RE: shorted Very interesting read and history leson
Since the last issue of Web Watch featured The Never Ending Story II: Crystallex, it seemed fitting to follow with A Short Story. This, too, is a tale that is probably familiar to many given that the basic story line can be adapted to accommodate a wide variety of characters and has been featured on many Internet stock forums.
Once upon a time, there was an ASE-listed company called Naxos Resources which, using unorthodox and changing assay methodology, began regularly reporting fantastically high gold and platinum results from its Franklin Lake, California property. Naxos became a front-runner in the 'desert dirts' phenomenon and Jay Taylor was one of its major cheerleaders, proclaiming in the May 3, 1996 edition of his newsletter that the rewards awaiting shareholders could make Bre-X gains look like kid's stuff. For many, Naxos was a Cinderella stock on a trajectory to dizzying heights. For those who managed to take their leave before the clock tolled midnight, including several insiders, it may well have been an enchanted investment. Not all were so fortunate, however, and Naxos became a rather grim story. A Vancouver Sun article in June 1996 called the Naxos assay technique "alchemy" and check assays ordered by the ASE using conventional methodology returned only insignificant traces of gold and absolutely no platinum. Naxos was a bust and was delisted by the Alberta Exchange on July 18, 1997.
If that was all there was to it, this would indeed be a short story. Varying a little in certain particulars, Naxos could simply be added to the list of companies such as Bre-X, Cartaway, Crystallex, Delgratia, International Precious Metals, and so on whose shareholders experienced the jarring collision of distorted beliefs and expectations with real facts. As it happens, however, Naxos Resources is less important to this article than an enduring spin-off to the tale.
Every story needs a story-teller and there is little doubt that newsletter author Jay Taylor is one of the best. He is articulate and persuasive, and the fact that he is frequently wrong doesn't seem to lessen the appeal of his stories to an audience eager for a chance at rewards that would make Bre-X pale in comparison. Mr. Taylor was an early and persistent advocate of Naxos and when the envisioned bright future of the company began to fly apart in 1996 he traded in advocacy for a position in the vanguard of the offensive mounted against its critics. In an article titled Investor Perils from Canadian Short Sales & Media Disinformation which appeared in the October 4, 1996 issue of his newsletter, Mr. Taylor launched a blistering attack on brokerage houses, short selling, and the media. At the root of his grand conspiracy theory was unreported short selling. Before turning to Mr. Taylor's article and its perhaps unintended ramifications, a brief consideration of short selling might be appropriate.
If Internet discussions of the subject are any indication, short selling is poorly understood by a large number of investors. In very basic terms, short selling involves the sale of shares which the vendor doesn't actually own at the time of the transaction but will purchase at a later date, hopefully at a lower price, thus realizing a profit. Perhaps understandably, this is a puzzling and unfamiliar practice to many and not one that is generally accepted in other circumstances. A person selling a car or a house that they did not own, for example, would be committing an illegal act and many people hold the view that short selling is little more than institutionalized criminal activity. Not surprisingly, those who hold this view ascribe a wide range of unflattering characteristics to short sellers: unethical; liars; parasites preying on the misfortunes of others; and so on. In short, they aren't the kind of people you would want to invite for Sunday dinner.
Whether it has general approval or not, however, short selling is an accepted, legal, and frequently prudent investment strategy. Moreover, it is a practice that is usually far more complex than many people seem to believe, involving considerably more than simply calling up a broker and placing a short sell order for a particular stock. Not all brokerages, for example, will execute an order on just any stock for just any client. Certain price thresholds may have to be met; there are graduated margin requirements; there is a borrowing cost for the short sale that varies from house to house; and so on. Often, a short sale is just one aspect of a more complex strategy. In a June 1998 newsletter, for example, Canaccord Capital outlined a convertible bond hedge as a form of cash flow arbitrage whereby an investor purchases a convertible debenture and at the same time short sells the underlying stock. In the Canaccord example using Brookfield Properties, the annual return on investment is just under 36 per cent. This type of hedge is an equity derivative strategy that has been used by hedge funds and individual investors for years. Less complex, is the practice of short selling in advance of the exercise of warrants or options. The irony here is that the short seller is often a participant in a previous financing or a company insider. In short, they are the kind of people that many shareholders would very much like to invite for Sunday dinner.
The foregoing brief look at shorting aside, it would probably be an understatement to suggest that, rightly or wrongly, among a large number of Internet retail investors, and perhaps even more widely, short sellers are despised. When the object of the short seller's strategy happens to be the company in which the investor has a financial stake, the perceived despicable nature of shorting seems to become particularly acute and the affected investor often appears to lose much of whatever objectivity might previously have been available. In part, this may help to explain why Jay Taylor's diatribe against short selling, the Canadian securities establishment, and the press was so widely and eagerly accepted.
In his lengthy October 1996 newsletter article, Mr. Taylor first outlined the "apparent unethical if not illicit behaviour on the part of the Canadian securities establishment" with respect to short selling. According to him, shorting "can and has often ruined good, legitimate Canadian companies." The Canadian regulation of short selling, by Mr. Taylor's account, is "enormously misleading to investors" insofar as the reporting of short sales creates "the false appearance of honesty when in fact very sinister behavior may be taking place." The crux of the problem, as Mr. Taylor saw it, was that brokerages were not required to report "covered short sales", those being short sales in which the firm doing the selling holds at least twice as many shares as it sells short. "Thus, if Canaccord held 5 million shares of Naxos on its books...it could sell 2.5 million shares of stock short and never report a single share of short sold stock!" According to Mr. Taylor this problem wasn't confined to Naxos. He "looked up every stock listed on the back page of this newsletter that is traded on the Vancouver Stock Exchange" and found that ten--Columbia Gold, Crystallex, GMD Resources, International Freegold, Jersey Goldfields, Navarre Resource, Northern Crown, Paramount Ventures, Stellar Gold, and Silver Eagle--had VSE Short Position reports. Mr. Taylor discovered that in a three month period that he reviewed, there were no "covered short sales" reported for any of those stocks. Using a hypothetical company, XYZ Co., and a hypothetical brokerage firm, Dishonest Brokers Ltd., Mr. Taylor suggested an example where the actual number of short sales was 101 times greater than the amount reported.
While the reporting of Naxos' short sales might be somewhat wanting by Mr. Taylor's account, there was no shortage of reporting on Naxos in the media suggesting that something was seriously amiss with the company and its fantastic Franklin Lake discovery. With the unwavering aplomb of the committed conspiracy theorist, Mr. Taylor had an easy explanation: "In fact, I believe the evidence points toward an unholy alliance between a major Vancouver based investment bank and its use of major Canadian media to create false stories and impressions to drive the price of Naxos lower so that these unsavory characters could cover their short positions at the expense of the investors." The short sales of Naxos reported by the ASE only amounted to 80,000 shares but Mr. Taylor suggested that there might be a very large discrepancy between the official count and the actual count: "According to one unsubstantiated rumour, the short sale position for Naxos, prior to the stock being halted for trading, was between 5 million and 7 million shares." In his 'hypothetical' Mr. Taylor pointed out that if a brokerage had a substantial short position on a company that "like BRE-X, discovers a gold ore body of upward to 75 million to 150 million ounces of gold" and the stock price rises to $250.00 per share, that firm could be in serious financial difficulty. Hence the need for some support from the Canadian media to drive the share price down, allowing "Dishonest Broker" to eliminate its short position.
Dropping his hypothetical example, Mr. Taylor became very explicit: "Just after the company's share price surged to new highs, a barrage of untruthful newspaper articles, most of which were written by David Baines of the Vancouver Sun, began to appear on a very frequent basis. As a person who has followed Naxos closely since 1990 and as one who has known key management people (and arguably the most significant research metallurgist associated with the company) since 1990, I have been absolutely certain that the stories reported in the Vancouver Sun have been comprised of half truths, innuendo and outright lies and that the reports were written with absolutely no prior research...Management had reason to believe that an enormous amount of short sales were coming from one major Canadian investment bank and they also believed that the defaming lies printed by the Vancouver Sun was a cover provided to protect perhaps millions of dollars from unannounced shorts sellers, especially one Vancouver based firm in particular."
Mr. Taylor was writing many months in advance of the public disclosure of the Bre-X fraud and well before it became readily apparent that his comparison of Naxos and Bre-X was very apt, though not for the reasons that he had proposed. Naxos' Franklin Lake property and Bre-X's Busang property did host similar gold deposits; that is to say, no deposit at all. Apart from some red faces and, perhaps, some apologies, the story should have ended long ago. As noted, however, Mr. Taylor's story has an enduring quality. In the real world there is a social phenomenon known as the "urban legend" and readers are probably familiar with some of the stories: alligators in the sewers of New York; mysterious 'disappearances' at certain locations; the boyfriend who gets out of the car on Lover's Lane to investigate a noise and is later found hanging from a tree, heels tapping on the hood of the car in which his terrified girlfriend still sits; and so on. The virtual world has similar stories and Mr. Taylor's "Canadian Short Sales & Media Disinformation" is one of them.
Given the high profile of the Naxos story at the time, it isn't surprising that Mr. Taylor's article was widely distributed on the Internet. Beyond the specific context of Naxos, however, the story had wide appeal for a number of reasons including its apparent confirmation of the general loathing for short selling and the unsavoury characters who engaged in it; it was a handy explanation for specific declining share prices in a generally declining market; and it was very difficult, if not impossible, to disprove. Those familiar with the Crystallex saga are probably aware of the considerable time and effort expended by Internet posters disparaging short sellers, levelling accusations of short selling against perceived critics, setting up short sellers as one of the principal antagonists to the company, and drawing a link between shorting and the unflattering media coverage of Crystallex. While Mr. Taylor's combined short selling and media disinformation scenario was especially appealing among hard-hit resource stock Internet posters, it wasn't limited to that sector. For example, it surfaced about a year ago in the context of Jot-it Software, since renamed Sideware Systems, which was experiencing a sharp decline in share price. It was widely taken up on the StockHouse discussion site and an e-mail campaign was launched in an effort to convince the VSE that the company was under attack by shorters, including 'undeclared shorts' that would increase the official short report totals by some multiple between two and ten times. Sideware Systems' price continued to decline and the stock is currently trading in the 30 cent range.
It seems to matter little what sector a particular stock might be in or whether, prior to a decline, it was trading in the $10 range as was the case with Naxos and Crystallex, $1 to $2 such as Jot-it, or the 20 cent range of a junior like Dynamic Ventures. There is often someone who will raise the spectre of an unwarranted and possibly illegal short attack, sometimes coupled with an equally unwarranted media disinformation campaign. Critics of this scenario are frequently accused of membership in the cabal or are confronted with the demand that they 'prove' the suggested conspiracy doesn't exist. As previously noted, this short selling scenario, as is the case with most conspiracy theories, is difficult, if not impossible to disprove. In fact, it may be no more amenable to 'disproof' than claims about ghosts or extra-terrestrial visitations. While people who accept as fact claims about ghosts and extra-terrestrials are often labelled 'flakes', the same doesn't seem to hold for comparable claims about short selling conspiracies. In the peculiar logic often exhibited in Internet stock discussions, if the scenario can't be disproved, it is frequently accepted as fact.
As the experience with Crystallex and Naxos should demonstrate, the facile short selling and media disinformation explanation for a falling share price is not very reliable. In fact, it often draws attention away from fundamental problems and issues that should be considered. In the case of Sideware Systems, the declining price may well have reflected the difficulty of breaking into an extremely competitive software market, among other things. As for Dynamic Ventures, trading has been halted by the ASE since August 18 pending receipt of certain regulatory filings and clarification of company affairs. These are but a few examples of the often misguided appeal to short selling conspiracy theories.
Having attained the status of a virtual "urban legend", it is likely that Mr. Taylor's short story, credited or not, will continue to surface on Internet stock forums whenever investors are in need of an easy explanation for a decline in share price. It is a short story that has become a handy 'tall tale'.
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