VideoOverstock.com CEO Patrick Byrne, who made headlines last year when he blasted Wall Street short-sellers, has put his lawyers where his mouth is. In February, his company filed suit against 10 prime brokers, accusing them of intentionally manipulating the company's stock through naked shorting. The suit names, among others, Bear Stearns, Citigroup, Credit Suisse, Goldman Sachs, Merrill Lynch, and Morgan Stanley. So-called naked shorting occurs when a brokerage sells stock it does not own and then fails to borrow the shares to cover the position, thus artificially boosting the supply of shares and deflating their price. The suit, filed in a California state court, seeks nearly $3.5 billion in damages.
In 2002, the same consortium of attorneys handling the Overstock case helped Jag Media file similar charges in a Texas court against 100 brokerages, only to have the claims dismissed. But this time, says one of the lead attorneys, Wes Christian of Christian Smith & Jewell, more information about the phantom shares is available, thanks in part to the Securities and Exchange Commission's 2004 Reg SHO. "The evidence just gets better and better," he says. Eight other companies have lodged similar complaints against brokers in state courts, Christian says, with more suits likely to follow; clearinghouses Depository Trust and The Clearing Corp. also face legal action.
Not all the suits involve companies whose stock was shorted. Last year, two hedge funds — Electronic Trading Group and the Quark Fund — filed claims against brokers for charging the funds interest on shares the banks never bought.
Despite all the activity, many are skeptical that suing will work. One Overstock.com director, John Fisher, resigned over his disagreement with the lawsuit. Other companies with naked-shorting problems are reluctant to do battle with the banks. Former True Religion Apparel CFO Charles Lesser (now a consultant with the company) is "very concerned" about his stock being a frequent target of naked short-sellers but prefers to focus on business fundamentals rather than pursue lawsuits, expecting that "over time, the shorts will go away" if performance improves.
Of the 10 banks contacted by CFO, 6 declined to comment and 2 claimed that the case is without merit. Experts say the banks are likely to avoid problems — regardless of the facts. "It's very hard for companies to prove malfeasance by prime brokers," says Josh Galper, managing principal of the Vodia Group, a consulting firm specializing in securities lending. "There is nothing obvious, short of turning the books upside down, that would show intent to defraud." — Alix Nyberg Stuart
Long Campaign Against Naked Shorts
2005: Byrne sues Gradient Research for allegedly conspiring with a hedge fund to issue negative reports on Overstock.com's stock, after blasting both (and financial journalists) in an earnings conference call.
2006: Byrne successfully lobbies Utah state legislators to pass a bill requiring brokers to quickly report trades that failed, aimed at curbing naked shorts.
2007: Byrne sues prime brokers. The SEC shuts an investigation prompted by Overstock.com's 2005 lawsuit without filing any charges. Utah moves to overturn its bill.
Debating a Policy for Honesty
The Public Company Accounting Oversight Board is convinced that fraud is a major problem for U.S. firms and is determined to do something about it. That leaves audit and financial professionals worried about exactly how the PCAOB will tackle the problem — and how much it will cost.
At a February meeting of the Board's Standing Advisory Group, experts who were quizzed on a variety of options largely dismissed the most extreme option — periodic mandatory forensic audits — as too expensive, and ineffective to boot. Brad Preber, managing partner at Grant Thornton, said the idea would be "outrageously expensive and [would raise] significant issues of potential liability because you'd be searching for something that you aren't sure exists."
But the tepid response has not dissuaded the PCAOB from considering some sort of requirement, according to associate chief auditor Greg Scates. "Fraud is a serious problem and has been for some time now," he says, adding that the Board is currently struggling with two concerns: that auditors are not adequately complying with existing anti-fraud provisions in the accounting standards (a fact highlighted in a scathing report issued by the PCAOB in January) and that even if existing standards were followed to the letter a significant amount of fraud would still go undetected.
Some forensic-accounting specialists doubt that the PCAOB can create a truly effective standard. To develop accounting rules designed to uncover fraud, "you have to know what triggers to put in place," says former KPMG principal Ellen Zimiles, now CEO of Daylight Forensic & Advisory, a firm specializing in management of fraud risk. Because the indicators of fraud are so variable, Zimiles says, "you need a detailed understanding of the industry and even of the individual company."
Reader Comments» Post a comment