Dust flux, Vostok ice core

Dust flux, Vostok ice core
Two dimensional phase space reconstruction of dust flux from the Vostok core over the period 186-4 ka using the time derivative method. Dust flux on the x-axis, rate of change is on the y-axis. From Gipp (2001).

Thursday, August 19, 2010

How the game is played, part 2; Why your broker can't get you in on that sweet private placement.

Today we look at yet another technique through which the sophisticated money picks the pockets of the unsophisticated. This one is a little worse than last time, because this time the sophisticated money is someone owing a fiduciary responsibility to the unsophisticated money.

The lesson today comes courtesy of the Toronto Stock Exchange. Go to the tsx website. Find the section that lists the largest short positions. I've placed the link here for you, but I find it by typing in "short positions" in to the search TMX.COM box. Now click on the report posted on March 18 ("Top 20 Largest Consolidated Short Position Report - March 15, 2010").

Yes, I could have sent you directly there, but I want you to have confidence that this data really exists and is not simply something I have made up.

The third entry on the list is Dundee Precious Metals (DPM). [Again, for disclosure, I have no position in DPM, either long or short]. We notice that the short position increased quite a bit during the reporting period, which is from February 28 to March 15. On February 28, the short position was 1,558,760 shares, and on March 15 the short position was 21,634,118 shares, for a net change of 20,075,358 shares.

Wow! A lot of people suddenly decided they didn't like this stock.

Still on the TMX website, get a quote on DPM. From the quote page, click on the price history tab, and then enter a date just after March 15, 2010 so you can see all trades over a 30-day period. We are interested in the trading that took place between February 28, 2010 and March 15, 2010. If you add up all the trades, you see that there were less than six million shares traded over that period.

Well WTF?! How do you increase the short position in a stock by 20 million when only 5 million trades take place?

Here's a game that some brokers play. Stock ABC announces good results, and a lot of buying comes in, so the price jumps. You call your broker, and tell him you want to buy 5,000 shares (let's say) of ABC. The broker says sure, gives you a quote, you send in the money.

Now your broker has been around a few years, and he has seen all this before. He knows that the price of ABC is going to fall soon, so he takes your money but doesn't exercise the trade. He scratches out an IOU for the back office so that any future statements in your account will reflect the presence of these shares. But no trade has occurred. Your broker believes that ABC will fall later, and he will buy the shares later at a lower price, put them into your account, and make some extra money for the brokerage. Is this acting in your best interest? Is this fulfilling his fiduciary duty to you?

In acting in this way, your broker creates a type of "synthetic short position". You are owed shares, yet no official share transaction has taken place. You would have no way of knowing that this is happening unless you call for delivery of your share certificates, because your brokerage statements will state that the shares are being held for you even though at this moment they are not.

This is fraud.

Virtually all the time, things work out for the brokers. ABC falls in price, the brokerage makes some extra money. Once in awhile the opposite may happen, and the broker is forced to buy at a higher price and takes a slight loss.

What happens if ABC now hits an enormous company-making hole and the stock rockets up by multiples? And what if the broker has not only done this in your account, but in a whole pile of client accounts, some of which may be owed a very large number of shares of ABC. It is possible that the brokerage may go bankrupt and you may not recover much of what you are owed. And the whole thing will probably be treated as an accident.

But it was fraud.

How might the brokerages protect themselves against a sudden rapid rise in the price of ABC?

Let's look at Dundee again. Go back to the quote, and this time click on the News tab. We are interested in news releases of the company this time. And we note that on February 22, 2010, DPM announced a bought-deal financing of 20 million units at $3.30. On that day, the share volume was rather high, and the price fell to basically the offering price.

Perhaps it is only one of those coincidences that the size of the offering happens to be the amount by which the short position grew by mysterious means over the three weeks until the offering closed on March 15. Or maybe it was one of those coincidences.

In this case it means that the brokerages sold the soon-to-be-issued shares to their clients. Which seems reasonable, as there were no warrants, and there are not reported to have been any brokers warrants offered to the brokerages, and the sales between February 22 (when the deal was announced) and March 15 (when the deal was closed) were all near the offering price; so the brokers did not overtly scam their clients.

The brokers did, however, put their clients at risk. The clients must have been sold undeliverable (by virtue of being nonexistent) shares. In a traditional offering, the clients' money would have been held in escrow until the offering closed--the money would be passed on to the company only when the shares were issued, and no short position would have been created. If for some reason the financing fell through, the money would be returned to the clients and they would lose nothing except an opportunity cost for the two weeks or thereabouts their money remained in the hands of the escrow agent.

But for things to work this way, the brokerages would need to find qualified investors willing to buy 20 million shares ("qualified" investors are sometimes called "sophisticated investors"--you are automatically considered sophisticated if you have more than a certain amount of liquid assets, or your annual salary exceeds an arbitrary amount--thus a wealthy orphan is a sophisticated investor, but you, who have been trading shares for twenty years, are not).

For the bought deal, the brokerages buy the shares, but in this case they pre-sell them to any and all of their clients, many of whom would not qualify as "sophisticated investors". Now what would happen if the deal is announced, the clients try to buy in but are filled with the nonexistent shares (creating the 20 million share synthetic short position) and then for some reason the deal doesn't happen? Suddenly all these clients are owed shares, and the scramble to cover could lead to an extreme market dislocation.

Once again--in this particular case, it would be unfair to call this a scam. But the electronic trail left suggests that the brokers did put some risk on their clients without any apparent compensation, which seems to be a breach of fiduciary duty. Furthermore, the clients who took on this risk were probably not "sophisticated investors", otherwise why not simply have them participate in a financing?

It is easy to see how the process can be used unfairly.

You call your broker because you've heard about this financing by ABC, in which units consisting of a share and half a warrant are being offered. You want in, but your broker tells you the offering is oversubscribed, too bad, but advises you it is so hot you should just buy shares, even though they are priced higher than the offering price. They could go higher still in the coming days because ABC is on a real tear, and with the financing complete they will advance . . .  blah, blah, blah.

You pay your money, your broker puts an IOU in your account and then later delivers shares from the financing to your account, skims a little extra profit, collects the warrants you should have had, and possibly some brokers warrants too. Not bad!

Thanks to Terry for doing the original legwork.

Next time we look at a simple game some brokers play.

1 comment:

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