Overstock: What About the Losses?

The big news for Overstock in the final days of May this year was victory in an appellate court of the state of California regarding its "Sith Lord" lawsuit.

(I haven't written about this matter since I moved over from blog-city, so if you know Pragmatism Refreshed only in its blogspot variant you may not know about the Overstock imbroglio. I'll remedy that today.)

On Aug. 11, 2005, Overstock.com, a web-based discount retailer, (known for the sultry woman who says "it's all about the O" on television) and one of its investors, Mary Helburn, filed a lawsuit in Marin County (Calif.) alleging that David Rocker and various associates and vehicles under his control had conspired to drive down Overstock's stock price in order to profit from short sales.

It alleged in particular that (1) Overstock was in cahoots with a purportedly independent stock analyst firm called Gradient Analytics, (2) Gradient allowed Rocker to write reports blasting Overstock, which Gradient then distributed as its own, (3) the fact that they were coming from an 'independent' source gave the charges credibility and did lower the price, enriching Rocker at the expense of such "long side" investors as Ms Helburn. And of course at the expense of the company itself, since (4) a lower stock price creates capital-raising difficulties going forward.

Rocker and Gradient have denied the charges.

On August 17, Mr. Byrne appeared on the program "Street Signs" on CNBC, with Ron Insana. Byrne gave a jaw-dropper of a performance. He spoke of a conspiracy among journalists, hedge funds, research firms, all headed by a mysterious "Sith Lord" whom Mr. Byrne refused to name.

The Sith Lord, in the terms original significance, is the evil mastermind of the recent Star Wars movie, who seduced Anakin Skywalker, turning him into the Darth Vader we all knew and feared in the 1980s when we watched the good Star Wars movies. Byrne seems to be casting himself as Yoda, the implacable enemy of the Sith Lord.

This would be just an amusing cat fight between Messrs Rocker and Byrne, were it not for the fact that it has tapped into broader animosities about (a) short selling as a practice and (b) "naked shorting" as an abuse of that practice.

Very briefly: most short selling involves borrowing stock certificates. Suppose I borrow a certificate of Overstock from a broker, and then "short sell," i.e. promise delivery of the stock to someone who believes in the company's prospects, (let's call her Mary) in 60 days, at today's price. Between now and then, I have to buy it outright from the folks I had borrowed it from, and then make the delivery. So my profit requires that the price of the stock fall after I make the deal. I buy it at the lower price, sell it to Mary at the higher earlier price, and use some of that profit to cover the cost of borrowing the share in the first place.

The significance of borrowing the share is enormous. (Or, as Yoda would say, "significant, this is.") It ensures that the share exists -- I'm not trading on imaginary stock. The fact that I've borrowed and am in possession of a share of the stock protects Mary against a fail-to-deliver. It also limits the amount of shorting that would net a profit, because I'm not just betting on a fall, but on enough of a fall to cover the securities-borrowing cost.

The controversy over shorting, and over the spreading of rumors or biased analyses for which shorters are always blamed, gets intertwined then with another controversy, over how much "naked shorting" takes place -- i.e. how many shorts don't borrow the stock before selling it. Resolution of those issues apparently will have to wait for the various lawsuits to wind their way through the courts. In the interim, pitched battles involving complex conspiracy theories, name-calling and the occasional rational argument are being fought online.

As for the independent research firm that was allegedly bribed to badmouth Overstock, it of course denies the accusation. Fortunately for those of us who've been trying to cover the story, although the short sellers themselves have been very closed-mouthed about the lawsuit, the researchers, as alleged co-conspirators, have been quite vocal. A typical press release from there side put it thus: "Gradient researches, draws conclusions and issues reports based on work conducted by highly-trained analysts who report to Gradient and Gradient alone. We will continue to do so, despite efforts like these to discredit the valuable and insightful analysis we provide to investors and shareholders.”

Anyway, in late May 2007, one year and three quarters after the lawsuit was filed, Overstock won a victory in a state appellate court that may end Gradient's and Rocker's hopes of bringing an early end to the lawsuit on procedural motions. This may have to go through the process of "discovery" and to a finding on the facts.

Still, I have to ask: what about the fact that Overstock keeps losing money? Doesn't that make it a bad idea for an investment, alleged conspiracies notwithstanding???

In the first quarter of this year, Overstock lost more than $17 million. That might be tolerable if Overstock were moving in the right direction, "you have to lose money to make money" and that sort of thing. But its moving the other way. Its first quarter losses for 2007 are $3.5 million greater than its first-quarter losses for 2006. "You have to lose money in order to lose larger amounts later," seems the implicit motto here.

There may, for all I know, be problems and abuses among short sellers. It would be surprising if there were none, since they're made of the same fallible human flesh as the rest of us. But that isn't the problem with the Overstock stock price. Its problem is that it has a business model that works like a yard sale. Overstock's only real reason for existing at this point is as a vehicle for its lawsuits. Its remaining investors might reasonably hope for a decent "go away" settlement down the line -- if not from the Rocker/Gradient defendants, perhaps from those in another of its lawsuits, notably one against most of the brokerage firms on Wall Street.