Fooling Some of the People All of the Time, a Long Short (And Now Complete) Story, Updated With New David Einhorn (best classic books of all time .TXT) 📖

firm met him. Obviously, there is no secret part of Greenlight where I hide. I own only one cell phone and didn’t know what a SIM card was until I asked someone after the conference call. Most days, I take a train to work, though I admit I don’t always come in at the same time. Pretty tricky of me. I was also unaware of an unmet demand or interest from people I don’t know to have my picture. I had no problem with Byrne having one, though.

I know all about CEOs of troubled companies lashing out at critics. I’ve had firsthand experience, but Byrne attacked anyone and everyone. It was a spectacularly bizarre performance.

Since then, Byrne has been on a crusade. Overstock.com even refers to it as the “CEO’s Crusade” on the Web site. Byrne’s big complaint is about what he calls “naked shorting.” Incidentally, his lawsuit against Rocker and Gradient has nothing to do with naked shorting. Presumably, in response to Byrne’s complaint and the related publicity, the SEC jumped into the fray to investigate these claims. The case made significant news when the SEC tried to force journalists to reveal their sources. The journalists refused and, ultimately, the SEC dropped the investigation.

Naked shorting is selling short shares that have not been borrowed. Byrne has made a big to-do about this by accusing hedge fund “miscreants” of driving good companies out of business. According to Byrne, a naked short is the equivalent of creating counterfeit shares and selling them on the market, thereby driving down stock prices. The SEC has listened to Byrne and other critics of the practice, eventually adopting rules in June 2007, making it harder to naked short. According to SEC Chairman Christopher Cox, naked shorting is a “fraud that the commission is bound to prevent and punish.”

The primary evidence of naked shorting is the large number of trades that don’t properly clear. These are called “failures to deliver.” I doubt there is a lot of naked shorting in the market. The practice is probably more widespread among market makers, who are permitted to short without borrowing the stock, and short-term traders, who plan to hold the position for such a short time that they will cover before the initial trade is due to settle. I don’t believe that research-driven short-sellers, who often hold positions for long periods, engage in much naked shorting. It simply doesn’t make sense, and the clearing brokerages don’t permit it.

However, there is an alternative explanation for the large number of failures to deliver. Suppose a shareholder lends his shares to a short-seller. The short-seller sells the shares to a new owner. The trades clear, and everything is fine. Now suppose the original holder sells his shares. His broker has to recall the lent shares to deliver them to the new owner. When the clearing broker for the short-seller gets the recall notice, instead of forcing the short-seller to immediately repurchase the shares in the market, the clearing broker looks for a new lender of the shares. It may take time to secure those shares. Perhaps the clearing broker has also lent shares and decides to solve the problem by recalling those shares. While the clearing broker looks for new shares to borrow or waits for his recall notice to be honored, time passes and the system can back up—creating failures to deliver.

When you extrapolate this over numerous brokerage firms that are each borrowing, lending, and recalling shares from one another as the underlying shares switch owners, often rapidly, the clearing system can get behind and a good pile of failures to deliver can develop. This can happen without anyone naked shorting, manipulating or creating counterfeit shares and so forth. This happens more in stocks where there is a great interest in selling them short, because it is harder for the clearing brokers to find substitute shares to borrow when faced with a recall request. If there is a problem in the system, Byrne should point his finger at someone other than “miscreant” hedge funds.

His real beef, though, is that some hedge funds figured out that his business model was no good and his stock overvalued. He has made a huge effort to force the shorts to cover. Overstock’s stock price was $43 on August 11, 2005, the day he announced his lawsuit. The stock hasn’t seen that price since and fell to $13 by November 2006. Too bad we weren’t short.

Byrne professes to have no issue with “legal” shorting or hedge funds. Sure. It burns Byrne that short-sellers have made money betting on his failure. The Byrne performance reminded me of something Warren Buffett once told me about the difficulty of shorting the stocks of companies run by crooks, because they’ll fight dirty to save themselves. “The crook’s life depends on it,” Buffett said. While I am not calling Byrne a crook, his made-up rant about me indicates his dishonesty.

In September 2005, nine months after Allied announced the criminal investigation, the U.S. attorney’s office in Washington, D.C., invited us to share our information about Allied to assist their investigation. I went to Washington in October to present the federal prosecutors with a fifty-page slide show. In a cramped conference room, I met for eight hours with Assistant U.S. Attorney Jonathan Barr and another prosecutor and three FBI agents. It was plain that they had done a fair amount of work and were well prepared. At various points, they even referred to my testimony to the SEC. They asked devil’s advocate–type questions, repeating what Allied’s lawyers were obviously telling them in defense.

We went through all Greenlight’s problems with Allied, including its numerous false and misleading public statements, the history of ten separate investments it valued without reasonable basis, how it changed its accounting, and how its valuations still lacked any reasonable basis. We also discussed BLX’s fraud, the loan-parking arrangement, and the oral agreement. We went through Kroll’s findings and Allied’s various attempts to manipulate the market