Blame Canada
BY MARK BROWN
Canadian Business Newsmagazine
October 28, 2002
About two years ago, Russell Godwin, a director of Medinah Minerals
Inc., noticed some unusual trading of its shares on the Nasdaq Over
the-Counter Bulletin Board service. A client reported purchasing
500,000 shares of the small Nevada-registered mining company,
headquartered in Vancouver, when the total trading volume for that
day was only 200,000. However, Godwin, now also company president,
didn't know the extent of the problem until a "shareholder census"
revealed that there were more than 168 million shares outstanding,
when only 117 million were available for trading. The extra shares
on the market arose from "naked short-selling," a practice banned in
the US but perfectly legal in Canada. And it is the reason why many
small companies trading mostly on the Nasdaq Bulletin Board or on the
Pink Sheets lay the blame for their misfortunes squarely on Canada.
Naked short selling is not the only way US securities are being
manipulated through Canada. Death-spiral financing - one of the
instruments of choice for financiers like Mark Valentine, from
defunct Toronto-based brokerage Thomson Kernaghan & Co. Ltd. - is
also being channeled through Canada, for the same reasons so much
naked short-selling comes from the north: our weaker securities
regulations. Indeed, "weaker" might not be a strong enough word.
When asked about the difference between Canadian and US short selling
rules, a senior official at the NASD, the US association of
securities dealers, put it this way: "What Canadian rules?"
Basic short selling, which is legal in both countries, is a high-
risk strategy that typically occurs when an investor believes a
particular stock is overvalued. Through a margin account, the
investor will borrow shares from a brokerage firm, say at $60 apiece,
and immediately sell the shares on the market. When the investor is
confident the company's shares won't fall further, he will repurchase
the shares, say at $40 apiece, and return the borrowed stock to the
brokerage (covering the position) for a per-share profit of $20 less
fees. In the case of naked short selling, the brokerage never
actually has the shares in its inventory, nor does it have access to
the shares' but it still allows the client to complete the short sale.
The effects can be disastrous for a small company. Even when
Medinah Minerals would release positive news about its exploration
activities, the stock would continue its free fall because of the
massive short selling. What the short-sellers are trying to do in
many cases is force companies to file for bankruptcy, says Wes
Christian, a partner in the Texas law firm Christian, Smith & Jewell,
which specializes in business litigation. "Once you get a company
down to $1, it can't raise capital, it can't get loans, it can't do
anything.'
Death-spiral financing adds yet another twist. In some cases,
financiers will approach a target company on the pretense of looking
to make a long-term investment. In exchange, the financiers ask for
some kind of preferred stock or convertible debenture, where the
company owes the investors a variable amount of stock that must equal
a prearranged fixed value. The provision guarantees the financiers
more stock if the share price goes down. But despite the confidence
the financiers claim to have in the company, the real money for them
come from shorting the stock. And if the high volumes of trading
don't scare away bona fide investors, death-spiral financiers can put
more downward pressure on the stock by releasing negative news on the
company. Often, the short sales start even before the financing
agreement is reached. "They're naked short-selling," says
Christian, "knowing that they're going to get some conversions [from
the preferred stock or debentures] so they can cover."
That is what happened to JagNotes.com Inc., a Florida-based market
information subscription service, when it signed a deal with
Valentine in May 2001. The naked short selling of JagNotes.com (now
JAG Media Holdings Inc.) is the first of what could be a series of
cases that high-powered Houston lawyer John O'Quinn, in association
with Christian, plans to take to court. Valentine is alleged to have
misrepresented himself to JagNotes.com by going against his word that
he would not short the company's stock.
US regulators changed the rules regarding short-selling years ago.
Broker-dealers are required to make an affirmative determination that
stock is available for borrowing so that it can be delivered by the
settlement date. In Canada, however, there is no such
requirement. "We've looked at it, we may look at it again, but we
haven't seen any need for it in the Canadian marketplace,' says Keith
Rose, vice-president of regulatory policy for the Investment Dealers
Association of Canada (IDA).
That's certainly not the way many small companies listed on junior
exchanges see it. They argue that the differences between US and
Canadian trading rules have made Canada a conduit for stock
manipulation schemes. The paper trail created when shares are routed
through Canada is so long that most companies simply can't afford to
trace all the documents. "I can show you 15 companies that these
guys have beaten," Christian says, "not because they're right, not
because they're moral, not because they are legally correct, but
because they ran them out of money.'
US investors can't legally open a trading account with a brokerage
firm in Canada. But if they opened a Canadian account before the
NASD cracked down and started to vigorously enforce the rules in
1998, they are not barred from trading. "[Canadian brokers] are not
blatantly opening accounts for Americans," says short-seller William
Gate, managing director of Beowulf Investments in California and
author of several books on venture capital financing and private
placements. "But if you are there, and you haven't caused any
trouble, then they aren't kicking you out, either."
US investors who want to bend the rules might approach a Canadian
brokerage firm to conduct short sales on their behalf, put up the
money and offer the broker a kickback or commission sharing for its
help. "Of course, the guy in Canada, if he's greedy and happy to
participate in that kind of scheme, is going to do it," says the NASD
official, who spoke on condition of anonymity. Brokers need clients,
and without strong rules in place there is nothing to discourage
these firms from doing it, he adds.
But if a group of investors is intent on shorting a company's
stock, but is not spreading rumors or misleading statements, then a
company has little recourse, says Mark Deslauriers, a partner with
Osler, Hoskin & Harcourt LLP in Toronto and past chair of the Ontario
Securities Advisory Committee - unless the short-sellers were
violating some other rule. 'It's never clean," be says. "They are
selling on the downticks, not disclosing their short to their brokers
[or] brokers haven't disclosed their short positions."
So what's a company targeted by naked short-sellers to do? One
option is reorganization. Christian and a team of 50 lawyers are
currently taking every one of their clients through a
recapitalization process that requires the exchange of the actual
share certificate. "You must redeem the certificate you supposedly
hold in order to get a new certificate;' Christian explains. "If you
don't got them, and you sold them, then you are liable. Simple."
Under the reorganization, as undertaken by Jagnotes.com and Medinah
Minerals, the company renames itself and the stock undergoes a
reverse split of at least 1:1.01, which is the minimum requirement.
However, legitimate shareholders run the risk of taking the biggest
hit. In several cases, including Medinah, the company gave investors
only 60 days to exchange shares, after which it had the power to
cancel any outstanding shares. The reason it could do so was because
it is registered in corporate-friendly Nevada, where securities laws
allow the board of directors to cancel any outstanding share
certificates for "any desirable reason." One such desirable reason
might be the fact that forcing investors to claim their certificates
could artificially inflate a company's share value, by forcing all
the short-sellers to purchase shares they don't want.
The goal of the reorganization is not so much to put a stop to
short selling, as it is to expose who is doing the shorting. Still,
the short-sellers aren't always the only ones at fault. "Some of the
companies don't come into this scenario with clean hands," says the
NASD official. "The types of stocks, that typically are targeted by
short-sellers may be companies that may be perpetrating their own
violations, in terms of pumping up their own shares through press
releases that are materially misleading, or other things."
Regardless of which side shoulders the blame, the shareholders are
the ones who really lose out. The IDA plans to revisit this issue in
the new year, but it's not a high priority. It's certainly a concern
for the NASD, which has tried to put a stop to the practice - albeit
with mixed results. In the meantime, a case being built by GeneMax
Corp. of Blaine, Wash., against two Vancouver firms, Global
Securities Corp., a full service brokerage, and Union Securities
Ltd., an investment dealer, challenges the legality of naked short
sales in Canada. But don't count on the case forcing a review of
Canadian rules - such actions seldom reach trial, because the
plaintiffs rarely have enough money left to see them through. |
