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Patrick M. Byrne is the CEO of the Internet retailer Byrne received his B.A. from Dartmouth, studied at Cambridge University as a Marshall Scholar, and earned a PhD in[…]

Byrne explains the illegal practice of borrowing and selling phantom shares of publicly traded companies. He argues Americans; savings are undermined by naked shorting.

Patrick Byrne: What’s naked short selling? There’s been a myth in the marketplace for 10 or 15 years that there’s a crime going on that’s very difficult to understand. It’s arcane. You have to know a lot of jargon to understand it; but it’s as if the savings of America are in a big fish tank, and some people have figured out how to open a ___________ and just drain it out and nobody up on top can see this is happening. Well it sounds lunatic, and I didn’t believe it. I heard it . . . Some version of that has been floating around the market since the early ‘90s. I didn’t pay it any attention. So people started getting in touch with me about three years ago and asking me to . . . talk to me about it, and telling me to look into and stuff. And I’m saying . . . I dismissed them all. And what eventually happened was one guy got through, and I put him on the speakerphone as I was packing up a suitcase. I’ll never forget. And he described this very arcane thing for about 45 minutes. And at the end of it I was saying, “Fine buddy. I understand, and thanks a lot.” And he could tell I was giving him the brush off. And he said, “Look, I can tell you’re giving me the brush off, so I’m going to give you a series of predictions. And when these come true, you call me. And the predictions are here’s a set of five journalists that are going to call you. And they’re gonna call you and do hatchet jobs on you.” None of them had ever called me before. Secondly, “So you’re going to get these calls Patrick, and you’re gonna find yourself the target of a federal investigation. You’re going to find yourself trading on some foreign exchanges that you never heard of that . . . you know, Bahamas and Australia and stuff. And fourth, the SCC is going to start publishing a list of companies that are seeing a certain oddity occur in their stock. It’s called the Regulation Show of Threshold List. And when they start publishing that in a couple of months, there’s only . . . half of one percent of companies are gonna be on it, but you’re gonna be on it.” And I said, “Okay buddy. Okay, okay, okay. Thanks.” Hung up. Well over the next eight weeks, every one of those stories came true. In fact on that trip that I was packing for, the journalists started calling me. Well that was odd. And you know the power of any . . . The journalists called me. We . . . we became the object of an FTC investigation that was sort of a very flimsy investigation that went nowhere and they dropped it. We started trading on exchanges in Stuttgart and very . . . Munich, Bahamas having nothing to do with that. And when this list came out of . . . and there were only 30 or 40 companies out of 7,000. When the list came out we were on the list. Well the power of any theory is its ability to make predictions. And if someone could make that sort of prediction, you gotta look into it. So I started looking into it. And I spent about three months and buried in it, and I gradually realized the guy was right. There is this crack in the financial system, and the savings of Americans are being drained out of that crack. There is one economist who says . . . excuse me, I mean a __________ economist who says it may be tens of billions. It may be hundreds of billions dollars that have been stolen through this crack. Now what is the crack? A normal stock trade is you’re buying stock from me, you give me money and I’ll give you stock. That’s called settlement. Believe it or not there’s a loophole that exists in the system. And when the time comes for me to give you the stock that you bought from me, I can give you just an IOU basically for some stock. Now you or I couldn’t do this, but big hedge funds and prime brokers have ways of doing this. And all they’re really giving is an IOU and you never know that. You get your brokered statement from Merrill Lynch or Morgan Stanley, and it says you got the stock. Well no stock ever came. All you got was an IOU. It happens . . . it happens only about one or two percent of the time, but . . . And the loophole was probably created for some good reasons – that you want . . . If somebody signs the wrong piece of paper, or somebody’s dog eats their certificate, you want them to be able to say . . . You don’t want the system to freeze. But what happened and what seems to have happened is some hedge funds have figured out how to manipulate this loophole and inject hundreds of millions or even billions of these what are, in effect, fake shares into the market. Now it creates three effects. There’s three problems – a small, medium and a large problem.

It creates a small, medium and a large problem. The small problem is it’s ruined corporate democracy. And there was an article by Bob Drummond in Bloomberg Markets magazine mid-last year that’s called “The Corporate Voting Charade”. Well here is people on the record in the back offices of Wall Street – the transfer agents who actually count votes – that say . . . with quotes like, “This is positively criminal. We regularly do not have any idea who’s entitled to vote and who isn’t. We regularly get two to three times as many votes as there are shares.” Now as crazed as all that sounds, the New York Stock Exchange did a study on 341 elections – found over voting in all 341. Why this is a problem is after WorldCom and Enron and such, the American government solution was to these corporate scandals of the early, you know, 2000, 2001, 2002 . . . was to tighten up corporate governance. Well corporate governance in the Boards of Directors that’s based on corporate elections, which is built demonstrably on quicksand. The whole system is broken, and you can look this article up. And it’s even . . . The SCC just two Tuesdays ago came out and basically said fixing this problem is gonna be our work in 2008. It had a market regulation. __________ said that. So that’s the small problem. Everything I just described is the small problem. That’s a complete hoax. Corporate democracy is not a hoax because of this over voting problem. If you have two . . . If you have all these fake shares in the system, and people voting the fake shares, and they all come in, there aren’t any . . . Believe it or not there aren’t even any rules, and it . . . on which votes get thrown out and which don’t. So that . . . that whole system is a _________, and that’s the smallest of the three problems.

The mid-sized problem is you can destroy companies using this technique. If you . . . If it just really happened by random human . . . human error . . . You see these fake shares, these phantom shares scattered around the market. Like peanut butter spread over a sandwich, they’d be spread. The SCC hired an economist named Leslie _________ to study this, and she came, she did the statistical analysis and saw where they’re concentrated. And she said no way this is happening by random human error. This is . . . it’s . . . it’s massive. It’s endemic in the system, and it’s clearly being used to manipulate. It’s clearly being targeted. And how it is targeted . . . how it is used to manipulate is you go after a small company – a small cat, meaning 300 million, 400 million or less. You . . . you pick a biotech, or a financial company, or just a technology company where it’s easy to create a lot of misdirection and smoke and mirrors. You couldn’t do . . . What I’m about to describe, you couldn’t do to IBM or Microsoft. You can do it to small companies. And you just flood the market with fake shares in their companies and you can crack the market. And if you can do this while you have a couple of your ___________ journalists just write stories after stories banging the company, you can basically drop it to nothing. And if it’s a company like a biotech, the biotech model in America has always been, you know, angel funding, small venture rounds, a couple of venture rounds. It goes public and then it sits at the capital market for five, 10, 15 years as it develops drugs. Well you can snap that life cycle . . . The company will collapse and you can walk out with this market cap. And maybe you can mark out . . . walk out with that market cap two or three times over. So is that going on? Well three years ago the SCC was saying, “This is a myth. This isn’t a myth.” They finally faced enough public pressure that they had to . . . they did . . . they passed a very tepid regulation, regulation show. And it . . . it said that they were gonna start disclosing the names of companies that see . . . that are seeing these excessive numbers and these phantom shares in their stock. And they actually said on their web site . . . The SCC web site actually said we have to grandfather . . . In other words, we have to forgive all of the phantom shares that are already in the system because we’re afraid of the volatility that might result from large, pre-existing, open positions. Now that’s bizarre because a month or a year earlier, they had been saying there are no . . . This isn’t going on. It’s a myth. It’s a myth. It’s all wacky. And then they came out and said, “Well okay. We’re gonna try to do something about it; but we have to forgive all that’s in the system, because if we don’t it’s gonna crack the system.” See I’ve been down this rabbit hole so long it’s hard for me to tell what normal people see. Do you see why that’s contradictory?

Recorded on: 10/29/07