More on the Perils That Confront the Unwary Short Seller

Here Mr. Levine riffs on the same ZeroHedge post I mentioned in "Izzy Kaminska-- So, Your Perfect Short Is Halted, You Know It's Going to Zero But ...'Short sellers, beware – the price also rises"' but he does it better, backwards and in heels.*
From Bloomberg:

Cynk Makes the Case for Buying Friends, Naked Short Selling

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....MORE

*This is not the first time I've used the quote about Ginger Rogers to refer to ML. In "The Last Word On Asness' Alpha, Buffet's Beta and The Failure of Commodity Quants (and how to turn hyperlinks into footnotes)" it was:

I was informed that the theses that took me three five posts to present was wrapped up by Matt Levine in one little package two days prior to my attempts. And he does it better, backwards and in heels. Plus, to get the alliteration in the headline I had to mix up the alpha and the beta.
From Bloomberg...

Finally, for some perverse-inverse reason I am reminded of a story I re-ref'd in "My Favorite Stock Scam Blowhards":

...After doing this a while you don't even need to call in the forensic accountants to spot the weird ones. A bit of backround, Equisure Inc. was purportedly a reinsurer based in Belgium that had, in a remarkably short period of time gone from the NASDAQ bulletin board to the American Stock Exchange by way of a reverse merger with a dormant shell company.

The heart of the scam was to hype the stock by way of news releases to a) gun the stock for the early buyers and b) get the stock on the Federal Reserve Board's list of marginable securities.

That step is a bit more sophisticated than your run-of-the-mill pump and dump because it allows the crooks to borrow against the shares rather than having to sell them. The lack of selling pressure makes it easier to maintain the run-up until the plug is pulled.

Of course the scammers also took whatever petty cash was in the company's coffers.
I never saw a complete accounting but a fair estimate of the EQE take was $100 Mil....