One only needs to read the Sedona Software/Rhino Advisors story to know that hedge funds need to be regulated. If you read the SEC transcripts it only tells a small fraction of the story. This PIPES reporter did some really excellent research. This is a dated story so if you've read this before, my apologies:
PAINTING THE TAPE
PIPE Players Accused of Global Stock Scheme
The PIPEs Report
Part One of a Three-Part Series
by Brett Goetschius
July 1, 2003
Some of the most active private placement agents and investment managers stand accused of conspiring to defraud hundreds of small-cap companies, including dozens of Private Placement in Public Equity (PIPE) issuers, TPR has recently learned. Specifically, government investigators and plaintiffs’ attorneys are charging the defendants with executing stock-kiting schemes to exploit loopholes in the U.S. stock clearing and settlement system. Through these methods, the agents and managers allegedly inflated small-cap companies’ downside trading volumes and reaped massive profits from short positions.
The allegations are contained in court documents and investigative reports of U.S. and Canadian authorities. An ongoing joint U.S.-Canadian investigation into the matter has already yielded 58 indictments of U.S. and Canadian offshore brokers and hedge fund managers. Those arrested include Mark Valentine, former president of the defunct Toronto brokerage Thomson Kernaghan. Valentine’s firm was closed by the Ontario Securities Commission a year ago. Its closure led to the largest claim ever against the Canadian commission.
Thomson Kernaghan is named in a $2.6 billion lawsuit filed in May by Sedona against its placement agent, Ladenburg Thalmann; several former Ladenburg executives; New York-based PIPE fund manager Rhino Advisors; and several offshore funds and securities firms associated with Rhino and British Virgin Islands-based Creon Management. In the lawsuit, a copy of which was obtained by TPR, Sedona’s attorneys assert that former Ladenburg executives Michael Vasinkevich, David Boris and Thomas Tohn schemed with Creon fund manager David Sims, Rhino principal Thomas Badian, and Rhino-managed funds Amro International, Roseworth Group, Cambois Finance, and Markham Holdings to defraud Sedona and its shareholders through the illegal manipulation of the funds’ investment in a $3 million floor-less convertible PIPE issued by Sedona in January 2000.
The Sedona suit goes on to allege that Rhino used its funds and cooperating broker/dealers in the U.S., the Caribbean, and Canada, including Thomson Kernaghan, to orchestrate a campaign of massive, uncovered short-selling of Sedona’s stock, despite specific prohibitions against such activity in the stock purchase agreement. Sedona claims this naked shorting campaign “painted the tape” with extraordinarily high selling volume and decimated its share value, ultimately allowing Rhino’s funds to convert their securities into common stock at a fraction of true value.
The SEC filed suit this spring against Rhino and Badian, alleging Badian manipulated the market through an illegal short-selling campaign against Sedona. The commission claimed Rhino was using brokers and electronic exchanges based in the U.S., Canada, and offshore to hide and wash short trades even after the NASD placed short restrictions on the stock. Rhino settled with the SEC for $1 million without admitting or denying the allegations.
All of the defendants in the Sedona suit have filed to have the case dismissed. Southern District of New York federal judge Kimba Wood has yet to set a hearing to rule on the motions. Court papers filed in the case set out for the first time the exact nature of the scheme. The papers also reveal the alleged players in a conspiracy that Sedona’s attorneys, famed tobacco and implant-liability lawyer John O’Quinn and accomplished attorney Wes Christian, believe has victimized hundreds of small-cap companies and cost shareholders billions.
A Rigged System
Some of the investors accused in the scheme have connections to offshore and European trusts operated by alleged money launderers working for the Russian mafia and Colombian drug cartels. Even more intriguing and insidious than these claims, however, are the methods used by the defendants to perpetrate the fraud. They are accused of exploiting weaknesses in the centralized book entry clearing and settlement system used by each of the nation’s stock exchanges. The Sedona court papers shed light on how market participants can manipulate the system, operated by the Depository Trust Company and known as FAST. The court papers argue that perpetrators have exploited the book-entry clearing system to “kite” stock by selling short shares and allowing the trades to fail, or covering them via surreptitious, off tape purchases that can drastically inflate a small-cap company’s outstanding float and greatly distort trading volume on the sell side.
Such a scheme was allegedly executed using Sedona stock by former Ladenburg executives working in concert with Rhino and its offshore network of hedge funds, U.S. market makers Wm. V. Frankel and Westminster Securities, and Thomson Kernaghan.
“The story here, in our belief, is about a rigged system. That rigged system occurs by virtue of a broker/dealer community that doesn’t deliver securities in a timely manner. We believe [the perpetrators] are aided by a lack of procedures at the DTC and the National Securities Clearing Corporation, each of which is owned by the broker/dealers,” Christian said last week in an interview in New York, where he was taking depositions for the case. “The case got much larger than just some bad guys and some money launderers when those guys found holes in the system and began using them profusely. They wouldn’t have been allowed to do this if everybody had been enforcing the rules that were created to keep this from occurring.”
Christian, of Christian, Smith & Jewell, and O’Quinn, of O’Quinn, Laminack & Pirtle, have devoted 70 attorneys to the 20 suits the Houston-based firms have filed against Rhino and other alleged perpetrators of the stock-kiting schemes. Christian says he expects to file similar suits on behalf of another 80 companies in the coming months.
“The Goldman Sachs of Small-Caps”
According to Sedona’s complaint, the scheme began to unfold shortly after Michael Vasinkevich and his team from Paul Revere Capital moved into Ladenburg Thalmann’s Long Island branch offices in the summer of 1999. There, they began soliciting financing business for Ladenburg’s structured finance group. At the time, Vasinkevich and the Paul Revere team were working with former Ladenburg executive vice president David Boris. Boris, now a managing director at Morgan Joseph, is a defendant in the suit. (All of the Sedona defendants contacted for this article declined to comment.)
Vasinkevich, in an August 1999 letter to Sedona’s CFO Bill Williams, asked Williams to consider using Ladenburg’s Secondary Offering Substitute and Private Placement Alternative, or “S.O.S.,” PIPE program to raise capital through a private offering. In the letter, Vasinkevich boasts of Ladenburg’s access to “$50 billion” of investment capital and trumpets Ladenburg as “the Goldman Sachs of small cap companies.” Vasinkevich goes on to describe the S.O.S. program as a “hard floor” convertible program that protects small-cap issuers like Sedona from short selling and arbitrage plays:
“S.O.S. . . . enables a company to raise funds when and as needed. The company sets a hard floor - a threshold price below which it will not issue any stock. The company knows exactly how much money it can receive every month during the life of the S.O.S. Product. Since the company decides when and how much money to draw down, the S.O.S. Product offers market ambiguity as to timing and dollars raised, keeping short sellers and arbitrageurs at bay.”
In what Sedona calls a “bait and switch” by Vasinkevich and former Ladenburg associate Thomas Tohn, Ladenburg allegedly agreed to provide up to $50 mil-lion over time through the S.O.S. program, beginning with a commitment to place up to $17.5 million. Sedona announced the initial agreement in January 2000. As part of the financing program, Vasinkevich subsequently suggested Sedona issue $3 million of variable-priced convertible preferred stock. He said it would “serve as interim financing in case our proposed underwritten common stock and warrant deal is delayed due to the SEC review of the registration statement,” according to a late December 1999 fax from Vasinkevich to Sedona’s Williams.
The Ladenburg PIPE did indeed include a $3.50 per share “hard floor” on the securities’ conversion pricing—but only for the first 90 days. After that, the fixed conversion price was replaced with a “floorless” pricing formula that used a conversion price equal to the lesser of $5.12 and “95% of the aver-age of the three lowest closing bid prices” of Sedona’s common stock during the 20 consecutive trading day period immediately preceding the conversion date, according to Sedona's S-3 filing for the offering.
Notably, the terms of the stock purchase agreement prohibited holders from engaging in any short sales of Sedona stock. Sedona executed the PIPE offering with Ladenburg in late March 2000. The company’s shares traded near $6 on the Nasdaq Small Cap Market.
The Offshore Players
Sedona agreed to pay Ladenburg a fee equal to 1% of the face value of an expanded $50 million shelf registration, plus 6% of the gross proceeds from each sale of the securities, and warrants equal to 7% of the gross proceeds. Ladenburg placed Sedona’s convertible securities with several funds managed by Rhino Advisors, Badian, and David Sims, a principal at Creon and British Virgin Islands-based Beacon Capital Management.
Rhino placed the Sedona securities with several offshore funds managed by Sims and a David Hassan of Gibraltar, including Amro, Roseworth, Markham, and Cambois Finance. Amro, which has invested more than $47 million in Rhino-managed PIPE deals according to private placement research firm Placement Tracker, is identified in SEC filings as a “sister fund” of Creon. Other filings declare Roseworth and Cambois as being wholly owned by Creon. Creon is also listed as the guarantor of another PIPE fund that uses the address of H.U. Bachofen in Zurich, Switzerland. Bachofen is, in fact, president of Amro. Finally, a funding announcement filed with the SEC in April 2000 by Stockgroup.com, a Rhino PIPE investment, states of Rhino that “in three years of operation its investment strategies have nearly quadrupled the base capital deposited into Amro and Creon.”
Several of Rhino’s funds, including Roseworth and Markham, are registered to a Lichtenstein-based law firm, Dr. Dr. Batliner & Partner. Batliner, who claims to hold two doctorates (hence the double Dr.), is a former German federal judge and confidant of former German chancellor Helmut Kohl. He has been the subject of investigations by German intelligence, reports of which were leaked to Der Spiegel, linking the doctor-doctor to money laundering operations with the Russian mafia, the Medellin drug cartel, the Ferdinand Marcos family, and Kohl’s Christian Democratic Union party.
Batliner has denied all wrongdoing. Nonetheless, Badian told The Daily Deal in October 2001 that Rhino had ceased doing business with Batliner after the allegations came to light. Christian said that Batliner and his firm would be added to an amended complaint in the Sedona case, expected to be filed soon.
With the $3 million of financing from the Ladenburg PIPE in hand, and a commitment letter from Ladenburg’s Boris to place up to $50 million in financing for the company over coming months, Sedona issued a press release in May 2000 announcing that it would increase its shelf registration to $50 million in anticipation of additional Ladenburg led placements. Ladenburg, however, would never fund even the original $17.5 million commitment announced in January 2000, despite alleged assurances from Ladenburg and Rhino that they could provide “all the financing the company would ever need.”
Within 90 days of closing the convertible preferred offering with Rhino, Sedona’s stock price would plummet from over $10.25 per share to less than $3, wiping away $195 million in value. By the end of 2000, Sedona’s stock hovered near $1 a share. Sedona executives, suspicious of trading patterns in its stock but still desperate for capital, would soon find themselves working on a second PIPE with Ladenburg and Rhino to retire the previously issued convertible preferred shares. It would be Sedona’s last offering as a Nasdaq-listed company.
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PAINTING THE TAPE
Anatomy of a Naked Short Scheme
The PIPEs Report
Part Two of a Three-Part Series
by Brett Goetschius
July 15, 2003
After software developer Sedona completed its first financing with Ladenburg Thalmann and Rhino Advisors in early March 2000, company chairman Marco Emrich was a confident man. He was sure that, however onerous the terms of the PIPE may be, Sedona would quickly retire the preferred stock and soon secure up to $50 million in straight equity financing, as allegedly promised by Ladenburg. Less than four months later, with Sedona’s stock down more than 70%, Emrich was concerned that he was being played—and that his company was quickly heading toward financial ruin.
According to Sedona’s legal counsel, John O’Quinn of O’Quinn, Laminack & Pirtle and James “Wes” Christian of Christian, Smith & Jewell, Sedona is only one of hundreds of companies that have been victimized by stock manipulation schemes linked to variable priced convertible PIPE investments made by a handful of U.S., Canadian and off-shore-based placement agents and investors. Christian says losses from these schemes may total $1 trillion and involve up to 1,000 public companies.
Syntax of the Alleged Scheme
Christian points to a common pattern that he believes marks these schemes. First, there is the floorless convertible bait-and-switch. A company seeking $10 million or more in financing is told by a placement agent that it can indeed finance a deal, but that it first must do two things: register or expand an existing shelf registration for the total amount contemplated, and complete a small interim financing in the form of a floorless convertible to pro-vide bridge financing until the larger funding is delivered. According to Christian, the shelf registration effectively takes the company “out of the market” for competing capital by signaling to the investment community that the company has found investors to complete a large offering in the near future. It also provides a pre-arranged mechanism with which to quickly issue several times over the number of shares contemplated by the initial PIPE conversion agreement.
Second, the convertible financing offered by the agent has a conversion pricing mechanism that is biased to reflect a stock’s short-term downside volatility. Conversion formulas for these deals feature pricing terms based on the average of a stock’s three lowest closing prices over a 20-day period, or a tight price ceiling on an otherwise sharply discounted floorless security. Others offer relatively straight forward common stock placements coupled with variable-priced “make whole” warrants capable of triggering the issuance of four to six times as much stock as in the original offering.
Third, the larger funding commitment is contingent on the company’s shares maintaining a minimum price threshold. The investors are released from their larger funding commitment if the stock drops below the threshold in the intervening period when the interim PIPE financing is in place. In this way, the placement agent and its investors can avoid funding the larger capital investment. This step completes the setup for the bait-and-switch, Christian contends.
Fourth, investors come invariably from outside the U.S., often from offshore tax havens. These investors often are not named until the documents are presented to company executives for signing. Typically, investor signatories are nominee directors with little real authority over the investment funds for which they are signing. One such nominee, David Sims of Navigator Management of Tortola, British Virgin Islands, is an agent for a number of investment funds used by Rhino Advisors and Southridge Capital Management, two investors accused by several issuers of orchestrating so called “deathspiral” schemes. Most of Sims’s PIPE funds use the address of Citco Trustees, a Grand Cayman-based hedge fund administrator with offices spread throughout the Caribbean, Europe and the U.S. It claims five of the ten largest offshore hedge funds as clients and 27% of the total offshore fund administration market.
Fifth, the investors’ broker-dealer is often Canadian. Canadian brokers provide easy access to U.S. securities markets, yet remain outside the jurisdiction of U.S. regulators. Canada’s patchwork of provincial securities authorities, with limited jurisdiction and weak enforcement mechanisms, provide ample opportunity for unscrupulous investors to conduct “regulatory arbitrage.”
Key to Canada’s prominence in these schemes is the country’s lack of a prohibition on “naked” shorting of stock, that is, the shorting of stock without first borrowing the shares from accounts controlled by the broker or its clients. While such “affirmative determination” rules that force brokers to borrow shorted shares to reconcile their clients’ aggregate short positions exist in U.S. markets, no such rules constrain Canadian brokerages.
Prominent in many of the “death spiral” suits brought by O’Quinn and Christian is shuttered Toronto broker Thomson Kernaghan. Ontario securities regulators suspended and then liquidated the brokerage last year after charges of widespread trading abuses were leveled against the firm and its former chairman, Mark Valentine. Valentine currently awaits trial in the U.S. on bribery and fraud charges stemming from a sting operation known as “Bermuda Short.”
Sedona’s Second Deal
Feeling he had little recourse to save his company, but wary of the negative effects of the original variable-priced convertible offering placed by Ladenburg, Emrich again approached Ladenburg’s top banker Michael Vasinkevich, to ask him to consider refinancing Sedona’s convertible preferred stock.
Before Sedona’s executives would agree to accept new financing from Ladenburg, they first sought some answers from Vasinkevich. Why, they wondered, was Sedona’s stock reacting negatively to the first financing? Vasinkevich was invited to a meeting of the Sedona board in June 2000. At the meeting, he was questioned about possible shorting of Sedona stock by Rhino or its funds. According to Sedona’s complaint, Vasinkevich denied any involvement by Ladenburg or its investors in manipulating or otherwise causing the company’s stock to decline. He suggested that he could arrange a $3 million common stock placement with two other funds, Roseworth Group and Cambois Finance, to retire the convertible preferred stock owned by Amro, Markham Holdings, Aspen International, and the Cuttyhunk Fund.
Sedona alleges Vasinkevich failed to say about the new deal that Roseworth and Cambois were wholly owned subsidiaries of Amro’s “sister” fund, Creon Management. Creon’s director and signatory is David Sims. Creon is the guarantor of another offshore fund with PIPE investments in U.S. companies that uses the address of H.U. Bachofen in Zurich. Bachofen is president of Amro.
The Roseworth and Cambois placements were bundled with a $3 million, convertible debenture. The debenture - discounted to $2.5 million in actual proceeds to Sedona - did not include a “hard floor” on the securities’ conversion pricing, only a volume-weighted pricing formula that fixed the conversion price if the debenture was held to its 120 day maturity before being redeemed. Prepayment or failure to redeem the debenture at maturity nullified the conversion formula and replaced it with a floorless pricing formula that reset the conversion price to 85% of the previous five-day volume weighted average price of Sedona’s common stock prior to the debenture investors’ notice of conversion.
The terms of the deal did include a con-version price ceiling of $1.41 per share upon maturity of the debenture. In addition, the debenture included warrants for up to 666,667 shares exercisable at $1.37 per share. Notably, the terms of the debenture agreement also prohibited holders from engaging in any short sales of Sedona stock. Ladenburg was paid $175,000 and given warrants for 167,576 shares of Sedona stock at an exercise price of $1.15 per share for serving as placement agent in the deal. Sedona closed the deal in late January 2001, and Ladenburg placed the debentures with Rhino’s client Amro.
What happened next is detailed in an SEC investigation and subsequent suit by the commission against Rhino Advisors and its president, Thomas Badian. Rhino settled in February, without admitting or denying the charges, for a $1 million fine.
According to the SEC, Rhino and Badian directed a series of short sales of Sedona stock through an account at a U.S. broker-dealer held in a Rhino client’s name and controlled by Badian. At the time, Rhino’s client owned no Sedona stock. Rhino did not deliver the shares that it was selling short by the settlement date, and the broker neither bought nor borrowed stock to cover the sales. Sedona’s attorneys have named Westminster Securities, a broker-dealer that has at times listed the same address as Rhino, as the broker referred to in the SEC complaint.
According to the complaint, each day in March 2001, Rhino placed Sedona sell orders with Westminster; subsequently, Westminster placed similar sell orders with a cooperating broker, identified by Sedona as Wm V. Frankel & Co., a Nasdaq market maker in New Jersey. According to the Sedona complaint, the cooperating broker often placed these sales through various electronic communication networks, providing some market anonymity to the traders.
As the cooperating broker-dealer owned no Sedona shares, it covered its short trades through the ECNs by purchasing the shares from Rhino’s client’s account at Westminster. It did this after-hours at slight discounts to its short sale positions to ensure itself a profit. Rhino’s client, however, had no Sedona shares in its account, resulting in a short position from the ECN sales. Because the purchase sides of the wash sales were executed after hours via the ECNs and because Rhino’s client did not report the sales as short trades, the trades were not reported to the market as short sales.
Despite repeated failures to deliver the shares to complete the “long” sales from Rhino’s client’s account, Rhino’s client reportedly shorted more than 872,000 shares of Sedona in March 2001 alone. As a result of the repeated clearing failures, Nasdaq placed a short restriction on the company’s stock. According to the SEC, Rhino then moved its trading activity to an account held by its client at a Canadian brokerage firm, identified by Sedona as Thomson Kernaghan. Rhino continued to short Sedona shares through Thomson Kernaghan through mid-April 2001, eventually building up an uncovered short position of 1.19 million shares in 31 trading days.
Christian says all of the uncovered shorting and false “long” sales had the effect of counterfeiting Sedona stock and flooding the market with fraudulent sell volume, decimating Sedona’s share price. In January 2003, with its share price well below a dollar, the company was delisted by Nasdaq.
Rhino, Badian, Ladenburg, Frankel and Westminster dispute Sedona’s allegations and have filed a motion to dismiss the case with Judge Kimba Wood in New York’s Southern District Court. PIPE issuers seeking redress for naked shorting and death spiral schemes have suffered a string of losses of late.
The events detailed in the Sedona case, as well as in other stock manipulation cases brought against PIPE investors by O’Quinn and Christian, leave behind troubling notions about the degree to which deficiencies in the regulation, enforcement, and execution of short sales of U.S. equities by foreign brokers and investors promote an environment ripe for manipulation. The bitter experiences of these PIPE issuers threaten to tarnish this innovative financing structure and prevent its maturation into a powerful capital-raising tool for public companies.
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PAINTING THE TAPE
Draining the Naked Shorting Swamp
The PIPEs Report
Part Three of a Three-Part Series
by Brett Goetschius
August 1, 2003
Market manipulators are bursting through loopholes littering the regulations and processes put in place to ensure the integrity of the securities markets: This is the charge that lies at the core of allegations made over the last year by PIPE issuers Sedona, Internet Law Library, JAGNotes, NanoPierce Technologies, Hyperdynamics and more than 80 other small-cap firms. They assert that, through the practice of naked shorting - selling shares of a stock without first determining that an equal number of shares is actually available to complete the trade - rogue short sellers are, in effect, counterfeiting shares of stock and selling them on the market. This scheme, its opponents charge, unfairly decimates the share value of targeted companies and threatens the integrity of the market as a whole.
As the plaintiffs in these shorting abuse suits have alleged in case after case, it is not only the short sellers that are the problem: NASD-regulated market players and the regulators them-selves facilitate these frauds by providing waivers, exemptions, and loans to short sellers. Such assistance provides perpetrators the time and leverage they need to execute their schemes, plaintiffs say. The issuers assert that damage done through shorting abuse is downplayed or denied by the clearing firms, broker-dealers, and regulators because each is complicit in supporting a trading system that accords extraordinary flexibility and discretion to brokers holding large undelivered short positions in small-cap stocks. Indeed, the toughest challenge for the prosecution in these cases typically is proving not that orchestrated naked shorting occurred, but that such schemes are specifically prohibited by law.
The trading records of the parties involved present clear pictures of the ability of short sellers to commandeer a small-cap company’s trading activity and drive down the stock price. In the Sedona case, the SEC found - and defendant Rhino Advisors did not contest - that accounts controlled by Rhino accumulated an undelivered short position in excess of 1.19 million shares in 31 trading days. That amount accounted for more than 25% of Sedona’s trading volume during the five-day pricing period prior to Rhino exercising its conversion rights on its Sedona convertibles.
In the NanoPierce case, shuttered Toronto broker Thomson Kernaghan accounted for an average 40% of NanoPierce’s daily trading volume from late October 2000 through early May 2001. Kernaghan client Harvest Court, a PIPE fund advised by Steve Hicks of Southridge Capital Management, held warrants with reset rights in the company during that time. Every trade executed by Thomson Kernaghan for that period was a sale. Total trading activity exceeded 4.5 million shares. NanoPierce’s share price fell during the seven-month period from $2.63 to $0.51.
Examination of trading records of Internet Law Library, another Southridge investment, by John Pinto, a former senior executive of the SEC’s examination and enforcement division, led him to conclude that Thomson Kernaghan’s “aggregate volume of heavy concentrated selling... is indicative of market manipulation.” In testimony as an expert witness for Internet Law, Pinto, a 29-year SEC veteran, described the one-way trading in Internet Law stock by Kernaghan as “indicative of a systematic and calculated initiative by [the] defendants to artificially depress the price of INL shares.”
The Tunnel Under the Border
Regulatory deficiencies in the Canadian securities regime, Pinto testified in the Internet Law case, is a key enabling factor in the alleged manipulation schemes. Canadian broker-dealers trading in Nasdaq stocks are exempt from NASD and SEC regulation, despite their open access to the U.S. markets. “In my opinion,” Pinto asserted, “ this fact was a key ingredient of the manipulative activity, as it facilitated the scheme that most likely could not have been effected if executed through a U.S.-based member of NASD...”
Canadian short sellers play the U.S. markets using a rulebook that differs from those of their domestic counterparts in two key respects. First and foremost, Canada’s system of provincial securities regulations lacks any rule equivalent to NASD’s “affirmative determination” rule. Known as Conduct Rule 3370, the rule requires a U.S. broker-dealer to affirm in writing that it has pre-determined each short trade it accepts can be matched with a similar amount of shares available for purchase or loan. Reinforcing it is SEC Rule 15c3-3, which requires broker-dealers to force “buy-ins” of undelivered short positions in their clients’ accounts after 10 business days. Affirmative determination, backed by forced buy-ins, is aimed at preventing shorting abuse by limiting shorting activity to only that trading volume which can be supported by the amount of registered securities issued and outstanding.
Canadian short positions, on the other hand, legally can extend well beyond the investor’s ability to cover or even complete the trades at a company’s current float and volume. Not only is naked shorting legal in Canada; the country’s regulators aren’t convinced enacting affirmative determination and buy-in rules would prevent it. “An affirmative determination rule would be nice to have,” a regulatory affairs official at the Ontario Securities Commission told TPR last week. “But if bad actors want to do bad things, they are going to do it regardless.”
PIPE Securities as Short Collateral
While not all of them involve variable-priced convertible securities, a majority of naked shorting schemes do. Ostensibly, a forced direct issuance of stock from the naked shorting target is usually the only way to deliver enough securities to cover the undelivered short positions built up over the course of a naked short raid. For schemes involving variable-priced convertibles, Canada offers short sellers a second shorting tool unavailable to their U.S. counterparts: the ability use unregistered convertible securities to collateralize undelivered short positions in the underlying common stock almost indefinitely.
Known as Rule 100 in the Canadian Investment Dealers Association rulebook, it states:
“A Member may hedge: ...Any long convertible security, including warrants, rights, shares, instalment (sic) receipts or other securities pursuant to the terms of which the holder is entitled to currently acquire underlying securities, held in the account of a guarantor that guarantees a customer account against any short positions in the underlying securities held in that customer account; provided that the convertible securities held in the guarantor’s account are readily convertible into the related underlying securities held in that customer’s account and the number of underlying securities available on conversion shall be equal to or greater than the number of securities sold short;”
Critics of Canada’s lax shorting regulations, including NASD enforcement officials familiar with the Sedona and Internet Law cases who spoke to TPR last week, condemn Rule 100 as the “tunnel under the border” that allows privately placed, unregistered securities held in Canadian accounts to finance the short sale of registered public stocks in the United States.
U.S. Protections Weak; Violations Frequent
Loopholes in the U.S. regulatory regime, meanwhile, remain legion. It routinely permits extended undelivered short positions to be held by domestic investors at U.S.-based broker-dealers; the lack of meaningful penalties and enforcement, even in instances of flagrant violations, invites even more abuse. Citing the U.S.-based NASD member firms in the Internet Law case that are accused of aiding and abetting Southridge’s alleged manipulation scheme, Pinto testified that “it is my opinion that many of the U.S.-based NASD member firms may have violated most if not all of [the] NASD and SEC rules [governing short sales].”
Though every U.S. broker/dealer is required to make an affirmative determination before executing a short trade, what should constitute a legitimate determination has been the subject of dispute between the NASD and the SEC. Current rules only require a broker to use its best knowledge and judgment to determine the availability of shares for purchase or loan, and to annotate each trade ticket that such a determination has been made. No actual seller or borrower of the securities in question need be contracted with, or even located. Nor does the information used to make the determination need to be authoritative.
In practice, affirmative determination compliance boils down to a reliance on “hard-to-borrow” lists distributed daily by large clearing firms and wire house stock loan departments. These lists are not routinely audited or reviewed by any regulator. Typically they contain no information regarding the actual liquidity; they simply are ticker lists. Criteria for inclusion in the lists vary with the list distributor, and often reflect only those companies the clearing firm or loan department regularly clears or trades - not the availability of every issue in the market. This reality makes a stock’s absence on a “hard-to-borrow” list affirmative of nothing other than the prima facie that it is absent from the list - not that it has been declared available for shorting in unrestricted amounts.
While drafting the affirmative determination rule in 1994, NASD pushed for a much more stringent determination standard. Proposed in its Notice to Members 94-80, it would have prohibited the use of such lists by requiring traders “to annotate, on the trade ticket or on some other record... the identity of the individual and firm contacted who offered assurance that the shares would be delivered or were available for borrowing by settlement date...” The NASD argued that “a ‘blanket’ or standing assurance that securities are available for borrowing is not acceptable to satisfy the affirmative determination requirement.” In particular, the NASD said brokers “cannot rely on daily fax sheets of ‘borrowable stocks’ to satisfy their affirmative determination requirements...”
Under pressure from the SEC, NASD deferred implementation of the rule for a year; then, it backed down to the agency and amended it. In a Special Notice on January 6, 1995, NASD stated that it would allow trading firms to “rely on daily fax sheets from their clearing firms as a basis for making their affirmative determinations made in connection with short sales.” Four days later, the SEC, which had never approved the more stringent rule, published a release confirming the NASD’s Special Notice. The SEC stated that one reason for the delay in confirming the affirmative determination rule was “the NASD’s concern that the prohibition against the use of daily fax sheets and other ‘blanket’ or standing assurances may have created an unnecessarily burdensome regulatory requirement on NASD members...”
Affirmative determination requirements on the books poorly protect small-cap issuers due to two major exemptions: (1) Nasdaq market makers engaged in “bona fide market making activities” and (2) short trades involving OTC stocks. NASD has defined bona fide activities to “exclude activity that is related to speculative selling strategies... and is disproportionate to the usual market making patterns or practices of the member in that security.” Decisions regarding which activities constitute speculation and which constitute market making are made by the NASD on a case-by-case basis.
Even when affirmative determination violations are discovered, which is routine according to NASD enforcement reports (the association says it keeps no data on the number of such actions), penalties typically add up to a charge of a few thousand dollars coupled with a letter of censure. A random review of the 112 NASD disciplinary actions reported for July and August 2001 reveals six actions involving affirmative determination violations and nine involving short selling violations. Penalties typically included a letter of censure and a fine of less than $20,000. NASD enforcement officials refer to such censures as “parking tickets” and admit that their resources do not allow them to “catch all the speeders.”
To date, the NASD has only successfully prosecuted one case against a naked shorting scheme brought under Rule 3370. In that case, NASD vs. Steve Carlson et. al and John Fiero, defendant Fiero was found to have committed extortion and fraud in a naked shorting scheme involving a group of OTC penny stocks. Like drivers who see parking and speeding tickets simply as costs of riding the roads, Fiero told the court that he viewed the penalties and buy-ins for failing to deliver securities sold short as “an ordinary course of business” and “pretty much a bookkeeping function.”
NASD officials admit that more naked shorting abuse cases have not been prosecuted because the likelihood of conviction is low, unless as in the Fiero case, insiders can be convinced to testify against their fellow conspirators.
For unlike a typical penny stock “pump and dump” scheme that involves managing a substantial sales staff, creating call scripts, making high volumes of out-bound calls to retail investors, and other evidence-generating activities, naked short schemes typically involve only a small, tightly-knit group with no paper trail to document trading strategies or intent. And until stricter shorting rules are established for affirmative determination and collateralization of short trades in the U.S. and Canada, they say few other short manipulation cases are likely to be brought. |
