Issues & Opinions

Seen in an article from today’s WSJ, Overstock.com Chairman and CEO Patrick Byrne is again in the news. Not for the first time this year, it seems that Overstock.com has lost another director: “Overstock Director Resigns, Citing Suit Against Brokers”. Ray Groves has resigned from the board. The storyline back on Feb 23, when John A. Fisher resigned? “Independent Director at Overstock Resigns Over Brokerage Lawsuit”. We’re way beyond having the makings of a pattern here.

Mr. Fisher, an investment-banking adviser who has served on Overstock’s board since 2002, praised Chief Executive Patrick Byrne’s leadership in his resignation letter filed with the SEC, but said he didn’t agree with the company’s lawsuit, which alleges a massive, illegal stock-market manipulation scheme by major brokerage firms.

It’s old news to anyone who’s followed this particular melodrama, but Byrne’s own father, John, resigned from the board on July 31, 2006. Initial reports (WSJ, March 3, 2006) claimed that he planned to relinquish his chairman’s post while remaining a director, and that he held of 9% of the company’s equity.

Among the reasons Mr. Byrne says he may leave that post is disagreement with one of his sons — Overstock Chief Executive Patrick Byrne — over the amount of time the younger Mr. Byrne is spending on a highly public battle with short-sellers and analysts the son alleges are conspiring to damage the company’s stock.
…
“I don’t think it’s a wise idea to be chairman with a headstrong son,” the elder Mr. Byrne added. However, he said he intends to remain on the board as a director and will also remain an investor.
…
Patrick Byrne has often referred to his fight with these shorts and analysts as a “jihad,” …
…
“I can’t tell whether this ‘jihad’ adds to the value of the stock or subtracts from it, but what it does is takes from Patrick’s time,” the father continued. He says he has voiced his concern to his son “endlessly,” but so far hasn’t been heeded.

(ellipses mine)

The current board of directors contains only 4 members for now. At least three directors, including his father, thought he was carrying his “jihad” too far.

The lawsuit at the center of the director resignations? (filing available at Overstock’s website)

Overstock’s $3.5 billion lawsuit, which alleges a massive, illegal stock-market manipulation scheme by major brokerage firms, including Morgan Stanley & Co., Goldman Sachs Group Inc., Bear Stearns Cos. and Citigroup Inc., has been a major source of tension within the company.

The Feb 2, 2007 filing named defendants, including those not listed above (BofA, Merrill Lynch, Credit Suisse, Deutsche Bank, BoNY, UBS, and “Does 1 through 100″), alleged to make up 80% of the prime brokerage market, based on “aggregate client assets”. That’s one way to measure size in the prime brokerage market, though I don’t know why it matters in this case. They could have radically simplified and shortened the filing without changing its meaning much simply by listing as defendants “Everyone”.

What is the problem they cite? You can read the full details either in the filing linked above or in the CEO’s FAQ at Overstock’s website, but in a nutshell:

• When a trader believes a stock’s overvalued, s/he can sell it short, profiting if able to repurchase it at a lower price. The mechanics of this are similar to normal trading, in that s/he buys low and sells high, just in the opposite order.
• In order to sell stock you don’t own, you must borrow it from someone who does
• The purchaser of your short-sold stock has the stock “delivered” (normally electronic book notation), T+3, or three business days after trade
• If the short seller, or the short seller’s broker, can’t locate stock to borrow, the book notation doesn’t occur, and a technical violation called a “failure to deliver” is triggered. Effective Sep 7, 2004, with compliance required from Jan 3, 2005, Regulation SHO was supposed to stop these failures to deliver, by forcing firms to do a “locate” (find borrowable shares), before selling on behalf of their own short selling client.
• Marketmakers are generally exempt from this rule, for liquidity reasons
• According to Byrne, the rule doesn’t work or isn’t enforced.

Having been on the sharp end of a shortseller campaign a time or two, I understand the Company’s instinctive reaction to try to do something about the problem. I’d even agree that some reaction is appropriate. My advice? Try addressing or proving wrong the naysayers, with actions not words.

Whining and bellyaching, on the other hand, are of no help. Ever. Neither, in the case of anything but the most solid and profitable company, is encouraging one’s stockholders to transfer all company stock from margin accounts into cash accounts, or worse, into physical share certificates. Such requests never come from solid and profitable companies, by the way, because they never have Overstock’s problem. Normally, such transfers would make it impossible for the stock to be lent. In Overstock’s case, it doesn’t matter, they claim, because their stock’s being naked shorted, and that the new buyers aren’t receiving the stock they bought. The effect of this, according to Byrne?

We know Overstock has sold just over 19 million shares to the world, but that the world seems to own between 35 to 40 million shares of Overstock.

Byrne is able to seem, in some cases, like a reasonable, intelligent executive. Heck, he might even actually be reasonable and intelligent. But I don’t know where he gets his numbers, either about number of shares naked shorted or supposed shares outstanding. Currently, it seems there are 21 million. And if he thinks that the imaginary 14-19 million phantom shares of stock are the reason the price is no longer $71 (Dec 2004), but instead $18.40 (today), then he should have no trouble rounding up private equity to take out the 21 million shares of equity, causing great financial loss, pain, and consternation to the supposed evildoers who’re trying to destroy his company. Pay no attention, of course, to the fact that as of Mar 31, 2007, several of his largest institutional holders happen also to be on the list of defendants in the Feb 2007 lawsuit.

He’s made his company a joke with his years-long battle against people who are either right, and the stock will go down, or they’re wrong, because he and his business model will be proven to be superior, causing his stock to go up and his short-sellers to lose the shirts on their backs.

PR and lawsuits on matters like this never work, and groups of aggressive shortsellers (as distinctly opposed to individual shortsellers) are, believe it or not, almost always right. The stocks they short don’t go down solely or even mainly because they sell them short or manipulate the market. They go down because they’re overpriced. Cause, meet effect.

As a side matter, the fact that marketmakers are allowed to naked short is interesting, particularly in the case of a small-cap stock like this one. If they decide to sell stock they don’t own or possess, they can do so until the cows come home. They risk getting smoked if the stock goes up instead of down, but they’re big boys.

Back during 1992 & 1993, a marketmaker and bankruptcy arbitrageur named the Scattered Corp sold short more of the stock of LTV than existed everywhere in the market. Think of it as naked shorting on steroids, pre-Regulation SHO. Scattered Corp made out like a bandit, along with any other short sellers in the market at the time, because when LTV exited bankruptcy on June 28, 1993, its stock was functionally extinguished, replaced with warrants valued at three or four cents per share. Gain? $27 million in 22 trading days, totally legal, and the result of nothing but legitimate use of the market. The inevitable legal case in the matter was styled “Sullivan & Long Inc. v. Scattered Corp.” and a Google search returns 20 or 30 links to other cases referencing it, plus an entry at the Scattered Corp. website, which is a copy of a pleading in a follow-on case by Scattered against the Chicago Stock Exchange et al, related to the LTV trading. That derivative case spells out the facts of Sullivan & Long Inc. v. Scattered Corp. pretty well. The original case was dismissed with prejudice, with dismissal confirmed on appeal. A highlighted version of the Seventh Circuit opinion (Judge Richard Posner’s court) in the dismissal is also available.

…the principal defendant, a Chicago Stock Exchange market maker (a dealer willing both to buy and sell a particular stock or other security for his account on a regular basis, 15 U.S.C. sec. 78c(a)(38)) with the alarming name of Scattered Corporation, sold short huge quantities of the old LTV shares. It sold short, in fact, tens of millions of such shares a week, for a total, when trading ended on June 29, of 170 million shares, far more than the 122 million old LTV shares outstanding. The excess of shares sold short over total shares outstanding is the focus of the plaintiffs’ complaint.
…
The effect of trading on an information advantage is to dispel, by penalizing, ignorance and to bring market values into closer, quicker conformity with economic reality. The profit that such trading brings at the expense of less knowledgeable traders provides the incentive for a private, for-profit firm, such as Scattered, to provide this economic service.

(ellipsis mine)

If you want to see an alternative take on naked shorting, the rest of the decision is an interesting read. See also the Business Week articles (from the 8/5/1996 issue), “The ‘Bad Boys’ of Chicago Arbitrage“, “The Secret World of Short-Sellers“, and two related tables, “The Truth About Those That Sell Short” and “Four Ways Shorts Get Stung“. (The rules under which Scattered did all of this have, of course, changed.)

The markets work when they’re allowed to work, as Byrne has apparently heard from at least three associates, along with their recommendation that he ought to focus on his business. If he dropped the matter and got on about proving his business really is a good one, in no time at all, the naked short problem would vaporize. Short sellers never do so for personal reasons - it’s always financial, and remans so until they’re proven wrong. Byrne does himself and his company no credit by feigning outrage and continuing his jihad.

Addendum - I hold no position in OSTK, long or short, by the way.
Addendum - 5/26/2007 - BusinessWeek details added

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