RespireRx Pharmaceuticals Inc (fka RSPI)

[DewDiligence]

Re: Hedge funds, short-selling, and private placements

>…you alluded to the fact that the ability of bio financiers to do naked shorting had been severely curtailed during the current economic crisis. Since this has long been part of their MO, any thoughts on how severely this impacts raising money?<

I presume you’re referring to #msg-33749911.

The issue is not naked shorting per se, but rather the ease with which hedge funds have been able to circumvent the SEC prohibition on covering a short sale with shares acquired in a private placement.

Let’s say Company X hears from the investment banker for the small biotech firm, Y, that Y is seeking to raise money in a registered direct placement. X cannot legally short Y’s shares and cover the short with shares of Y acquired in the placement.

But X can cut a deal with Company Z to accomplish essentially the same thing. X says to Z, “If you short Y, we’ll furnish the shares you need to cover. If the short makes money (as we know it will [wink]), we’ll split the proceeds. If by some chance, the short loses money, we’ll make you whole.”

If Z has a decent working relationship with X, the proposed deal is a no-brainer for Z because there is zero risk and a high probability of a profit. Hence, Z opens a short position in the shares of Y.

When Y’s private placement goes off, X gets its registered shares. After a brief waiting period for cosmetic purposes, X delivers the shares to Z. Using these shares, Z closes out its short position; X and Z split the proceeds according to their prior agreement.

Now take the above transaction and multiply it by 15. Why? Well, Company X is nobody special—it’s just a run of the mill hedge fund. If X knows about Y’s pending placement, the chances are many other firms know about it too and some of them will opt to play the same game.

All told, it’s hardly surprising that the share prices of small biotechs commonly went into freefall in the trading sessions immediately preceding the announcement of a private placement.

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Fast forward to the present: The crisis in the financial markets has has made it harder and more costly to borrow shares of small, relatively illiquid companies for shorting, and this renders the kinds of schemes described above substantially less appealing. The consequence is that several small biotechs who would probably have been able to obtain financing in the old days have either filed for bankruptcy or are on the verge of doing so. Some of the affected companies are mentioned in #msg-33720220 and the Reply chain to that post.