Friday, November 03, 2006

Peter and Paul

A renewed and healthy debate is shaping up over how much influence government and industry regulators should exert on securities trading. Nowhere has the debate been more polarized than over “naked short selling,” wherein a trader can sell securities at will without having access to shares for delivery.

Critics of naked short selling claim it is like “robbing Peter to steal from Paul.” They want to see stronger rules requiring delivery and swifter enforcement action against illegal short selling.

Protagonists of unfettered trading argue that short selling is a legitimate investment strategy. Action by regulators is an undesirable interference in the natural forces of supply and demand that help to set fair prices for securities. The Wall Street Journal has editorialized on the topic, contending that the practice is not as frequent or as harmful as many claim.

The SEC took its first legal swipe at hedge funds this week over the practice. Sandell Asset Management, a New York-based hedge fund, is facing a civil suit for its short sale of Hibernia stock just after Hurricane Katrina. Hibernia was being taken over by Capital One (COF: NYSE) at the time, but the deal terms had not been finalized before the wind and water started rising. Sandell was making a bet on Capital One reducing its offer price.

On the surface it would seem that Sandell traders were acting on a well thought out investment strategy. Certainly the magnitude of Hurricane Katrina altered the fortunes of many companies with business interests in the region. Many of Hibernia’s customers were dislocated to other regions and moved their accounts elsewhere. It was logical to think that the stock was likely to reflect those reduced fortunes sooner or later and Capital One would respond accordingly.

Such are the forces of supply and demand that form the basis for our capital markets. However, the naked short sales take legitimate investment strategies one step further. Naked short sellers are not acting within the normal market forces because they are not using the true supply of stock to execute. Since they are not going to deliver any shares, they can sell as many shares as they like, even beyond the actual number of shares outstanding.

No conclusions have been reached regarding the actions of Sandell Asset Management, but it is clear that such distortions do occur. I wrote about the travails of Pegasus Wireless, Inc. (PGWC: OTC/BB) in the posts “What Goes Up, Must Come Down” and “Short Sale Side Step.” The company elected to move from the Nasdaq National Market to the Over-the-Counter Bulletin Board to escape what management argues is a naked short selling scheme. Indeed, at one point records indicate that as many as 30 million more shares were at play in trading than was on record as issued by Pegasus. There may be many arguments for why Pegasus was overvalued at some given point. However, the short sellers were clearly able to exert undue influence in the balance but “voting” many times over.

The SEC is not alone in frowning on short selling even when it does not involve a “naked” sale. The NASD recently fined a Long Island firm for improper short selling of stock using shares acquired through private placements of equity. Authentidate Holding (ADAT: Nasdaq), Escalon Medical Corp. (ESMC: Nasdaq) and Radyne Corp. (RADN: Nasdaq) had all placed equity securities into the market through private offerings. Many contend that such actions cast a shadow over companies that fosters volatility in the stock price and inhibits access to capital markets in the future. None of these companies appear to have been harmed by the short selling activity, but the management of Vonage, Inc. (VG: NYSE) argues its stock price was impacted by naked short-selling in the days following its initial public offering. Vonage has since been hit with class action lawsuits and has had to return some money raised in the offering to investors.

If you are on the fence about the role of regulators in the naked short selling question, you might be swayed by the arguments of Gary Weiss in Wall Street Versus America: the Rampant Greed and Dishonesty the Imperils Your Investments. Weiss, who is a BusinessWeek reporter, is sharply critical of impotent regulators but has plenty to say about all Wall Street players. Even though his suggestions for reform of short selling seem a bit polyanna, in my view, the book is entertaining and informative.



Neither the principal of Crystal Equity Research nor any of its associates own shares in the securities mentioned in this post. Crystal Equity Research has as a current Buy recommendation on Radyne Corp. (RADN: Nasdaq).

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