Replies to post #214510 on CMKM Diamonds Inc. (fka CMKX)

[nufced]

back atcha..Betting Stocks to Fall

BY GREG SAITZ
c.2006 Newhouse News Service

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The dispute had all the markings of a classic battle between a company and short sellers.

On one side was a well-known shipping firm complaining about speculators spreading rumors as part of a "dirty scheme" to depress its share price.

On the other, a group of businessmen who claimed the company had no one but itself to blame for its flagging shares. They pointed to the sinking of several vessels, substantial losses and excess inventory as reasons.

Sound like a tale from today's New York Stock Exchange? Try the Amsterdam Stock Exchange, circa 1610.

Dutch authorities ultimately banned short selling after the scandal involving the Dutch East India Co. and a group of speculators. It likely was the first instance of investors in an established stock market betting shares would fall in price. But it was far from the last.

Short selling -- selling shares of borrowed stock in anticipation of buying them back at a lower price -- has been around for 400 years. During that time, the practice has been pilloried and promoted, banned and restricted.

These days, the spotlight is again on short selling. Lawsuits and insults are flying. Conspiracies and manipulations are floated. Regulators are investigating. Lawmakers are outraged. The very fabric of the country's financial markets, some say, is at stake.

Yep, Wall Street has short selling on the brain.

Proponents say the practice helps maintain an efficient marketplace, and short sellers often are the first to raise concerns about fraud (see: Enron). Critics say abusive short sellers can conspire to crush companies and some even claim the manipulation threatens the foundation of the country's financial markets.

One of the industry's most well-known short sellers, David Rocker, has been accused in a lawsuit of participating in a conspiracy to drive down the price of Internet close-out retailer Overstock.com. And Biovail, a Canadian pharmaceutical company, is suing other hedge funds and analysts on similar allegations.

"They (critics) look at short sellers as being kind of dark, anti-social, un-American," said Parker Quillen, who runs Quilcap, a New York hedge fund management firm that sells shares short. "You need to have counterviews. It's just like having a two-party system. A one-party political system is not healthy."

In theory, most everyone involved in the business world agrees short selling is a valid investing technique.

The first step for traders who are betting shares will decline in price is to borrow those shares to sell, typically from a brokerage firm. Another method that is in most cases illegal, called naked short selling, occurs when the seller doesn't borrow the shares but conducts the transaction anyway.

From there, an investor sells the shares and waits. If the stock drops, the short seller can buy back those shares and return them to their original owner. The short seller's profit is the difference between the price they initially sold the shares and the price at which they bought back the shares.

Of course, if the stock increases, short sellers can lose big time. Practitioners often say the perfect short can only go down to zero, while a stock's upside potential is unlimited and therefore, so is a short's exposure to loss.

Short interest is a relatively small part of the overall market -- about 2 percent to as high as 5 percent of the outstanding shares on the New York Stock Exchange -- but it still accounts for billions of dollars in trading.

The reasons investors short stocks vary. Some may believe a company is overvalued or shows signs of fraud.

But money managers also use short sales to hedge their overall positions. And market makers, who buy and sell shares of a particular stock to maintain its liquidity, sell short to ensure smooth trading.

"If you were to ask sophisticated investors, they would say short sellers add to the marketplace because they add liquidity," said Owen Lamont, a finance professor at Yale University. "If you didn't have short sellers, then the pessimists wouldn't have a voice and if pessimists aren't heard, prices are too high."

One frequently cited case of the short seller as a vanguard to the markets is Enron. James Chanos, founder of the short-selling focused investment New York firm Kynikos Associates, began shorting the energy business in November 2000.

He was one of the first to start raising concerns publicly about the company at a time when Wall Street was shaking its pompoms in support of Enron.

A year later, Enron sunk into bankruptcy and in time was revealed to be one of the business world's most egregious frauds. At his conspiracy and fraud trial in Houston earlier this year, former Enron Chairman Kenneth Lay blamed short-sellers, in part, for the company's demise.

Both Lay, who died of heart disease two weeks ago, and former company CEO Jeffrey Skilling were convicted.

"Blaming the short seller is like blaming the police for finding the criminal," Lamont said.

But the blame game -- with short sellers cast as the villains and companies as the virginal maidens -- has been played for decades, if not centuries. Sometimes there is truth to the allegations, but sometimes the bad guys are the ones complaining.

Since the Dutch controversy in the 17th century, the reputation of short sellers has advanced about as much as that of religious fanatics.

In some cases, there is good reason.

Last year, hedge fund manager Hilary Shane agreed to pay securities regulators $1 million in fines and restitution for a short selling scheme she employed in 2001 involving shares of CompuDyne. Shane had agreed to buy a certain number of CompuDyne shares at $12 each through a private investment in public equity, or PIPE offering.

The purchase price was more than $5 lower than the trading level at the time. However, prior to the company publicly announcing the transaction -- which sent shares sliding -- Shane shorted CompuDyne's stock, regulators said.


She covered, or closed out, her short position with shares she obtained through the PIPE offering.

Earlier this year, Deephaven Capital Management agreed to pay $5.7 million to settle similar charges. In its case, Deephaven and one of its portfolio managers were accused of improperly shorting stocks in 19 instances where they learned confidential information about soon-to-be announced PIPE offerings.

Once the transactions were made public, the stocks declined. And in March, three other hedge funds agreed to pay $15.8 million to settle charges they engaged in the same type of short selling involving PIPE offerings.

The short-selling problems have drawn the interest not only of securities regulators but also lawmakers. The Senate Judiciary Committee held a hearing last month to explore potentially improper relationships between hedge funds and independent analysts.

"We have seen, in increasing frequency, orchestrated efforts by short-selling hedge funds to drive down stock prices through surreptitious campaigns aimed at disseminating unfounded or grossly exaggerated disinformation," Biovail attorney Marc Kasowitz testified at the hearing. " ... The damage to the targeted companies as a result of these attacks provides huge profits to the short-selling perpetrators of the disinformation campaigns, to the great detriment of honest investors."

Going after short sellers by suing them is nothing new for Biovail and other companies. Biovail filed a complaint in 1996 against Quillen, the short seller who runs Quilcap, accusing him of spreading false information.

Quillen countersued, and a confidential settlement was reached two years later. It involved Biovail making an investment in one of Quillen's funds, according to published reports.

Another company, Solv-Ex, also sued Quillen in 1996. In a separate case, a federal judge decided Solv-Ex's chief executive and one other executive defrauded investors by making repeated false statements between 1995 and 1997 that painted an overly rosy impression of company prospects.

During that period, shares rose to $38 from about $5.

"When companies publicly attack short sellers and wage war, those companies are almost always guilty of what you thought they were guilty of, and other stuff you haven't," said William Fleckenstein, a short seller in Seattle who operates Fleckenstein Capital.

But many companies that draw the interest of short sellers aren't fraudulent. And while executives at those businesses may not be happy about the attention, they aren't looking to file lawsuits.

In February 2005, a month before the share price of Rockaway-based Able Energy experienced a drastic rise, short interest in the stock was virtually nonexistent. But in March 2005, short sellers flocked to the stock and short interest ballooned by more than 5,000 percent.

Within months, shares hit a multiyear high of nearly $23. The number of shares sold short also climbed.

Since then, short interest in Able has risen to as high as 585,976 shares in March, which is more than a quarter of the company's float, or available shares. The stock price has steadily declined, hitting a low of $4.11 last month.

Gregory Frost, Able's chief executive, isn't sure why short sellers have taken such an interest in his company. He acknowledged Able doesn't have "the most attractive financials" the company has lost $4.8 million in the past two years.

But Frost noted that with a float of just 2 million shares, Able's stock is susceptible to downward pressure.

"When your stock price is negatively affected, your shareholders you're trying to work for get upset and disenchanted with management," Frost said. "We're very conscious of our shareholders and want to create value for them, and when someone is undercutting value, that's upsetting to us."

However much he may dislike short sellers, though, Frost isn't racing to the courthouse to wring them from Able's collar.

"I think it's more effective as senior management that we run our company and try to build value in it," Frost said. "A lot of times, that's the best way to fight off the shorts."

So short sellers may not be getting many invites to the spring dance. Lamont, the Yale professor, compared short selling with money lending in the Middle Ages and life insurance sales in the early years.

Both were viewed suspiciously at the time, he said, but have gained acceptance. Four hundred years after it first appeared, however, short selling is still pretty early in the cycle.

July 19, 2006


(Greg Saitz is a staff writer for The Star-Ledger of Newark, N.J. He can be contacted at [e-mail].)