Manipulation and Markets

By Steven Syre,
The Boston Globe
January 31, 2006

American Business Financial Services Inc. was a big business with serious problems long before it ended up on the bankruptcy liquidation scrap heap. The company's line on its own slow-motion demise relied heavily on stock market conspiracy theories.

The Philadelphia subprime lender has filed several lawsuits claiming illegal market manipulation by investors trying to profit on the company's woes. The latest version was filed last month in federal court in Delaware by its bankruptcy trustee against Boston Partners Asset Management.

Based on facts in public view so far, the case is not at all persuasive, and Boston Partners vehemently denies the charges. But the broader issue and the specific allegations play in harmony with a larger debate among some investors and regulators over the manipulation of stocks.

The key elements: anonymous smear campaigns and illegal trading strategies, especially a practice known as naked short selling, meant to destroy the value of stocks. The bogeymen most often alleged to be working in the shadows: hyper-aggressive hedge fund managers.

Normal short selling is an accepted practice that takes place every day. Investors who believe a company is overvalued borrow some of its stock and sell the shares immediately, expecting they can go back into the market later to buy the same number of shares at a lower price, cover their bets, and pocket the difference between the two prices.

Naked short sellers never borrow the stock in the first place, but still execute the sale of shares they don't hold. Enough of that puts pressure on the price of a stock and gums up regular trading. It can take weeks or more to sort out responsibility for the failed trade of a naked short seller and, by then, the damage is often done. Naked shorting is almost always against the law.

It's unclear how often naked short selling really hurts a stock, but howls by some investors led to a new regulation last year requiring exchanges to report daily on stocks with sizable failed-trade problems.

The exchanges identified 276 stocks on last Friday's list, mostly obscure little companies. But some bigger names, like Krispy Kreme Doughnuts Inc., Martha Stewart Living Omnimedia Inc., and Netflix Inc., have each appeared on the list for more than 250 consecutive trading days, virtually since its inception.

The size and scope of the failed-trade list ''indicates there is a problem," says finance professor James Angel of Georgetown University. ''We just don't have good enough data to determine how severe the problem is."

The list is a useful place to start, but it lacks enough detail necessary to make real sense of the numbers. One simple example: Knowing exactly how many shares of a particular stock went undelivered would help.

But investors crusading against naked shorts look at the public numbers and declare a crisis. Exchanges describe a minor problem on the fringes of the stock market. Occasionally, a company will pronounce itself a victim of stock manipulators. Everyone's motives deserve closer scrutiny.

The first time American Business Financial Services cried foul, it targeted two financial analysts working for First Union Corp. (now called Wachovia Corp.). A lawsuit alleging that the analysts legitimately shorted the company's stock but then spread malicious rumors on Internet stock bulletin board was settled out of court, according to news accounts.

The next time the company went to court, it told a more elaborate story about Boston Partners and one of its stock analysts, Eric Connerly. A lawsuit filed in Suffolk Superior Court in 2004 alleged that a hedge fund operated by the Boston firm had been executing naked short sales through an account at Goldman Sachs, targeting American Business Financial Services stock.

Meanwhile, the suit alleged, Connerly was writing malicious things under aliases about the company on a Yahoo message board. Worse, it claimed Connerly and various unknown ''John Doe" defendants were mailing off more damaging false correspondence about shady business practices to regulators, the Pennsylvania attorney general, the FBI, lawyers, and the media.

The company, which made billions of dollars of loans to customers with poor credit, argued that a short campaign had done a lot of damage. The cost of doing business went way up for American Business Financial Services. At one point, Credit Suisse First Boston backed out of an important deal to buy a large number of loans the company had written.

But the case had some big holes. Connerly really did write some of the Internet postings under an alias, but they appeared to be obviously opinion postings and not very objectionable. American Business Financial Services hasn't offered any proof Connerly wrote any of the anonymous private correspondence, or that Boston Partners was engaged in any naked short selling.

And there were other reasons beyond the stock market to explain many of the company's problems. For one, Philadelphia's US attorney had launched a high-profile investigation of its home foreclosure practices in 2003. (A settlement was struck later.) State officials had also investigated the company's billing policies.

By the time the business crashed, the company's funding strategy of selling high-yield notes through newspaper ads and direct mail come-ons had created a line of 21,000 small investors owed $490 million.

The lawsuit in Boston was put on the shelf after American Business Financial Services filed for Chapter 11 bankruptcy reorganization a year ago. A deadline to resume the case by Dec. 31 approached when the new, very similar case was filed in Delaware last month.

In a written statement, Boston Partners denied the ''absurd allegations" in the suit and said its ''records indicate that no naked short selling took place." The firm said the bankruptcy trustee had chosen to ''improperly target" it in an attempt to raise money for creditors. Goldman Sachs declined to comment.

The bigger argument over naked short sellers and the damage they do to the stock market has generated more heat and smoke than light. The case of American Business Financial Services, at least what we've seen so far, looks and smells like smoke.

But that can't be the case for all of the hundreds of stocks listed by exchanges every day, the ones getting bogged down by chronic failed trades. Dozens have been fixtures on the list for months at a time. Investors deserve more information about those problems, and regulators who view the worst of the naked short offenders as real troublemakers to a functional stock market.

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