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Saturday, October 07, 2006

THE SHORT SQUEEZE

Have you ever seen a short squeeze? If not, you may soon see one with the stock that I described as "The Easiest Money That You Will Ever Make!" Reliant Home Warranty Corporation (OTCBB: RHWC) is currently poised for a huge potential short squeeze. When I put out the Easy Money story last month, RHWC was trading for 7 cents...yesterday RHWC closed at 18 cents. Were you listening? I sure hope so, otherwise you missed out on some huge gains! Over the past 2 months, I have put out a cornucopia of picks that have all been big gainers. HTRE was up 80%. CKCM was up 52%. TBSI was up 51%. TRID was up 46%. ADAM was up 33%. RADN was up 25%. BRVO was up 22%. You get the point. I found all of these picks with the same strategies that I discuss in my new text The Little Black Book of Microcap Investing. You can grab a copy at Amazon.com.

Anyway, back to the RHWC short squeeze. Over the past few days, RHWC has gained over 157%. That may sound like a huge gain, but you must remember that not too long ago, RHWC was regularly trading above 20 cents. In fact, earlier this year, RHWC traded as high as 44 cents. Since that time, the stock has been heavily shorted and its price has slowly declined. Even when RHWC dipped under a dime, the shorting continued. During RHWC's decline, a multitude of new individual investors entered the stock. Some picked up shares in the 20 cent range while many others picked up shares in the teens and lower. What RHWC now has that it did not have before is a core base of investors. This has led to increased message board activity for the stock and a small measure of recognition amongst penny stock investors. On Wednesday October 4, 2006, RHWC had the 6th most active message board on Ragingbull.com. Without a doubt, investors are starting to take note of this stock.

According to my sources, RHWC is estimated to have a very large short position. Although I cannot confirm this, my suspicion is that there are anywhere from 2-4 million shares shorted for RHWC. When you consider that the actual tradable float for RHWC is an estimated 10 million shares, the short position for RHWC is enormous. With Friday's close at 18 cents, the hedge funds shorting RHWC may get margin calls on Monday. If there is any buying pressure for RHWC on Monday, a serious short squeeze could develop and this stock could see a tremendous spike. You would be wise to keep a close eye on RHWC next week!

Since we are on the topic of shorting OTCBB stocks, let's take a closer look at the subject. According to many investors, short sales are one of the most confusing aspects of microcap stocks. It seems as if the general investing public has no clue as to the rules regarding this matter. To test this theory, I anonymously posted some questions regarding short selling microcap stocks on a few message boards. The responses that I received were quite varied. One respondent confidently informed me that you could not short stocks costing less than $5. Another poster said that it was $4. Many posters flatly stated that OTCBB and Pink Sheet stocks cannot be shorted. My favorite explanation, and this one was definitely the most off-the-wall, was that terrorists were naked short selling US stocks via foreign exchanges in an effort to undermine the US economy! Obviously, there is some definite confusion regarding microcap short selling amongst layman investors. To clear up this confusion, let’s take a look at short selling microcap stocks.

As you all know, I am not an investment professional. I am neither a securities broker/dealer, market maker nor do I work for any type of investment firm. Like you, I am an individual investor. As such, I too had questions regarding the short selling of microcap securities, specifically OTCBB and Pink Sheet stocks. To find some answers, I decided to go straight to the source. First, I called the NASD. Since, according to the SEC, the NASD oversees the OTCBB, I felt that this would be the logical place to start. I called the NASD and a secretary transferred me to the proper department. Of course, no one was available to take my call, so I left a voice-mail. To my surprise, someone from the NASD actually called me back by the end of the day. Unfortunately, this particular NASD representative must have been a summer intern because she had no idea what I was talking about. Each time I asked a question, I could hear her typing on the computer to find the answer on the NASD website. As expected, this person could not answer any of my questions and with each query I was informed to visit the NASD website. I politely informed the rep that I had already visited the NASD website and that I had additional questions. Eventually, the rep gave up and told me to call the SEC. Wow, that was a lot of help! By sheer coincidence, I just happen to live just a few short miles from the NASD’s Rockville, Maryland office. I thought that if I went to the NASD in person, maybe someone could provide me with some answers. I drove down to the NASD offices and requested to speak to someone regarding the short selling of OTCBB securities. An NASD employee asked if I was part of an NASD member firm. Upon hearing my negative answer, the NASD employee told me that since I was not a member of an NASD firm, no one could help me. They did, however, provide me with a phone number to an NASD department that could answer all of my questions. Guess what the phone number was? It was the number to the summer intern!

Well, my NASDexperience was a bust so I took the summer intern’s advice and called upon the SECfor help. I gave the SEC a buzz and reached the ubiquitous secretary. Like the NASD secretary, the SEC secretary thanked me for calling and transferred my call to the “correct” department. The “correct” department must be a secret code word for voice mail because that is exactly what I got. As instructed by the soothing computer generated voice, I left my message with a number where I could be reached. Guess what….I am still waiting for that SEC phone call. I guess they don’t have time to talk to the common man. I thought about heading down to D.C. and paying the SEC a personal visit, but I figured it would be a fruitless endeavor and, besides, the Metro trip costs five bucks. Thanks for the help guys! Even if I was able to talk to someone down at the SEC, I am sure that I would have been given the standard company line of “Go check the website.”

I’ll tell you what, just for grins, let’s check out the SEC and NASD websites to see if they can answer the mysterious questions about short selling microcap securities. First up is the SEC website. Some documents on the SEC website are actually fairly helpful. Regarding short sales, the SEC website notes that a short sale occurs when an investor sells a stock that he or she does not own. To do so, the seller borrows shares from their broker and sells them at the current bid. The seller must then cover their short position at a later date by purchasing shares of the short sold stock. Logically, the short seller anticipates that the price of the stock in question will decline and that they will be able to purchase to cover their short position at a lower price.
The SEChas long recognized that unregulated short selling can undercut the price of a stock and lead to manipulative trading strategies such as “bear raids.” In such situations, a concerted effort is made to short a stock with the intent of creating significant downward momentum to negatively affect market sentiment towards the security. As this occurs, many investors will have stop-loss orders triggered leading to a further decline and others will eventually capitulate with panic selling. To deter such beguiling practices, the SEC adopted rules and regulations that attempt to control short selling. SEC Rule 10a-1 of the Securities Exchange Act of 1934introduced provisions commonly referred to as “tick tests” in an effort to thwart short selling in a declining market. With such tests, stocks may only be sold short on a “plus tick” or on a “zero plus tick.” A plus tick occurs when the price of a short sale executes at a price higher than the most immediate preceding sale while a zero plus tick occurs when the price of a short sale executes at a price equal to the most immediate preceding sale so long as that price was higher the next immediate preceding sale. While this SEC rule applied to most exchange listed securities, they did not apply to NASDAQ listed stocks. The NASDremedied this situation in 1994 with the implementation of Rule 3350, commonly referred to as the “bid test”. Similar to SEC Rule 10a-1, NASD Rule 3350 prohibited short sales in NASDAQ securities at prices equal to or lower than the current best bid when that bid was lower than the most immediate best bid price. In essence, both the bid and tick tests prevent short sales during declining market conditions. Unfortunately, these rules do not apply to OTCBB or Pink Sheet stocks.

Allright! We are making some definite progress in our quest to learn about short selling microcap stocks. To be quite honest, I must admit that the SECwebsite was quite helpful. For this I say, “Kudos to you SEC!” Now let’s see what we can find on the NASD website. I am feeling pretty confident with this one. The NASD homepage boldly states, “We believe that the most potent form of investor protection is investor education.” Well that sounds pretty good. Let’s see if the NASD can educate us. I visit the investor information page and click the frequently asked questions link. This link says that I can get answers to commonly asked questions, so let’s see if “short selling microcaps” is one of them. The top ten most commonly asked questions pop up and eight of the ten questions deal with information for professional brokers. No information on short selling here. Let’s use the search tool and see what happens. I do a little bit of sleuthing and I come up with NASD Notice to Members 06-28-June 2006: SEC Approves New Rule 3210 Applying Short Sale Delivery Requirements to Non-Reporting OTC Equity Securities; Effective Date July 3, 2006. Alrighty then! Now we are talking. Let’s see what this update has to say:

“On April 4, 2006, the Securities and Exchange Commission (SEC ) approved new Rule 3210, Short Sale Delivery Requirements, which applies short sale delivery requirements to those equity securities not otherwise covered by the delivery requirements of Regulation SHO, namely non-reporting OTC equity securities.1 Rule 3210, among other things, requires participants of registered clearing agencies to take action on failures to deliver that exist for 13 consecutive settlement days in certain non-reporting securities. In addition, if the fail to deliver position is not closed out in the requisite time period, a participant of a registered clearing agency or any broker-dealer for which it clears transactions is prohibited from effecting further short sales in the particular specified security without borrowing, or entering into a bona-fide arrangement to borrow, the security until the fail to deliver position is closed out.”

Okay, now we are getting somewhere. Rule 3210 essentially applies the delivery requirements of Regulation SHO to OTCBB and Pink Sheet stocks. So, what in the heck is Regulation SHO? Back to the NASD search feature. Ah yes, here we go, Regulation SHO. Wow, my query returned a paltry 3,642 documents. That should be easy to navigate! A little more searching and I find some information on Regulation SHO.

“Regulation SHO, among other things, imposes uniform delivery requirements on broker-dealers for certain securities that have a substantial level of failures to deliver at a registered clearing agency, referred to as “threshold securities.” Regulation SHO requires broker-dealers that are participants of a registered clearing agency (clearing agency participants) to take action to “close-out” failure-to-deliver positions in threshold securities that have persisted for 13 consecutive settlement days by purchasing securities of like kind and quantity.”

With the implementation of Regulation SHO, the SEC has consolidated locate and close-out rules related to short selling. Rule 203 of Regulation SHO requires broker-dealers executing a short sale to locate securities to borrow before selling and requires broker-dealers to maintain documentation of their compliance with this rule. Additionally, Rule 203 of Regulation SHO also imposes delivery requirements on broker-dealers for securities in which a substantial number of failures to deliver have occurred. This rule requires brokers to close out positions for which they are responsible in securities designated as “threshold securities” after ten consecutive days. If a clearing broker has a fail to deliver position for thirteen consecutive settlement days, said broker is prohibited from executing short sales until the locate requirement is fulfilled.
According to the SEC, “Regulation SHO provides a new regulatory framework governing short selling of securities. Regulation SHO is designed, in part, to fulfill several objectives, including (1) establish uniform locate and delivery requirements in order to address problems associated with failures to deliver, including potentially abusive “naked” short selling (i.e., selling short without having borrowed the securities to make delivery); (2) create uniform marking requirements for sales of all equity securities; and (3) establish a procedure to temporarily suspend Commission and SRO short sale price tests in order to evaluate the overall effectiveness and necessity of such restrictions.” Blah, blah, blah. The documents regarding Regulation SHO go on for days on end. As an added bonus, they are peppered with language only a lawyer could love.

In my quest to dig up information on Rule 3210 and Regulation SHO, I found this interesting tidbit of information. Reports on the web regarding a recent meeting of the Securities Industries Association(SIA) noted that the SIA was successful in its bid to significantly weaken Regulation SHO. It was reported that the SIA fought tooth and nail to oppose language in the regulation that would have required its members to locate and contractually borrow a security prior to executing a short sale. Instead, the language of Rule 203(b) “creates a uniform Commission rule requiring a broker-dealer, prior to effecting a short sale in any equity security, to "locate" securities available for borrowing.” The language of the rule also states that a broker/dealer can execute a short sale so long as they have “reasonable grounds to believe that the security can be borrowed so that it can be delivered on the date delivery is due.” I don’t know about you, but that type of language sounds like it favors the investment professionals and reduces protection for the common man.

A few paragraphs ago I mentioned a “threshold security.” What in the heck is a threshold security? Regulation SHO Rule 2003(c)(6) defines a “threshold security” as any equity security of any issuer that is registered under Section 12 of the Exchange Act, or that is required to file reports under Section 15(d) of the Exchange Act (commonly referred to as reporting securities), where, for five consecutive settlement days: There are aggregate fails to deliver at a registered clearing agency of 10,000 shares or more per security, the level of fails is equal to at least one-half of one percent of the issuer’s total shares outstanding, and the security is included on a list published by a self-regulatory organization (SRO). The NASDAQ publishes a Regulation SHO Threshold Security Listfor NASDAQ-listed issues, OTCBB issues, and Other-OTC issues on each settlement day prior to midnight, Eastern Time. Additionally, in support of NASDRule 3210, the NASDAQ, as the NASD’s service provider, will expand the Regulation SHO Threshold Securities List to include non-reporting OTC equity securities (Pink Sheet stocks) effective July 11, 2006. The list can be viewed at the following link: http://www.nasdaqtrader.com/aspx/regsho.aspx

On June 14, 2006 there were 166 stocks on the Threshold Securities List. As expected, many of the stocks on this list were OTCBB securities, but there were a surprisingly high number of NASDAQ securities as well.

One final item to note on the NASD website regarding the short selling of microcap securities is NASD Notice to Members 06-14-April 2006: SECApproves Amendments to the Short Interest Reporting Requirements; Effective Date July 3, 2006. According to this notice, the SEC has approved amendments to Rule 3360expanding short interest reporting requirements to OTC equity securities. Prior to this amendment, Rule 3360(a) required NASD members to maintain a record of total short positions in all customer and proprietary firm accounts in only NASDAQ securities and required members to report such data to the NASD on a monthly basis. Reporting for OTC securities was not required. For the purpose of this rule, OTC equity securities are defined as any equity security that is not listed on the NASDAQ or a national securities exchange. As the OTCBB and Pink Sheets are technically not exchanges, Rule 3360 previously did not apply to these stocks. Now, with the approval of the amendment to Rule 3360, NASD member firms will be required to report their short positions for OTCBB and Pink Sheet stocks.

Well, I guess the NASD summer intern was correct. You can find information regarding short selling microcaps on the NASD and SECwebsites, but I hope you have a lot of patience and a penchant for legalese. Although I never found a direct answer to my questions, it is apparent that shorting of microcaps including OTCBB and Pink Sheet stocks is definitely allowed. While this is true for the investing professional, most of us common folk are prohibited from shorting these stocks via restrictions from our brokerage firms on marginable trades. Federal Reserve Regulation T requires investors to utilize margin accounts to post collateral for short sales. Most brokerage firms use this regulation to prevent investors from shorting most microcaps. E-Trade, for example, reports that stocks under $2 are not marginable. Schwabb reports that marginable stocks must be traded on a major exchange and cost $3 or more. Scottrade reports that stocks costing less than $5 are not shortable. In effect, by imposing regulations on marginable accounts via minimum pricing and exchange membership requirements, most brokerage firms have indirectly prohibited the common man from shorting the majority of microcap stocks. Each brokerage firm has their own rules and regulations regarding the short selling of securities, so be sure to check with your broker for specifics.

Naked Short Sales

Now that we have discussed short selling microcap stocks, let’s turn our attention to a subject that is even more mysterious and controversial…naked short selling. Nearly every penny stock investor has heard about naked shorting. In fact, if a penny stock begins to tank, you will undoubtedly see someone posting that the stock is being killed by naked shorting. Just what exactly is naked shorting? To find out, let’s check back with our friends at the NASD. During my conversation with the alleged summer intern, I posed a question about naked shorting. Once again, the rep could not answer my question. She kept babbling on about short selling rules (as she read them off of her computer screen), but could not answer any of my questions about naked shorting. To be honest, I don’t think she knew what naked short selling was! Clueless…simply clueless. I gave up that line of questioning and decided to check the NASD website. Utilization of the search feature returned 1,704 documents when the words “naked shorting” were queried. Of course, none of the documents I examined specifically dealt with naked shorting directly and if they did mention anything about it, the information was buried deep within the confines of the document. I did find an NASD document stating “NASD rules restrict naked short sales, that is selling a stock short without ensuring that the stock can be borrowed or otherwise provided for by settlement date, also known as an affirmative determination.” For all intensive purposes, the NASD provided me with little answers for my research on naked shorting. Once again, thanks for the help guys.

Since my NASD search proved relatively fruitless, I turned to the SEC for assistance. As you might have guessed, my attempts to talk with an actual human being associated with the SEC were nonproductive. I, therefore, attempted to utilize the SEC website. By making use of the search feature on the SEC website, my query for naked shortingreturned 1,100 documents regarding naked shorting. Unlike the NASD website, however, the SEC website ranked these documents in order of relevance and some of the documents were easy to read and went right to the point. My review of the documents on the SEC website noted that naked short selling distorts market pricing by creating artificial supply/demand imbalances that benefit the manipulator. Well, everyone knows that. What we need is more specific information regarding naked shorting. By digging a little deeper, the SEC website noted that naked short sellers have the ability to destabilize the market for a stock due to the lack of enforceable restrictions requiring the actual borrowing of securities prior to a executing a short sale. As such, the inability to borrow said securities creates a “fail-to-deliver” situation. As shares are naked shorted and, therefore, are not actually borrowed, the potential exists for the number of fails in a stock to actually outnumber the public float for the stock. This point is easily demonstrated by the very famous story of Robert Simpson. In early 2005, Mr. Simpson filed documents with the SEC concerning his purchase of 100% of the issued and outstanding stock for the Global Links Corporation. As legend has it, Mr. Simpson stuck all of his Global Links stock in his sock drawer for safe keeping. Despite the fact that Mr. Simpson had every share of this company safely nestled next to his tidy whities, this OTCBB stock still somehow managed to trade nearly 60 million shares in the two days following his SEC filing! Can this really happen? You bet it can!

Tom Ronk, founder of BUYINS.Net, a California based internet firm that researches and reports on companies that are targets of abusive or naked short selling practices, has said that nearly 20% of publicly traded companies have been naked shorted between 2005-mid 2006. According to Mr. Ronk, “BUYINS.Net has built a proprietary database that uses list feeds to generate detailed and useful information to combat the naked short selling problem.” Additionally, Ronk noted that, “…actual trade by trade data is available to the public that shows the volume, price, and average value of short sales in stocks that have been shorted and naked shorted.” According to the website, BUYINS.net utilizes its massive database of nearly 800 million short sale transactions dating back to January of 2005 to calculate “Squeeze Trigger Prices” to alert investors to the exact price point when a short squeeze can start. The Squeeze Trigger database collects individual short trade data on over 7,000 NYSE, NASDAQ, and AMEX stocks as well as general short trade data on nearly 8,000 OTCBB and Pink Sheet stocks. BUYINS.net provides this service for a very nominal fee. To date, BUYINS.net is one of the few services available to investors for combating abusive short selling and naked short selling practices. This website is definitely worth a look. Check it out at http://www.buyins.net/

With such a potentially enormous problem, you would think that the mainstream press would focus more attention on naked shorting. One of the biggest whistleblowers regarding naked shorting has been Dr. Patrick Byrne, CEO of Overstock.com. According to his posts on the Overstock.com message board, Dr. Byrne equates naked shorting to counterfeiting shares. Because the naked short seller does not actually borrow the shares that he is selling, these shares are, in essence, simply made up. As such, there is no limit on how many bogus shares that hedge funds can create. Dr. Byrne presents multiple scenarios as to how naked shorting can occur in our “regulated” U.S. market place. One theory essentially states that a “Good-ole-boy” network exists on Wall Street whereby the Depository Trust and Clearing Corporation (DTCC, the agency that keeps electronic records of who owns which stock at which brokerages, and settles the trading of stocks) and various brokers look the other way for favored clients. A second explanation insinuates that hedge funds will list a U.S. stock on a foreign exchange without the permission or knowledge of the parent company and will utilize this listing to naked short the stock in question. When contacted by the DTCC to locate and deliver the shorted shares, the fund will reference the foreign exchange in an effort to buy time and allow their naked short position to continue. While this sounds quite fantastic, many companies have indeed found their stock to be listed on foreign exchanges without their knowledge. In fact, Dr. Byrne noted that in late 2004, Overstock.com was listed on five German exchanges and one in Australia. None of these listings were ever requested by the company.

When I think about naked short selling, I wonder why it takes the CEO of a large company to bring this matter to the attention of the investing public. The media reports on every detail of a celebrity’s life and runs stories on every minor political scandal, yet they rarely mention a problem that is costing honest investors billions of dollars? I wonder why a private company such as BUYINS.net can research and create lists of naked shorted stocks while regulatory agencies such as the SEC and NASD, which are supposed to protect investors, cannot or will not do the same. Others, it seems, are beginning to wonder the same thing. A recent online survey of nearly 2,500 U.S. adults found that 38% of respondents would be more likely to vote for a congressional candidate that would address the issue of naked shorting. Congress, it seems, is starting to get the message. In a 2005 hearing of the Senate Banking Committee, Utah Senator Robert Bennett questioned former SEC Chairman William Donaldson about the potential shortcomings of Regulation SHO by noting ways that collusive brokers could get around the regulation. Perhaps the issue of naked shorting will receive more attention during the elections of 2006.

Simply put, naked shortingis an illegal practice that may be costing investors billions of dollars. Some reports have estimated that the extent of naked shorting on Wall Street could be up to 100 times greater than the alleged $10.5 billion short position of the disgraced financial firm Refco. While this practice appears to affect stocks of all sizes, microcap stocks tend to be commonly victimized as many are fairly illiquid and make easy targets for unscrupulous naked short sellers. Though the SEC and NASD have recently announced new regulations to improve the environment of short sales, it is obvious that the issue of naked short selling still has much to be addressed.

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