Sold Short?

Short-sellers, despised on Wall Street, are a needed check on rampant hype

Solv-Ex President and Chief Financial Officer W. Jack Butler is the kind of man who might have been called a captain of industry, back in the days when that really meant something. A dignified man in his late seventies, he spent 35 years at Mobil Oil and was chairman of Mobil Saudi Arabia in the heady 1970s. Solv-Ex has a process for turning oil-laden sand into crude oil--a vital, almost unimaginably lucrative process, if it succeeds.

But Solv-Ex Corp. is under attack. At a cafe near his Manhattan apartment, Butler ticks off the problems. Rumors of improprieties and involvement by penny-stock manipulators. A Securities & Exchange Commission investigation. A drumbeat of negative publicity that has slashed Solv-Ex' share price by 60% over the past few months and has so hurt Solv-Ex' reputation that its efforts to finance its sand-into-oil project have been gravely harmed. "We feel we're a good company," he says. Solv-Ex would succeed, he insists, if it weren't for a mudslinging campaign by a small band of stock-bashing traders: the short-sellers.

About a half-mile downtown, a man about half Butler's age, polo-shirted and barefoot, is staring at a stock-trading screen that shows some cheerful information: The Dow Jones industrial average is falling. Something resembling panic seems to be taking place, and at trading desks around the country, men and women are picking up their phones and yelling "Sell!" But this man is buying--replacing stocks he had previously borrowed and sold, hoping their prices would decline. They have. But there's one stock he borrowed and sold that he is not replacing: Solv-Ex. For he feels that Solv-Ex has a long way to go before it stops falling. The company, he asserts, is burning cash like an overheated furnace--one that eventually will blow up.

Short-sellers are as old as Wall Street, and no group on the Street is more widely despised. They were profiteers in the 1929 crash; aggressive "stock-busters" in the 1980s; and, nowadays, secrecy-worshipping, often embattled traders who bet on what is almost un-American--that share prices will collapse. Until the past few weeks, the bull market has made them suffer. An investor who put $100,000 in the hands of a typical short-seller at the end of 1990 was left with $50,400 by the middle of this year.

But the misery that has enshrouded the market lately-- NASDAQ in particular--has been great for short-sellers. In recent weeks, they have come roaring back, with shorts gaining 10% in June and another 10% to 15% through mid-July, according to Harry Strunk, a Palm Beach investment consultant who tracks short-sellers. The short-seller revival is likely to exacerbate their reputation as piranhas--particularly among investors in small-cap stocks, who often view short-sellers as assassins of Corporate America. "Small companies can be seriously affected by short-sellers. Some of these shorts target particular issuers and don't know a damn thing about the companies they're shorting," says Edward Mishkin, a prominent New York securities lawyer and vocal critic of short-sellers.

Even hardened pros on Wall Street--particularly institutional investors, small-stock underwriters, and brokerage analysts--shun the shorts. Critics maintain that short-sellers don't just bet on share-price declines, they make them happen. Shorts are blamed for the travails of dozens of high-flying stocks that have taken heavy hits during the recent NASDAQ massacre: Solv-Ex, Diana, WellCare Management, Presstek, SyQuest, and a host of other high-tech companies. "Short-selling and bear raids are part of the business," complains Solv-Ex CEO John S. Rendall. "But when you put out false rumors and get the SEC involved--that, I believe, is criminal activity."

Are shorts the bane of Wall Street? Are they villains or scapegoats, responsible whistle-blowers or venal rumormongers? To find the answer, BUSINESS WEEK delved into the world of short-sellers. It was not always easy, for shorts cherish their privacy, and many fear attention with an intensity that can border on paranoia. The picture that emerged is dramatically at odds with the conventional view of short-sellers as market manipulators.

OVERBLOWN. To begin with, only a fraction of short sales are bets on the direction of stocks. The vast majority--perhaps 98% by one informed estimate--are merely efforts to hedge stock holdings or take advantage of arbitrage opportunities with other forms of investment. Traders who exclusively short-sell are but a tiny cadre of partnerships and small brokerage firms. Despite their raptor-like image, they are often victims--not perpetrators--of stock manipulation. And though they can certainly put a dent in stocks by leaking stories to the media, their image as "stock-busters" is overblown. Exchange and NASDAQ rules ban short sales while a stock is declining. This "uptick rule," which allows shorting only when the most recent price change was positive, makes it tough to beat down stocks by short-selling alone.

To be sure, there are instances of questionable practices by shorts, such as the aggressive short-selling that allegedly led to the demise of the Adler Coleman penny-stock trade-clearing firm last year. Regulators are investigating charges by Mishkin, the court-appointed trustee, that shorts engaged in such nefarious practices as "naked" short-selling--shorting stocks that haven't been borrowed. But the negative publicity overshadows the contributions that shorts make to the market--particularly in raging bull markets, when Wall Street hype runs rampant.

Because of their contrarian stance and the liquidity they contribute, short-sellers' impact on the market is essentially positive. They frequently alert investors and regulators to financial frauds. And short-selling abuses have often been exaggerated. Naked short-selling certainly happens, but far more common is the "short squeeze," a chain of events that can be a blatant effort to punish short-sellers by forcing them to buy stocks when they are artificially high.

The shorts' principal advantage may be their dedication. Take Manuel Asensio. Like most shortsellers nowadays, Asensio does other work, from conventional money management to municipal-bond underwriting. But short-selling is clearly his first love. Asensio, who runs investment boutique Asensio & Co., is something of spokesman for the shorts. "I respect what he does," says one short who has never met Asensio but has read his research and admires his courage for taking a public stance on stocks.

RED FLAGS. Asensio hews strictly to the exhaustive, detail-oriented approach that is the short-sellers' stock in trade. A good example is his short sale last January of General Nutrition Cos., the national vitamin and health-food chain. Red flags were fluttering: a high price-earnings ratio, selling by corporate insiders, and oversaturation of the health-food market. "I saw nothing but bad news in the future. There were problems with the vitamin market, insiders were bailing out, same-store sales were weak. What more can you need?" Asensio recalls.

There was more. Asensio got wind of an upcoming study on the benefits of supplemental antioxidants such as beta carotene--a type of nutritional supplement widely promoted at GNC stores. He began by calling secretaries and receptionists at hospitals where the study was taking place. On the day of the release of the study, which cast doubt on the efficacy of beta carotene supplements, he hired a lawyer to get hold of it the instant it was released in Washington.

Asensio shorted the stock--and issued a press release dumping on the company. Nothing happened. "Their defense was that beta carotene was only a small percentage of their sales," says Asensio. "But I said at the time: `The problem is store traffic, stupid!' People come into the stores for antioxidants." Eventually, GNC announced that same-store sales were on the wane, and the shares fell. GNC stock, which traded at 23 in early January, are now at 14. (A spokesman declined to comment on Asensio but says GNC "firmly believes our business strategy is in place and working.")

Asensio's No.1 stock now is a company he despises--and the feeling is mutual. It is Diana Corp., a Milwaukee company that is dramatically shifting its product line from meat distribution to telecommunications equipment. Asensio thinks Diana is an ill-managed company that has put out misleading information; Diana says Asensio is doing the same thing. "He has continually made misstatements about our company," fumes Diana CEO Richard Y. Fisher.

The whistle-blowing element of short-selling is a sensitive subject. Short-sellers don't like to trumpet it, but if they feel that a company is using improper accounting or making inadequate public disclosures, they have no qualms about contacting the company's auditors, the exchanges, the SEC, and lawyers seeking to bring class actions on behalf of disgruntled investors. And then, there's the financial press. One short-seller keeps a small stack of articles from financial publications in which he was a source--all exposing fraudulent and shady companies that ripped off thousands of shareholders. Indeed, many prominent financial frauds of recent years were spotted by short-sellers long before they were picked up by regulators and the press.

DUELING EXPERTS. Specialized expertise is another area where shorts can bring powerful resources to bear. One short-seller, who has a physician on staff, is shorting Oxigene Inc., a New York pharmaceutical company. The physician-analyst studied a company-sponsored clinical study of its flagship product, an anticancer medication, and found it offered scant evidence that the product is effective. As is often the case, however, the company has a dramatically different point of view. Ronald Pero, Oxigene's chief scientific officer, says the shorts are dead wrong and that the study offers evidence of the drug's efficacy.

Right or wrong, such research is often shared among short-sellers, which gives rise to the not unjustified view that short-sellers work as a pack. Of course, so do institutional investors and brokerages, which also often share stock picks. But there's a darker side to short-selling that has recently gained attention in the wake of the failure last year of Hanover Sterling, a penny-stock broker, and the subsequent failure of Adler Coleman & Co., the clearing firm that executed Hanover's trades. Trustee Mishkin found that Hanover and Adler were driven out of business by short-sellers. The shorts, in response, accuse Mishkin of enacting a short squeeze that deliberately gave them losses. The two sides are slugging it out in court.

If the bankruptcy court determines that Adler Coleman was driven out of business by the shorts, it will be a rare legal victory for the "longs." In one landmark case involving short-selling by Scattered Corp., a Chicago stock-trading firm, Scattered won a ringing victory. Moreover, shorts are often the victims of manipulation in short squeezes. Squeezes have become common in recent months, abating only during the recent market setback.

A short squeeze can be quite benign--perhaps a bull market putting pressure on short-sellers. But it can also be a deliberate effort to push up prices by forcing shorts to buy back shares. To bet on a share-price decline, short-sellers must sell stocks that they borrow. There are two sources of stock loans: institutions and brokerage accounts. Institutions lend shares for a small fee--usually just a quarter of 1% of the value of the shares. Brokers are permitted to lend shares from their own accounts and from customers' margin accounts that have not been fully paid for.

FRIEND OR FOE? But shares available for short-selling are growing increasingly scarce--particularly for the NASDAQ issues that are most popular with short-sellers. One brokerage executive, who requested anonymity, notes that institutions are increasingly chary about loaning shares to shorts. The result is that shorts must borrow stock from retail brokerages, leaving themselves open to short squeezes if customers demand delivery of their certificates.

Short squeezes are not a problem for one of the most lucrative, little noted, and troublesome forms of short-selling-- shorting of private-issue stock sold abroad under Regulation S of the securities laws. According to short-sellers and regulators, who are considering tighter rules on Regulation S stock, such short sales are carried out by favored foreign investors--or sometimes, illegally, by corporate insiders. No matter who carries out the short sales, however, the deals are invariably extremely lucrative.

When used to raise capital for small companies, Regulation S stock is usually sold at a discount to the prevailing market price. The stock may not be sold in the U.S. for at least 40 days. Shorts often consider such offerings a red flag because of the dilutive effect of the stock when it's eventually sold in the U.S.--and because they show that the company may be having trouble raising capital. Shorts insist that insiders sometimes buy such cut-rate stock through foreign shell corporations and then sell short in the U.S. market--locking in the profit between the discounted shares and the shares sold in the U.S. The SEC last year acknowledged abuses in Regulation S offerings, including improper short sales, and is considering tightening the rules.

But any rule changes are unlikely to curb foreign investors, who often sell short--quite legally--to lock in their profits. Solv-Ex, which has made heavy use of offshore offerings, recently disclosed that Curacao-based GFL Advantage Fund bought 530,000 cut-rate shares in a Regulation S offering and then sold short in the U.S. a half-million shares--one-quarter of Solv-Ex' short interest--locking in a profit that probably exceeded $2 a share, or $1 million. (The filing says the short sale was conducted "to hedge GFL's downside market exposure at the time.") GFL was still short as of early July--in the midst of Solv-Ex' campaign against the shorts.

The offshore shares have been registered for sale in the U.S., where they will further dilute the equity of Solv-Ex' hard-pressed shareholders. So Solv-Ex executives seem to be right--short-selling is hurting their shareholders, though the problem is from Solv-Ex' overseas friends and not from home-grown short-sellers.

HARDBALL. But what about the other shorts in Solv-Ex--the ones who are betting that it's a hot-air balloon? Are they right? Or is the company correct in its view that shorts are a roadblock on the path to oil-patch immortality? Ultimately, the markets--the oil and stock markets alike--will answer that question. But so far, the outlook for Solv-Ex isn't good, for the shorts are playing hardball. Somehow, a short-seller obtained a company-sponsored engineering report and "project financing study" and had them evaluated by an engineering firm of his own. The short-sellers' engineering review contends that the Solv-Ex process is not "unique, nor does it appear to be capable of being effectively protected by defensive comprehensive patents," nor is it particularly different from competing oil-extraction methods. It goes on to estimate that the project, at full capacity, will yield a $10.5 million annual loss, vs. the $24.7 million profit projected by the company. CEO Rendall strongly disputes the shorts' study and has commissioned Kroll Associates, a private investigative firm, to probe the short-sellers' activities.

That's the way it is in the world of short-selling: charge and countercharge, study vs. study. The shorts can be nasty at times. But their excesses are like a drop of ink in an ocean of Wall Street hype. For the first time in this bull market, short-sellers are finally beginning to see the playing field tip, just a bit, in their favor. They are unlikely to wind up winners if the bull market picks up again. Nor will they pick up any friends. In their ceaseless, profit-driven quest for rotten apples, short-sellers will continue in their role as the market's hated--but indispensible--prophets of doom.

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