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Executives turn to odd tactic to fight shorts
Wednesday, August 02, 2006
By Kara Scannell, The Wall Street Journal
Some executives are reaching for an odd tactic in an expanding battle against short sellers, who profit when share prices fall.
The executives -- at smaller companies that often don't trade on big exchanges -- are pushing shareholders to lock away their physical stock certificates so the short sellers can't get their hands on the shares.
Stock trading rarely involves the actual exchange of physical stock certificates anymore, because Wall Street trades and tracks most stocks electronically. But in a perhaps quixotic effort, the executives hope they can short-circuit the short sellers by rounding up stock certificates and taking them out of the electronic loop.
Short sellers borrow shares and sell them, hoping the share price will fall, allowing them to profit by replacing the borrowed shares with less costly ones bought later. The activity is legal, and many investors and scholars argue it helps share prices to adjust to changes in a company's outlook.
But a number of executives -- at companies like Fairfax Financial Holdings Ltd., a Canadian insurance company, and Overstock.com Inc., a U.S. Internet company -- argue short sellers are manipulating their shares. They are challenging the shorts with lawsuits, private investigations and publicity campaigns.
Few companies have been able to prove improper trading, but the stock-certificate effort is a sign the battle between short sellers and aggrieved executives is widening. By getting shareholders to take physical possession of their stock, the executives hope, brokers won't be able to lend the shares out to short sellers.
"The problem is shorting has gotten to be so popular that there's no accountability," says Wes Christian, a partner at Christian, Smith & Jewell LLP, a Houston law firm that says it is working for 20 companies -- including Overstock and Sedona Corp. -- against short sellers.
Peter Fiorillo, founder of Rx Processing Corp., a Tampa, Fla., provider of laboratory tests, says he became suspicious about activity in his company's shares in February, when 85,000 Rx shares traded at 0.0001 cent, well below the one cent where it had been trading. He suspected short sellers were involved.
"You see somebody print 0.0001, and you know that they're not real trades," he says. The shares trade as pink sheets, part of an unregulated stock-quote service populated by many small companies, and don't change hands on an exchange like the New York Stock Exchange or Nasdaq.
The following month, he issued a news release recommending shareholders of Rx Processing ask their brokers to deliver physical certificates. "This action limits interbrokerage borrowing and market manipulation," he said in the release.
Company executives complain that some traders sell borrowed shares that don't even exist, a practice known as naked short selling, which is typically illegal. These executives argue that if short sellers can't find stock to borrow and sell, it will be harder for them to short the shares.
Moreover, if fewer shares are in the hands of brokers to lend out, some short sellers might be forced to return borrowed shares, relieving downward pressure on share prices.
James Angel, an associate professor of finance at Georgetown University in Washington, calls the executives' efforts a fruitless attempt to "go back to the early 20th century." Mr. Angel says chief executives blame short sellers, when in fact short sellers are often first to identify companies with problems.
"Much the same as when the hyenas are targeting a pack of zebras," he says, "they're likely going to get the weak ones."
It isn't clear just how many executives are asking shareholders to go paper. It is even less clear how many are succeeding.
At Rx Processing, fewer than 15 stockholders followed the CEO's advice and requested certificates. That amounted to about 500,000 shares, less than 6 percent of the nine million shares outstanding.
Mr. Fiorillo says he is unlikely to push the effort further. Now, he hopes to leave the murky over-the-counter market by going private, reorganizing and trying for a Nasdaq listing that would bring more market surveillance.
Holding physical shares can be costly. Investors often have to pay a brokerage as much as $25 to receive a paper certificate. The Securities Industry Association, Wall Street's main lobbying group, has tried to get rid of paper certificates for years, estimating it costs the industry more than $250 million.
Most companies involved in the current campaign have risky, thinly traded penny stocks not listed on the NYSE or Nasdaq. These companies often don't meet corporate-governance standards or financial requirements to trade on the big exchanges.
Some of these companies have tried to grab control of their shares by offering stock or cash dividends that require a shareholder to redeem their securities to get a new class of stock or cash dividend.
Riverbank Investment Corp., a small Wilmington, Del. broker, announced a cash dividend last month hoping to "trigger a short-squeeze forcing naked shorting to be covered," it said in a news release. Primeholdings.com Inc., a Salt Lake City holding company for Internet businesses, said last fall it planned to issue a stock dividend for the same reason.
Philip Verges, chief executive of communications company NewMarket Technology Inc. suspected two years ago that naked short sellers drove his company's stock price lower on the OTC Bulletin Board and urged investors to demand stock certificates. "Do not take no for an answer," he wrote in a letter to shareholders.
Yet only a handful of NewMarket shareholders responded, and the company abandoned the effort. "We started thinking it was not going to help," said Rick Lutz, head of investor relations for NewMarket.
The company has applied for a listing on the American Stock Exchange. It is awaiting approval.
AI
