Spongetech Delivery Systems, Inc. (fka SPNGQ)

[loanranger]

Spongetech fans smell a naked, short rat

Crain's New York
Aaron Elstein
on September 28, 2010 1:52 PM

It seems as if the naked portion of the always-fascinating Spongetech Delivery Systems case will have to wait.

Last week, a federal bankruptcy judge denied a motion from some shareholders to investigate allegedly illegal naked short selling of Spongetech shares. And what, pray tell, is naked short selling? More on that in a minute, though I'll admit right now it's not what it sounds like.

Spongetech was a New York-based sponge-maker and prominent advertiser at Mets, Yankees and Knicks games before management was charged with criminal fraud in May and the company collapsed into bankruptcy. Prosecutors say 99% of Spongetech's purported sales were fake.

Now, one would ordinarily think a company that is accused of cooking up essentially all its sales would be an excellent candidate for failure. But that is not what is believed by some Spongetech investors, who appear to have rooted for the company as fervently as the cowbell-carrying Hilda Chester rooted for the Brooklyn Dodgers.

These Spongetech fans, in the words of U.S. Bankruptcy Judge Stuart Bernstein, "allege that the naked short selling resulted in a proliferation of purported shareholders, an inability to identify them and ultimately, the destruction of Spongetech's business."

Now, a few words about naked short selling. In a conventional short sale, an investor sells stock borrowed from a broker that he hopes to replace later with shares bought at a lower price. But in naked shorting, the stock is never formally borrowed and the result, say people who believe this is a serious problem, is a permanent dead-weight of selling on a small company's stock. The SEC has investigated and determined most such "borrow failures" are the results of administrative snafus rather than bearish plots, but nonetheless decided the problem was real enough to in 2004 adopt a rule to restrict naked shorting.

Nonetheless, there is a group of people -- journalist Gary Weiss aptly calls them the "baloney brigade" -- who believe naked-short selling conspiracies continue to thrive and bring down worthy companies. On my desk I have a 2005 letter from the general counsel of a company called Universal Express in which he says he has faxed me 85 pages of background material on "the national 'naked shorting' scandal, now popularly referred to as 'Stockgate.'" The lawyer, Chris Gunderson believed his company was a victim of naked shorting; in 2007 the SEC charged him with fraud.

If in fact Spongetech was brought down by naked short-sellers and not, as the government contends, deceitful management, it will be up to the investors to find out. Judge Bernstein in a ruling last week acknowledged that the allegations are "serious, and obviously relevant to the administration of the case and Spongetech's financial affairs." However, he added, Spongetech appears to be insolvent and its estate lacks the money to conduct an investigation.

"It would be inappropriate to force the creditors - who are also victims - to shoulder the cost of the investigation that is sought," the judge wrote.

Let us wish the Spongetech sleuths well should they pony up enough money to uncover the real truth.

(note: posted prior to reading.)