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Part II On Short
Selling- Illegal Naked Short Selling in Microcap Stocks |
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The regulators are beginning to take
a hard look at the practices of short sellers. After several years of high
profile cases surrounding the excesses which caused stocks to go artificially
high, the extended bear market has fostered a climate wherein the regulators
are examining the practices of those who benefit by illegally forcing stocks
artificially low.
On April 19th I published an edition
entitled "Is
the SEC Pendulum Swinging? - Regulators Go After Short Sellers". I
covered the recent actions the SEC took against one fund manager who used
short selling in a death spiral financing to illegally enhance his profits.
Today we're looking at the issues
surrounding naked short selling in microcap stocks, and how the regulatory
landscape may be changing to level the playing field for small public companies
and their shareholders.
About 80 small public companies have
signed up for the "OTC Rebellion". To learn more, read on:
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The
OTC Rebellion |
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The DTC, or Depository Trust Company,
is responsible for the electronic transfer of billions of shares of stock
in the US markets. The DTC electronically handles the delivery of stock
from buyer to seller in the open market once a trade takes place. DTC handles
billions of transactions annually and has a monopoly in the US markets
despite being a private company.
There are about 80 microcap companies
attempting to withdraw their shares from being handled by the Depository
Trust Company. If successful, they go back to the old fashioned practice
of having every transaction handled by the company's Transfer Agent. They
believe short sellers are able to illegally create millions of shares of
stock which don't exist, and are flooding the markets with these counterfeit
shares. The practice only works because of flaws and loopholes in the DTC
system.
In a legitimate short sale of stock,
shares are borrowed by the seller against a future pledge to buy the stock
back. If the shares drop in value, the short seller makes money when he
closes his position with a buy transaction.
Naked short sellers flood the markets
with millions of shares that simply don't exist and which have not been
legitimately borrowed. Microcap companies are targeted because they don't
have institutional shareholders with deep pocketswho have the conviction
to take on the short sellers. Short sellers are able to bully this end
of the marketplace. Furthermore, microcap companies have a much higher
failure rate, giving the short sellers much greater odds of long term success.
Naked short sellers are able to sell
shares which simply don't exist because the normal three day settlement
rules are mostly ignored by the DTC System. As the buyer you purchase shares
in the open market and pay for the purchase within the normal three day
time frame. The shares show up in your account as a line item entry. However,
most investors don't know that your shares might never be electronically
delivered to your account in any reasonable time frame. These "open fail
to delivers" can stay on the books of brokerage firms for months because
the DTC system does not force them to be delivered.
This allows naked short sellers to
flood the market with millions of shares which don't exits and where no
shares have been pledged or loaned against the short trade.
There are two primary mechanisms
short sellers use to execute these trades.
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Market Makers- Market
makers are allowed to go naked short stocks in which they make a market.
This regulation is designed to encourage a "stable" market. Large pools
of funds are pledged to market makers in the guise of trading capital which
are really used to create huge excess supplies in microcap stocks, which
acts to destabilizes the market.
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Trading through Canada:
You can execute trades with a Canadian brokerage firm simply by opening
an account. The NASD regulates the actions of brokerage firms, but has
no regulatory authority of Canadian brokerage firms, where huge short positions
are often parked and moved or "kited" around to disguise their existence.
When a company successfully withdraws
its shares from trading in the DTC system, naked short selling abuses are
prevented. Once removed from DTC, every transaction is handled by the old
fashioned way by the Transfer Agent. Every buyer is matched up with a seller
who actually has real shares for sale. The transfer agent matches the two
and short sellers cannot artificially create immense supplies of stock.
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Genemax
Corp (OTC BB: GMXX)- The Anti Naked Short Selling Poster Child |
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Pictured here is a chart of Genemax
Corp, one of the few microcap companies which has been successful at
having the ownership transfer of its shares removed from the DTC system.
The company was targeted by naked
short sellers last year. At the end of last July, Genemax succeeded
in having its shares removed from ownership transfer in the DTC system.
Eventually, naked short sellers were forced to cover their open positions,
and the stock traded from $4 in October to $20 in November as a short squeeze
drove the price to absurdly high levels.
Genemax is a biotech company
with less than $1 million in cash which has yet to begin clinical trials
on any new drug. There are about 15 million shares issued and outstanding.
At $20, the market value of the company was pegged at $300 million, which
is absurd.
As you can see from the chart, the
stock turned around and now trades in the more reasonable range of about
$2.50. The company has filed civil law suits in both Canada and the US
to stop what it describes as "illegal and manipulative" practices.
Just last week the company filed a law suit against a Bermuda based brokerage
firm for illegally lending shares of its unregistered stock to short sellers.
The success of the Genemax case
has fostered an interest by like companies. About 80 small public companies
are attempting to withdraw from the DTC system today. Several in addition
to Genemax have succeeded.
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Recent
Developments |
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As a result of the Genemax case,
the DTC (Depository Trust Company) became alarmed that it would have a
customer rebellion, and has asked for a ruling from the SEC concerning
this issue. DTC argues it should be up to the shareholder to remove himself
from the DTC system, which can be accomplished by simply requesting the
delivery of your certificate.
The SEC has decided to allow those
companies already out of DTC to remain outside the system. The SEC has
not ruled on whether companies have the option to remove themselves.
The NASD has been in favor of enforcing
proper settlement and delivery times. The NASD has successfully ejected
several offenders from its ranks for abuses in this area.
Many believe the SEC has dragged
its feet in dealing with the problem, as the SEC views the naked short
sellers as their unofficial "watchdogs" for preventing excesses to the
upside in the market. One glance at the chart of Genemax shows why. If
stocks trade like Genemax, individual investors could be naively purchasing
shares at $20, which are one way tickets to losses.
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Political
Muscle Gets Involved |
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One company which is purported to
have been a target of naked short sellers is Life Energy Technologies
(OTC BB: LETH). Dr. Albert Reynolds is the Chairman of LETH,
and the former Prime Minister of Ireland.
Dr. Reynolds has been lobbying ferociously
on Capitol Hill for legislative change, along with former US Senator Vance
Hartke who has taken up the cause. Here is a quote from Dr. Reynolds taken
from a recent press release:
"From what I can observe, the
trading system in America allows for abusive trading practices to over
inflate share ownership in a U.S. Public Company. The 3-day settlement
securities clearing system operated by the NSCC and DTC fails to operate
correctly to ensure that a fair marketplace exists to trade U. S. Public
securities. A few market markers and brokers are determining the value
of a company and not the legitimate buyer of the securities. The U.S. has
been faced this last year with much corporate misconduct, but have not
faced the fact that the U.S. Trading System lacks integrity. If these practices
are not fixed, it will destroy the next generation of business in the United
States. Who is to say that the OTC-BB market is down over 75%; how much
is the economy how much damaged has been caused by unscrupulous market
makers and brokers. What happens when the World Markets realize that short
sellers can sell you securities, never deliver them, and collect the money?
You would have to ask yourself why anyone should invest in American Companies"
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Conclusion |
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I could write 20 more pages on this
issue, and still not begin to cover all the complexities. There will be
more editions on this fascinating subject. Aggressive regulatory enforcement
with the existing laws, or changes, could bode well for more favorable
valuations in microcap stocks.
One thing is certain- the regulators
need to level the playing field for everyone. We should all be able to
go long if we think a stock is undervalued and has potential. We should
all be able to go short if we think a company is overvalued. There is nothing
wrong with short selling, and if it is going to be allowed everyone should
be able to do it. Perhaps we should all be forced to borrow the stock and
only short on a plus or zero plus tick in any security, not just those
that are marginable.
Call your brokerage firm on Monday
and try to execute a short transaction in a $2 stock on the Bulletin Board.
You won't be able to do it. However, if you are a Cayman Island based trust
with a brokerage account in Canada, you will be able to short all the stock
you want without having to pledge anything buy money. The NASD won't be
able to look at your Canadian broker's books and force you to cover, and
the DTC system won't ever expect you to deliver the stock you don't own
which you've sold to someone else.
These naked short sellers do help
prevent excesses in the marketplace, but there is a cost to all investors.
If you invest in a small company, and it moves forward, grows, and becomes
profitable, you will generally make money on the investment. On the flip
side, there have been hundreds of small companies who might have had a
chance to execute their business plans if they could have gone to the capital
markets to raise funding. Their stocks were decimated by massive counterfeiting
of their shares, forcing their valuations to zero and inevitable failure.
Despite the word "illegal" being
used by to describe this practice, it has not been fully established that
these practices are indeed illegal. The NASD has successfully prosecuted
brokerage firms for rules violations. The SEC has yet to take any agressive
steps to curb these practices. Until a Judge in a civil or criminal court
decides these massive counterfeiting schemes are illegal, it is misleading
to say they are. Certainly, it would be fair to say certain unscrupulous
investors are using loopholes in the system to bypass the rules which apply
to normal short selling practices.
The Regulators need to fix the problem.
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References |
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If you want to learn more about this
whole issue, an excellent reference point can be found at www.nakedshortselling.com.
This is the home page of the National Association Against Naked Short
Selling.
If you want to read a more complete
discussion of the issue, a treatment entitled the "Counterfeit Stock
Scheme That Is Destroying US Companies" can be accessed in PDF form
by clicking
here.
Charts Provided Courtesy
Of TradePortal.com |
