This post has been floating around on RB for a while. I would like to find the source.
ALERT Education:Manipulation of Bulletin Board Stocks Through "Shorting"
Whenever a bulletin board stock goes down, investors seem to always
blame "shorting". Some of it is undoubtedly true, but much of it is not.
Before I begin to discuss the different kinds of shorting, I want to
cover 2 other kinds of manipulative market activity which are not
uncommon in bulletin board stocks but is often confused with "naked"
shorting. These are sales of Reg S shares and convertible instruments,
especially so-called "death ride" convertibles.
SEC Regulation S allows US public companies to sell shares of their
stock very quickly. The rule was originally intended to help growing
companies to raise money without time consuming and costly regulatory
interference. Unfortunately, Reg S has instead been used as one of the
most common conduits for securities fraud. Reg S shares are typically
sold at a significant discount to the current market price because they
can only be sold overseas to non-US individuals and investment entities.
The other major catch is that they can not be resold into the US market
for a specified period, usually 45 days from the date of closing. The
idea is that the company can raise money quickly with a minimum of
regulatory requirements and the newly issued stock does not flood the
market. Unfortunately in practice, this has often not been the case.
Some of the buyers of Reg S shares have actually been Americans hiding
behind ownership in offshore investment companies. The biggest problem
with Reg S shares, however, have been violations of the required hold
period. Because the Reg S shares are sold at a discount to the current
market price, there is a huge temptation for the buyer to quickly resell
the stock into the open market to capture and pocket the difference.
This is difficult to do since the certificates are restricted. What is
often done instead is the stock certificate is deposited in a foreign
brokerage account (often Canadian) and then a like amount of shares are
sold short. This immediately "locks in" the full amount of the
difference between the discount sale and the current market price, minus
commissions and margin interest. When the required hold period is up,
the now unrestricted certificate is turned over to the transfer agent
and the short position is eliminated. Technically, this is not "naked
shorting" but "covered shorting" because the seller owns the same amount
of shares it has sold short. It has the same overall effect on the
stock, though, especially since the stock is sold so quickly and without
the requirement of public filings current shareholders usually know
nothing about it. The SEC recognizes that Reg S abuse has been a huge
problem. They have begun to take steps to clean up the Reg S market.
The convertible securities that are such a problem for OTCBB companies
are often called "death ride" or "death spiral" convertibles. Normal
convertibles give the holder the right to convert the first security
(either a stock or a bond) into another type of security (usually common
stock) at a given price (i.e., since the price is fixed, the total
number of shares underlying the convertible instrument is a known
quantity. Death Ride's, however, are not convertible at a given price
per share but instead at the number of shares required to meet the face
value of the convertible instrument. For instance, if the convertible is
preferred stock worth $1000 and the common stock is worth $1, then the
convertible is worth 1000 common shares. However, if the common stock
subsequently declines to 50 cents, then the preferred is now convertible
into 2000 shares. What some buyers of the death rides do is to play them
like they do Reg S shares. They deposit the convertible shares into a
brokerage account and then short sell a like amount of the common stock.
The short selling activity helps drive the common share price lower,
which means the convertible is worth a higher amount of common shares.
The additional common share equivalent is then sold short, driving the
share price even lower. This almost never-ending cycle is why these
instruments are called "death spirals". Since the short sellers own the
convertibles, this is also considered by many to be covered shorting and
not naked. If the issuer of the convertibles is on the Federal Reserve
list of marginable securities, then the owner can conduct their shorting
with a U.S. brokerage. If the issuer is traded on the OTCBB, then they
will often use a Canadian brokerage because, in certain situations, they
do allow shorting OTCBB securities.
Most individual investors cannot -legally- short bulletin board stocks
in the US. There are several reasons why, but for this discussion I
think it is enough to say it really is not done. If anyone doesn't know
why, ask your broker or drop me a line and I will explain it further.
Although individual investors cannot short these stocks, market makers
can. Market makers can go short on any stock as long as it is related to
""bona fide market making activity" (Rule 3350). Naturally, the key is
the term "bona fide". The NASD manual clearly states that market makers
should not go short a security simply for speculative purposes. However,
there are several market makers widely known to do almost nothing but
short stocks for their own account. NASD rules make it extremely easy
for a market maker to begin making a market in any stock very quickly,
so these particular MM's often show up suddenly in many hot, high-flying
OTC stocks. When they do, it is a pretty good indication that they stock
price will soon be under pressure and it is a good time to take a hike.
Besides the fact that market makers are professionals and some do a
efficient job identifying overpriced stocks, they also have very deep
pockets. Considering the average OTCBB stock has a tiny market
capitalization, it doesn't take much to help nudge a stock one way or
the other.
Finally, we come to the last form of shorting, the so-called "naked"
shorting. Yes, it does occur in OTCBB stocks. Yes, Canadian exchanges do
allow for shorting of OTCBB shares. However, the actual amount of
shorting in these shares by individuals is probably a lot less than most
people think. For some reason, every time an OTCBB stock goes down it
seems someone starts screaming "naked shorts". The facts are that
although Canadian securities regulations do allow OTCBB and other low
priced shares to be both marginable and shortable, the amount of
collateral required is large. For instance, to short an OTCBB stock
selling for under 50 cents per share, Vancouver Stock Exchange rules
require the account must have credit equal to the market value of the
shorted stock plus 50 cents per share. Can an American short OTC BB
shares this way? This is where it gets sticky - US regulations say no.
This is almost certainly one of several areas in which the ongoing SEC
investigation of Canadian brokerage firms is focusing upon. More on this
later.
Just about every stock promoter likes to trot out the "naked shorting"
excuse when the stock they are hyping is falling. With 20/20 hindsight
(and some help from regulators' legal briefs) we can often see that
these same stock were declining not because of "naked shorting" but
because insiders, control persons as well as the promoters themselves
were dumping huge blocks of stock into the open market. Thus, they were
using the "naked shorting" excuse to cover their tracks and perhaps
entice gullible investors into buying more of the stock, which is likely
the promoter's own shares. Often, this selling and shorting is being
done through Canadian brokerages.
A new updated and expanded edition of the "Dirty Tricks" report is
coming soon. In the meantime, read an excerpt from the new version
regarding "Death Spiral Convertibles" and how some company's management
takes advantage of their shareholders HERE.
Toxic (Death Spiral) Convertibles
In many ways, the issuance of toxic convertibles are a legal method to
transfer assets from the existing common shareholders into the pockets
of the toxic convertibles and, to a smaller degree, the management. The
toxic convertible holders get the bulk of the benefit, but don't be
fooled - the issuing company's management is also a beneficiary. Let's
face it, most of the companies that stoop low enough to issue these
death ride convertibles do it because without the quick cash they bring
in the Company would be forced to go out of business. In almost every
case, the small amount of cash they receive is not enough to rescue the
business which is almost always a casualty of bad business decisions our
faulty business plan capped off by the terminal decision to issue the
death ride convertibles. The small amount of cash and brief window of
time afforded by the convertible's issuance is almost never enough to
rescue a company which by all rights is already on life support. In the
meantime, management gets to draw what is usually generous salary and
benefits for awhile longer and may even bail out of their own share
positions before the ship sinks entirely.
While the only winners in the issuance of death rides is the convertible
holders and the management, there are lots of losers on the deals. The
biggest losers are usually the company's original creditors. If we
assume that most of the issuing companies are destined for business
oblivion anyway, then certainly the company should end its life while
there are still assets left to pay off existing debts. After the death
ride is over, there is usually nothing left and the creditors are left
with nothing. That money is almost always siphoned off into the pockets
of the toxic convertible holders who almost always short the issuing
company right into the ground. The common shareholders are also losers.
Like the creditor scenario, any possible assets that might be available
to the common shareholders end up in the pockets of the convertible
holders. However, smart and attentive common stockholders should be able
to recognize a toxic convertible deal and bail out of the stock before
the death spiral begins, assuming, of course, that they have adequate
warning of such a pending deal. Unfortunately, most companies do not
inform their common shareholders of such deals until long after the deal
has been struck and the toxics issued. There is no regulatory
requirement that issuing companies must warn their shareholders of such
deals beyond their regular SEC filings, particularly if the issuing
company's shares are traded on the OTCBB or the Pink Sheets. Therefore,
I have seen cases where a company issues toxics immediately after they
complete their regular filing and shareholders are in the dark until
their next one, which could be anywhere from 3 to 5 months down the
road. By then, the stock price might have already cratered. The same is
true of Regulation S stock sales which are also often done without the
knowledge of the existing common shareholders. By the time they found
out, the holding period has expired and the share resold into the US
market for a quick (and usually very large) profit.
If management understands what happens with "Death Rides", then why do
they sell them in the first place?
One of the scenarios could be that the management and Board of Directors
really, truly thinks the little money raised through a toxic convertible
will be enough to save the Company. You could call this the "prettiest
baby syndrome" where the management thinks that their company is such a
good investment that the toxic buyer won't want to short the stock but
instead hold the common shares through conversion. Unfortunately, I
realistically have seen almost no cases where I think this scenario
could actually be the case. The likely outcome of any toxic issue is
almost completly intuitive. If, for some reason, a company officer or
director doesn't know what will happen the minute they issue one, they
could spend 5 minutes checking the history of these instruments and find
out.
If the management of an issuing company truly and genuinely believed
without a doubt that the issuance of toxic convertibles was the
company's only hope to succeed in business, then I have a few
suggestions. First, company management should agree to accept no salary
or benefits until the convertibles are extinguished. After all, they
believe the money provided by the sale of the toxic convertibles will
help the company succeed. If so, then by forgoing the benefits and
salary the company can use the money saved and become successful that
much sooner! Company management should also "lock-up" every share,
warrant and option they hold, directly and indirectly, to prevent them
from cashing in until the convertibles are extinguished. Again, if they
really believe that money will put the company on the long-term path to
success, they should be thrilled to wait and hold every share they own
until after the selling pressure from the toxics are gone, the company
is on sound footing and the stock price will be higher. Hey, locking up
management shares will pay off for them down the road, right? Finally,
if management is so sold on the deal, they will have no qualms about
informing existing shareholders of the terms before the deal is done. If
they are that confident that selling toxic convertibles is a good deal
for all shareholders, then management should be ecstatic about getting
the opportunity to inform shareholders just how good a deal it is,
right? And, since it is the existing shareholders that will be most
effected by the toxic issuances, let them vote on it first. Of course, I
have yet to see the management from an issuing company do many of the
above, let alone all off them.
To no one's surprise, the management of many of the companies which
perish after issuing these toxic convertibles blame the buyers for
"killing" the companies through the fully hedged shorting of the common
shares against the discounted convertible shares. They claim they had no
idea that their stock would be shorted to oblivion. Unfortunately, this
is highly unlikely. Most of the buyers of these toxic convertibles have
very long track records, bought lots of previous toxic convertible
issues and almost without exception the share prices of the issuing
companies approach zero shortly after the buyers get their hands on the
security. It doesn't take a genius to figure out the buyers are not
losing money even though the stock tanks. Additionally, shorting against
a convertible debenture is not illegal, nor is it "naked shorting". It
is, in fact, "Covered" shorting and in most cases is allowed by market
regulations, regardless of what the ignorant internet chat room and
discussion board posters claim.
The outcome of these deals is well known and, frankly, a no brainer. The
management of the issuers are giving the convertible buyers a license to
take shareholder money. It is very clear that the management of the
companies issuing these floorless "Death Ride" convertibles DO know
exactly what is going to happen. Even though they want you to think they
are after the fact, they really are not that stupid. If you read the SEC
filings related to the registration of the common stock reserved for the
conversion of the floorless convertibles you will almost always see
under "Risk Factors" a complete discussion of the "death spiral" and
what it is likely to do to the company and the price of its stock. In
other words, their regulatory filings clearly state that it is likely
that the common stock will be shorted into the ground. Considering that
the officers and directors have signed these documents, I think they
know right away what is going to happen to their shares. Management
knows very well that they are likely committing suicide for the company
when they issue them, but they do it anyway.
So what does all this mean? The answer is simple - selling toxic
convertibles is NOT in any way good for shareholders or creditors. In
essence, it is like putting a dying company on temporary life support
and making shareholders pay for it, usually without their knowledge or
consent. If you are management of a Company and you are stupid enough -
yes, STUPID - to sell a toxic convertible, you should be striped naked
and paraded up and down the streets with a sign around you neck that
says "I stole all my shareholders's money". And, if you think you aren't
stupid but you sell a toxic convertible anyway, then you are GREEDY.
Yes, greedy. The only explanation (if not stupidity) is that you wanted
to milk the company for a little more money, either in salary, or
benefits or personal stock sales, all the while you are selling your
shareholders down the river to the toxic convertible buyers who are
shorting your stock into oblivion.
As the regulations are now, I see absolutely no economic benefit for
allowing the existence of toxic convertibles. None. For whatever reason,
there has been no real call by shareholder groups to eliminate toxic
convertible sales. Considering that many of the most active and best
known hedge funds which buy these deals are connected to some of the
largest financial firms in North America, I would imagine that any move
to do so would be bitterly fought by these financial powerhouses. Buying
a toxic convertible is like shooting fish in a barrel. It is almost
impossible not to make lots of money on the deal which explains why
there are now so many hedge funds looking to invest in discounted share
deals be it either toxic converts or Regulation S stock sales.
Unfortunately, there seems to be no shortage of ignorant investors
willing to buy the converted common shares all the way down, either. If
the victimized shareholders wake up and stop aiding and abetting the
convertible sellers, it might remove much of the financial incentive for
the buyers and management of the selling companies and reduce the amount
of toxic convertible sales over time. So far, though, I find that highly
unlikely. As long as the practice continues, the best thing an investor
can do is not to buy any company that has issued a toxic convertible and
don't become a victim.
Toxic Convertibles are not the only ways that some companies are able to
issue discounted shares. There are also Regulation S sales and
"Consultant" shares, both of which have been immensely popular among
stock fraudsters. By no means all Reg S and Consultant share issuances
are fraudulent, but unfortunately it is not uncommon. More on those
forms of issuances coming up. |
