entered into a federal lawsuit in the United States to force delivery.
Why does Nutek want so badly for its shareholders to have shares in paper form? The company says on its Web site that it is trying "to ensure the integrity of the market for shares of Nutek's common stock and to protect the investments of bona fide shareholders."
The preceding is truly a laudable instinct, but it is also a mischievous interpretation of the facts.
Companies like Nutek are convinced that short-sellers -- people who borrow stock and sell it, hoping to buy it back later -- are driving down the value of their shares. Short-sellers, for their part, see their actions as a necessary response to overpriced companies, large or small. Neither think very much of the other side, and they are both prepared to use whatever tactics they can to prevent their counterpart from gaining any sort of advantage.
So, late last year, Nutek, as well as a better-known and more picked-upon company named GeneMax, announced that they were withdrawing from the Depository Trust Company (DTC). The firm is a global electronic securities settlement clearing house, a mechanism for allowing brokerage firms to manage stock trades without having to deal with an avalanche of stock certificates and collateral paper.
Their idea in withdrawing from DTC? By forcing owners of their shares to hold them in paper certificate form they could make life much more difficult for short-sellers. Why? Because, and this is a much-debated point, short-sellers in the United States need to make an "affirmative determination" before selling the shares. In other words, they need to have borrowed the stock before they can sell it. By tying ownership to paper certificates, Nutek and GeneMax hope to make short-selling much more difficult -- and thereby frustrate their opponents.
In Canada the situation is somewhat different, with no affirmative determination required. In other words, short-sellers in Canada, or using Canadian brokerage firms, can sell stocks short without borrowing the stock first. Called "naked shorting," it is even more loathed by its targets, because it means there is always a ready supply of stock to be sold.
Naked short-selling is so despised that there is a new and somewhat suspicious-sounding National Association Against Naked Short Selling (NAANSS) in the United States. It provides a helpful checklist for executives worried that they are "victims" of naked short-selling: If your company experiences repeated sales of stock that drive the share price down, or it has unreasonable trading volumes, or there generally seems to be more shares around than you wanted, you too may be at risk!
The truth, of course, is that the biggest detractors of short-selling (naked or clothed) are promoters and principals in penny stock companies. Why? Because promoters of penny stocks want to keep those stocks thinly traded. That is how they engineer the price. If short-selling were to suddenly make the market for those stocks more liquid, their prices might, after all, fall to some more reasonable approximation of what the underlying company is worth, and that is often closer to zero than to $100.
Opponents act as if short-sellers are getting a free ride, especially when they naked short. The truth is something else. One of the most dangerous games in the world of selling short is shorting penny stocks. These stocks could go up 50-100%, or more, just as easily as halve. Short-sellers messing with penny stocks are taking on immense risk -- they don't need the rules to change against them.
For its part, DTC is fighting back. It has a proposal in front of the Securities & Exchange Commission rightly arguing that it should be shareholders who demand their certificate in paper form, not the issuing companies who force shareholders to hold shares in one form or another. Good for DTC, and its proposal stands a reasonable chance of success.
It won't, however, change anything for GeneMax or Nutek. They managed to demand paper certificates from shareholders before DTC asked for the rule change. It may seem mad in a world of electronic communications to suddenly become fond of paper share certificates, but no gambit is too tricksy in the Spy-vs.-Spy tussle between penny-stock promoters and short-sellers
nationalpost.com
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