March 2006 –

Naked Shorting: How It Works
   (Continued from previous page)

When you sell a stock short, you must "borrow" the shares from someone who currently owns them. You promise the "lender" you'll return an equal number of shares, which you plan to purchase later, in the open market, after the stock's price has fallen. Meanwhile, you sell at today's price. It's buy low, sell high, but in reverse order. Sell high, buy low.

So far, it's all kosher. One clarification, however, is that normally you can execute the short sale only with your broker's assurance that shares are available to borrow. Sometimes it may take a day or two for your broker to deliver those shares to the buyer. No sweat, Byrne allows. There are in fact rare cases where the stock certificates may be printed on paper (although about 97 percent of shares exist electronically). So conceivably it could take a day or two for the owner to hunt down the certificates in a sock drawer, or wherever they may be, and send them in. The SEC has long allowed up to three days for a broker to "deliver" shares after a short sale. More recently, a grace period of 10 days was tacked on.

In the real world, unfortunately, it sometimes takes much longer than the allowed 13 days for the buyer to receive the shares. Like month or two. Or never. Why? It's simple, says Byrne, along with a growing legion of followers who agree with him. The selling broker-dealer never had them in the first place. It had neither a stockpile of shortable shares, nor knowledge of anyone with paper certificates in a sock drawer. The broker-dealer allowed its customer (probably not you, but maybe a big, important customer, like a hedge fund) to go "naked." That is, to sell the stock short even in the absence of shortable shares. In effect, the broker-dealer produced counterfeit or "phantom" shares.

The legal term for this practice is "strategic failure to deliver." To be sure, it is as criminal as robbing a bank. But it's much easier to get away with.

The potential consequences of this practice--if it became common--are mind-boggling. Counterfeit shares? Consider the consequences of artificial Treasury bills, or fake natural gas futures contracts, created by short sellers whose sole interest in the matter is seeing their price decline. If the stores filled up with fake Rolexes, surely the price of real ones would be affected too. But at least an appraiser can hold a wristwatch in hand, examine it with an eyepiece, and so on. With a share of stock, how can the buyer have any opinion about its authenticity? The buyer's brokerage statement says the shares are indeed in his or her account. But what's really there is just an IOU. A negotiable, saleable one, but an IOU nonetheless. If the buyer is nervous about it, they can sell. They may get whacked on the trade, given the recent downward pressure on the stock. But at least the fake shares will move into someone else's account.

Where is the harm? Certainly the shareholders as a whole take a hit. How would you feel, as an investor in a small company, if you knew about ongoing dilution of the share base, by people who intend to sell the shares as fast as they can counterfeit them? If you're an active trader of small cap stocks, this may have already happened to you. Some say it occurs only to a very small extent, and some say it's out of control. More on that debate in a moment.

Substantial harm, likewise, comes to the company itself. If its share price keeps falling, its balance sheet deteriorates. Its ability to borrow and finance expansion, or refinance debt, is reduced. Suppliers and potential partners may shy way, fearing bills won't be paid or promises won't be kept. The customer base may shrink, because of inferior products, less-robust sales processing, or all the negative press that paints the company as a loser. Perhaps the shares fall below $5, or to the penny stock range, at which most investors no longer want them. The shorties, meanwhile, are praying for the company to go under. Because if the shorted shares become worthless, according to Byrne, taxes are often greatly delayed or avoided altogether.

But the most egregious damage may be done to the market in general, and perhaps to the economy as a whole. Many would say this idea is ridiculous; blaming a broad phenomenon, such as falling stock prices, on a marginally influential cause. But if an upstart tech company can be quashed by stock market bullies, perhaps the next Microsoft never gets off the ground. Also, consider this: For the past several years, U.S. stocks have been subject to severe "multiple compression." That is, company earnings have improved but stock prices haven't kept up. The price-to-earnings ratio of the S&P 500 is currently 16.4. Five years ago, a full year after the March 2000 crash, it was about 28.

Many reasons may account for declining P/E multiples. Likely factors include high energy prices, rising interest rates, hurricanes, and geopolitical strife. But what I've observed personally, especially in the past three years, is the increasing frequency of freakish, outsized moves in individual stocks. New, powerful forces seem to be at work, pushing share prices around in proportions rarely seen in the past (except in the months leading up to the crash in 2000). It happens to the up side as well (witness Google in 2005). But the really amazing moves usually are downward. The stocks fall out of bed and then, inexplicably, keep falling, down the stairs and into the basement. Such moves are not just due to illegal short selling, I'm sure, but from many forces, some new and some not, both known and unknown.

What's unprecedented and most influential, I believe, is the effect of gun-slinging hedge funds, heavily capitalized and motivated by their fee structures either to profit big or die trying. They're unbound by the constraints of traditional mutual funds, which generally don't sell short at all. Often hedge funds are accused of aping each other, pursuing pretty much the same strategies. It's as if the managers all get together at the same racquetball club and agree on what to buy and sell. Or Allen has lunch with Bill, then Bill has lunch with Charlie, Charlie has lunch with Dave, etc. The word could get around in many ways. It's not necessarily collusive, either. These people may despise each other, but know that profits come from ganging up on vulnerable stocks. So whenever a few known telltales start to blow, they overwhelm long shareholders with an unexpected, seemingly impossible blitz of sell orders. Suddenly everyone's selling.

Maybe stock prices in general are now subject to a built-in "fear tax," stemming from the threat that on any given day, a few unfortunate victims will be hammered by hedge funds. Conceptually, the fear tax idea is much like the terrorism premium that now seems to be baked permanently into oil prices. Will P/E multiples ever expand again? Maybe, maybe not. Maybe multiples will decline further. Maybe short sellers will cook up even more ways to extract the increasing capitalization from companies with improving performance, and to annihilate those that stumble. Maybe their methods will be even more ingenious and devious, and perhaps equally illegal.

Maybe the SEC shouldn't be making it so easy for them.

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