Cloud of short selling
Companies say they want to uncover the dirty truth of so-called naked transactions
By Bob Mims
The Salt Lake Tribune
sltrib.com
Illustration for short selling
Wall Street's reaction was swift and vitriolic last August when Overstock.com CEO Patrick Byrne unveiled what he called the Miscreants Ball - an alleged conspiracy to drive down his company's stock.
Frivolous. Erratic behavior. Off the deep end, various analysts and financial scribes hooted. Others insisted that Byrne was the leader of the "tinfoil hat" brigade, or at least one of those "overeducated weirdos" looking for market windmills to tilt.
Flash forward nine months, and Byrne's claims aren't so quickly dismissed - and he is hardly alone in making them. A spate of lawsuits from other companies have followed, and the Securities and Exchange Commission has begun its own investigations related to the practice Byrne hates most: manipulative, or naked, short selling.
Short selling is legal - a bet, using borrowed stocks, that share prices will fall, allowing "shorts" to pocket the difference when they do. Naked shorting, though illegal, occurs when the same transaction is attempted without first borrowing real shares.
"We're making a lot of progress in this war," Byrne says today. "Everyone seems to finally be getting it - that I'm right. We've passed the tipping point on this debate. The rock I rolled up the hill is now rolling on its own."
In his watermark webcast, Byrne painted a picture of market researchers timing negative reports about his online closeout retailer to aid client hedge funds in subsequent massive shorting -even naked shorting - of his stocks.
It was a conspiracy, Byrne said, in which a shadowy "Sith Lord" - an otherwise unidentified financial criminal mastermind - profited by manipulating small companies' stocks into oblivion. The day before Byrne's multimedia presentation, Overstock had filed suit in Marin County, Calif., against Gradient Analytics, a frequent critic of his company, and Rocker Partners, a hedge fund that had begun shorting Overstock's shares in early 2004.
The Marin County Superior Court suit alleges that the defendants had together "orchestrated a wide-scale predatory campaign" against Overstock, contributing to a share price slide from a high of $77.18 in January 2005; shares have traded in the $24-$29 range in recent weeks.
Both companies deny the charges, and Gradient is appealing a judge's March decision to allow Overstock's libel and unfair business practices claim to proceed to trial.
Neither Rocker nor Gradient would answer questions for this story, citing litigation that also includes a similar suit against Gradient by the Canadian pharmaceutical company Biovail.
Earlier this month, naked short selling also was at the core of lawsuits against prime brokers. In a notable switch, 11 Wall Street firms - among them Bank of America, Bear Stearns and Citygroup - were sued by hedge funds, claiming those institutions were the real culprits behind failures to deliver borrowed stocks, resulting in naked shorting.
A serious issue
Although hardly unanimous about the seriousness of the threat short selling poses, traders, academics, analysts and financial journalists are affording the topic more than the quick derision and dismissal so common just nine months ago.
"Nobody really knows for sure how much naked shorting is going on," says Tad Borek, a San Francisco investment adviser, attorney and contributor to AllExperts.com. "But I don't think these conspiracy theories ring true, either."
Borek argues that in the end, markets right themselves and naked shorts eventually must settle their accounts.
However, he admits that the Depository Trust and Clearing Corp., or DTCC, the primary clearinghouse for such trades, is not perfect and often seems slow in forcing settlements.
"As an investor, I have a lot of faith in the market," Borek adds. "For every hedge fund trying to drive down stock prices, there's another ready to pounce on them to buy stock that has gone down too far."
Dave Young, president of Provo-based Paragon Capital Management, says shorting is a must-have technique in any serious trader's tool kit.
"It's part of having a totally efficient market [and] we've used short selling here for years," he adds, but warns that its timing comes down to minutes, even seconds. Few investors succeed with shorting unless they develop a sense of when to return to "long" tactics - the traditional buy low, sell high approach.
Although Young argues true naked shorting is rare, because perpetrators ultimately flirt with prison time, he allows that the illegal practice "can be a company killer."
Remember the fall of scandal-plagued Enron? "With all its issues, its stock went down - and the shorts stayed with it, all the way down," Young says.
Attacking abuse
Byrne, who says phantom shares of Overstock at one point were traded at a rate more than double the actual shares in existence, joins others in declaring naked shorting to be out of control. But opinions on the extent of the practice vary widely.
Last month, the DTCC acknowledged that 1.5 percent of the dollar volume of stocks traded daily end up "fails to deliver," or FTDs. In all, those FTDs - dubbed "counterfeit" stocks by shorting foes - can tally as high as $6 billion a day.
Regulators, private and public, have drawn fire from such Byrne fellow travelers as the grass-roots National Coalition Against Naked Shorting for ignoring the problem. The agencies, though, insist that they take the allegations seriously.
Steve Luparello, executive vice president for market regulations with the National Association of Securities Dealers, says regulators "have long recognized the potential for substantial failures-to-deliver-on-sales could aggregate in a single stock over periods of time."
However, such stock manipulation "has proved a very difficult thing to prove. . . . We needed a more ethnical, easily defined set of rules to enforce," Luparello adds.
He and other market regulators believe they got much of that with the new Regulation SHO, a January 2005 addition to SEC rules that tracks stocks considered most abused by naked shorts.
A regular on that "Threshold Security List" has been Overstock. Under SHO, no company should be listed for more than 13 days; Overstock long ago passed 200, Byrne says.
Still, Luparello argues that overall, FTD abuse is in retreat. "It may not have completely eliminated failures-to-deliver, but I would not gloss over the fact that the numbers of stocks on the threshold list declined over a period of time."
Inconsistent enforcement
SEC spokesman John Nester notes that since the advent of Regulation SHO, the average of threshold-qualifying FTDs - failures-to-deliver on 10,000
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or more shares - has dipped nearly 31 percent. Actual numbers of companies on the list daily have declined more than 35 percent.
"Put another way, 99 percent of all trades, by dollar value, settle on time without incident," Nester says, adding that the SEC is working to further tighten monitoring and enforcement.
Theoretically, Regulation SHO requires brokers to close out all threshold-list FTDs by purchasing the supposedly borrowed stocks themselves. Until those transactions are cleared, such brokers are supposed to be barred from further short sales in that particular stock.
In practice, the requirement often fails. It can take several weeks to catch up with FTDs, while some brokers are allowed to continue shorting.
Karl Thiel, a Portland, Ore., investment manager who writes for the Motley Fool column, would like more effective enforcement. He has recently opined that the threshold list has done little more than "turn rampant abuse into a spectator sport" without violators being called to accounts.
"No one, including the DTCC, seems to be able to answer the question of how much naked shorting is out there," he told The Salt Lake Tribune. "[But] I certainly think it makes sense for the SEC to look into the trading around companies with persistent settlement failures."
Still, Thiel suspects naked shorting is not the major curse on markets some envision. It "might cause some market distortion around companies with high short demand, but I don't see evidence that naked shorting is destroying truth, justice and the American Way."
Who gets targeted
What makes a company attractive to shorts, legitimate and naked alike?
Mark Skousen, a nationally renowned economist, investor, professor and author of financial tomes based in Washington, D.C., suggests two categories:
First, shorts are lured to stocks that are grossly overvalued compared with their company's bottom line - think Google, which speculators propelled into the $475-per-share range this past January before dropping it by more than $100 within the ensuing six weeks.
Second, companies that are clearly in a down trend, with the investors grapevine warning of more bad news to come.
Skousen, who also runs his own hedge fund, does not hold any short positions - but he has in the past, and probably will in the future, depending on what opportunities develop.
"Short selling is extremely difficult and few are successful at it," he says. "Falling prices happen quickly, while bull [long] markets build over long periods of time."
Skousen sees tighter regulation as anathema. Another believer in the market righting itself, he says true naked short sellers inevitably reap the whirlwinds they sew.
"If you want to play such games, you will eventually get burned," he says. "If you oversold . . . that [nonexistent] stock will eventually bounce back on you."
Another believer in the ability of stocks to right themselves is Neil Harrington, who has run the Harrington Trading Co. out of Provo for 10 years. But he also thinks Byrne has a point when it comes to his fear and loathing of naked short selling.
"I do not discount that somebody, or group of somebodies, want to do damage to his business by artificially triggering an effect on his stock by selling short," he says. "If you have a big enough player, they could . . . bring on a cascade [short selling] effect."
If a targeted company proves financially sound, however, Harrington believes it will not only survive the short selling attacks, but thrive as long-term investors find attractive, lower prices to buy in.
Financial fundamentals are indeed key in any discussion of a company's short selling laments, says Gary Weiss, a veteran New York-based financial journalist and author of Wall Street Versus America: The Rampant Greed and Dishonesty That Imperil Your Investments (Portfolio, 2006).
Weiss remains among the still sizeable number of Wall Street observers skeptical of Byrne and other CEOs who complain of naked short selling, seeing their campaigns as cover for less-than-stellar earnings reports and questionable management.
Even ongoing SEC investigation related to Overstock's allegations does not change Weiss' view. Such probes only "demonstrate yet again the regulatory incompetence" of agencies charged with monitoring stock transactions, he says.
Convinced Regulation SHO is, despite criticisms, proving effective, he sees the claims of unbridled short selling as "wildly exaggerated" and "paranoid rubbish."
Adds Weiss: "It is a disgrace that regulators take these people seriously, and I believe that [it is] the funding and tactics of these people [that] should be investigated."
bmims@sltrib.com
A primer on short selling
Think of short selling as reverse investing. Instead of buying low to sell high (taking a "long" position), short sellers borrow stock from a broker and sell them on a bet that share prices will fall; when they do, they buy back the shares, return them to the broker, and pocket the difference between high and low prices.
Naked short selling is said to occur when an investor shorts a stock without first borrowing real shares. The result can be an artificially inflated volume and downward price pressures on stocks when "shorts" fail to deliver borrowed shares to cover their trades.
In March, the Depository Trust and Clearing Corp. reported that 1.5 percent of the dollar volume of stocks traded daily ends up "fails to deliver," or FTDs. In all, those FTDs run as high as $6 billion a day.
Overstock.com recently announced that while it had just under 8.9 million shares on deposit with the DTCC on March 10, short interest on its stock totaled nearly 9.6 million shares.
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