To OTC Journal Members:
 

Special Announcement- Lending Tree (NASDAQ: TREE) Earnings Out Monday After Close

In our April 5th edition we published a trading alert on Lending Tree at about $12 per share. We suggested the stock could trade up into the $15 to $16 range kicked off by an upside surprise in earnings. Lending Tree is the premier destination site on the internet which matches customers seeking to finance a new home purchase or refinance an existing mortgage with mortgage lenders.

Housing starts continue to be incredibly robust. Mortgage finance companies have been reporting extremely strong earnings (Fannie Mae). Internet stocks are also delivering earnings surprises to the upside, with Yahoo's recent blow out quarter leading the pack. This evidence leads us to believe Lending Tree could deliver a big upside surprise.

Lending Tree will be announcing March quarterly results this coming Monday, April 21st just after the market closes. We are hoping for an announcement which exceeds analysts' expectations, leading to a gap up in the stock on Tuesday morning.

Stand by and keep your fingers crossed. The stock closed at $12.50 on Thursday, about $.50 above our suggested entry level and at the high point of our entry range.
 

Is the Pendulum Swinging in the Regulatory Environment? - The Feds Turn Their Attention to Illegal Short Selling

As promised, this edition is the first in a series we plan to publish on what appears to be burgeoning interest by the regulators to deal with the problem of manipulative and fraudulent practices by short sellers. 

During the go-go bull market of the 90's, the regulators focused most of their attention on illegal practices designed to artificially inflate the price of stocks to the detriment of investors.

In the microcap arena the internet was the preferred to medium for getting out the message. Dozens of electronic stock newsletters appeared, making outrageous predictions on potential stock performance and failing to provide proper disclosure. The message boards also became an uncontrollable forum for making absurd predictions and fraudulent claims with disclosure in absentia.

The problem in large cap stocks turned out to be much worse. Just after the market began to recover from the devastating effects of 911, the massive accounting fraud perpetrated by the management of Enronwas uncovered, leading to revelations of rampant accounting fraud by a startling high number of America's most high profile companies. 

The technology revolution gave way to the "Tech Wreck", and the regulators have been very busy cleaning up the mess in order to help restore confidence in the stock market.

Three years of the ugliest bear market in history has led to soaring bank balances for money managers on the short side. This excessively negative market environment has also fostered many of the same kind of fraudulent and manipulative practices designed to artificially force stock prices lower. 

There is growing evidence that the regulatory community is beginning to take notice and action against these practices. The regulatory pendulum could be swinging back in favor of the investors betting stocks will go up.
 

Short Selling- Betting A Stock Will Go Down

Stock market regulations allow investors to bet both ways. Most of us simply go long- another words we purchase a stock in the open market in the hopes the stock will trade to higher levels and we can sell it at a profit.

Less than 10% of individual investors regularly participate in short sales. Short positions allow investors to profit if a stock price goes down. When you short a stock, you sell first, pledge the capital, and buy the stock back later. If the stock's value is lower when you buy it back, you make a profit.

Retail investors must borrow the shares, which is arranged by their brokerage firm, in order to execute a short sale. Investors cannot legally short a stock unless it is both marginable and borrowed.
 

Death Spiral Financings

A Death Spiral Financing can be the catalyst for illegal short selling.

On February 27, 2003, the United Securities and Exchange Commission announced a settlement agreement with Thomas Badian of New York based Rhino Advisors. The settlement called for Badian to pay a fine of $1 million in order to settle claims that he had fraudulently engaged in large scale short selling designed to force down the price of publicly traded Sedona Corporation.

According to SEC filings, Badian has agreed to settle the case for $1 million without admitting any wrongdoing.

There are many kinds of fraudulent short selling. This case was associated with a "Death Spiral" financing.

According to the SEC, in November of 2000 Badian negotiated a $3 million convertible note between Sedona and an offshore investor. The investor had the right to convert the debt into shares of Sedona stock at a price based on 85% of the current market price. After conversion, the note holder could then sell those shares in the open market, nearly insuring a reasonable 15% profit.

The terms of the agreement specifically forbade Badian from short selling the stock in advance of conversion.

According to the SEC, in March of 2001, Badian illegally short sold 872,796 shares of Sedona stock, creating an excess supply and artificially forcing the price of Sedona much lower. The trades were printed using the ECNs after market hours, and therefore never reported in the volume or to the NASD. However, the game did not end there.

The NASD placed a restriction on short selling Sedona shares because there was so much undelivered stock in the DTC system that month (fail to delivers in the DTC system is an issue for another entire edition). 

In the first two weeks of April 2001, Badian illegally short sold another 350,000 shares through a Canadian Brokerage account. Canadian firms are not subject to the same NASD regulations, allowing him to pull it off at the time.

All in all, over a six week period, Badian was able to illegally short sell 1.2 million shares of Sedona Corporation, forcing the price substantially lower. To complete the process, Badian then submitted for a conversion at the agreed upon 15% discount to the market at the time. However, because his brokerage accounts had 1.2 million share short positions at much higher levels, he was able to effect transactions between the various accounts to cover the short, thereby locking in substantially higher prices than the reasonable 15% contemplated by Sedona when they entered into the transaction.

The convertible note Sedona issued is commonly known as a "Death Spiral" financing. Illegal short selling against the future conversion forces the price much lower. Other traders and money managers learn of the financing, and they jump on the bandwagon, exacerbating the problem. Individual shareholders who see prices plunging also sell out of fear, which plays into the hands of the short sellers. All in all, shareholders of Sedona were slaughtered in order to artificially line the pocket of one money manager.

To read the SEC filings on the case and the settlement, simply click here. 
 

Conclusion

The isolated case of Thomas Badian is business as usual in the small and microcap world. Since Wall Street seems a long way from a full recovery of the excesses of the Bull Market, more legitimate sources of equity capital for small companies are virtually non existent. Companies like Sedona Corp have been forced to go to the proverbial loan sharks of the industry to raise much need capital.

The Badian case is highly unusual because the SEC took action. We know of dozens of Death Spirals, but don't know of any similar actions in the past. Here is an excerpt from the SEC's press release on the matter:
 

The SEC's aggressive action in this case provides evidence the regulatory community is taking steps to curb excesses designed to force stocks lower. The pendulum seems to be swinging back in favor of retail investors.

The scuttlebutt on Wall Street suggests Badian got off fairly easily, and many believe in return he is actively helping the SEC uncover a number of other cases where illegal practices have been employed to force stocks lower. Wall Street insiders tell us more cases like this one are expected in the future.

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