Hedge Fund Hell
Complaints about stock market manipulation by aggressive short sellers are starting to resonate.
By Liz Moyer
July 28, 2006
Toronto-based Fairfax Financial Holdings filed a $5 billion lawsuit against SAC Capital, Rocker Partners and a number of other hedge funds, claiming they manipulated the insurance company's stock, shearing its market cap by one-third.
Earlier this week, the regulatory arm of NYSE Group, fined Daiwa Securities America, Goldman Sachs Execution & Clearing, Credit Suisse Securities, and Citigroup Global Markets $1.25 million for violations of Regulation SHO--a rule put in place in January 2005 to clamp down on abuses--related to how they handle and monitor short-sale transactions by hedge funds and other clients.
Meanwhile, 40 individual investors in Novastar Financial, a Kansas City specialty finance company, have filed suit in a California state court against 11 of Wall Street's biggest firms, alleging the firms are responsible for artificially suppressing Novastar stock by skirting stock clearing and settlement rules. The banks are trying to get the case moved to California federal court.
In recent weeks, Congress has listened to groups of witnesses testifying about abusive trading practices, with at least two Senate panels, Judiciary and Banking, considering whether new legislation is needed to rein in the hedge fund industry. Regulators have also been trying to take a tougher stance on rogue trading.
Earlier this month, U.S. Securities and Exchange Commission Chairman Christopher Cox said he would try to close loopholes that have allowed some abusive trading to continue even after Regulation SHO came into effect. He said he "is particularly concerned" about loopholes that can be deliberately manipulated "to drive down a company's stock."
But for some, change isn't coming quickly enough. The Fairfax suit alleges the defendants prepared "a massive and fraudulent disinformation campaign attacking Fairfax and other targeted publicly traded companies" using "biased, negative" analysts reports, and then "made money by shorting the stock."
A lawyer for Rocker Partners, now named Copper River Management, said the firm had no comment for now. "This is another baseless lawsuit by a company attempting to shift the blame for its fundamental business problems," says a SAC Capital spokesman. "We are confident we will prevail."
Frustrating for some is the perceived tepidness of the response so far by regulators, despite their tough talk. Fines by NYSE Regulation against the four member firms are minuscule, complains Patrick Byrne, chief executive of Overstock.com, who has tried to rabble-rouse on the issue of market manipulation for the last two years.
Not surprisingly, Overstock.com is a heavily shorted stock. Last year, the company also filed suit against Rocker Partners and against a research firm, Gradient Analytics, making similar claims to those of Fairfax. Both Fairfax and Overstock have acknowledged being subpoenaed by the SEC. (Incidentally, Fairfax is a big holder of Overstock.com shares.)
NYSE Regulation "is a cop eating a donut and writing a parking ticket for someone who's robbing a bank across the street," Byrne says of the fines. As for Cox's tougher take on short-selling, Byrne says, "when I am not being cynical, I think Chris Cox inherited a tough hand, an almost unplayable hand, but has figured out the only way to play it is aggressively."
Sympathetic lawmakers in Overstock's home state of Utah shoveled a bill through the state legislature and got it signed into law after a special session in May. The new law, which fully takes effect in October, threatens to cost brokerage firms operating in the state $10,000 each time they fail to report a failed-to-deliver trade of a Utah company stock within a 24-hour window. The Securities Industry Association, the brokerage industry's trade group, was caught flat-footed then and is still trying to come up with a response.
But brokers are under attack elsewhere. The Novastar holders' lawsuit attempts to hold 11 Wall Street firms responsible for allowing, and even arranging, manipulative trading that they claim has wiped out half the value of the stock.
The firms targeted in the suit, Bank of America, Bank of New York, Bear Stearns, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, Lehman Brothers Holdings, Merrill Lynch, Morgan Stanley and UBS, control the prime brokerage business, which includes facilitating and financing trades for hedge fund clients, among other services.
Most of the banks either said they wouldn't comment on the lawsuit or didn't return calls for comment. Merrill Lynch and Citi said the suit is without merit.
The suit is similar, though not identical, to two lawsuits filed in April in New York federal court, accusing the same 11 firms of fraud and anticompetitive practices in stock lending. The plaintiffs in those two cases are a broker-dealer, Electronic Trading Group, and a hedge fund, Quark Fund. In each case, the accusers claim they have been charged bogus or excessive fees for services they never received.
Stock lending is a little understood but highly lucrative business for Wall Street, raking in $10 billion to $12 billion in fees annually. Hedge funds also happen to be among Wall Street's most important clients, not least because the funds contribute some 30% of the daily volume in stock trading.
One of the favorite tactics of hedge funds is short-selling, a bet that a stock will fall. When a fund sells-short, it borrows the shares from its prime broker to sell them, with the hope that its instincts were right and it will be able to buy back the stock at a lower price to close out the loan.
Some stocks are easier than others to borrow, however, and hedge funds pay big fees to have their prime brokers borrow the harder-to-find stocks. According to market rules, stock transactions have to settle in three days, with the shares delivered to the buyer, or the broker at least has to prove it has reason to believe the shares will be delivered. When the deadline is blown, the trade "fails to deliver," and becomes what's called a naked short sale.
In all three lawsuits against the prime brokers, the accusers say Wall Street firms intentionally and routinely allowed these failures-to-deliver and engaged in a conspiracy to do so. Novastar shares are down 50% from the beginning of 2005, and last year, fails-to-deliver represented 6.5% of its outstanding shares, the investors said in the lawsuit.
"Prime brokers are motivated to intentionally fail to deliver stocks, because this removes a core cost from their securities-lending business," the Novastar suit contends, "thus allowing them to earn more money through the charging of fees, commissions and/or interest through phantom securities transactions."
Novastar's stock regularly shows up on daily lists maintained by the major stock exchanges, NYSE Group and Nasdaq, that tell the market which stocks have high numbers of fails-to-deliver. In fact, Novastar has been on these Reg SHO lists since they began being published in January 2005.
Other stocks that routinely show up on the SHO lists include Martha Stewart Living Omnimedia, NetFlix, and Overstock.com. And Fairfax.
In its suit, Fairfax says it's looking for $6 billion in compensatory damages as well as punitive and treble damages for the defendants' "egregious misconduct."
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