Is Cynk a short-seller trap? Maybe? I don't know. I guess http://www.thefreedictionary.com/naked cam not? But wouldn't it be cool if it was?
I confess I had a feeling that not all was right with Cynk Technologies. Just a hunch that I had, that I mentioned repeatedly here and here and on Twitter and on television and to strangers on the subway. Something about a company with no revenues and a brilliant but undeveloped business model (buy friends on the Internet! friends not included) having a $4, 5, 6, whatever billion dollar market cap struck me as fishy.
This morning the Securities and Exchange Commission halted trading in Cynk "because of concerns regarding the accuracy and adequacy of information in the marketplace and potentially manipulative transactions in CYNK’s common stock." So I guess I was right? Everyone was right! I mean everyone who said anything about Cynk this week said either
umm this looks like a pump-and-dump scam, or
umm this looks "overvalued," or "frothy," or like a "sign of a new tech bubble," or some other euphemism for pump-and-dump scam.
Good job, everyone!
A weird fun fact is that even after lots and lots of media outlets fretted about Cynk on Wednesday, and the stock briefly dropped Thursday morning, it then kept rising for a while, reaching a peak of $21.95 per share -- a $6.4 billion market cap! -- just before noon yesterday. That peak came over an hour after Bloomberg TV expressed on-air skepticism, over 12 hours after Zero Hedge expressed online skepticism, over three weeks after Seeking Alpha published a post titled "CYNK Technology: Promoters Push Market Cap To $655 Million Despite $39 In Assets And No Revenue; 100% Downside," and, y'know, three months after Cynk decided to stop publishing financial statements. So this is not a great case for the power of financial media, or of market efficiency, at least in penny stocks.
Here is one theory for why not, from Seeking Alpha. I have no idea if it's true, and I suspect it is at least not the whole explanation for Cynk's rapid and imperturbable rise. 1 But it's beautiful, and I'm going to describe it to you in simplified form because for what do we live but to contemplate beautiful financial scams?
First, though, here is a traditional pump-and-dump, in schematic form:
You and I start a company.
It issues 300 million shares, 150 million to me and 150 million to you, for no consideration.
The company has no assets, does nothing, and is worth $0.
On Monday, I sell you 10,000 shares for $1 each. All of a sudden we have a $300 million company.
On Tuesday, you sell me back those 10,000 shares for $2 each. Now we have a $600 million company.
On Wednesday, we find some suckers and say "hey, this $600 million company is poised to take off! It was up 100 percent just yesterday! Get in while there's still value!"
The suckers, being suckers, buy 100,000 shares for $2 each.
Now we have $200,000 of the suckers' money, which we split.
We flee to, I don't know, Belize.
This is a good scam. (I mean, super illegal obviously. But otherwise.) People have been running this scam for centuries, "everyone" knows about it, the SEC warns about it constantly, but you can still sometimes find some people who don't know about it and who fall for it.
Here is a schematic version of the scam that Seeking Alpha describes:
You and I start a company, it issues us 300 million shares, I sell you 10,000 shares at $1, you sell me 10,000 shares at $2, and we have a $600 million company.
We don't even try to find outside suckers to buy the stock because, come on, everyone knows about pump-and-dump scams.
Instead, on Wednesday, we make some of our shares available to brokers to lend out for short sales.
Clever short sellers, who read Seeking Alpha and Zero Hedge and finance Twitter and watch Bloomberg TV, are like "well this is obviously a pump-and-dump scam and can't really be worth $600 million, come on. But of course you can never short those things, there's no stock borrow and it's illegal to do naked short selling. Oh wait -- there's stock borrow here! And it's cheap!"
So the clever short sellers borrow and sell 100,000 shares of stock at $2 each, hoping to profit when it crashes to zero.
By hypothesis, there are no buyers. But we buy. We buy those 100,000 shares for $2 each, laying out $200,000. 2
Now we own 300.1 million shares, out of 300 million outstanding. 3
On Thursday we go to our brokers and say "you know what, we changed our minds, we want our stock back from whoever you loaned it to." 4
So the brokers call in the short sales.
The short sellers can't borrow the stock anywhere else. We own it all. So they have to close out their short sales by buying in the stock.
But they can't buy the stock anywhere else either. We own it all. So they have to buy it from us.
How much do we charge?
Yeah, $15. Or $20 or whatever, I don't know. We can charge whatever we want. If the short sellers don't buy the stock, they're breaking the law. So they'll pay whatever we ask. 5
They pay $20 to buy back the shares they sold us at $2, making us a $1.8 million profit.
Belize.
What is so pretty about this scheme is that it doesn't rely on anyone being wrong. 6 You never need to find an outside investor to say, "oh hey this nonexistent social network looks like a great buy at $600 million." Instead you just need a few people to say, "wait this nonexistent social network seems terribly overvalued at $600 million and I am going to bet against it." That's ... that's what they're supposed to do, right? Short sellers are supposed to try to root out scams and bet against them. That's good for price efficiency (it keeps down the valuation of scams) and it's good for exposing scams (short sellers have every incentive to expose frauds to the government to drive down the price of the frauds and make money for themselves).
But the "good" short sellers here get hammered, more even than regular pump-and-dump suckers do. I mean, they get hammered in the theoretical story that I just told. They definitely got hammered in the real world of Cynk: Whether or not that story accurately describes Cynk's trading, it does seem (via Zero Hedge) that at least one person is short Cynk, unable to cover now that trading is halted, and paying 12 percent interest to his broker while Cynk is in limbo. 7
And whether or not the schematic story that I told above is true about Cynk, it's relevant to future incentives. If you spot what you think is a penny stock pump-and-dump scam, don't short it! It might be a trap! 8 Just let the price stay inflated and let other suckers keep buying.
Last month my Bloomberg View colleague Noah Smith wrote a post arguing that short sellers are socially useful, and laying out the many obstacles that they confront -- including that "dealers generally have the ability to recall a stock loan at any time" so short sellers "might lose money even though [they] were right." He called for easing restrictions on short selling, and for "centralized exchanges for lending stock shares." I asked at the time: Isn't that actually a case for allowing naked short selling, in which short sellers sell stock without borrowing it first? If you don't have to borrow stock, you don't run the risk of losing your borrow, and you can short safely. This is good for price efficiency and for exposing frauds.
I don't know that I entirely endorse allowing naked short selling; I suppose there's an argument that unrestricted naked shorting would allow increased opportunities for fraud and manipulation, 9 and it would be administratively complicated and just sort of all-around creepy. 10 But next time you see a crackdown on people who short stock without borrowing it, spare them a little sympathy. There are worse things than naked short selling. This might be one of them!
This is really based only on a pure hunch; for all I know it could be exactly right. I just -- there are a lot of trades, the company probably has some outside shareholders, there's some capital intensity to the scheme described here, I don't know. On the other hand, yes, stock borrow costs in Cynk do seem to have once been lower and then been higher, which is consistent with this scheme. In any case, what happened in Cynk is not as simple and elegant as I describe in the text.
Alternatively, there are outside buyers. This is good for us since we don't have to actually stump up the $200,000, but makes the rest of it more complicated and probabilistic since the long shares are not all in our hands. The simpler form is in the text, where we are the only buyers, but we can't really control that, it's a public market. Less pure versions of this scheme should also mostly work though.
This is fine by the way. Happens all the time. See footnote 6 here.
We can do this because regular-way stock borrow is an overnight transaction, so we can change our minds any time. Seeking Alpha describes a scheme in which we raise the stock borrow fee, earning us some income, rather than just calling in the borrow outright, but I've elided that for simplicity.
Incidentally, this reminds me of a beautiful short squeeze that Phil Falcone once ran, not for motives of fraud or profit, but just out of spite. Falcone learned that a broker was shorting some bonds -- called "MAAX zips" -- in which Falcone had a position, and he felt that that was rude. So Falcone bought more than all of the outstanding MAAX zips (that is: all of them, plus some extra that the broker was shorting). Then he called in the borrow on them:
73. Sometime in the spring of 2007, Harbinger, at Falcone’s direction, paid off the debt in its margin account and demanded that the Wall Street firm return any securities it had borrowed, including MAAX zips. …
83. At some point, the conversation turned to the trading in the MAAX bonds. The senior officer asked Falcone how the Wall Street firm might satisfy its obligation to Harbinger. Falcone stated that the Wall Street firm should just keep bidding for the bonds. Falcone acknowledged that the Wall Street firm would suffer some losses doing so, but told the senior officer and the others that sometimes you are just on the wrong side of a trade.
84. In the course of this discussion, Falcone stated that he knew that the short position in the MAAX zips had created a “long” position in excess of the issue size. When the senior officer asked how he could possibly know this, Falcone stated that he was working the position himself and that he (i.e., Harbinger) had acquired approximately 190 million bonds. The senior officer and the other the Wall Street firm personnel were stunned.
Just keep bidding, buddy. Just keep bidding.
Though of course you can combine it with a traditional pump-and-dump: Nothing stops you from working both angles at the same time, except that if you sell enough shares to outsiders you run the risk that they will lend (or sell) their shares to the short sellers and undercut the short-selling scam. (See footnote 2.)
Which, honestly, 12 percent, not that bad. Could be 600 percent.
Not investment advice blah blah blah. Probably just never think about penny stocks, is my personal lifestyle advice.
I think, though, that those arguments are mostly overblown. In particular most people who complain about naked short selling frauds are hopelessly confused. Naked short selling, in practice, is a stock-borrow scam, not a price manipulation scam; if you got rid of borrow requirements you'd get rid of borrow scams. I am not fully confident, though, that there'd be no additional mischief with unrestricted naked shorting.
Particularly: If you could just "create" shares of stock to short, and sell them fungibly with other shares, who would get to vote the stock? Incidentally I owe this and other points in this post to conversations with pseudonymous finance blogger Kid Dynamite.
This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.