Naked and Confused
By Liz Moyer
January 26, 2007
Most investors have never heard of Sedona Corp., a piddling Pennsylvania outfit that sells customer relationship management software for small U.S. banks and credit unions. But to a rogue band of short-selling hedge fund managers, Sedona was prime meat.
And so from early 2000 through 2003 Sedona shares gyrated wildly on the Nasdaq, crashing from $10 to less than a buck. Helping run down the shares were the brazen trades of raiders who later were accused of an illegal--but flourishing--practice known as naked short-selling.
In two civil cases filed by the Securities & Exchange Commission and in a criminal case pursued by the U.S. Department of Justice, regulators and prosecutors have pieced together a lurid tale of greed, replete with tape-recorded conversations of traders moving in for the kill.
Regulators are investigating dozens of other examples of naked short-selling and possible insider trading. Many of these deals involve companies that raised money as Sedona did, in so-called PIPEs, or private investments in public equities. A PIPE has the supplier of capital directly or indirectly getting newly issued shares at a discount. If the discounted pipe shares are a good indicator of where the stock is headed, the higher-priced existing publicly traded shares cry out to be shorted. Depending on who's doing it and when, those short sales may be verboten.
The case involves some key names: Ladenburg Thalmann, a New York City boutique investment bank that is a prominent player in the PIPEs business; Refco Inc., the now defunct brokerage investigated by the SEC for how its traders hammered at Sedona stock; and investment adviser Rhino Advisors, which helped line up investors in the Sedona PIPEs, including hedge funds Amro International, Aspen International and the Cuttyhunk Fund. In 2003 Sedona sued these companies and other defendants in federal court in New York; the case is pending.
Sedona's complaint accuses Ladenburg of being linked to at least nine companies that accepted PIPE financing and then saw their stock prices plummet below the one-dollar mark, including Sedona, Pet Quarters, Viragen, General Magic and Alpnet. Ladenburg's outside counsel denies any wrongdoing and says there isn't any evidence to support Sedona's claims. And a federal judge in the Sedona civil suit has tossed out several of Sedona's claims against Ladenburg. Refco filed for bankruptcy in October 2005 after its former chief executive, Phillip Bennett, was accused in an unrelated case of hiding $430 million in debt from investors. Its attorneys declined comment.
Naked short-selling is a controversial tactic that was supposed to have been stamped out in the late 1980s. Hundreds of companies have collectively lost $100 billion in market value since 1997 because of naked short-selling related to PIPE deals, asserts former Under Secretary of Commerce Robert Shapiro, a paid consultant to attorneys for Sedona. Dozens of large- and midcap companies have been targets, but smaller companies are especially vulnerable.
"There is a belief that it's not that big of a deal," says Peter Chepucavage, a former SEC staffer who helped write the current rules meant to clamp down on the practice. "But where it's deliberate, it can have a terrible impact on a company."
In short-selling a trader borrows shares and then sells them, hoping to replace the borrowed stock with replacement shares purchased later at a much lower price. In naked short-selling the sale is booked, but the shares are not delivered. The buyer of those shares has, in effect, only a brokerage firm chit saying he is entitled to the shares. This buyer fully participates in any appreciation (or depreciation) in the shares, but he does not have any voting certificates to hold on to.
The naked gambit's rise is seen on the New York Stock Exchange. Each day on the Big Board some 50 million shares lack "proper settlement," meaning the trading firm fails to deliver the shares within three days, as required by SEC rules. Some volatile stocks, including Martha Stewart Living Omnimedia, Novastar and Krispy Kreme, have settlement "failures" that persist for weeks or months.
Sedona was a far lesser light, but it drew a pack of short-sellers anyway. The small company in King of Prussia, Pa. recruited a new chief executive, engineer Marco Emrich, in 1999 to push into banking software. He set out to raise $12 million in financing. Within a few months he had lined up the debt, scored a distribution deal with IBM and landed 65 bank customers. "I was in heaven," Emrich says; he dreamed of $30 million in sales by 2003.
In early 2000 Sedona took its first $3 million PIPE--short-term bonds convertible into stock, courtesy of Ladenburg Thalmann. Sedona was so desperate (or naive) that it signed off on a dangerous conversion feature: The more the stock went down, the more shares the bondholder was entitled to upon converting. Soon after, trading volume in Sedona shares spiked sixteenfold, to more than 4 million a day. Were bondholders shorting the stock, hoping to profit by running the stock down? If they did any short sales before converting, they were violating the terms of the securities they bought.
Just months after the first Sedona PIPE the company's shares had fallen from $10 to $3 and lower. Emrich arranged a second $3 million PIPE in November 2000, and the shares spiraled down in a similar pattern. By the spring of 2001 the traders at Refco were in full assault mode, captured on tape-recorded phone calls that federal prosecutors later subpoenaed.
An investment adviser is heard exhorting brokers to use "unbridled levels of aggression" in shorting Sedona shares: "Clobber" the shares until they have "collapsed." "Keep on whaling away--this is very good," he says. A broker boasts to a colleague: "Want to short something illegally for 12 months? You got my number."
Clueless for the most part, Sedona executives were thunderstruck by an anonymous, 300-page dossier dumped on their doorstep in September 2001. It detailed manipulations in Sedona and some 60 other stocks. Sedona took the report to the SEC.
By late 2002 Sedona, its customers and partners wary of the travails, had shrunk from 70 employees to 15, who at one point went nine weeks without a paycheck. The SEC first targeted Rhino Advisors and its president, Thomas Badian. Rhino and Badian settled without admitting or denying guilt. Then Justice lawyers filed criminal charges against the Austrian-born Badian and his brother Andreas in December 2003. Federal prosecutors charged each with one count of securities fraud related to Sedona.
Thomas Badian had left the country by then, and has yet to return; he is believed to be living in Austria. Andreas Badian was arrested and eventually was released on $2 million bail. But in 2004 Justice dropped its case against him for undisclosed reasons. He is believed to be cooperating with the investigation, which continues against his brother Thomas. "I don't see a criminal violation here," says Steven Cohen of Cooley Godward Kronish, until recently Thomas Badian's lawyer. (Cohen was just named chief of staff for New York's new attorney general, Andrew Cuomo.)
A 2006 SEC civil suit identifies Andreas as the person on the Refco tapes who directed the aggressive short-selling of Sedona stock in 2001. He and several brokers from Refco and Pond Securities are the targets of that SEC civil investigation. The SEC has not sued Ladenburg in connection with this.
Enforcement of rules aimed at curbing naked short-selling is weak. Last year regulators fined firms a combined $5 million for violating rules in the stock-lending business, which yields $10 billion of revenue annually for Wall Street. The SEC wants to impose stricter rules on trading and is currently sifting through hundreds of comment letters on proposed amendments to short-selling regulations.
Sedona has survived, barely, by taking a $1.5 million loan and equity investment from an outside investor, a Louisiana real estate developer named David Vey. "I was a little bored," Vey says, "and this seemed like an exciting endeavor." He since has increased his stake to 43%.
"We felt abused," says Michael Mulshine, a former board member. He quit in June 2003 after getting a phone call at home on a Saturday morning from someone who warned, "People can disappear over things like this." Says Mulshine of Sedona: "We refused to walk away."
The company is running on sales of less than $2 million a year now. Emrich still toils away. "We lost four years of our lives on this," he says. "Are there companies that should not exist? Probably. But not Sedona."
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