Glossary | Strategic failures
SEC seeks to curb naked ambition | Toxic funding
Stung by the German connection
Letters to the editor: Reader responses
Responses:
- Larry Thompson: Defending the DTCC
- Robert J Shapiro: A case still to answer
IN FEBRUARY THIS year, Michigan-based entrepreneur Robert Simpson decided to see what would happen if he bought the entire stock of one company.
Using a single broker, within a couple of days Simpson had paid a little over $5,000 for 1,285,050 shares in OTC bulletin board property-development company Global Links. According to Simpson, these shares were delivered into his account shortly afterwards. Yet the following day 37,044,500 Global Links shares were traded on the bulletin board. The next day, 22,471,000 shares were traded. On neither day had Simpson traded a single Global Link share, he insists.
And events surrounding Simpson's investments became yet more confusing. Global Links had only ever issued 1,158,064 shares. Simpson had managed to acquire 126,986 shares that did not exist. How he had managed to be sold more shares than were in issuance is exactly the question Simpson hoped his foray would raise.
Simpson is CEO of OTC bulletin board company Zann Corp, a provider of advanced technology products for niche markets, and has experienced an inexplicable excess shares situation over the past two-and-a-half years. Since November 2003, Zann's stock price has plummeted over 98%. This, Simpson claims, makes no sense since his company has performed relatively well. The reason for this extreme underperformance, Simpson believes, is that his company has been subject to severe naked short selling – where stocks are short sold without having been borrowed before the time of settlement, if at all.
Law suits pending
Simpson's case is not a one-off. About 20 lawsuits are pending in the US, brought by investors and companies that claim to be the victims of naked short sellers. Many of the companies affected are those whose shares are traded on the Nasdaq's OTC bulletin board. More than 3,300 companies are traded on the lightly regulated platform. They are small cap, often start-up companies and they tend to be thinly traded, although they do have to make intermittent filings with the SEC. They are by definition high-risk investments. Other companies affected are those on the Pink Sheets – a daily publication compiled by the National Quotation Bureau containing price quotations for OTC stocks. These companies are considered riskier still and do not have to file with the SEC.
Indeed, some of these 'penny-stock' companies have turned out to be extremely risky. Many are legitimate companies, offering products which tend to include software, technology, and healthcare solutions. Global Links' CEO Frank Dobrucki points out, for example, that his company has millions of dollars in real estate assets.
Others offer no products or services at all – they are just shells.
Many are struggling young companies which are just starting out, perhaps on the way to the big board of the New York Stock Exchange. Consultant C Austin Burrell notes that "companies such as Microsoft, Intel, Dell, Oracle and Cisco started out on the Pink Sheets." As he says: "In 1975 Microsoft had three employees, and revenues of $16,005. These companies can grow into major corporations if given a chance."
But with volatility expected, and odds against their success, such stocks can be prime targets for naked shorting. The SEC's new short sales regulation, which came into effect in January, attempts to stop this. But for the 20 or so companies and their shareholders with lawsuits pending, this regulation has come too late. Three of the cases claim that the naked shorting problem started as far back as 1981, and were facilitated by alleged inefficiencies at the US Depository Trust & Clearing Corporation (DTCC). If their claims are correct, it would suggest a serious flaw in the infrastructure of US securities markets.
Systemic problem
The stock borrow programme at the DTCC, they allege, enables the naked shorting of shares to the extent that the number of shares in circulation of some companies is now several times in excess of that issued. Even companies listed on the NYSE, could have been affected. As Wes Christian, partner in law firm Christian, Smith & Jewell in Houston, and lead lawyer on several of the cases, explains: "With the revelation of the Regulation SHO Threshold Securities list and the Leslie Boni report, published in November 2004 [see glossary], it is now crystal clear that this problem of naked short selling is systemic in Wall Street, and virtually impacts every business sector on every exchange including numerous billion-dollar companies listed on the NYSE and other companies listed on the Amex."
Burrell, who worked as an options trader before establishing himself as a consultant to small IT, healthcare, and generalist companies – the type that would be listed on the OTC bulletin boards – has researched the problem. His conservative estimate is that more than 1,000 companies presently have shares in circulation in excess of their floats, and that for at least 500 this number exceeds the number outstanding (the float plus shares that are not available on the market) – in some cases many times that number. If the claims are correct, this could mean that these companies have been susceptible to artificial deflation of their share price, and, even, that investors might be holding shares that do not exist.
David Lott, president of Limelight Media, a provider of digital media networks, is not surprised by Burrell's findings. His company is listed on the OTC bulletin board, and he believes more shares are held by investors than are outstanding. "It's my company, and I have an understanding of how much stock the large shareholders own. I know we have about 700 shareholders. I called 20 of them in December last year to ask how many shares they were holding. Those 20 alone owned more shares than there had been in the float."
It is possible that it is not just small OTC bulletin board companies that are affected. Patrick Byrne is the president of Nasdaq-listed Overstock.com, a discount shopping website, with a market capitalization of almost $900 million. He claims to have been informed by "someone in the know" that his company has "hundreds of thousands of shares in circulation above the outstanding amount".