March 2006 –

Going Naked:
How Short-Selling Hedge Funds
Wreak Havoc in the Stock Market

When you're a hammer, everything looks like a nail. When you're a journalist and an active stock trader, as I am, it's hard not to hammer on a controversy that affects both worlds. So I'll try not to overplay the significance of this situation. Even though it pits--at opposing angles-- freedom of the press, integrity of the capital markets, the trustworthiness of our government, and other values that I hold dear and consider essential not only to the ways in which I make a living, but to life as we know it in America.

In February, the SEC issued subpoenas to three journalists: Herb Greenberg, who writes for Marketwatch.com; Jim Cramer, who rants on CNBC TV and in other venues; and Carol Remond, a reporter with Dow Jones Newswires. I'm calling them all "journalists" here, although Cramer, a highly opinionated stock picker and fund manager, has been known to disavow the title, with good reason.

For the record, the SEC suspended enforcement of its subpoenas a couple of weeks later, after Greenberg and Cramer shined a bright light on the matter. They loudly decried the subpoenas in their respective media outlets, and appeared together on Cramer's "Mad Money" show on CNBC, to further bash the SEC. Attention came from other media sources as well, including a Feb. 25 column by Joe Nocera of the New York Times.

The SEC was (and presumably still is) investigating communications between the journalists and certain stock analysts and large-volume traders. As far as we know, the journalists weren't accused of wrongdoing, at least not by the SEC. The government may think of them merely as witnesses.

This case is about much more than questionable financial journalism. It is connected with serious allegations of:

●  Malicious stock market manipulation, by analysts and big hedge funds;
● Mass counterfeiting of shares (also known as "naked" short- selling) by broker-dealers;
● --Lax enforcement or collusion by "captured regulators" at the SEC;
--Inattention to their corporate and government watchdog role--and perhaps even a market-manipulating conspiracy--by the "Fourth Estate," the nation's financial media.

The controversy is multi-faceted and fascinating; intriguing though rather tedious to explain. It divides investors into two camps, both bolstering their cases emotionally, daily, on the Internet. One movement calls loudly for a congressional investigation. By its followers, its leaders are praised as American heroes whose efforts may literally save the market from collapse. On the other side, the accused perpetrators label their assailants--publicly, frequently, and savagely, it seems to me--as whackos. The media is generally dismissive of it all, I'd say, yet wary of sleeping through the next Enron or Watergate. "Stockgate," as it's called, stems from efforts to expose the whole affair by one persistent public-company president.

Get Shorty

Patrick Byrne is the 43-year-old founder of Overstock.com, an Internet retailer based in Utah. For at least the past year, Byrne has railed against Wall Street. Hedge funds and analyst firms constitute the ultimate insiders' club, he says, opposing the interests of everyday investors and doing so with at least tacit approval from the SEC. He's also been critical of the nation's financial media, especially a handful of specific journalists and most especially Herb Greenberg, of Marketwatch.com.

Byrne says his company, of which he and his family own millions of shares, has been illegally targeted and damaged by short sellers. In mid-2005, Byrne sued Gradient Analytics, a research firm based in Arizona, and Rocker Partners, a hedge fund based in New Jersey. The suit alleges unfair competition in the form of systematic manipulation of the markets. Byrne says he also voiced his complaints to the SEC, which, it seems, may have influenced the subpoena action.

Short selling, for the unaware, is a bet that a stock will go down in price. If you're right, you make money. If you were to sell a stock short at $75, for example, and later "buy to cover" at $23, you'd have a $52 profit. In fact, those were precisely the price points at which shares of Overstock (ticker symbol: OSTK) traded, respectively, 15 months ago (in late 2004) and at this writing in March 2006. Many short sellers have profited handsomely from Overstock's fall.

Short-selling can be (and usually is) a legal and legitimate practice. Investors do it to hedge against the risk of a market downturn. For example, to protect recent gains in industrial stocks, they might short the "Dow Diamonds" (ticker symbol: DIA). That's an exchange-traded fund that trades like a stock, moving up or down in conjunction with the Dow Jones Industrial Average. Some speculators (as opposed to hedgers) do nothing but bet against stocks, and that's perfectly legal too. Note that in the stock market game--unlike, say, betting on NCAA basketball--short selling can actually affect the outcome. (Some say this a myth, a claim that mystifies me. I say sell anything en masse, and the price tends to drop.)

What indisputably hurts share prices is bad news. Suppose a short seller bets against a stock and then starts bashing the underlying company, in a public forum. Worse, what if the claims about the company are exaggerated, false, or presented out of context? Frankly, this happens all the time. Check out the message board for most any volatile stock on Yahoo Finance. You'll see an ongoing free-for-all slugfest between the "shorties" and the "longs" (the latter own the stock outright, and generally support the company). Worst case: Suppose the short sellers hook up with dishonest or gullible journalists, feeding them false info with hopes of harnessing the press to do their dirty work.

Apart from shady deals with the media, according to Byrne, there's even more sleaze to reckon with. Short selling has taken on a new, pernicious dimension. The sale of non-existing "phantom" shares creates an oversupply of counterfeit stock, which has caused certain companies to suffer extended, undeserved declines in market value. One victim is Overstock. And a few bad apples in the press have helped it happen, he says.

(Continued)
  How It Works
  How Common?
  Never Say Sith Lord
  Fighting Back