'Naked Short-Sellers' Target Overstock


Monday, February 6th 2006, 10:30 am
By: News On 6


NEW YORK (AP) _ Overstock.com Inc. has problems, and its CEO wants you to believe they're your problems, too.

Patrick Byrne, the Internet retailer's chief executive officer, has called short selling of his company's shares _ essentially a bet their price will fall _ a conspiracy orchestrated by a ``Sith Lord.'' He later likened the conspiracy to an organization structured like al-Qaida and said his stock has been targeted by ``naked short-sellers,'' a practice he said has ties to Italian, Russian and Israeli mafia. It's a practice, he maintains, that should worry other corporations and their shareholders.

This has attracted a great deal of attention, much of it incredulous.

Overstock has more easily proven problems, clearly visible in its financial reports.

In its most recent quarterly filing with the Securities and Exchange Commission, the company said its net loss for the 12 months ended Sept. 30, 2005, widened to $18.41 million, up from a loss of $10.63 million during the same period the previous year. Net cash provided by operations was negative $28.15 million for the recent period, a sharp turn from $9.53 million cash generated the previous year.

An upgrade of the company's information technology system that Byrne said was ``the equivalent of a heart, lung and kidney transplant'' didn't go smoothly. In September, the company said it hadn't loaded new products onto its Web site in five weeks.

Piper Jaffray cut its rating on Overstock in December to ``underperform'' from ``market perform,'' saying ``we believe it could prove very difficult for Overstock to achieve profitability under its current business model.'' The stock fell $2.35, or 7.5 percent, to $28.80 that day. The day before, the stock dropped 7.4 percent after Overstock said its earnings would miss previous targets.

Pacific Growth analyst Derek Brown reiterated his ``sell'' rating on the stock in January, saying the company's disappointing holiday season put ``a rather telling exclamation point on a tumultuous and financially woeful 2005.''

But what about the ``naked short selling''?

This is murky territory, just the thing if you want to send investors away from your profit and loss statements and down a rabbit hole.

Traditional short sellers borrow a stock, then sell it, betting its price will decline and they will be able to buy it back, and return it to their lender, at a cheaper price. In ``naked'' short selling, as defined by the SEC, the seller does not borrow or arrange to borrow the securities in time to ``make the delivery'' to the buyer within the standard three-day settlement period for trades. This is called a failure to deliver.

It's hard to prove or disprove whether a stock is the target of naked short sellers.

The SEC has instructed the stock exchanges to keep a daily list of stocks that show an excessive level of failures to deliver. Overstock was on that list Wednesday and had been for a total of nearly 200 business days, said Jonathan Johnson, the company's senior vice president for legal affairs.

``When people tell me that naked shorting doesn't happen very often, I always ask, 'Why do we show up on the threshold list day after day after week after month?''' Johnson said. ``There is no good answer.''

As of Feb. 1, there were 208 Nasdaq listed securities on the list, out of roughly 3,300 Nasdaq-listed stocks.

Were all 208 stocks suffering from naked shorting? It seems unlikely. Failures to deliver can occur for a number of reasons, including human or mechanical errors or processing delays, and they can occur on both long and short sales. On an average day, approximately 1 percent of all trades by dollar value fail to settle, according to the SEC.

Overstock has asked the SEC for information on how many failures to deliver there have been in its stock, but the SEC hasn't released the information, Johnson said. An SEC spokesman was not immediately available for comment.

Stocks that fail to deliver are most often what the SEC calls ``very low priced and volatile 'microcap' stocks,'' also called penny stocks. These stocks are usually thinly traded, so it's hard to get your hands on shares to buy or sell.

How prevalent is naked shorting?

Byrne has been a voice for an advocacy group called the National Coalition Against Naked Short Selling-Failing to Deliver. Its Web site says the organization is ``a grassroots advocacy group composed of small investors who are tired of predatory hedge funds on Wall Street violating the rules against naked short selling.''

It goes on to say, ``The systemic violation of the rules against failing to deliver poses an imminent threat to the credibility of the U.S. financial system.''

But some of Wall Street's best-connected investors say naked shorting is as uncommon as an investment bank managing director who drives a Kia.

``I don't know any broker who'd be willing to short a stock without getting the borrow,'' said Whitney Tilson, who manages $115 million. ``Any reputable fund manager and broker wouldn't do this _ it's inconceivable. I don't know anyone who's done it and I don't know anyone who knows anyone who's done it.''

Said Randy Frederick, director of derivatives at Charles Schwab Corp., which does not allow naked shorting, ``I really don't think it's quite as widespread as some people would speculate. If it's going on, it's going on in a very small amount.''

CNBC personality and longtime money manager James Cramer wrote on TheStreet.com, ``Perhaps the most over-observed, over-chronicled and falsely over-weighted topic on Wall Street these days is naked shorting ... (t)he concept of not finding shares before you short them, not locating them, is something that happens very rarely ...''

If naked shorting is a problem, it's most likely a problem for small, volatile, thinly traded illiquid microcaps. So, it isn't a problem retail investors should lose sleep over, because retail investors shouldn't be buying these risky, fraud-prone stocks anyway.

Is it a problem Overstock's Patrick Byrne should be losing sleep over?

``I think that naked shorting contributes to a lower price, because it creates more supply than there legally should be,'' said Johnson. ``When supply outpaces demand, economics tells us the price goes down. What else has contributed to our stock price? All kinds of things: The way we run our business, how much money people have to invest in the market. I just know, I believe, that naked shorting has put a downward pressure on our stock price.''

Here's what Whitney Tilson says: ``If Byrne had spent half as much time managing his business as he did waging war with shorts and trying to drum up a campaign against naked shorting, maybe his stock wouldn't have fallen from $69 to $28.15, 59 percent, last year.''