Re: SULLIVAN & LONG, INCORPORATED, et al., v. SCATTERED CORPORATION
Excellent find and quite interesting reading. Here's part:
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Scattered had no intention of delivering any of the LTV stock that it sold short. The last thing in the world that it wanted to do was to acquire and hold a stock that it believed certain to lose most of its value within weeks. Since it had no intention of buying any of the stock, it had no compunctions about selling short more LTV stock than existed. It ran the risk that the people on the other side of the short-sale transactions were right in betting that the price would rise before its terminal plunge, that those people would go into the market and buy stock when the price rose during the five-day period for delivery, and that they would force Scattered to reimburse them for these purchases, as in our hypothetical example of the stock sold short at 50 cents that rises to 65 cents. This risk--the risk that, if the Crain's article can be believed, Mr. Sullivan flinched at--did not materialize, because the price maintained its downward course. There were few buy-ins, and Scattered ended up making more than $25 million from its campaign of short selling. The plaintiffs claim that Scattered ignored such buy-in demands as were made upon it, but this is imprecise. Scattered refused to deliver old stock in response to such demands, but did offer warrants on new stock. The amount of old stock that it had sold short represented fewer than 2 million shares of new stock. This was only a small part of the total equity capitalization of the reorganized firm. The vast majority of the new stock was to go to the debtholders of the old firm. It would not have been infeasible for Scattered to buy enough warrants to satisfy all potential buy-in demands with new stock. It would have been infeasible for it to obtain enough old stock to satisfy all such demands in old stock.
We can understand, therefore, Sullivan's flinching. The risk was enormous, precisely because Scattered had sold short more old LTV stock than existed. If all the buyers decided to buy in, and if Scattered were deemed not entitled to pay these buyers with warrants rather than with old stock, the price of the old stock would skyrocket-- unless Scattered sopped up all this demand by continuing to sell short to these buyers. But at some point the buyers would worry about Scattered's ability to make good on all its promises to redeem its short sales. They would demand stock, not further promises to pay a high price if the stock rose in value. When this happened-- this balking by the buyers--the plaintiffs would, until Scattered did go broke, be able to make money buying in the stock that Scattered had sold short to them. They say that Scattered prevented the price from rising (and thereby discouraged buy-ins by making them unprofitable) by selling short more and more stock. This is just to say that Scattered, like a bluffer in a poker game, kept redoubling its bet until the other players lost heart. But so what? Scattered's principals may be reckless gamblers, sharpies, wise guys, exploiters of loopholes, even violators of the letter or spirit of the rules of the Chicago Stock Exchange. Cf. United States v. Naftalin, supra, 441 U.S. at 776-77. We take no position on these questions, except to note that the Chicago Stock Exchange has forbidden the practice in which Scattered engaged--that is, selling short without having borrowed the stock being sold short or having equivalent guarantees of delivery. But it did this after the short-sale spree that is the basis of this suit, and anyway not every stock exchange rule confers a private right to sue. Spicer v. Chicago Board of Options Exchange, Inc., 977 F.2d 255, 262-66 (7th Cir. 1992).
What troubles us most about this suit is the plaintiffs' failure to identify any harm to the objectives of the securities laws under which they have sued; for that matter they have failed to identify a rule that Scattered violated. The central objective, we take it, is to prevent practices that impair the function of stock markets in enabling people to buy and sell securities at prices that reflect undistorted (though not necessarily accurate) estimates of the underlying economic value of the securities traded. An efficient stock market is one in which stock prices reflect all potentially available information that is relevant to the economic value of the stocks. Eugene Fama, "Efficient Capital Markets: A Review of Theory and Empirical Work," 25 J. Finance 383 (1970). Not every practice that might reduce the efficiency of a stock market is prohibited; the securities laws compose a patchwork of rules rather than a seamless standard. But we would think twice before concluding that these laws prohibit "schemes" that accelerate rather than retard the convergence between the price of a stock and its underlying economic value and therefore promote rather than impair the ultimate goals of public regulation of the securities markets. Objectively, from May 27 on old shares of LTV stock were worth only 3 or 4 cents, and the defendant's campaign of short selling helped move the market price toward that true value. Had the plaintiffs succeeded in their scheme of reselling for, say, 50 cents stock that they had bought for 40 cents but that was worth only 4 cents, they would have been contributing to an irrational gyration in stock prices.
The plaintiffs call what Scattered did "market manipulation," a term that refers to tactics by which traders, like monopolists, create artificially high or low prices, prices that do not reflect the underlying conditions of supply and demand. Ernst & Ernst v. Hochfelder, supra, 425 U.S. at 199. The only artificial prices, however, were the prices at which LTV stock sold between the confirmation of the plan and the expiration of the old stock. They were artificially high because they so greatly exceeded the stock's true value, which was only 3 to 4 cents. Far from launching a balloon, Scattered's short sales punctured a balloon, bringing prices down to earth where they belonged.
The name for what Scattered did is not market manipulation, but arbitrage. Arbitrageurs are traders who identify and eliminate disparities between price and value, or as in this case between today's price and tomorrow's price where the difference cannot be attributed to any prospective change in value. See Falco v. Donner Foundation, Inc., 208 F.2d 600 (2d Cir. 1953). By doing this, arbitrageurs promote the convergence of market and economic values that we suggested was the central objective of securities regulation. Consider a case in which the identical stock is selling for different prices on two exchanges at the same time. Since the value is the same, the prices should be the same. By buying stock on the exchange where the price is lower and reselling it on the other exchange, the arbitrageur brings about a convergence of price with value. This case is only a little subtler. The old LTV stock and the new stock that was to be issued when the plan of reorganization was implemented were not identical, but they were nearly so. The old stock was the stock until June 29, the new stock the stock thereafter. The two stocks were so far identical (putting aside the irrelevant difference in the roughly 100 to 1 rate at which old shares were convertible into new) that any difference in price between them was more likely to reflect a failure of the stock market to work properly than a difference in underlying conditions of demand and supply. Scattered played the arbitrageur's role in trying to equate the prices of these two nearly identical goods. Arbitrage is not market manipulation. The opposite of a practice that creates artificial prices, it eliminates artificial price differences.
The plaintiffs complain that the defendant prevented them from profiting from their purchases by flooding the market with successive waves of short sales, thus keeping the market price from fluctuating upward from time to time ("capping the price," they call it). Such upturns would have enabled them either to buy in at a higher price than the short-sale price and thus make a profit, if they had bought from Scattered, or to sell at a profit stock that they already owned. But "flooding" a market with short sales is not a rational formula for keeping price falling. On the other side of each such sale is a buyer who thinks the market price will rise. If he is right, the short seller will lose money, and the more shares he has sold short, the more money he will lose. As we have already intimated, the short seller could sell so many shares short that his solvency was jeopardized. Suppose price rose and everyone who bought the shares sold short by Scattered tried to buy in. Since there would be more stock demanded than there was stock capable of being supplied, the price would soar and Scattered, which we are told was capitalized at only $1.5 million when the short selling began, would, unless it could redeem with warrants, soon go broke. But the plaintiffs are not complaining that if Scattered guessed wrong about the direction of the market, the price of the stock would rise faster than if Scattered had sold short fewer shares, for if that had happened the plaintiffs might have made money. And the threat of insolvency is one reason that buyers would have stopped accepting Scattered's offers to sell short, would instead have insisted on delivery or would have bought in and sought reimbursement from Scattered.
The plaintiffs analogize Scattered's plan to the scam in the movie The Producers. The "defendants" in that movie sold shares in a play to investors. They sold more than 100 percent of the shares, confident that the play-- "Springtime for Hitler"-- would be a flop, so that the investors would not ask for their share of the profits (there would be no profits). The play was a success, so the scam was exposed and they were sent to jail. Where the analogy fails is that while investors reasonably believe that the promoter will not sell more shares than exist, since he would then be defrauding the investors, a buyer of stock does not have a basis for equal confidence that the number of shares of a stock that is being sold short does not exceed the total number of shares in existence, since the seller is not trying to raise money for a venture. If even one share of a stock is sold short, there will be more shares actually or potentially for sale than there are shares in existence--since by definition the short seller does not own the share or shares that he is selling short--unless the short seller has borrowed stock in order to be able to make delivery if the buyer wants delivery. Scattered was not the only short seller of LTV stock. Apparently the first-listed plaintiff in this case also sold LTV stock short. If Scattered had sold only 85 million shares short, and other arbitrageurs had sold in the aggregate another 85 million, the imbalance between shares for sale and shares in existence would have been identical, unless the arbitrageurs borrowed the stock they sold short.
Granted, it is customary for a short seller to borrow the stock that he sells short; if he did not, the buyers would lack confidence that he could deliver, and might worry that if they tried to buy in, the short seller would not have the money to reimburse them. But the plaintiffs do not point us to, and we have not been able on our own to find, a law that requires arbitrageurs or other short sellers to borrow the stock that they are selling short. So the plaintiffs could not count on the volume of short sales being capped at the total number of shares outstanding. They were on notice that the sort of thing that did happen might happen, if there were any trader as audacious as Scattered. Being on notice, they were not deceived.
It is true that in 1994--a year after the short selling of LTV's old shares-- the Chicago Stock Exchange adopted a rule requiring a short seller to borrow the stock sold short or provide equivalent guarantees of being able to deliver. Self-Regulatory Organizations: Chicago Stock Exchange, Inc., 59 Fed. Reg. 42082 (Aug. 16, 1994). But that is too late to help these plaintiffs. A further complication is that, as we have mentioned, Scattered did have, so far as appears, enough warrants to deliver new stock to cover any demands for old stock, though we do not know whether responding to such demands in this way would have satisfied the short-sales rules of the Chicago Stock Exchange or for that matter the contracts of short sale. Since there is not as yet any requirement of public disclosure of shortsales (hence the allegation that Mr. Sullivan abused his position as a governor of the Chicago Stock Exchange), see Large Trader Reporting System, 59 Fed. Reg. 7917 (Feb. 17, 1994); Self-Regulatory Organizations: Notice of Filing of Proposed Rule Change by New York Stock Exchange, Inc., 60 Fed. Reg. 518 (Jan. 4, 1995), Scattered itself could not know the precise contribution that its short selling was making to the imbalance of which the plain tiffs complain.
We have thus far assumed that the short seller is not trying to deceive the market about what he is doing. The plaintiffs charge deception. They charge first of all that Scattered did not disclose that it had no intention of delivering any of the stock that it sold short. But if it was selling more shares than were outstanding, it could not deliver them--the requisite number of shares did not exist--so the plaintiffs' real complaint must be that Scattered did not disclose how many shares it was selling. But it was not required to disclose the number and the plaintiffs were not entitled to assume that Scattered would not sell more shares than were outstanding. Beginning on May 27, Scattered bought warrants so that it could deliver new shares to anyone who demanded delivery. The plaintiffs argue and we may assume for purposes of our decision that anyone who demanded delivery before June 29 would have been entitled to old shares. That individual's remedy, when Scattered refused to deliver old shares, would have been to buy them in. Apparently no one bothered to do that. No one who bought from Scattered is complaining that it was not able to buy in old shares, so that the Brennan case on which the plaintiffs rely is in apposite. Brennan v. Midwestern United Life Ins. Co., 286 F. Supp. 702 (N.D. Ind. 1968), aff'd, 417 F.2d 147 (7th Cir. 1969). No matter how many tens or for that matter hundreds of millions of shares Scattered sold short, it could not extinguish any of the outstanding shares and thus it could not defeat the right of the buyers, including the plaintiffs in this case, to buy in the old shares and if the price was higher than the price of the short sales to charge the price to Scattered and pocket the difference. And this is on the assumption that rule or contract required Scattered to deliver old shares, rather than warrants for new shares. If the latter form of compliance with the short-sale contract was permissible, the plaintiffs' case evaporates completely, since Scattered no longer would have been selling short more shares than existed.
etc.
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