SEC Brings Enforcement Action for Manipulating Stock Prices
Through Short Sales and Deceptive Covering Practices

(As published by Investment Management Developments in their Winter 2003 edition

By Harry S. Davis
Schulte Roth & Zabel LLP.

The U.S. Securities and Exchange Commission (”SEC”) recently signaled its continuing concern about market manipulation schemes that are designed to drive down the price of publicly traded securities by bringing an enforcement action against an unregistered investment advisor.

On February 27, 2003, the SEC sued Rhino Advisors (an unregistered investment advisor) and its president Thomas Badian for violations of the antifraud provisions of the Securities Act of 1933 and the Securities Exchange Act of 1934 as a result of a scheme to manipulate the price of Sedona Corporations’ common stock. According to the SEC, Rhino and Badian engaged in concerted short selling of the company’s stock price down ahead of planned conversions of a convertible debenture into common stock. In order to obscure the short sales and covering transactions from both the company as well as the market, the SEC charged that Rhino effected a series of matched orders and wash sales involving the covering securities. The SEC’s enforcement proceeding against Rhino and Badian was simultaneously settled with respondents paying $1 million and consenting to entry of an order enjoining future violations of the anti-fraud provisions of the federal securities laws.

This enforcement proceeding – and the size of the penalty imposed by the SEC – signal the SEC’s continuing concern about market manipulation schemes and suggests that the SEC is looking carefully at short selling activity that may be part of an effort to artificially depress stock prices.

The Alleged Misconduct

In its complaint, the SEC charged Rhino and Badian with manipulating the stock price of Sedona Corporation in order to benefit an advisory client who bought a convertible debenture from Sedona, a Pennsylvania based technology company whose stock is traded on the NASDAQ SmallCap Market.

On November 22, 2000, Rhino’s advisory client provided Sedona with $2.5 million in financing as consideration for the latter’s issuance of a $3 million 5% convertible debenture. The debenture obligated Sedona to pay $3 million on March 22, 2001. Under the agreement, the advisory client had the right tot convert all or any portion of the debenture into Sedona common stock at a price equal to 85% of the volume weighted average price (“VWAP”) of Sedona’s common stock on the NASDAQ SmallCap Market during the five day period prior to the conversion date. The debenture expressly prohibited the advisory client from selling Sedona”s stock short while the debenture remained issued and outstanding.

The SEC’s complaint alleges that Rhino violated the contractual provision by engaging in extensive short selling through a series of broker-dealers on behalf of its advisory client. As a result of the short selling, the VWAP for Sedona’s stock steadily declined, enabling the advisory client to get more common stock upon conversion of the debenture than it otherwise would have been entitled to.

What made this into an SEC enforcement proceeding – and not just a breach of contract claim – is that Rhino’s misconduct involved more that just selling Sedona’s stock short in violation of a contractual prohibition. Rather, Rhino hid its short selling from Sedona (and the rest of the market) by arranging for a “cooperating broker” to make the short sales in its own proprietary account. The broker then covered its own short position at the end of each day – after the markets had closed – by buying an equivalent number of shares from Rhino’s advisory client (and the broker did so at a slight premium so as to ensure a profit on each series of stock transaction). This left Rhino’s advisory client with an undisclosed short position. By conducting the trades in this manner, Rhino hid the short sales from the issuer because, although the cooperating broker’s short sales were included in the market’s reported price and volume data (and, therefore, affected the VWAP), neither the broker’s covering purchases nor Rhino’s short sales were printed to the NASDAQ tape.

Rhino then engaged in further manipulative conduct when it covered its advisory client’s short position (after repeatedly failing to deliver the stock sold short to the buyer on the settlement date either by borrowing the stock or covering) with share the advisory client received upon the conversion of the Sedona debenture. Although the advisory client covered its short position utilizing the stock it acquired from Sedona in the debenture conversions, Rhino did not want it to appear that the client was using the stock obtained from Sedona for the purpose (since Rhino’s advisory client had pledged to Sedona that it would not engage in short sales while the debentures were outstanding). Accordingly, rather than deliver the newly acquired Sedona shares directly to the brokers where Rhino’s advisory client had short positions, Rhino effectuated a series of wash sales and matched orders between the advisory client’s long account at one broker-dealer and the advisory client’s short account at other broker-dealers. In doing so, Rhino gave the appearance that the short position were being covered through open market purchases when, in fact, the advisory client was using the stock obtained in the debenture conversion to cover its short positions. 

Conclusion

The SEC’s actions in bringing this enforcement proceeding and imposing a substantial fine on the unregistered investment advisor evidences the SEC’s commitment to crack down on market manipulation schemes of al l flavors. What is particularly interesting about this case is that by seeking to find a way around a contractual provision prohibiting short selling – thereby doing indirectly what it could not do directly – the investment advisor bought itself into a series of securities law violations, an SEC investigation and a hefty fine. At a time when hedge funds and short selling are under increasing scrutiny, this enforcement proceeding is an important reminder to always stay on the correct side of the line between lawful shorting activities and illegal market manipulation.

Harry S. Davis
Schulte Roth & Zabel LLP.
212-756-2222
harry.davis@srz.com

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