The Secret Lives Of Short-Sellers

The rise of hedge funds and indie research raises new questions about a shadowy world

Sitting in a conference room in a Manhattan office, the researcher explains how he digs up financial information, often of the damning variety, for hedge funds and other big investors. His clients need the intelligence because they frequently sell short, meaning they bet on shares falling. "Look at the Web as a giant fish pond," he says, on the condition that he not be quoted by name. "We try to develop bait that will hook someone who knows more than anyone else."

On another day, not far away, a private investigator hired by the other side can't resist a little boast, which, of course, is not to be attributed to him. He has been employed by several companies to help prove that a group of short-selling hedge funds are fraudulently collaborating with analysts and journalists to push down stocks. He claims he has planted moles at funds and sent phony book authors to interview unsuspecting targets. "It's amazing how people just open up," he says with a grin.


Once again, the War of the Short-Sellers is surging. This time there are new twists to both public hostilities and shadowy spy-vs.-spy activity. Helping to drive the controversy is the proliferation of a breed of independent researcher prone to greater skepticism than traditional Wall Street analysts. The growing influence of these little-known characters is a by-product of the Enron-era corporate scandals, as well as New York Attorney General Eliot Spitzer's campaign against the overly rosy analysis produced by many Wall Street firms.

Businesses targeted by shorts are fighting back more aggressively with undercover investigations and lawsuits. Biovail Corp. (BVF ), a Canadian drug company, and online retailer Inc. (OSTK ) claim that hedge funds run by two of the most powerful traders on Wall Street, Steven A. Cohen and David Rocker, have engaged in fraud to drive down share prices. (Those allegations have been vociferously denied.) Public relations campaigns related to the suits have drawn intense media interest, with CBS's 60 Minutes featuring a sympathetic segment on Biovail. The Securities & Exchange Commission, meanwhile, is investigating allegations about abusive short-selling concerning the two companies, as well as potential underlying problems at both.

Criticism of short-sellers is as old as stock trading. The technique involves selling borrowed shares in hopes that prices fall so the shares can be bought back more cheaply before being returned. Some aggrieved executives accuse shorts of crushing shares with whisper campaigns. But shorts often expose hidden corporate weaknesses and have sounded early alarms about Enron, Tyco (TYC ), Krispy Kreme (KKD ), and many other debacles.

Pending suits by Biovail and Overstock allege a wider conspiracy than has been claimed in the past. One reason these complaints have resonated loudly is growing unease over the number and clout of hedge funds, the secretive, lightly regulated investment pools that frequently sell short. Since 2000 the number of funds has soared from 3,873 to 8,661, according to Hedge Fund Research Inc., while assets have more than doubled, to $1.1 trillion. "The perception is they're a bunch of cowboys, willing to do whatever it takes to get their returns," says Richard Leggett, CEO and president of the Center for Financial Research & Analysis, a forensic accounting firm whose clients include hedge funds, mutual funds, and regulators.

Short-selling has become much more prevalent. Hedge funds dedicated strictly to the technique, such as those run by famed short-seller James S. Chanos of Kynikos Associates LP, had $603 million in assets in 2001, according to HFR; by 2005, assets in all short-only funds had grown to $3.3 billion. Many of the thousands of hedge funds that primarily focus on "long" investing, betting that shares will rise, also short at times. Short sales on NASDAQ hit a record high of 6.2 billion shares for the month ending Mar. 15.


The growth in hedge funds has fueled a shift in stock research. To keep up returns, and to justify earning the highest fees on Wall Street, hedge funds have turned away from much of the research broadly distributed by investment banks. It's a commodity now. "The hedge funds will pay, but they value research that's not widely read," says Frank A. Fernandez, research director for the Securities Industry Assn., a trade group.

That trend has accelerated since Spitzer's 2002 probe of Wall Street research. One of the New York State prosecutor's goals was to jump-start the independent research industry as a counterweight to the management-friendly research big investment banks did. The settlement of the Spitzer probe also ended the practice of analysts being paid to help win banking deals from the companies they covered, leading Wall Street to cut research spending.

All that has opened the door to new, high-priced independent competitors. Two specialized categories have benefited the most: "forensic" firms, which look for suspicious accounting, and "direct research" outfits, which arrange confidential interviews with industry sources paid to answer questions posed by hedge funds and other institutional investors. It all adds up to more research highlighting potential problems with company financial statements or operations, and much of it is in the hands of hedge funds that sell short. Traders and analysts sometimes pass along such reports to the media, and that has led to harder-hitting coverage of some companies.

Biovail, in its suit filed last month in state court in Essex County, N.J., alleges that Cohen's powerful hedge fund group, the $8 billion SAC Capital Advisors, conspired to create false reports about the company's financial health with independent stock research firm Gradient Analytics Inc. of Scottsdale, Ariz. Biovail alleges that Gradient let the Stamford (Conn.)-based SAC "ghost-write" negative reports, which Gradient sent to other clients and journalists as its own analysis after SAC had sold Biovail shares short.

Overstock has filed a similar suit in state court in Marin County, Calif., alleging that Gradient worked with Rocker's fund to push its stock down.

SAC dismisses the charges as false and says Biovail's stock fell due to regulatory problems and its repeated failure to meet earnings targets. Gradient co-founder Carr Bettis says its research is based entirely on its analysts' views, and claims that it allowed clients to sell short ahead of reports are "absolutely false." Rocker Partners LP also denies any wrongdoing, calling the allegations "frivolous."

Critics of the shorts say recent government investigations of other funds demonstrate that abuses do exist. The SEC has brought a string of enforcement actions against smaller hedge funds that sold stock short in connection with deals known as private investments in public equities, or PIPEs. On Mar. 14, three hedge funds and their portfolio manager, Jeffrey Thorp, agreed to pay $15.8 million to settle fraud and insider-trading charges related to 23 PIPEs deals. Thorp allegedly obtained unregistered shares in the private placements and shorted the stock. He then used the unregistered shares to cover those short positions, a violation of federal securities law. The defendants settled without admitting or denying charges. SEC officials say they are investigating two-dozen hedge fund players involved in such deals.


Still, defenders of short-selling argue that corporate critics are usually trying to divert attention from their own internal problems. Moreover, they want to silence analysts who publish critical research and discourage journalists from writing about the issues raised. "One of the more disturbing aspects of this is if they don't like what you say, then they'll use shareholder money to sue you for calling attention to their shortcomings," says Chanos, the short-seller who issued early warnings about Enron.

John O'Quinn, a plaintiffs' lawyer in Houston who has won multimillion-dollar settlements against manufacturers of cigarettes, breast implants, and diet drugs, is at the center of the escalation of the hostilities. He has coordinated an effort by a consortium of law firms over the past several years to develop cases concerning allegedly manipulative short-selling. Overstock turned to this group to press its suit in California, and Wes Christian, the day-to-day manager of O'Quinn's legal campaign, says his team has helped Biovail with its case. "When we've turned up things related to other companies, we've made sure that information got to them," says Patrick M. Byrne, Overstock's president. In this carefully orchestrated campaign, O'Quinn's group has filed lawsuits related to about nine companies in half a dozen states, Christian says. With other analyst firms and big-name funds targeted, more litigation is in the works.

By Jane Sasseen, with Amy Borrus in Washington and Emily Thornton in New York

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