Smaller-Cap Companies: Beware the Short Seller! – reprinted by Ronald Woessner

This article illuminates how smaller-cap companies (particularly OTC-traded companies) are getting the “short end of the stick”^[1] due to inadequate legal protections against abusive short-selling practices.Investors can either participate in the market by going “long” a stock or by going “short” a stock. Investors that are “long” a stock believe it will increase in value. Investors that are “short” a stock believe it will decrease in value.A short sale occurs when an investor sells a security the investor does not own. If the price of the security drops, the short seller buys the security at the lower price and makes a profit.^[2]A sudden influx of short sales in a thinly-traded stock can cause an immediate and material decrease in the stock price. This results from the temporary imbalance between sales and purchases.^[3]

The SEC and the courts have said there is nothing inherently wrong with short sales because short selling contributes to price efficiency and market liquidity. For example, in a 2014 short selling study, the SEC noted, “Short selling as employed by a variety of market participants can contribute substantially to overall market quality through its positive effects on price efficiency and market liquidity.”

While short selling, even in large volumes, is not inherently illegal, the following is illegal:

• “Naked” short selling: This occurs when the short seller sells short but does not borrow the stock sold short or make arrangements to borrow the stock before the sale. SEC regulations require the short seller’s broker, prior to executing a short sale, to either borrow the security being sold, enter into a bona-fide arrangement to borrow the security, or have reasonable grounds to believe that the security can be borrowed so that it can be delivered to the buyer’s broker within the required two day (“T + 2”) settlement period.

• “Short and distort” campaigns: This occurs when a stock manipulator shorts the stock of a particular company, then spreads false or unverified rumors about the company for the purpose of driving down its stock price. Once the stock price has fallen on these rumors, the stock manipulator purchases shares at the lower price to cover the manipulator’s short position and pockets the profit. Given the speed with which information (including false information) moves throughout the investment community via social media channels, these short and distort campaigns can gather momentum very quickly and cause material downward spikes in an issuer’s stock price within a short period of time during one day.

Those of us that operate in the public company ecosphere are grateful that the law protects issuers against the two abusive short-seller tactics noted above. We are relying on the SEC to be vigilant in monitoring for these abuses and aggressively move to stamp them out. Notwithstanding, there are at least four “gaps” where the law does not adequately protect issuers, as discussed below.

Gap No. 1: No Required Disclosure of Short Position

There is no public reporting requirement for investors who go “short” a company’s stock. In contrast, there are extensive public disclosure obligations for investors who go “long” a company’s stock. For example, Section 13(d) of the Securities Exchange Act of 1934 and the regulations thereunder require persons owning more than 5% of the outstanding stock of a ’34 Exchange Act listed company to report their stock ownership with the SEC.

NASDAQ recognizes that not requiring public disclosure of short positions is poor public policy, according to Mr. Edward S. Knight, chief legal officer for NASDAQ. In his testimony before the Capital Markets Subcommittee of the House Financial Services Committee in May 2018, Mr. Knight testified that there is material harm to the efficacy of the public markets without short position disclosures. He made the following specific points:

• Short sellers can amass short positions secretly
• This is “untenable” since short sellers have in recent years taken an activist role in corporate policy and governance
• Because short sellers are not required to disclose their short position, neither the public nor companies know that the short seller may have a “hidden agenda” with respect to the activist positions it is pushing
• Lack of information regarding short positions is detrimental to market efficiency

Biotech companies are particularly vulnerable to manipulative short-selling practices, according to testimony the same day, also before the Capital Markets Subcommittee, by Mr. Brian Hahn, chief financial officer of the bio-tech firm GlycoMimetics, Inc. Mr. Hahn testified on behalf of the Biotechnology Innovation Organization, a trade association for biotech companies. According to Mr. Hahn’s testimony:

• Biotech companies often face attack by short sellers who spread online rumors or publish false or misleading data about clinical trials
• Short sellers use the auspices of the US Patent and Trademark Office (“USPTO”) to drive biotech company stock prices down. After shorting a company’s stock, the short sellers then file spurious patent challenges through the USPTO. The company’s stock price is driven down as false rumors spread that the company’s patents may be in jeopardy.

In sum, these commentators (and our common sense) informs that short sale position disclosures would shine a “light” on short seller stock manipulation. Moreover, if short sale positions were disclosed, the SEC will know the identities of those who are potentially benefiting from stock price declines linked to false rumors and other manipulative behavior — and can start their investigation with those folks!

Gap No. 2: Holders of Convertible Notes Are Permitted to Short Prior to Note Conversion

Holders of convertible promissory notes are legally permitted to short the stock of the company that issued the convertible note and thereby drive the stock price down and receive more shares pursuant to the note conversion.

Here is a typical scenario where this could occur: a company issues a convertible promissory note to evidence a loan. Amounts owing under the note may be converted into the company’s common stock at the noteholder’s discretion. The conversion price is typically at a discount (often 15-20%) to the then-current trading price of the company’s common stock. (Convertible notes issued by OTC-traded companies often have “floorless” convert provisions, meaning there is no “floor price” that limits how low the conversion price can go. Floorless convert provisions are not permitted under NASDAQ rules for NASDAQ-traded companies.)

The convertible note holder could then legally short the company’s stock to drive the share price down. The note holder then coverts the note at the lower share price and receives more shares in the conversion.^[4] While many CEOs and CFOs are shocked to learn that this abusive and manipulative tactic is legal — indeed it is! See the case of ATSI Communications Fund, Ltd. (2d Cir. 2009), where shorting prior to note conversions was alleged to have occurred. The court said it was perfectly legal for the convertible note holder to short the company’s stock prior to initiating a note conversion. The court stated, “Purchasing a floorless convertible security is not, by itself or when coupled with short selling, inherently manipulative.” (emphasis added.)

PRACTICE TIP: The above discussion should not be interpreted as suggesting that every convertible note holder will engage in this abusive, manipulative behavior. Nevertheless, as CEO or CFO it is prudent to attempt to protect your company against this manipulation by ensuring that the definitive agreements prohibit this behavior.

Gap No. 3: Short Selling Prior to Purchasing Shares in a PIPE

A “PIPE” is a Wall Street acronym for Private Issuance of Public Equity, meaning a transaction whereby a publicly-traded company issues shares in a private offering, typically via Regulation D.

The SEC short selling rules permit an investor who is purchasing stock in a PIPE transaction to short the issuer’s shares before purchasing the issuer’s shares in the transaction. The short seller/PIPE investor then uses the shares it purchased in the PIPE (which shares are typically priced at a 5% – 20% discount to the market price) to cover its short position!

Here is a typical scenario where this could occur: An issuer hires an investment banking firm to help the issuer raise $X by selling shares of its common stock in a PIPE transaction. The shares in the transaction will typically be sold at a 5-20% discount to the share market price on the day the deal closes.^[5]

The investment banking firm approaches a number of potential investors to determine if they are interested in investing in the PIPE transaction. (This is considered “soliciting indications of interest” in Wall Street jargon.) Once indications of interest for the $X sought to be raised have been collected, the deal is “priced” and closed (i.e., the discounted price at which the company’s shares are to be sold is determined), the definitive agreements are signed, and the deal closes.

During the period between learning of the PIPE and the deal closing, an investor is legally permitted to short the issuer’s stock and then use the discounted shares it acquires in the PIPE to cover its short position. For example, if the market price of the issuer’s stock is $10 per share and the PIPE discount is 20%, the investor will be entitled to purchase the issuer’s shares at $8 per share. The investor legally could sell the issuer’s shares at the market price of $10 per share and then cover its short position using the $8 shares purchased in the PIPE transaction. The investor realizes a $2 gain per share in an apparently legal, riskless transaction.

The SEC has pursued legal claims, with limited success, against investors who have engaged in this manipulative behavior. See the May 2014 article, “SEC Enforcement in the PIPE Market: Actions and Consequences” in the Journal of Banking and Finance for more information on this topic.

Again, many readers — not surprisingly — are shocked to learn that this abusive and manipulative tactic is apparently legal.

PRACTICE TIP: The above discussion should not be interpreted as suggesting that every PIPE investor will engage in this abusive, manipulative behavior. Nevertheless, as CEO or CFO it is prudent to attempt to protect your company against this manipulation by ensuring that the definitive agreements prohibit this behavior.

Gap No. 4: The “Alternative Uptick Rule” Does Not Protect OTC Companies from Bear Raids

SEC Rule 201 (the “alternative uptick rule”) restricts short sellers from driving down the price of shares of NYSE- and NASDAQ-listed companies whose shares have experienced a price decline of 10% or more in one day. Once this “circuit breaker” price decline occurs, short sale orders for the remainder of the day and the following day must occur at a price above the current national best bid, subject to certain exceptions.

The purpose and effect of the Rule is to protect the company from short-seller attack by impeding a short seller’s ability to drive down the price of a stock that has experienced such a one-day price decline.

The Rule does not protect OTC-traded companies. This makes them vulnerable to “bear raids,” where a gang of short sellers collaborate and sell short shares of a particular company in an effort to drive down the price of the shares by creating a temporary imbalance of sellers versus buyers or creating the perception that the share price is falling for fundamental reasons. These “bears” then cover their short positions by purchasing the company shares at the manipulated, lower price and pocketing the gain between the higher price at which they sold the shares and the lower price at which they purchased the shares back.

In sum:

• Smaller-cap companies with thinly-traded stocks, particularly OTC companies and biotech companies, are especially vulnerable to “bear attacks” and stock manipulation from short sellers because of these legal “gaps.”
• Gaps 2 and 3 are disproportionately harmful to smaller-cap OTC companies because PIPE and convertible note financings are common sources of financings for OTC-traded companies.

Bottom line: CEOs and CFOs — be wary of short sellers!

©Ronald A. Woessner

January 9, 2019

Mr. Woessner mentors and advises companies in the start-up and smaller-cap company ecosphere and helps them raise capital. He also advocates in Washington DC for policies that create a more hospitable public company environment for smaller-cap companies, enhance capital formation, support small business, promote entrepreneurship, and increase upward mobility for all Americans, particularly minorities. For more information on Mr. Woessner’s background, see https://www.linkedin.com/in/ronald-woessner-3645041a/.

^{[1] To get the “short end of the stick” is getting the bad end of a deal or receiving the least desirable outcome from something. The origin of the phrase dates back to the 1500s and appears to be a reference to carrying loads mounted on rods (sticks). When carrying a load, the person who has the shorter end of the supporting rods carries more of the load and, hence, they are getting the worst aspect of the situation.}

^{[2] If the price of the security increases, the investor loses money. The higher the price goes, the more money the investor loses.}

^{[3] It’s more difficult to drive down the price of liquid stocks by short selling because there is more order depth (demand) on the buy-side to absorb the short sales. The more liquid the stock, the more shares required to be sold short to create a material price drop. The more illiquid the stock, the fewer shares required to be sold short to create a material price drop.}

^{[4] Some have asked me why it would benefit a convertible note holder to obtain more shares at a lower stock price. The answer is that the lower stock price caused by the short selling is typically temporary, having been caused by an artificial imbalance between sales and purchases caused by the influx of the suddenly-introduced short sales. Once the normal equilibrium between purchases and sales is re-established, the stock price typically rebounds.}

^{[5] The share purchase price is at a discount to the market price because the shares being issued are “restricted” and cannot be sold until the earlier of six months after purchase or such time as they are publicly registered for resale with the SEC.}