Biting the Bear

For the better part of the past two decades, public companies from microcap penny stocks to Nasdaq-traded Overstock.com have had to do battle with the bears, in the form of short-sellers. The two questions every CFO wants answered are: Who’s shorting our stock? and How can we stop them?

The battle with the bear is an age-old problem that typically hits companies with weak fundamentals, thin balance sheets, and high hopes. However, there are some simple steps to scaring the bear off your company stock. In many cases, in fact, it’s the company itself that is feeding the short-selling frenzy.

Before looking at how to limit short-selling, let’s take a quick look at how it works. In effect, short-selling is contracting to sell something you don’t own at today’s price, with the hope that the price will decline and you can create a gain by buying it at a lower price in the future to complete the sale. While many consider this practice manipulative, short-selling is a necessary market strategy, and the much-maligned short-sellers have often been the canaries in the coal mine, identifying corporate frauds long before regulators. Former Securities and Exchange Commission chairman Harvey Pitt said it best when he said: “Short-selling is a useful and critically important capital market phenomenon, but only if done appropriately.” Thus, the commission has recently instituted rules to regulate shorts. According to the SEC’s Regulation SHO, short-sellers must enter into an agreement to borrow the shares they are interested in selling short before placing their bets. While the rules are helping to keep shorts “appropriate” to some extent, there is still work to be done. As recently as last year, Goldman Sachs, Fidelity, and Deutsche Bank were each flagged by regulators for violating SHO, allowing so-called naked shorting to occur.

Short-selling inherently requires multiple parties to be involved. One of the big surprises to corporate executives is that a short-seller’s best ally may very well be someone who is ostensibly working hard on behalf of the company. In most instances it’s your custody bank, or your prime broker or clearing firm, that is gladly helping the shorts exert downward pressure on your stock.

How so? Time and again, we find that company insiders are holding company stock in margin accounts, and unknowingly allowing their clearing firm to lend that very stock to the enemy. That’s thanks to a clause that is tucked into most customer agreements on trading accounts known as a hypothecation agreement. Hypothecation means that when the clearing firm extends you leverage (i.e., a margin loan), the firm has your permission to take any security in your account and lend it out as collateral to raise the capital to fund your loan.

Hypothecation can be confusing, because many people think that if for example, they buy Microsoft stock on margin, it is the Microsoft stock that would be loaned out. But that’s not how it works. The clearing firm can hypothecate any security in your portfolio it wishes. So if that microcap stock you think is safely tucked away in your portfolio is in high demand from the shorts, you can bet the Microsoft shares will remain in your portfolio while your own clearing firm feeds the bears your shares.

To resolve this problem, the first step is to request from your prime broker or clearing agent a copy of the monthly DTCC (Depository Trust & Clearing Corp.) activity report. This report will show you the DTCC clearing member firms that are holding your shareholders’ securities in street name, and provide a road map to the source of the shorts. In addition, a company should poll all its insiders and majority shareholders to determine who may be holding the stock in a margin account, and ask them to transfer those shares to a Type 1 or cash account. The practice of corporate insiders holding fragile stocks in their margin accounts is akin to taking your family camping in the wilderness and then spreading a healthy dose of red meat around the outside of the campsite. While there may still be shorts once you resolve this, the fewer shares available, the less short-selling you should see.

It’s also important to avoid provoking the bears in the first place. One thing that struggling companies should steer clear of is very public road shows for secondary or convertible debt offerings. Don’t publicize the issuance much, and don’t shop it to 10 different firms. Some of the best short-sellers I know have investment-banking subsidiaries that vet deals daily. Every time a company opens that kimono, it lets a whole slew of future short-sellers get an inside look at due diligence, current cash flows, and future business plans. If the revenues, earnings, and growth aren’t in line with current market cap, the mere mention of additional issuance is a blue-light special for bears to begin building a short position, as they know that at some point in the near future there will be a pool of newly issued shares to dilute the current market cap and provide liquidity to cover their shorts. Once again, it’s the company itself that is fueling the ability of shorts to attack.

In the bigger picture, finance chiefs should look at short-sellers as a spur to step up their game. Warren Buffett once stated that he willingly lends shares of his company to any short-seller, because he knows that today’s short-seller is a guaranteed future buyer of his shares. With confidence in your business and focus on value creation, bears may in fact be able to add more than they detract from your business.

John Tabacco is the founder and CEO of Locatestock.com, an electronic securities lending platform used to locate a stock prior to a short sale. He also advises public companies on how to manage short-sellers.