Expert Financial Analysis and Reporting

Introduction

The current conventional wisdom on how a short sale is transacted is that a short seller borrows stock from a specific investor who is long the stock, then at some later point buys back the stock in the open market. They then return the stock to that “same specific investor” from whom it was borrowed. Before I met ShareIntel, this is what I thought happened, but as I began to work with them and to do more research on my own, I was jolted when I realized that this is not what goes on in the real world of Wall Street and in later reports I will address how the actual process facilitates widespread naked shorting that enables stock manipulation by some hedge funds..

I am writing this to describe to you my original thought process which I believe reflects current, incorrect conventional wisdom. In later reports, I will describe how I changed to a new perspective on how shares actually are handled in a short sale. This led me to an entirely different understanding on how shorting and in particular naked shorting is actually done in the real world. There is some complexity in explaining this and as I mentioned previously, I prefer to write a series of reports dealing with narrow issues rather than penning one huge, complex report that no one will read in its entirety. In the end, I will attempt to bring it all together. As I teased in part 1 of this series, the answer to combating naked shorting lies with the “borrow rate”, but it is too early to go into this.

Bear with me. In the end, I think that you will agree with me that ShareIntel may have found the Rosetta stone to understanding naked shorting and how to combat it. I think that if you are like me you will be outraged at how some hedge funds and Prime Brokers routinely use naked shorting to manipulate stock prices. If you are like me, you will question how something that is so corrupt and damaging to our economy as naked shorting has not been exposed and corrected? The resulting stock manipulation goes on in plain sight virtually every day, but seemingly all efforts of companies and investors to fight back have failed and the perpetrators grow ever more brazen. Regulators and legislators who should be all over this seem to not have a clue or……………….

I think that you will be amazed and shocked to find that the institutions who actually execute naked shorting are the Prime Brokerage operations of “household name” investment banks. While hedge funds involved in stock manipulation benefit from naked shorting, contrary to conventional wisdom they actually submit a short order to a Prime Broker and have no idea (nor do they care) as to whether the order was filled with a legitimate short or with a naked short.

It is daunting to think of the economic and political clout of the Prime Brokers and hedge funds who employ naked shorting as a critical part of their business models. I must admit that I came to the point of despairing that nothing could be done, but I now believe that ShareIntel can deliver a fairly easy solution.

Conventional Wisdom on How Short Sales are Executed

Short selling is a technique that allows an investor to make a profit by betting that a stock will decline in price. Conventional wisdom suggests that it works as described in the following bullet points. However, some of what you are about to read related to the borrowing and lending of the shorted stock is incorrect.

• Investor Short does not own any shares of company XYZ and believes that the price is going to decline. To capitalize on the expected price decline, they decide to short 1000 shares of XYZ or put another way they are selling shares they do not own.
• To execute this trade, Investor Short borrows 1000 shares of XYZ from Investor Long who owns that many shares or more. The broker of investor Short sells the 1000 borrowed shares in the open market to Investor Third Party. Investor Short receives the cash proceeds from the sale, but has to pay interest on the borrowed stock to the Prime Broker.
• Investor Third Party now owns 1000 shares of XYZ.
• At some future point, Investor Short buys 1000 shares of XYZ and returns them to the account of Investor Long.

This juggling of shares is how conventional wisdom incorrectly describes what happens in a shorting transaction. It is also interesting that conventional wisdom does not consider or understand that the Prime Broker is receiving the interest income which is generally not shared by Investor Long? Isn’t it strange that Investor Long in most cases is not receiving any of the interest income from loaning out their asset (1000 shares of XYZ) and passively accepts this as status quo?

What are The Economics of the Trade for Each Investor?

Even though the conventional wisdom is wrong on the mechanics of share lending and borrowing among Investor Short, Investor Long and Investor Third Party we can still use it as a template to understand the economics for each.

Investor Short

Investor Short is betting that the share price of XYZ will decline and that they can buy back the 1000 shares of XYZ that they are short in the open market at a lower price- a process called covering. Investor Short receives the difference between the proceeds of the short sell and the cost incurred in covering the short. If the stock price of XYX goes down, they have made a profit and if the price goes up, they have a loss.

Investor Short has to pay to borrow the stock in the short sale from the time of shorting through covering so there is a time urgent incentive to see the price of XYZ decline. Here is the formula that determines Investor Short’s profit or loss.

Investor Short’s Profit/Loss =

1. The difference in the proceeds from the sale of borrowed stock minus the cost of covering, less
2. the borrowing cost which is based on the time that the short is maintained and the interest or borrow rate, less
3. transaction costs due to buying and selling shares.

Let me repeat the teaser that the key to ShareIntel’s approach to combating naked short selling is all about the borrow rate, but it is still too early to go into that.

Investor Long

In most cases, Investor Long has no idea that their shares of XYZ have been borrowed and the Prime Broker usually keeps all of the money from the borrowing cost paid by Investor Short. However, some mutual funds, pension funds or other large investment pools knowingly lend their shares and receive a share of the borrowing costs paid by Investor Short. Ironically, investor Long may unwittingly be aiding and abetting a scheme to drive down the price of XYZ.

Investor Third Party

There are no direct economics related to the short sale.

Prime Broker

Conventional wisdom does not reflect that the Prime Broker receives very significant economic benefits from the borrowing and transaction costs paid by Investor Short.

Conventional Wisdom on Dealing with Stock Manipulation

Investors and companies trying to combat shorting attacks on their stocks usually start by trying to expose the manipulation scheme to the public and/or SEC or perhaps sue hedge funds or social media bloggers and websites that aid the schemes. Most do not realize that the most important culprits are the Prime Brokers and Depository Trust & Clearing Corporation (DTCC) that actually create counterfeit shares through naked shorting. (I will discuss the DTCC’s central role in upcoming reports.) It is not surprising then that virtually all efforts fail and leave the plaintiffs frustrated and angry.

After initial attempts fail, companies resign themselves that their best (only) strategy is to buckle down and that through successfully executing on their business model, they will turn the tide in their favor. Using biotechnology as an example, they might hope that success in an important clinical trial or achieving an important regulatory milestone will thwart the stock manipulation scheme, but this only rarely works. The hedge funds have a huge contingent liability in that their use of vast numbers of counterfeit shares to short the stock of a company leaves them enormously exposed if the stock price were to go up significantly. Faced with positive news that a Company and its investors expect to significantly boost the stock price they double down on their short positions to drive the stock price lower and in doing so to “make good news appear to be bad news”. Because naked shorting can create an unlimited supply of counterfeit shares to sell, it is usually the case that they can do this.

I had come to the conclusion that conventional approaches were futile and nothing short of a dramatic event like finding a meaningful new treatment for cancer or an acquisition by a much larger company could overcome stock manipulation fueled by naked shorting. Then I met ShareIntel and was startled to see that they had developed an out of the box solution to what looked like an intractable problem. ShareIntel has devised an approach that is not intuitively obvious, but I hope to explain the rudiments of what they are doing in upcoming reports. Stay tuned.