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At a time when the stock market is in a state of chronic schizophrenia, with a year's worth of gains being chipped away, one corner of the market has withstood the recent travails far better than any other: small-cap stocks. The Russell 2000 Index of such stocks is up 37% so far this year -- double the gain in the Standard & Poor's 500-stock index.And in October, trading volume in the very smallest stocks, which are listed on the OTC Bulletin Board, climbed 400% over a year ago. Good news -- but only up to a point. Regulators have long warned that such stocks are notoriously prone to manipulation and hype.
And that is where short-sellers perform a valuable role. Shorts wager on stock price declines by borrowing stocks and then selling them, in the hope of buying them back at a lower price. So, with microcaps becoming frothy, you'd think that the Securities & Exchange Commission would be encouraging the practice. Instead it has done the exact opposite. On Oct. 29, in a move that received little attention outside the securities industry, the SEC caved in to a vociferous campaign by microcap companies and proposed a rule that would curtail the primary form of short-selling that can deflate the hype of small stocks.THE NEW RULE is designed to stamp out what is known as "naked" short-selling. It works like this: Ordinarily, traders must borrow a stock, or determine that it can be borrowed, before they sell it short. But some professional investors and hedge funds take advantage of loopholes in the rules to sell shares without making any attempt to borrow the stock. The new rule would effectively ban such short-selling.
Critics of shorting say this move is a good idea. They maintain that thinly traded microcap stocks are vulnerable to aggressive short-selling. Gayle Essary, CEO of Investrends Inc., a research service that focuses on small companies, says naked shorting "screws shareholders. They put $3,000 into a stock they think is going to cure cancer or something, and before you know it their stock is worth $300."
But there is another side to the story. Short-sellers argue that the SEC action would eliminate the only market force against overhyped -- or even fraudulent -- small-cap and microcap stocks. And that, they maintain, would be as devastating for ordinary investors as it would be -- financially -- for the short-sellers. "It would crush the whole business of market-making and short-selling and enhance a hundredfold the crime level in these stocks," asserts one New York short-seller who -- like all shorts interviewed for this article -- requested anonymity.THERE'S NO DOUBT that shorts often drive down the prices of thinly traded stocks. The problem is that such stocks often became tempting to shorts only because they are richly priced as a result of manipulation. A good example of that took place in the mid-1990s, when several microcap brokerage firms, including Hanover Sterling & Co., collapsed after shares they had promoted to sky-high levels were attacked by aggressive shorts. Hanover brokers and managers were subsequently imprisoned for stock fraud.
Shorts argue that if naked-shorting had not taken place during the microcap crime wave of the 1990s, such stocks would have climbed even higher before they crashed. In the past, the SEC was loath to act against naked shorting, but it now has succumbed to organized pressure -- including a letter-writing campaign encouraged by more than 100 microcap companies, organized as the National Assn. Against Naked Short-Selling (NAANSS).
The arguments used by the organized opponents of naked shorting, lamenting the supposed depredations of short-sellers, are so repetitious that the SEC has categorized their comment letters -- which are piling up at the agency -- as "Letter Types A, B, C and D."
So who is behind this campaign? Calls to the NAANSS were answered at a firm called Investor Communications International, whose clients include companies attacked by shorts. Their anger is understandable. The market is a ruthless place, but it's supposed to be. The SEC should let it work -- and not cave in to this campaign to suppress the only force that can curb hype in the resurgent microcap market. By Gary Weiss