By Brian Bradley
Refraining from private investment in public equity transactions, shunning reverse mergers, and avoiding flashy publicity that may attract “stock pumpers” are a few ways that microcap companies can protect themselves from the potential impact of predatory short-selling, including dramatic price fluctuations resulting from a short squeeze.
Lawyers tell DealFlow that companies can take several steps to safeguard themselves amid a recent string of short-selling practices that have forced microcap companies like Helbiz and Genius Group to take action to blunt the effects that short selling has had on their stocks.
“Wall Street has figured out how to make more money doing this naked short-selling and other illegal practices, and rigging the system, than they have building a company,” said Wes Christian, an attorney for Christian Smith and Jewell who focuses on financial fraud. “That that hurts all of us.”
Companies are examining the practice of naked short selling as the potential culprit behind recent steep hikes in their share prices. Sudden upswings can signal market manipulation and make potential long-term investors wary of buying stock due to a perceived lack of stability in the companies experiencing such volatility.
On Feb. 15, New York-based micro-mobility product provider Helbiz announced it had enlisted Buyins.net, which collects short-selling data and monitors regulatory compliance, after Helbiz found that short selling composed about 49 percent of its daily trading volume, and after its share price surged by 280 percent over a few days in January.
Singapore-based ed-tech company Genius Group on Feb. 22 announced it is suing “various parties” to recover liquidated damages after its share price soared more than 1,000 percent in the first few weeks of 2023.
Naked short selling refers to short-selling a stock without first borrowing it from a lender or verifying that the share can be borrowed. Lenders periodically cannot deliver these trades on schedule because they don’t actually have access to the shares. If additional investors become interested in the shares associated with the shorting, it can increase those shares’ liquidity as marketplace demand outpaces actual share supply. A dramatic share price spike resulting from short-selling is known as a “short squeeze,” which happens when an unexpected price rise in a heavily shorted stock causes a large number of short sellers to exit their positions, pushing the stock price even higher.
What can susceptible microcap companies do to protect themselves from the potential volatility inflicted by short-selling practices?
Hamilton and Associates Law Group attorney Brenda Hamilton said that companies should be as transparent as possible in their disclosures to investors, even when that’s difficult.
“Many microcaps fail to properly disclose insider and other transactions that would cause material dilution to shareholders, such as the issuance of shares to insiders and/or the existence of and risks related to market-adjustable securities,” Hamilton explained. “These types of transactions often result in dramatic price decreases.”
Failing to disclose can leave microcaps open to cavalier outside marketers that embellish the company’s products and position, and to “stock pumpers” whose overarching purpose is to stoke high share prices rather than build the actual value of a company, Hamilton said.
“Rumors run amok, constantly, about [microcaps],” Hamilton said. “Now, a lot of pumpers operate in the microcap space. And they’re able to do that because a lot of companies don’t provide the level of disclosure that they should be providing to investors. And so, the rumor mill starts and spreads like fire.”
When a microcap is hit by a pump-and-dump scheme, perceptions could spread that the microcap had something to do with it, which creates the risk of SEC investigations, leading to legal and compliance costs for the company.
In addition to erring on the side of full disclosure, microcap companies can protect themselves from the negative impacts of short-selling by limiting or even avoiding private investment in pubic equity (PIPE) transactions, wherein private investors buy shares of public stock below current market value.
In such cases, if private investors quickly sell their stock, it can depress the company’s market price, potentially leading companies to issue more stock at a much lower price. Short sellers can also profit from the situation through continually selling their shares and reducing the stock price, potentially resulting in PIPE investors having majority ownership of the company.
In these transactions, private investors can “give you $5 million and then they can manipulate your stock down and then they get repaid in stock,” Christian said. “Ultimately, that’s going to hurt you.”
Both Christian and Dickinson Wright securities enforcement attorney Jacob Frenkel also cautioned small companies to be wary of reverse mergers. These deals can rapidly relieve some of the burden that small companies face in preparing for an initial public offering and quickly increase a company’s stock value and liquidity.
But Frenkel, who previously worked as senior counsel in the Securities and Exchange Commission’s Division of Enforcement, said the reverse merger transactions leave small companies open to “toxic” lenders and shell companies that can exploit the firms’ inexperience in the capital markets.
It may not be easy for a small company with limited resources to conduct the requisite due diligence to identify which shell companies bidding to take them public are shady and which ones are aboveboard.
“The challenge for these companies is really to scrub a shell, to go through the history, to go through all the public filings by someone knowledgeable—not just knowledgeable, but independent,” Frenkel said. “The person who is bringing the ‘clean shell’ to the table has a vested interest in that project….What are the relationships that that person is bringing to the table?”
There is also a risk of reverse mergers related to short squeezes and naked short-selling, Frenkel said.
Certain brokers are “willing to lend the stock, regardless of whether they do or don’t have it,” Frenkel said. “The quick run of the stock right after the reverse merger and frequent and immediate fall of the price becomes a black eye for when (management) is trying to build a company, including for investors on the underlying merits of the company’s business.”