Rant 3 for RamjetNaked short selling makes it to TIME Magazine
From the Magazine | Time Bonus Section
December 2005: Inside Business
Watch Out, They Bite!
HOW HEDGE FUNDS TIED TO EMBATTLED BROKER REFCO USED "NAKED SHORT
SELLING" TO PLUNDER SMALL COMPANIES
By DANIEL KADLEC
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Posted Sunday, Nov. 06, 2005
Thomas Badian was expecting a package, just not this one. Standing in his doorway,
smiling, he opened the envelope a courier handed to him. Then he froze, and the
color drained from his face. It was over: after two years overseas, the former New
York City hedge-fund operator had been located. Badian slammed the door of his
posh Vienna, Austria, apartment in the heart of the city's embassy quarter--but not
before being officially served with a civil lawsuit linking him to the beleaguered U.S.
commodities firm Refco and tying him and Refco to a type of fraud that some argue
has destroyed thousands of companies and bilked investors out of billions of dollars.
The boyish-looking Badian, 36, of East European descent, seems an unlikely key
figure in a high-stakes Wall Street intrigue. Yet long-standing criminal and civil
charges place Badian at the center of a scheme to lend Arizona software developer
Sedona much needed operating capital, then trigger the collapse of its stock and
profit from the company's demise. This pattern is also alleged in the civil suit handed
to Badian on Aug. 8 in his apartment in Austria--only this time the mark was pet-
supplies company Pet Quarters, based in Lonoke, Ark.
Three years ago, Badian paid a $1 million fine to settle a Securities and Exchange
Commission (SEC) charge that he had manipulated Sedona's shares. Related criminal
charges were filed a few months later, but by then Badian had fled. His whereabouts
were recently given to U.S. Attorney Michael Garcia in New York City, whose office is
handling the criminal case. Garcia's office said only that the case remains open.
Yet the Badian episode might have been forgotten if not for its ties to Refco, which
last month admitted to reporting false results after hiding $430 million of
uncollectible debt. Refco CEO Phillip Bennett was charged with fraud, and his
company sank into bankruptcy protection within days. It turns out, plaintiff lawyers
say, that Badian had been making some of his Sedona trades through Refco, which
has acknowledged an SEC investigation.
Looking the other way while clients manipulated the shares of small companies
through what's known as naked short selling appears to have been yet another
questionable way of doing business at Refco. Short selling is legal: you borrow stock,
then sell it and hope to buy it back at a lower price, profiting from the difference. But
naked short selling is illegal, barring certain exceptions for brokers trying to maintain
an orderly market. In naked short selling, you execute the sale without borrowing the
stock. The SEC noted in a report last year the "pervasiveness" of the practice. When
not caught, this kind of selling has no limits and allows a seller to drive down a stock.
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Brokers are required to ask a client the nature of a stock sale. If it's a short sale, the
broker must ascertain if the client has been able to borrow the stock. "I have seen
evidence that links Badian and/or Refco to more than 50 stocks that were driven into
the ground," says Wes Christian, part of a legal team headed by billionaire Texas
tobacco litigator John O'Quinn, who is amassing a case against Badian, other hedge
funds and now possibly Refco. Refco declined to comment. Badian didn't come to the
door when a TIME reporter rang his bell. His lawyer in the civil cases, Perrie Weiner,
says that the suits against Badian have "not a shred of merit" and that courts have
consistently dismissed such cases.
After high-profile alleged frauds like Refco's and another this summer at hedge fund
Bayou Management, where managers shut down the firm without notice, the call for
strict oversight is growing. Largely unregulated investment pools for institutions and
the wealthy, hedge funds make big bets--up or down--on stocks, bonds,
commodities and currencies. Officials are investigating trading records at 35
institutions as part of their probe into naked short selling. And starting in February,
hedge-fund advisers must register with the SEC.
Usually the victims of hedge-fund excesses are their rich customers, who lose when
the hedge fund makes a bad bet. But through naked short selling, hedge funds can
stir up trouble for any publicly traded firm. In the case of Pet Quarters, the suit
alleges that Badian's hedge fund lent the firm sorely needed operating capital on
terms that allowed the hedge fund to convert the debt to shares at any time. Through
naked short selling, Badian then pushed Pet Quarters stock from $4 to just pennies.
Badian balanced his massive short selling with cheap shares obtained after he
converted the loan to stock.
Meanwhile, with its stock sinking, Pet Quarters couldn't raise the funds it needed to
keep operating, and shut down. CEO Steve Dempsey and an executive who had
invested with him wound up filing for personal bankruptcy. "There was nothing wrong
with our business," says Dempsey. "We fell prey to the perfect crime." Weiner counters
that "most of these companies" that blame short sellers when their stock falls are
financially "barely skating by."
SEC data show that such relatively big firms as Overstock.com and Martha Stewart
Living Omnimedia have been targets too. Overstock CEO Patrick Byrne has launched a
crusade against naked short selling, charging that an unnamed criminal "mastermind"
is conspiring against his company. Byrne says the attacks have "put limits on the
amount of capital we can raise, how fast we can grow and how many people we can
employ." His company's stock, at $76 in January, has tumbled into the low $30s.
Byrne filed an unfair-practices suit in August against Rocker Partners, which
specializes in short selling. Rocker says the suit is "frivolous" and blames Overstock's
disappointing results for the stock slide.
But small companies are especially vulnerable because even modest trading can
move the stock. Naked short selling "has got to push the price down," says James
Angel, associate professor of finance at Georgetown University. He says the rate of
short selling has nearly doubled in the past five years, to 36% of all trades. In the
same period, assets held in hedge funds, which are active short sellers, more than
doubled, to more than $1 trillion.
Illegal naked short selling, according to Robert Shapiro, a former Under Secretary of
Commerce, has cost investors $100 billion and driven 1,000 companies into the
ground. Shapiro is on O'Quinn's legal team, which has brought 16 cases against
hedge funds and other traders. For their part, the hedge funds say that they have
done nothing illegal, that the stocks they sell short ultimately drop because the
companies are not doing well.
Papers filed in the Sedona case offer a rare glimpse into the cut-throat nature of
naked short selling. Federal prosecutors, in a case that remains open against Thomas
Badian but has been dropped against his brother Andreas, charge in the complaint
that Andreas ordered brokers to sell Sedona shares short with "unbridled levels of
aggression." After the stock had "collapsed," according to the complaint, he
congratulated the brokers on a "good job" and instructed them to be "merciless" in
selling the stock a day later.
Around that time, Thomas Badian was living the high life. Registered in his name was
a two-seat 1998 Aston Martin. "He told me he liked to put the top down and take a
long drive," recalls Pet Quarters' Dempsey. "I asked him if he'd like to drive out to
Humboldt [Pa.] to take a look at our distribution center. For a guy who had just
loaned us money, he seemed strangely detached. He never did make the drive." He
had other plans for Pet Quarters. Just not the ones Dempsey had imagined.
https://www.time.com/time/insidebiz/article/0,9171,1126706-3,00.html