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When the bears show their teeth, stay calm.
John Tabacco, CFO Magazine
September 1, 2011
For the better part of the past two decades, public companies from microcap penny stocks to Nasdaq-traded Overstock.com have had to wrestle with bears, in the form of short-sellers. The two questions every CFO wants answered are: Who is 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 that can scare the bears 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 transaction.
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 stated: "Short-selling is a useful and critically important capital-market phenomenon, but only if it's done appropriately."
Thus, the commission has instituted rules to regulate shorts. According to the SEC's Regulation SHO (see "Reg SHO at a Glance" at the end of this article), 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? Company insiders often hold company stock in margin accounts and unknowingly allow 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 (that is, 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. 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 of 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 margin accounts is akin to taking your family camping and then spreading 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.
Don't Reveal Too Much
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 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; 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 reason 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 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.
Reg SHO at a Glance
While the securities acts of the 1930s did address some aspects of short-selling, not until January 2005, when Regulation SHO took effect, was this form of trading scrutinized by the Securities and Exchange Commission.
The new rule created a definition of ownership and a requirement to determine a short-seller's net aggregate position. It also specified uniform "locate" and "closeout" requirements intended, in part, to rein in "naked" short-selling, in which sellers never actually borrow the shares they are betting will fall in value. The "locate" provision requires broker-dealers to have reasonable grounds for believing that the security in question can be borrowed and delivered before a short sale. The closeout provision creates additional requirements for broker-dealers to address failure-to-deliver positions.
The SEC further amended these rules in 2007 to eliminate certain grandfather provisions included in the 2005 rule that were deemed no longer necessary.
Despite those new rules, many market watchers continue to push for additional regulations around the practice of short-selling. The issue is not limited to the United States; last month Greece imposed a two-month ban on short-selling as the Athens Stock Exchange reached a 14-year low. At press time, the European Union was considering various ways to limit short-selling in order to quell volatility.