West Coast Editor
Naked short selling - it's something not many biotechnology firms want to talk publicly about, lest their legitimate investors become spooked that the company is targeted by the illegal practice, which dilutes stock and can lead to ruin.
But it's happening, and some activists working for tighter rules say the practice is far from rare.
"I think it's across the board," taking in various industries, said Russell Godwin, president of Vancouver, British Columbia-based RGM Communications Inc., and small-cap biotech companies are among those at risk.
Short selling, of course, is legal, though regarded as somewhat questionable by many investors (not to mention quite risky for practitioners). It involves selling shares borrowed from a broker, in hopes that the price falls and the shares then can be bought back at the lower amount, thus taking a profit and returning the borrowed stock. There's no formal certificate and the lender is not disclosed.
In naked short selling, the seller has not determined the stock can be borrowed, so the buyer never gets the phantom securities he thinks he has bought. More shares are traded than actually exist and the stock's value is diluted, sometimes to a degree that smaller companies can ill afford. And it's typically the small-cap and micro-cap firms trading "over the counter" that are targeted.
In some instances, naked short selling also can be legal - that is, if it's done by a market-making entity and only for a few days, with the shares truly bought later. But it's the others that have investors and regulators up in arms.
The SEC in June voted to adopt what it calls Regulation SHO, which brought rule changes regarding short selling, but has delayed implementing it until January. Critics say SHO is hardly enough anyway. The National Association of Securities Dealers (NASD) has taken steps, too, with its Short Sale Act Reporting Requirements for the OTC BB and Pink Sheet securities, but those rules have been held up, too, and won't take effect until late September (the previous date had been July 26).
Action by the SEC isn't enough, said former broker Godwin, who is trying to spread the word about what's been called "StockGate." Godwin urges those concerned by naked short selling to sign the petition at a website he sponsors, www.investigatethesec.com.
"The reason naked short selling is such a problem is the non-delivery of a purchase by a client," Godwin said. "Who's doing it? We could have a long discussion on that. It's a consumer fraud by the brokerage houses, aided and abetted by the SEC."
Godwin claims the SEC is "bought and paid for" by brokerage firms doing naked short selling. Employees of the SEC are less likely to adopt rules with teeth because they might one day want to work for the firms guilty of the nefarious practice, he said.
"It's an incestuous little relationship," Godwin said.
For years, the SEC ignored naked short selling altogether, he said.
"A number of consortiums realized they could short sell naked various companies that were weak to start with - trading at 50 cents or a dollar per share," Godwin said. "They could push out 50 million shares at 50 cents, which nets them $25 million, and then orchestrate with a disinformation campaign the demise of that company and never have to pay out."
Such campaigns proved easy enough to conduct, he added. "Human beings by nature are more willing to believe the negative than the positive," Godwin said.
The SEC's new rules are simply reiterations of the un-enforced old rules, he said.
"NASD is probably at the forefront of trying to clean it up, which is somewhat surprising since they're an industry advocate for the brokerage community, and the SEC is the cop," Godwin said.
"Regulatory people don't seem to understand the basic premise," he said. "If I'm buying a horse from you, or shares, the agent for me should be receiving the goods or chattels that I paid my money for" - and in naked short selling, it doesn't happen.
Godwin blames unscrupulous brokerage firms and electronic trading, which provides only the illusion of security.
"It's also ignorance on behalf of the shareholder, but I don't blame him," Godwin said. "He shouldn't have to be a Philadelphia lawyer specializing in securities" to play the market.
A scandal is likely to erupt over naked short selling before much longer, he added. The likely scenario is a larger company taking over a smaller firm that has been victimized - and both sides finding out a percentage of shares that have been traded don't really exist.
"It hasn't happened yet, but it will occur, most likely with a mining company or a biotech company," Godwin said. "It's a zoo out there."