Blame Canada

 US companies are saying our lax regulation lets short-sellers get away with murder

Canadian Business Newsmagazine
By Mark Brown
October 28, 2002

About two years ago, Russell Godwin, a director of Medinah Minerals Inc., noticed some unusual trading of its shares on the Nasdaq Over the-Counter Bulletin Board service.  A client reported purchasing 500,000 shares of the small Nevada-registered mining company, headquartered in Vancouver, when the total trading volume for that day was only 200,000.  However, Godwin, now also company president, didn't know the extent of the problem until a "shareholder census" revealed that there were more than 168 million shares outstanding, when only 117 million were available for trading.  The extra shares on the market arose from "naked short-selling," a practice banned in the US but perfectly legal in Canada.  And it is the reason why many small companies trading mostly on the Nasdaq Bulletin Board or on the Pink Sheets lay the blame for their misfortunes squarely on Canada.

Naked short selling is not the only way US securities are being manipulated through Canada.  Death-spiral financing - one of the instruments of choice for financiers like Mark Valentine, from defunct Toronto-based brokerage Thomson Kernaghan & Co. Ltd. - is also being channeled through Canada, for the same reasons so much naked short-selling comes from the north: our weaker securities regulations.  Indeed, "weaker" might not be a strong enough word.   When asked about the difference between Canadian and US short selling rules, a senior official at the NASD, the US association of securities dealers, put it this way: "What Canadian rules?"

Basic short selling, which is legal in both countries, is a high-risk strategy that typically occurs when an investor believes a particular stock is overvalued.  Through a margin account, the investor will borrow shares from a brokerage firm, say at $60 apiece, and immediately sell the shares on the market.   When the investor is confident the company’s shares won't fall further, he will repurchase the shares, say at $40 apiece, and return the borrowed stock to the brokerage (covering the position) for a per-share profit of $20 less fees.   In the case of naked short selling, the brokerage never actually has the shares in its inventory, nor does it have access to the shares' but it still allows the client to complete the short sale.

The effects can be disastrous for a small company.  Even when Medinah Minerals would release positive news about its exploration activities, the stock would continue its free fall because of the massive short selling.  What the short-sellers are trying to do in many cases is force companies to file for bankruptcy, says Wes Christian, a partner in the Texas law firm Christian, Smith & Jewell, which specializes in business litigation.  "Once you get a company down to $1, it can't raise capital, it can't get loans, it can't do anything.'

Death-spiral financing adds yet another twist.  In some cases, financiers will approach a target company on the pretense of looking to make a long-term investment.  In exchange, the financiers ask for some kind of preferred stock or convertible debenture, where the company owes the investors a variable amount of stock that must equal a prearranged fixed value. The provision guarantees the financiers more stock if the share price goes down.  But despite the confidence the financiers claim to have in the company, the real money for them come from shorting the stock.  And if the high volumes of trading don't scare away bona fide investors, death-spiral financiers can put more downward pressure on the stock by releasing negative news on the company.  Often, the short sales start even before the financing agreement is reached.  "They're naked short-selling," says Christian, "knowing that they're going to get some conversions [from the preferred stock or debentures] so they can cover."

That is what happened to Inc., a Florida-based market information subscription service, when it signed a deal with Valentine in May 2001.  The naked short selling of (now JAG Media Holdings Inc.) is the first of what could be a series of cases that high-powered Houston lawyer John O'Quinn, in association with Christian, plans to take to court.  Valentine is alleged to have misrepresented himself to by going against his word that he would not short the company's stock.

US regulators changed the rules regarding short-selling years ago.  Broker-dealers are required to make an affirmative determination that stock is available for borrowing so that it can be delivered by the settlement date.  In Canada, however, there is no such requirement.  "We've looked at it, we may look at it again, but we haven't seen any need for it in the Canadian marketplace,' says Keith Rose, vice-president of regulatory policy for the Investment Dealers Association of Canada (IDA).

That's certainly not the way many small companies listed on junior exchanges see it. They argue that the differences between US and Canadian trading rules have made Canada a conduit for stock manipulation schemes.  The paper trail created when shares are routed through Canada is so long that most companies simply can't afford to trace all the documents.  "I can show you 15 companies that these guys have beaten," Christian says, "not because they're right, not because they're moral, not because they are legally correct, but because they ran them out of money.'

US investors can't legally open a trading account with a brokerage firm in Canada.   But if they opened a Canadian account before the NASD cracked down and started to vigorously enforce the rules in 1998, they are not barred from trading.   "[Canadian brokers] are not blatantly opening accounts for Americans," says short-seller William Gate, managing director of Beowulf Investments in California and author of several books on venture capital financing and private placements.  "But if you are there, and you haven't caused any trouble, then they aren't kicking you out, either.”

US investors who want to bend the rules might approach a Canadian brokerage firm to conduct short sales on their behalf, put up the money and offer the broker a kickback or commission sharing for its help.  "Of course, the guy in Canada, if he's greedy and happy to participate in that kind of scheme, is going to do it," says the NASD official, who spoke on condition of anonymity.   Brokers need clients, and without strong rules in place there is nothing to discourage these firms from doing it, he adds.

But if a group of investors is intent on shorting a company's stock, but is not spreading rumors or misleading statements, then a company has little recourse, says Mark Deslauriers, a partner with Osler, Hoskin & Harcourt LLP in Toronto and past chair of the Ontario Securities Advisory Committee - unless the short-sellers were violating some other rule.  'It's never clean," be says.  "They are selling on the downticks, not disclosing their short to their brokers [or] brokers haven't disclosed their short positions."

So what's a company targeted by naked short-sellers to do?  One option is reorganization.  Christian and a team of 50 lawyers are currently taking every one of their clients through a recapitalization process that requires the exchange of the actual share certificate.    "You must redeem the certificate you supposedly hold in order to get a new certificate;' Christian explains.  "If you don't got them, and you sold them, then you are liable. Simple.” Under the reorganization, as undertaken by and Medinah Minerals, the company renames itself and the stock undergoes a reverse split of at least 1:1.01, which is the minimum requirement.

However, legitimate shareholders run the risk of taking the biggest hit.   In several cases, including Medinah, the company gave investors only 60 days to exchange shares, after which it had the power to cancel any outstanding shares.  The reason it could do so was because it is registered in corporate-friendly Nevada, where securities laws allow the board of directors to cancel any outstanding share certificates for "any desirable reason." One such desirable reason might be the fact that forcing investors to claim their certificates could artificially inflate a company's share value, by forcing all the short-sellers to purchase shares they don't want.

The goal of the reorganization is not so much to put a stop to short selling, as it is to expose who is doing the shorting.  Still, the short-sellers aren't always the only ones at fault.   "Some of the companies don't come into this scenario with clean hands," says the NASD official.  "The types of stocks, that typically are targeted by short-sellers may be companies that may be perpetrating their own violations, in terms of pumping up their own shares through press releases that are materially misleading, or other things."

Regardless of which side shoulders the blame, the shareholders are the ones who really lose out.  The IDA plans to revisit this issue in the new year, but it's not a high priority.  It's certainly a concern for the NASD, which has tried to put a stop to the practice - albeit with mixed results.  In the meantime, a case being built by GeneMax Corp. of Blaine, Wash., against two Vancouver firms, Global Securities Corp., a full service brokerage, and Union Securities Ltd., an investment dealer, challenges the legality of naked short sales in Canada.  But don't count on the case forcing a review of Canadian rules - such actions seldom reach trial, because the plaintiffs rarely have enough money left to see them through.


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