Naked Hunch

Companies do battle with banks over naked shorting.

Overstock.com CEO Patrick Byrne, who made headlines last year when he blasted Wall Street short-sellers, has put his lawyers where his mouth is. In February, his company filed suit against 10 prime brokers, accusing them of intentionally manipulating the company’s stock through naked shorting. The suit names, among others, Bear Stearns, Citigroup, Credit Suisse, Goldman Sachs, Merrill Lynch, and Morgan Stanley.

So-called naked shorting occurs when a brokerage sells stock it does not own and then fails to borrow the shares to cover the position, thus artificially boosting the supply of shares and deflating their price. The suit, filed in a California state court, seeks nearly $3.5 billion in damages.

In 2002, the same consortium of attorneys handling the Overstock case helped Jag Media file similar charges in a Texas court against 100 brokerages, only to have the claims dismissed. But this time, says one of the lead attorneys, Wes Christian of Christian Smith & Jewell, more information about the phantom shares is available, thanks in part to the Securities and Exchange Commission’s 2004 Reg SHO. “The evidence just gets better and better,” he says. Eight other companies have lodged similar complaints against brokers in state courts, Christian says, with more suits likely to follow; clearinghouses Depository Trust and The Clearing Corp. also face legal action.

Not all the suits involve companies whose stock was shorted. Last year, two hedge funds — Electronic Trading Group and the Quark Fund — filed claims against brokers for charging the funds interest on shares the banks never bought.

Despite all the activity, many are skeptical that suing will work. One Overstock.com director, John Fisher, resigned over his disagreement with the lawsuit. Other companies with naked-shorting problems are reluctant to do battle with the banks. Former True Religion Apparel CFO Charles Lesser (now a consultant with the company) is “very concerned” about his stock being a frequent target of naked short-sellers but prefers to focus on business fundamentals rather than pursue lawsuits, expecting that “over time, the shorts will go away” if performance improves.

Of the 10 banks contacted by CFO, 6 declined to comment and 2 claimed that the case is without merit. Experts say the banks are likely to avoid problems — regardless of the facts. “It’s very hard for companies to prove malfeasance by prime brokers,” says Josh Galper, managing principal of the Vodia Group, a consulting firm specializing in securities lending. “There is nothing obvious, short of turning the books upside down, that would show intent to defraud.”

Long Campaign Against Naked Shorts

2005: Byrne sues Gradient Research for allegedly conspiring with a hedge fund to issue negative reports on Overstock.com’s stock, after blasting both (and financial journalists) in an earnings conference call.

2006: Byrne successfully lobbies Utah state legislators to pass a bill requiring brokers to quickly report trades that failed, aimed at curbing naked shorts.

2007: Byrne sues prime brokers. The SEC shuts an investigation prompted by Overstock.com’s 2005 lawsuit without filing any charges. Utah moves to overturn its bill.

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