The more a company complains about naked short sellers driving down its stock price, the more worried you should be.

(Bloomberg) — Here is a lawsuit that I pass on to you mainly because it is adorable. There’s a little company called Life Partners Holdings that is “engaged in the secondary market for life insurance known generally as life settlements.’” 

Life Partners has an equity market cap of about $53 million based on yesterday’s closing stock price of $2.83 a share, but traded at almost 10 times that price in early 2009. So it seems to have fallen on hard times.

I know very little about the company so I will not speculate on the reasons for that, though I will throw out there that the Securities and Exchange Commission’s long-running case against Life Partners and its executives for fraud probably didn’t help. However, Life Partners won that case last month, and is perhaps understandably aggrieved about having had to litigate it.

The other thing that Life Partners is aggrieved about is naked short selling, and I must say, there seems to be an uncanny correlation between (1) being accused of securities fraud and (2) accusing your enemies of naked short selling. But Life Partners is pretty sure that naked short selling brought it down, and now it’s suing optionsXpress, a brokerage subsidiary of Charles Schwab Corp., for helping those naughty naked shorts.

From its complaint: Plaintiffs are informed and believe and thereon allege that Defendants, and each of them, have engaged in the unlawful creation and sale of millions of shares of counterfeit-phantom stock which said Defendants have mischaracterized to be the genuine stock of Life Partners and 24 other public companies.

Once the counterfeit-phantom stock trade is placed into circulation, it continues in circulation in the securities markets much like counterfeit bank notes continue in circulation after they are introduced into the monetary system. It thus has the effect of increasing the supply of stock available on the market for sale.

The increased supply of stock, albeit counterfeit-phantom stock, generally has a depressing effect on the price of the genuine stock of the public company whose name the counterfeit-phantom stock bares. As alleged below, naked short sales of counterfeit-phantom stock harm investors holding genuine stock, investors who receive the phantom stock, and the public company whose stock is diluted with counterfeit-phantom stock. It goes on irresistibly in that vein.

None of this is even a little bit true, but, like I said, it’s adorable. I mean, wait, no, one important part of it is true: OptionsXpress really did facilitate illegal naked short selling in Life Partners stock! I guess that’s a big one.

Here is the SEC’s case against optionsXpress, and here is the administrative law judge’s decision (referred to by Life Partners). OptionsXpress totally helped its clients do a lot of naked short selling, in Life Partners and other stocks, and was fined millions of dollars for it.

Otherwise, though, nope. We’ve talked about naked short selling before (and about optionsXpress’s naked short selling before that). The key thing to remember about naked short selling is that it’s a way to make money off of stock borrow costs without taking stock price risk; it’s not usually a way to make money by manipulating stock prices.

The scheme here seems to have been all about stock borrow. OptionsXpress’s clients would effectively buy Life Partners common stock, and then write deep-in-the-money call options. So they’d be long Life Partners on one trade and short on the other.

The call options would be exercised immediately, so the clients would have to deliver stock — they’d be “naked short.” They would deliver this stock by buying it in the next day, but also immediately writing another deep-in-the-money call option. That call option would also be exercised almost immediately, and the cycle would continue.

So the result is that the optionsXpress client would continually be long Life Partners on one trade and short on the other. They were neutral to any moves in Life Partners’ stock; they had no reason to want it to go up or down. A pointless trade, except that it was very expensive to borrow Life Partners stock.

It was expensive to borrow because, one, its chief executive officer owns about half of the outstanding stock and wouldn’t lend it, so supply was low. But also because demand was high: A lot of people wanted to borrow and short it. Not naked short it, mind you: Naked shorting doesn’t drive up borrow costs. Only regular legal shorting does. And a lot of people wanted to short Life Partners stock, because they thought it would go down. (It did!)

So the optionsXpress clients could make money lending the stock that they were long, not pay to borrow the stock that they were (illegally naked) short, and not take price risk. It was a pure stock-borrow strategy, indifferent to moves in Life Partners’ stock price. If you wanted to manipulate the price, this strategy — of buying and selling the same amount of Life Partners stock — would make no sense.

The naked short sellers did create supply of Life Partners stock, I guess, but they also soaked up the same amount of supply by buying Life Partners stock. Their net result was a nothing.

As for counterfeit shares of stock that still circulate …Nobody had a printing press. If you look again at the mechanics of how the naked shorting worked, you can see that the short positions were deep-in-the-money written call options that were open for a few days at a time. The options would be exercised, the client would buy shares (real shares!) and deliver them, and would then get naked short again through another call option.

When the scheme was shut down, the call options vanished: They were exercised and not replaced. There’s no vast pool of phantom — sorry, “counterfeit-phantom” – Life Partners stock outstanding that is driving down the price of the real stock. This whole thing is a phantom.

Look, naked short selling really is confusing. And it sounds so evil and nefarious. Markets are rigged, haven’t you heard? Because it sounds so bad and is so confusing, it is very tempting for troubled companies to blame their troubles on naked short selling.

This is always wrong. The more a company complains about naked short sellers driving down its stock price, the more worried you should be. But not about naked short sellers.

 

 

 

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