For Sale – Independent, Untouchable, Incorruptible Research

By now, everyone knows the “O” lady. Sometimes, it’s about the office, sometimes, it’s about the gOOOOld, and sometimes, it’s about pretending that you’re not thinking about what you want her to do with that tennis racket.

Sometimes, however, it’s all about the market manipulation. Overstock.com has alleged that one research did just that, filing a complaint with the SEC. The complaint alleged that a stock-research firm, after researching Overstock’s stock, tweaked its conclusions about the online retailer’s future performance. Overstock alleged that the research firm, Gradient Analytics, Inc. made changes to its conclusions at the request of a hedge fund, Rocker Partners, LP.

Why does this matter, and what reason could any of the parties have for doing any of these things? First, research firms, or firms that are dubbed research firms are supposed to conduct independent research. Investment firms of various types and shades then pay these research houses for the independent research and make investment decisions accordingly.

Hedge funds purchase this research. More so than other parties buying up the product of research firms, however, hedge funds engage in riskier investment strategies. They are more highly leveraged than other investment firms, they buy and sell more derivatives than other firms, and they sell short on positions more often than other firms. In short, they pursue much riskier bets, and they put down more money on each one. If they win, they’re heroes, but if they lose, the result is catastrophic.

Add to this volatile mix the fact that research firms have high overhead. They receive money on the back end – that is, after they’ve performed the research; to do otherwise would compromise their independence (i.e.: research to order). Additionally, independent research is highly fungible. Further, good research is very expensive (e.g.: tens of thousands of dollars per year for a subscription). Each firm, in order to make the sale and get the order to make up for all the money they’ve already burned must distinguish themselves from other research firms. They must provide added value. Or they must provide less rigorous research for a lower price, and possibly open to manipulation. And yet another alternative in the research game was played by institutional investors channeling portions of commissions to research firms in the form of “soft dollars”– the better the institutional investor did, the better the research firm did.

Some parties are only too willing to pay for that added value – whether it comes in the form of adjusted results or a lower price. As with drugs that bind to the vacant nerve receptors of glassy-eyed addicts and compromise the receptors’ ability to bind with organic compounds, so too with hedge funds that are willing to pay a premium to research firms with vacant checking accounts, thereby compromising their ability to sell an untainted product to blind parties. Gradient, however, counters that no one would want a biased report, especially in light of the money firms are paying for those reports; second, it would be bad for independent research. This is a nice thought, yet it presupposes what it seeks to prove – “Bad things aren't done by good people, and we haven't done any bad things, so we must be good people.”

However, assuming the initial thesis is true, Overstock alleged that certain hedge funds paid Gradient extra money to alter their research conclusions to conform to the bet that the funds had made. The complaint alleges that the hedge funds had sold short shares of Overstock – to wit, that Overstock share prices would go down.

Why would the fund do this? The fund has already made the bet. However, success or failure of the bet rides on how the rest of the market perceives the stock. Essentially, because of the nature of a short sale, the fund needs a market where they can go at the appointed time of the short sale, and buy up shares cheaply. A short sale occurs when a party that does not own a stock borrows the stock from a party that does own it, and sells the stock to someone else for a given price; the short seller makes his money when the price of the stock drops by the time he must buy up that stock in the market and give it back to the party from whom he initially borrowed it; his profit is between the high price for which he sold the shares, and the low price for which he bought them up to repay the debt. A few notes regarding short selling. First, the potential for profit is very narrow. While a stock price can go up with no limit in theory, the share of a price can only go down so far – to $0. Further, because the profit is limited, short sellers must place a large amount of money on the bet. If the share price drops, as they bet, they recoup their costs and then make the profit in the difference between the advance sale and late purchase. If they lose, however, and the stock price jumps, they must purchase all of those shares for whatever price the market currently dictates. Liability is, therefore, infinite.

Another theoretical problem is that, while the bet is for share prices to decline, share prices generally increase. This, however, is offset by the fact that in the short term (which is how long the bet of a short sale lasts) stocks are equally likely to go down as go up. Further, if share prices do increase in the short term, they do not increase significantly, thereby limiting the loss.

A practical problem goes to the borrowing aspect of short sales. Because there is a loan of shares involved, there is, as in all other loans, interest charged. Overstock shares, for instance, commanded an interest rate of 24% on the loan. In the problem alleged by Overstock, the high interest rate does provide support for the allegation that research was fudged – not only did the Rocker fund have to win, they needed to win big.

If the rest of the market believes that Gradient’s research is an independent, good faith prediction that Overstock will go down, there will be a race to the bottom, to see who can unload Overstock shares the fastest. The hedge fund which paid for the report will have created its market and will succeed on its bet.

Can a hedge fund create a market? Absolutely. Because of the size of hedge funds and the capital they can throw around, the question is not so much, “Can a hedge fund create a market?” but rather, “How big will the market be?” Further complicating this problem, hedge funds, while regulated, are in the nascent stages of only minimal regulation. They are still largely opaque, scooping up large packets of capital from an increasing number of investors while revealing remarkably little about themselves in the process. The exchange is not quite even.

Short selling, like nearly all other capital market activity, is regulated. Doing so makes sense, particularly in light of the fact that short selling only works when stock prices decline; were everyone to sell short, stock prices would all be driven inexorably down, and with all share prices at $0, all equity would be lost. Markets would have failed. (Arguably, the need for regulation in place of the invisible hand means that markets have failed already anyway, but that is a topic for another day). As a result, Congress gave the SEC authority to regulate – but not entirely ban – short selling in Section 10(a) of the Securities Exchange Act of 1934. Under this provision, the SEC has promulgated four rules to regulate short selling.

Rule 3b-3 defines a short sale. A short sale is any sale of a security which the seller does not own or any sale which is consummated by the delivery of a security borrowed by, or for the account of, the seller. Rule 10a-1 prohibits a short sale in a falling market. A person may not effect a short sale of any exchange traded security, wherever traded 1) below the last reported price at which such security was sold, regular way; or 2) at the same price, unless that price is above the next preceding price at which a sale of such security, regular way, was reported. Put another way, short sales may not occur on a minus tick or a zero-minus tick. They may be made on a plus tick or a zero-plus tick. A plus tick occurs when the last previous sale price is lower than the price at which the short sale is effected. A zero-plus tick occurs when a short sale is effected at the same price as the last previous price, provided that price is higher than the preceding different sale price of the security. These rules are security specific; that is, the market may be going down, but as long as the security is on a plus tick or zero-plus tick, the short sale may be effected.

Rule 10a-2 prescribes the methods used in covering a short sale (when the short seller buys the necessary shares back to repay the original loan of shares). Rule 105 of Regulation M prevents manipulative short selling of securities in anticipation of a public offering of those same securities. Rule 105 applies to short sales during the five business days prior to the pricing of an offering; as to these short sales, it is unlawful to cover short sales of equity securities of the same class as securities offered for cash pursuant to a 1933 Act registration statement.

The accusation against Gradient is both bold and serious. It is accusing Gradient of pimping itself out, and violating the trust placed in it by market players, as well as violating its fiduciary duty, and a host of securities laws and regulations. If proven true, it could spell the end of the organization, and it would implicate various parties. It would also likely create the second tremor in securities research in five years – the first coming after the dot-com bust of the early 21^st century, when it was discovered that research and investment were bedfellows and outlooks were driven not by probing inquiry but by sales goals. After all, as recently as 2003, the major players on Wall Street agreed to overhaul a system plagued by conflicts of interest. So, is there evidence to support these allegations?

It is true that Overstock’s share prices have dropped precipitously since their public debut in 2002. Trading at more than $75 per share in 2004, they hovered in the low $20s in late February of this year. Analysts predict Overstock will lose $31 million this year, and its share price dropped 40% between October 2005 and March 2006. However, Overstock’s share price rose threefold during the time that Gradient covered it, and even after its long fall, is still higher than it was when Gradient began covering it. This weighs heavily against Overstock’s allegations. However, Overstock could quickly counter that the players in this game are sufficiently sophisticated that they could still corrupt the information, win the bet, and leave room above the original share price, thereby chipping away at Overstock’s allegations. Yet, other research firms complain of lawsuits which claim they filed negative reports on companies for which they never actually wrote reports; with a narrow profit margin already, strike suits (i.e.: nuisance suits) are sufficient to drive a research firm out of the market. Often, funds filing these suits are only after the sources used by the research firms.

Moreover, stock prices fluctuate wildly all the time, and this practice, of purchasing corrupt research to bet on a race that, for all intents and purposes has already been run, is easy to explain, and even easier to conceive and execute. Yet, other corporations with publicly held shares that do not perform exceedingly well, are not as quick to make these allegations. Why Overstock?

There is a second issue that made this case notable. The SEC, investigating these claims, subpoenaed two journalists from Dow Jones & Co (i.e.: The Wall Street Journal). Why subpoena journalists? Because, the theory goes, sources tell journalists material information about capital markets, market players and other interested parties, and journalists then share that information with their readers, listeners and viewers; in short, those wishing to manipulate the market are using the media as their tools to do so.

This manipulation and the subpoenas of journalists, in and of themselves, are not so uncommon as to merit attention; however, in the wake of the Judith Miller/Valerie Plame affair, increased public awareness and sensitivity to the issue will constitute a bigger story, sell more newspapers, and facilitate drumming up sympathy with journalists and against large, federal entities with subpoena power. Whether that sympathy is warranted or not is another matter.

Twenty days after the subpoenas were served, however, SEC Chairman Christopher Cox denied any prior knowledge of the subpoenas, promising an investigation into the investigation. Amid a debate that the SEC’s enforcement division operates too independently – “cowboys” come to mind – he reproved his staff publicly, although there was no mention in the media of his withdrawing the subpoenas – only that the SEC would not seek to enforce them at the time.

Complicating this story further, Biovail Corp., a pharmaceuticals firm, filed a lawsuit in February against SAC Capital Management, LLC, an $8 billion hedge fund, David Maris, a Bank of America Corp. research analyst, and yes, Gradient Analytics, the independent stock-research firm noted above. Like the Overstock allegations, this lawsuit also alleged that different parties had conspired to drive down the price of the Biovail stock. It is worth noting that Biovail’s stock did decline more than 50% between 2003 and spring 2004. As a result, the SEC subpoenaed Gradient with regard to communications between it and journalists and other parties. This would complement the subpoenas that the SEC had served on several financial journalists and then put on hold after media outcry. Banc of America Securities LLC responded by terminating research coverage of Biovail.

There are those who argue that if the stock is going down, it must owe to the market manipulation of a conspiracy between hedge funds in the analysts in their pockets. However, there are those who point out that rather than any conspiracy, these companies merely have poor fundamentals, and short sellers, as they have been in the past, most notably with the Enron stock, are right in their evaluations of a company’s fundamentals and correct in their predictions about the direction of its share price. Rather than any conspiracy, this is really a story about the success of the efficient free market hypothesis and a group of investors who fundamentally understand it and know how to apply it. Casting further doubt on the merits of the Biovail suit (and, collaterally, on the Overstock suit), is that Biovail tried the same tactic in 1996; they did not lose, nor did they win – they settled out of court, with Biovail agreeing to invest in the hedge fund that was the target of the suit.

Further, as some writers have been bold enough to point out, hedge funds, since their entry to the market, have been traditional and convenient scapegoats for the rise and fall of financial markets and those who negotiate their waters. Again, nodding to their relative opacity, this is not entirely surprising, nor given their dazzlingly brilliant returns over the past decade – like money, envy is green, and a powerful motivating force. Moreover, insiders assert that the allegations are not entirely without foundation: hedge funds are bold in publicizing their predictions, and according to some analysts, have even pressured them to write reports that coincide with funds’ strategies. Such reports are called “hatchet jobs.”

Strangely enough, Gradient has already fired the analysts at issue.

The above does not constitute legal advice.