Doing battle with stock scamsters and corporate creeps requires a warrior with a unique combination of qualities:
A smattering of people possess the first three criteria: some regulators and prosecutors, a few journalists, and a handful of market-savvy, pistol-toting FBI men and Postal Inspection Service agents. However, few of these people have—or, if they have, are allowed to exercise—that essential fourth ingredient that is required if you want a full-time, 24/7, record-scouring, private-eye-hiring, journalist-nagging, whistle-blowing, ferocious, irritating, scam-fighting machine. What you need are people who have a profit motive—short-sellers. Only short-sellers make money by rooting out corporate crime of all kinds.
They are the free-market solution to stock fraud. They are the boas you throw into the attic to hunt rats, the ladybugs you carefully return to the garden if you find one on your hoe. They are a holistic, natural, sandals and vitamin C approach that works when more orthodox approaches fall flat.
Short-sellers arouse profoundly mixed feelings on Wall Street. Although almost every major brokerage engages in some kind of short-selling, traders who do nothing but short-sell occupy one of the less-prestigious fringes of the securities industry. You don’t see short-sellers in the Styles section of the Sunday New York Times, photographed alongside slinky beauties in the VIP section at the grand-opening reception of the Edwin Lefèvre Pavilion of NYU Medical Center. The Street profits from them and pays lip service to the desirability of short-selling, while at the same time keeping its distance, much as you would from a poor relation who can’t hold a job. The self-regulatory pyramid alternates between ignoring short-sellers, prosecuting them, and sitting back passively while the shorts spoon-feed them information that they usually ignore.
Right now the pyramid, and particularly the SEC, has shifted over to hostility, under pressure from a coalition of microcap-stock pushers and their dupes. Regulators have actually made life harder for shorts at just the wrong time—when the rig-happy microcap market is exploding, and when the market in general often shows the kind of rampant hype that it exhibited in the Internet and IPO frenzy of the 1990s.
That’s not very smart—in fact, it’s downright idiotic—because the market needs short-sellers. Just about every major corporate and accounting scandal in recent memory that involved a publicly traded company was initially uncovered by short-sellers. Not by the media, not by the self-regulatory pyramid, and not by Eliot Spitzer. At least as important are the day-to-day hypes and lower-level frauds that shorts uncover, passing on tips to the press and to regulators.
Shorts, and newsletters catering to short-sellers, were investigating accounting abuses long before it was fashionable. If allowed to do their work without government meddling, they are capable of being the only market participants—alongside an aroused, educated, phone-slamming and spam-deleting public—that can counteract the perennial plague of stock hype and fraud. In some cases they are swifter than the FBI and federal prosecutors—and certainly more effective than the SEC and NASD—because all those guys usually show up after the smoke has cleared and the robbers have run off with the loot. Shorts can actually stop the crooks dead in their tracks.
All that being said, shorts don’t deserve halos. Some of them live up to their reputations by being, well, scum. One short once offered to give me the low-down on a major public figure—if I wrote a story lambasting a reporter he didn’t like. (I don’t know the merits of his beef with the reporter, but what he offered me on that public figure was a lot of crap.) Other shorts have been occasionally accused of extorting money from companies. Others lie, cheat, and steal—in other words, they act like the Wall Streeters that they are.
One rogue short who received a lot of attention was a Texas trader named Amr Elgindy, who in January 2005 was convicted of getting info by bribing an FBI agent (he’s appealing the conviction). Elgindy was actually a pretty good scam fighter, but he couldn’t resist the lure of easy bucks. An occupational hazard, I guess.
Another short with a knack for getting himself into trouble—he has had more run-ins with authority figures over the years than Leo Gorcey in the old Bowery Boys movies—is a fellow by the name of Manuel Asensio. Manuel appeared more or less out of nowhere in the mid-1990s. I had the rather dubious distinction of giving him some of his earliest publicity, and over the years have watched him go from stock to stock, controversy to controversy, mess to mess, and lawsuit to lawsuit. It’s been sad, or perhaps a better word might be expected. He’s a bright guy, but he is a bit like a car with a chronically malfunctioning radiator. Manuel can’t seem to go very far without letting off steam, and it usually blows right back in his face.
The Manuel I knew when I was at BW liked to affect a street-smart Antonio Banderas persona, but at heart he was a wannabe white-shoe type who belonged to the Harvard Club, hired a PR firm at one point, and liked to hold conference calls with the media—just like the grown-ups. Manuel, however, had that malfunctioning radiator, or slipping fanbelt, or leaking water pump—I just don’t know. Out it always came, the steam. Thus it would be Company X “launches another outlandish promotion” and Company Y’s “reported earnings raise serious legitimacy concerns.” All in public statements for the whole world to read and enjoy, or not enjoy, as the case may be.
Hey, nothing wrong with any of this. The First Amendment entitled Manuel to his moments of steam. He was the first short in memory to put out press releases promoting his recommendations—a perfectly valid and, in my view, even laudable practice. It got him plenty of attention, plenty of clippings he’d put on his Web site. It also got him an anti-Asensio Web site of his very own, asensioexposed.com, which published his disciplinary record in full. It got him plenty of attention from the NASD, which in January 2005 issued a ruling kicking Manuel out of the securities industry. By then he had closed his shorting operation.
The charge was that Manuel’s steam was a bit too hot. He allegedly made “unwarranted or misleading” statements in research reports, and was accused of not providing the NASD with requested information. Manuel is appealing the decision. Fortunately for the markets, if not for the image of short-selling generally, an NASD ban, if upheld, will not keep the guy from shorting. I hope Asensio returns to vigorous, outspoken short-selling no matter what, because I think that he and guys like him play a valuable if irritating role in the market. But for his own good, he might want to do something about that radiator thing I mentioned.
Other shorts have also been penalized by the regulators every now and then. But one thing that you will not find, despite all the racket being put out by anti-shorting forces, is even the most unscrupulous short-selling, even the obnoxious Asensio at his alleged worst, doing any tangible harm to investors. In fact, naughty as they sometimes are, there’s no getting around the fact that shorts fulfill an essential economic function, one that ought to gladden the hearts of believers in free markets everywhere. Economists have always maintained that short-sellers provide a vital role in the market. You need a bearish viewpoint if you want a stock’s price to include all available information. That’s one of the underpinnings of the market’s pricing mechanisms.
To understand why short-sellers are so important, why they need to be nurtured and pampered and allowed to thrive, you have to understand what they do, and—at least as important—what they don’t do. Short-sellers don’t cause market crashes, and they don’t hurt investors in stocks that are freely traded in the open market—as opposed to fool’s-gold microcaps that are rigged by rogue brokers or hyped to absurd levels on the Internet. Sure, there is such a thing as a “bear raid.” They happen. You should pray that a stock in your portfolio is so afflicted, if it is a legitimate and not a rigged stock. If it is rigged, then it doesn’t matter if there is a bear raid or not—you’ll be taken to the cleaners sooner or later.
It’s easy to blame short-sellers (or “program trading,” or “hedge funds,” or “Jews,” or “Commies,” or “capitalists,” or whomever we may find distasteful) when we lose money. It’s human nature. A good example of that took place after the crash of 1929. A handful of shorts profited, and years later people were still upset. “Much has been said recently about the evils of short selling, and proposals have been made to prohibit it by state or federal law,” said the authors of a book called High and Low Financiers, an examination of “Some Notorious Swindlers and Their Abuses of Our Modern Stock Selling System,” back in 1932.
The muckraking authors of that book—lawyers who worked for Spitzer’s antecedents at the New York attorney general’s Securities Bureau in 1929 and 1930—refused to bad-mouth the shorts. They called short-selling a “useful break on excessive speculation or manipulation.” This was a brave sentiment during the Great Depression, when stocks were in the doldrums and there was a widespread belief that short-sellers put them there.
What caused the 1929 crash, and all market setbacks, was that the market became overheated in the first place. The fault for that was speculators and manipulators—not the shorts. The market was widely rigged before the 1929 crash, but the culprits were syndicates, or pools, that combined their resources to drive up the prices of certain stock sectors. Also contributing to the frenzied speculation was unrestricted leverage. Traders would buy stocks on margin using borrowed money—frequently putting up only one dollar for every ten bucks’ worth of stock they bought. Yet, the authors of High and Low Financiers observed that it was the shorts, not the margin lenders, who were getting all the knocks: “There would be more justification,” they wrote, “for a ban on all purchases on margin, which has never been seriously proposed.”
Academic researchers have been dissecting short-sellers for quite some time, to see what makes them tick and to find the black heart that is supposed to reside therein, and have never found it. What they have found, repeatedly, monotonously, is perfectly innocent and, usually, beneficial—for bulls as well as bears. For example, researchers at Vanderbilt University studied all 101 global stock markets, and found that when short-selling restrictions are removed, share prices don’t decline. They rise. That’s because short-selling improves the overall quality of a market, increasing liquidity and reducing volatility. Nor did they find that stock market crashes take place more frequently in markets that allow short-selling.
An “efficient, fairly priced stock market” is one of the “good things” that responsible people are supposed to want, along with “fair employment practices” and “a solvent Social Security system.” People are supposed to want all that good stuff, but in fact they don’t. I can string academic papers on the benefits of “equal employment opportunities” from here to Jupiter, and it won’t matter. People want a “job,” not a system that offers “equal employment opportunity for all.” They want a “monthly check,” not “a solvent Social Security system.”
Shorts make markets more efficient but they root for stocks to go down, and nobody wants stocks they own to decline. That’s like wanting your children to die. We want our children and our stocks to grow up big and strong, so they can support us in our old age. It’s an emotional thing. No less a Wall Street expert than the author and consultant Charles D. Ellis—an official Street sage, appointed by Bill Donaldson to chair the SEC’s investor education effort—put it this way in his book Winning the Loser’s Game: “We smile when our stocks go up and frown or kick the cat when our stocks go down. And our feelings get stronger and stronger the more—and faster—the prices of our stocks rise and fall.”
Falling in love with stocks is a common flaw in large and small investors alike. In fact, even market superstars have fallen in love with their stocks, only to be left in the lurch when the stocks did not love them back. Two of the big hedge fund stars of the 1990s, Michael Steinhardt and my pal Julian Robertson, were left at the altar by the same stock—US Airways—some years apart, with Robertson really going meshuga and buying up a 25 percent stake in that dog of an airline, and not unloading even as the stock plummeted 55 percent because of all the usual airline-related problems. * Now, is that love, or what? Steinhardt and Robertson were truly the Tarleton twins of lovesick investors back then, with US Airways playing the fickle Scarlett O’Hara. Then came Stanley Druckenmiller, the George Soros deputy who had once been viewed everywhere as the cold, stalwart type, the Ashley Wilkes of Wall Street. His passion was technology stocks at just precisely the wrong time—who said only amateurs are lousy market timers?—and he wound up dragging down Soros’s Quantum Fund in 2000 because of his general codependence and neediness whenever a cute, well-endowed microchip stock beckoned. In investing, as in life and Gone with the Wind, it is always better to stomp off like Rhett Butler than to be left panting in the doorway or chewing radishes in the fields.
Short-sellers arrived briefly—very briefly—as heroes in the wake of Enron, back in the days when people were falling out of love with stocks generally. But even then, their contribution was only grudgingly acknowledged. In their account of the Journal ’s coverage of the Enron saga, reporters Rebecca Smith and John R. Emshwiller described shorts as “shadowy denizens of Wall Street,” and lamented that there are “lots of ruthless shorts who will spread rumors, hoping to instigate a sell-off that will make them money.” Though Emshwiller found them “smarter and harder working than the average analyst,” his coauthor, Smith, didn’t like them. “The whole business seemed somewhat unsavory to her.”
Prejudice against shorts among the financial press is understandable, because writing anything negative about a big company can result in considerable heat—as Bethany McLean found when she was pursuing her early negative Enron story in Fortune. All things being equal, it gets a reporter considerably less grief to write a positive rather than a negative piece on an Enron or a Tyco—before, that is, such companies become piñatas. It’s easy to forget that these were once reputable companies that posed a serious lawsuit threat against any financial journalist who dared to probe their inner workings.
The problem is that nobody knows for sure which companies might become piñatas down the road. The word Enron is synonymous with “crook” today, but in the financial press it used to be synonymous with “powerful, nasty company that hires powerful, nasty lawyers.” I’m told by colleagues at Business Week (I was on leave at the time) that in early 2001 a BW reporter took a hard look at Enron’s trading operations, but was unable to persuade BW editors to publish her reporting about what was then a perfectly respectable company. BW instead ran a favorable cover story focusing on the “derring-do” of Enron’s future felon Jeff Skilling. The Enron cover haunted BW for years afterward not only because it was spectacularly off base, as became obvious in the months ahead, but because of a reason known only within the magazine—that BW had missed a chance to rain on Enron’s parade. Fortune more or less broke the Enron story in March 2001—with the company, naturally, blaming shorts for badmouthing it. But only the month before, Fortune named Enron the “Most Innovative Company in America” for the sixth year in a row.
Short-sellers make their living by trying to uncover scams before they become public knowledge. Whether they are right or wrong, they benefit investors. I know, it’s counterintuitive. But you have to keep saying to yourself, over and over again: Short-selling always benefits investors. Another principle needs to be underlined: The smaller the stock, the bigger the investor benefit from short-selling. There is no way anyone other than a scam artist can be hurt by a short-seller. All the propaganda to the contrary, and there is plenty of it out there, this is one of the biggest con jobs being perpetrated by the microcap-stock pushers, their allies and dupes.
To understand how shorts gum up the works for stock promoters and cruddy brokers, and only for stock promoters and cruddy brokers, let’s look at the mechanics of short-selling.
In order to short a stock, you borrow and then sell it. The stock is borrowed from other people’s accounts without their knowledge—it’s allowed by the standard language of brokerage agreements for margin accounts. Now, a lot of people have trouble with this “borrow and then sell” concept, and I don’t blame them. After all, most people wouldn’t borrow a book from the library and then sell it. That wouldn’t be nice. It probably also wouldn’t be legal.
Just for the heck of it, let’s imagine for a moment that it were legal. Let’s say you borrow from the library a newly published bestseller that retails for thirty dollars. You believe that this book doesn’t have much value as a collectible, that it’s really just a flash in the pan, so you sell it to a used-book dealer for ten dollars.
Let’s say the library doesn’t impose fines, so you have time to test out your hypothesis concerning this book’s lack of lasting value. You wait a few months and find you were right. The same book that was retailing at thirty dollars, and which you sold at ten dollars, is now selling for one dollar at a yard sale, so you buy it and return it to the library. You’ve made a nine-dollar profit.
That may seem like easy money, and it is. I hate to tell you this if you bought this book on the day it was published, but books almost always depreciate immediately. Stocks, of course, are an entirely different animal—sometimes rising quite dramatically in price, either because the market itself is rising or because the stock is terrific, or rigged. That makes short-selling hazardous. In fact, the smaller the stock—and thus the more crucial the role of shorts in deflating hype—the riskier it is, because small stocks are notoriously prone to manipulation. One common scam is the short squeeze. That happens when a stock is deliberately made scarce through various mechanisms.
Let’s go back to the book-shorting analogy for a second. Let’s say a publisher out there is tired of guys like you undercutting his prices by borrowing his books from the library and then selling them. So he gets an idea. He sends out to the libraries a book in which he has planted a huge mistake—a libelous comment. Then he sends out a panicky notice calling back the books so that they can be pulped. The publisher knows that if he recalls the book and pulps it, any remaining unpulped copies of that book will be scarce, and thus valuable—really hurting you lousy book-shorters! *
You sold the book for ten dollars, and now, because it is scarce, it is worth a lot more. You want to wait until the price of the book declines, because you feel it is a crummy book and it eventually will be worthless. But the library says, “Uh-uh.” It wants the original book back right away. So you shop around and buy it on the open market for, say, fifty dollars. Or maybe the library just buys it from the nearest used-book seller for eighty dollars, and bills you for that. You take a pretty heavy loss either way. If there are a lot of people like you who shorted this book, you’ll all be in the used-book stores at the same time, driving up the price of the book.
What I’ve just described is a short squeeze. The library buying the book and billing you is called a buy-in when it happens with stocks. This manipulative conduct is a common occurrence—and the SEC, rather than curbing short squeezes to prevent artificial price inflation, is actually encouraging squeezes to wipe out microcap shorting. We’ll be coming to that in the next chapter.
The problem with short squeezes is that small investors get hurt. Short squeezes push shorts out of the market, thereby allowing rigs to flourish. Speaking of restrictions on short-selling generally, Yale University’s Owen A. Lamont said, “The evidence is consistent with the idea that short sale constraints allow very substantial overpricing, and that this overpricing gets corrected only slowly over many months.”
Fortunately, the constant threat of short squeezes is somewhat offset by the other edge of the two-edged sword of short-selling. That edge, the one that is death to the stock swindler, is that short-selling sometimes has the effect of temporarily—I repeat, temporarily—reducing share prices, which often can be sufficient to put the kibosh on stock-fraud schemes.
That word temporary needs to be emphasized because the downward pressure on stock prices from short-selling is what gets people mad at shorts. If a stock is not an artificially inflated ripoff, the shares will rebound if shorting hurts the price. Short-induced price declines don’t happen at all in large-cap issues, and are restrained for stocks generally because of the uptick rule, a New Deal-era restriction that allows shorting of exchange-traded and Nasdaq stocks only at a higher price than the preceding trade. Despite the uptick rule—which is viewed as so expendable by the SEC that its enforcement was suspended during 2005, as you’ll be seeing—shorting still exerts some downward pressure on stock prices, and that gets people upset for no good reason.
If you like a stock enough to buy it, what difference does it make that somebody is pushing down the price—any more than it would if you were dealing with rare books or Depression glass or vintage Sergeant Fury comic books? While you may not be happy that people are bad-mouthing your fave stock or author or collectible, you know that they’re all really valuable, and you’ll snap up even more at their current depressed prices.
Glassware and comic books are obviously different from stocks, but the principle is the same. A short-seller’s machinations, or the hype of a stock promoter for that matter, should not change your opinion of the company. If the underlying fundamentals of the company are good, if it really is making a better mousetrap or has found a cure for herpes, the stock price will eventually recognize that. That same principle applies, by the way, whether you are a believer in the Efficient Market Hypothesis or value investing or behavorial finance. There is no real disagreement among all schools of market analysis that if a stock’s price is out of whack because it is manipulated downward or upward, it will eventually revert to the price that reflects its genuine, nonmanipulated value.
That principle was expressed eloquently way back in 1923, long before academics systematically put the markets under a microscope, by the author of Reminiscences of a Stock Operator. Edwin Lefèvre put it this way: “As I have said a thousand times, no manipulation can put stocks down and keep them down.” If a bear raider were to push a stock below its intrinsic value, Lefèvre noted, “the raider would at once be up against the best kind of inside buying. The people who know what a stock is worth will always buy it when it is selling at bargain prices.”
Lefèvre was right. But he could say it a million times and it wouldn’t matter, such is the prejudice against short-sellers.
In scams, the determinant of a stock’s price is not information but manipulation. The market price is rigged, either by controlling the mechanisms by which the stock is bought or sold and/or by inducing people to buy the stock at ever-higher prices. The latter is carried out by some combination of the following: hyping the stock on the Internet, pushing the stock in a media campaign, or having salesmen at a boiler room cold-calling you or your uncle in Florida or cousin in Donegal.
Short-sellers disrupt scams by horning in on the scamsters, selling the shares that are involved in the manipulations, and generally making a mess of the thieves’ carefully scripted schemes. One of the few documented examples of shorts in action, busting up a major stock scam, came in early 1995. Traders systematically shorted the stocks being sold by Hanover Sterling & Co., one of the leading boiler rooms of the 1990s—a major stock-fraud operation that geared up in the early part of the decade, at the same time the SEC and NASD were assuring the public that penny-stock fraud was a thing of the past.
By incessantly selling the shares of Hanover stocks, shorts drove down the prices of the shares, making it impossible for Hanover brokers to rip off the public. That’s because their scheme was predicated on an inflated share price. The Hanover stocks had a built-in commission—a humongous, illegal commission that was split between Hanover and the broker. In Born to Steal, my account of the chop-house world, I described how the massive profit, or chop, for one Hanover stock consisted of three dollars of the eight-dollar share price. If the eight-dollar share price could not be maintained, the whole scam would have crumbled into dust.
If you’re engaged in a stock rig, the last thing that you need is for the free market to intrude. Remember our template: “Freedom, not free markets.” In this case, the freedom to steal. Such were the economic underpinnings of vast swaths of the microcap market in the 1990s, and the same holds true today. Microcap-stock promoters and Internet stock pushers—who are usually paid with cheap stock or stock-purchase warrants—want the freedom to shill their stocks without anyone getting in the way of their rigs.
When Hanover collapsed, the people at the NASD were mad. They weren’t mad at Hanover. They weren’t mad at sky-high commissions. They didn’t even know about the sky-high commissions. What made them mad was that a member firm, Hanover Sterling, was put out of business, and short-sellers appeared to be the culprit. The firm was their priority, not the firm’s victims. That’s how screwed up the self-regulatory pyramid’s priorities were at the time, and they have not changed measurably since then when it comes to microcap fraud.
The NASD investigated Hanover’s demise by taking testimony from key personnel, including a fellow who was one of the hidden owners of the firm. His name was Bobby Catoggio. Mind you, this wasn’t some suit counting beans in a quiet office. This was the head of trading for Hanover, the guy who told the brokers every day how much swag they were going to rip off from their customers. It was quite a spectacle: an “aggrieved party,” later identified by law enforcement as a Mob associate, who was a crook of such magnitude that in 2001 he was sentenced to 141 months in prison and ordered to pay $80 million in restitution to his victims.
In an interview with the NASD in May 1995, Catoggio was righteously indignant. He was furious that short-sellers, functioning in loco NASD, had accomplished what the snoozing regulators would have done, had they been competent. It was world-class gall. It was also illuminating. A transcript of this mutt’s NASD testimony provides a rare inside account of how short-selling helps the markets by interrupting stock schemes.
Catoggio told the NASD that “for about six weeks before we were closed we were getting hit with large amounts of sell orders from the Street.” Note those words—the Street. That means “other than Hanover Sterling and its accomplices.” Since Hanover stocks were rigs, since the shares were kept high so that the built-in profit (chop) was substantial, Hanover was forced to buy all those stocks being sold short, and buy and buy and buy—until it ran out of money. Its clearing firm, Adler Coleman, collapsed at the same time as a result.
The only reason the shorts seriously hurt these stocks was because they were manipulated. If the prices of Hanover stocks had been determined by market forces, if even a crazy market—such as the Internet bubble—had driven the prices upward, a raid by short-sellers would not have been sufficient to drive down the prices of the shares. The market would have come to Hanover’s rescue. Just as Edwin Lefèvre said decades ago, the bear raider would have been “up against the best kind of inside buying.” That didn’t happen because there was no market for these stocks outside Hanover. Its prices were artificially boosted to provide under-the-table payoffs, or rips, to the brokers.
The shorts gave Hanover a taste of the free market—and it was bitter as hell.
The people who put Hanover out of business weren’t angels. Some of them were traders at Sovereign Equity Management Group, a brokerage that prosecutors later contended was controlled by Phil Abramo, a capo in the DeCavalcante crime family. The DeCavalcante crime family and the other shorts were not in the investor-protection business. Yet, purely out of greed, they were able to do something that the NASD and SEC weren’t contemplating, which was to shut down a firm that was ripping off investors.
By putting Hanover out of business, the shorts protected investors from being ripped off by the firm in the future. They didn’t hurt Hanover’s current investors because they were doomed anyway. Customers were not allowed to sell their shares at elevated prices—Hanover had strict rules against that, like most chop houses. The purpose of a rig is to make money for the broker, not for the customer.
Except for standing around with their hands in their pockets and investigating the wrong people, the denizens of our self-regulatory pyramid reacted to the Hanover fraud in classic, somnolent fashion. Hanover’s principals and brokers melted away, moving on to other firms, where they ripped off investors until the law-enforcement crackdown years later.
The Hanover stocks were special stocks, and special stocks require a special kind of short-selling. There is only one way to short-sell the schlock stocks that most richly deserve to be shorted. The technique that put Hanover out of business was known as naked short-selling.
As rigged stocks, the Hanover shares were controlled entirely by the scamsters. We’ve already seen how shares must be borrowed if they are to be shorted. So how did the shorts borrow Hanover shares for the purpose of selling them short? Simple. They didn’t borrow them. They just sold stocks that didn’t exist. That is the only way to disrupt stock rigs.
We’ll be dealing with naked shorting in the next chapter. Suffice to say, for the time being, that there’s no question that naked shorting bends, or even breaks, the rules that govern short-selling. That is not because naked shorting is wrong. It is because the rules are wrong. Rule-breaking as it is, naked shorting performs the greater good of allowing the free markets into a region of the market that is the least free, the most prone to manipulation, and the most in need of bearish input into the price-discovery mechanism. Naked shorting breaks a window that lets in some fresh air and lets out the stench.
Opponents of naked shorting, however, have duped a lot of people into believing that the problem isn’t overinflated stocks. They want you to believe that the problem is overinflated stocks collapsing. What their arguments ignore is that overinflated stocks always collapse when the rig ends. It’s inevitable. It happens 100 percent of the time. Naked short-selling, when it exists, just accelerates the process—which is good for investors, because the sooner an overinflated stock collapses, the sooner the rig is stopped. What difference does it make whether a rig is stopped by a regulator or a naked short-seller?
In fact, a fine line separates naked shorting from ordinary, perfectly legal trading. Brokers sometimes have to do that—sell stocks to their customers that are not in the inventory. None other than Bobby Catoggio lamented that he didn’t go short when he sold his customers Hanover’s scuzzball stocks. It was pretty routine among the chop houses for brokers to sell more stocks to their customers than they had in inventory.
A lot of the guff surrounding naked short-selling involves that word. Naked is a Street term that means “unhedged.” Every day, thousands of people engage in the perfectly legal practice of selling call options, in which they agree to sell a stock at a certain price. A good many of them don’t own the stock they’ve agreed to sell. This is called writing a naked call option. That’s risky, but you can do it if you fill out the right forms, and it’s perfectly legal. Selling a call option on a stock that you do own is called writing a covered call.
See? You can get “naked” yourself, right there in the privacy of your brokerage account, and nobody will hold it against you.
Being a naked short-seller of a stock is similar to selling a naked call option. In both situations one creates a position in one’s portfolio that didn’t previously exist, for the purpose of betting on the future price movement of the stock. The difference is that naked shorting of stocks is something only professional investors—mainly brokerages—have been able to do, by exploiting loopholes in the existing rules.
If anything, regulators should be working to make it easier for people to short microcaps, so that you or I or anyone can do so. Sure, buying individual stocks is a bad idea. Buying microcap stocks is an even worse idea. But since people have the ability to buy those doggies, they should be able to short them too. If a certain stock is a pile of dung, that is all the more reason to short it, whether or not the shares are available to be borrowed. It wasn’t fair that only a few market players, some allegedly Mob-affiliated, were able to make a bearish bet against Hanover Sterling stocks. If it had been possible for any investor to short those stocks as easily as buy them, the Hanover rig would have been nipped in the bud and thousands of investors would not have been ripped off. The same holds true for just about every stock rig.
In his 2001 book Sold Short, the usually unrestrained Manuel Asensio doesn’t say anything about naked short-selling per se. But he does make a valid point: It should be allowed. Or, as he put it in his book, daintily not using the term, the borrowing requirement for short-selling should be abolished. Asensio argued, “If traders can prove they have sufficient funds to cover fully the risk of any upward price movement, why should it matter whether their particular broker or any broker happens to have shares of that stock available to borrow on a particular day?” Asensio’s Web site includes a well-reasoned analysis of short-selling’s impact on stock fraud. He’s right. Unfortunately, Asensio is such a loose cannon that his perfectly valid views on the subject have received scant attention.
No matter how much you may dislike individual short-sellers, they are good for you, like spinach. They are the Greek chorus, the naysayers, the whistle-blowers. They are inconvenient but necessary. Short-selling isn’t rocket science, and neither is its effect on the markets. It’s just as Lefèvre said long ago, in Reminiscences, as he contemplated how a bear raid can help investors: “There is nothing mysterious about this. The reason is plain to everybody who will take the trouble to think about it half a minute.”
That’s all you need to do: Think about it half a minute. Unfortunately that’s a lot more thinking than has been devoted to the subject of short-selling by regulators or, too often, the financial press.