OT: Illegal Naked Short Selling in Microcap Stocks
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:
The OTC Rebellion
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.
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.
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.
Genemax Corp (OTC BB: GMXX)- The Anti Naked Short Selling Poster Child
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.
Recent Developments
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.
Political Muscle Gets Involved
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"
Conclusion
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.
References
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.
