Financial crime is not limited to bank robbers and charlatans. Today’s criminal may be found sitting behind a glossy boardroom table or on the internet. As a due diligence investigator, I am hired by clients who suspect financial malfeasance from within their company or from their competitors. There are varying levels of intensity in due diligence investigations. On one hand, you can check out someone’s Facebook page or LinkedIn profile and get a sense of who they portray themselves to be. On the other hand, you can spend tens of thousands of dollars on a battalion of investigators to ferret out every last bit of information available.
After twenty years of conducting both types of investigations, Hg has developed the Phased Approach—a systematic process that enables us to explain to our clients the various types of due diligence investigations. The benefit of a phased approach for the client is their understanding of what is supposed to happen when and the costs involved. Much of our work is concluded after Phase 1, because we are able to answer the client’s key questions through online research. Phase 2 is needed in the event there are outstanding questions that require boots-on-the-ground work.
In this blog series, we examine the most common types of financial fraud—Ponzi Schemes & Manipulation, Backdating Stocks, Insider Trading, Short Selling, and Pump and Dump Schemes—and how due diligence investigators can protect your company’s assets and investments by tracking down fraudsters.
Most long-term investors are “Going Long,” meaning they purchase stocks with the hope of gaining wealth as the price of the security increases. But a Short Seller borrows on a stock and sells, hoping the price will decrease. MotleyFool.com offers several examples of short selling. The example below is of a profitable trade. Shares Company XYZ currently trade at $100 per share, which the investor believes is overpriced.
- A short seller investor borrows 10 shares of Company XYZ and immediately sells them for total of $1,000.
- Subsequently, the price of the shares falls to $90 per share.
- The short seller buys those shares back for $900, returns them to your broker, and keep the $100 profit. They buy it back, because they are contractually obligated to return the borrowed shares.
Matthew Frankl, CFP explained:
With short-selling, there is a ceiling on your potential profit, but there’s no theoretical limit to the losses you can suffer. For instance, say you sell 100 shares of stock short at a price of $10 per share. Your proceeds from the sale will be $1,000. If the stock goes to zero, you’ll get to keep the full $1,000. However, if the stock soars to $100 per share, you’ll have to spend $10,000 to buy the 100 shares back. That will give you a net loss of $9,000—nine times as much as the initial proceeds from the short sale.
And all of this is completely legal; shorting becomes illegal when it gets Naked.
Naked Shorting is when you are selling stocks you do not own. Companies and investment firms can be greatly damaged by naked short selling. Lehman Brothers Chairman and CEO Dick Fuld testified before Congress that the firm’s fall was due to naked short selling:
As the crisis in confidence spread throughout the capital markets, naked short sellers targeted financial institutions and spread rumors and false information. The impact of this market manipulation became self-fulfilling. As short sellers drove down the stock prices of financial firms, the rating agencies lowered their ratings because lower stock prices made it harder to raise capital and reduced financial flexibility. The downgrades in turn caused lenders and counter parties to reduce credit lines and then demand more collateral, which increased liquidity pressures.
In the midst of the 2008 financial crisis, the SEC codified Rule 204T. Under that rule, Person X has to deliver within 3 days after the trade. If not, a “failure to deliver” (FTD) is identified, and penalties start to mount if the transaction doesn’t occur by the beginning of the next trading day.
Perhaps the most famous denouncer of naked short selling is Patrick Byrne, chairman and CEO of Overstock.com, who alleged that Merrill Lynch, through naked short selling, was drawing down the online retailer’s stock prices even while its revenues were flying high. In January 2016, Merrill Lynch settled Overstock.com’s claim with a $20 million payout.
Cynthia Hetherington, MLS, MSM, CFE, CII is the founder and president of Hetherington Group, a consulting, publishing, and training firm that leads in due diligence, corporate intelligence, and cyber investigations by keeping pace with the latest security threats and assessments. She has authored three books on how to conduct investigations, is the publisher of the newsletter, Data2know: Internet and Online Intelligence, and annually trains thousands of investigators, security professionals, attorneys, accountants, auditors, military intelligence professionals, and federal, state, and local agencies on best practices in the public and private sectors.