Short High, Buy Low, Break the Law

"Short high, buy low" sounds like a great investment strategy, but doing so at the same time can cost you all your profits and then some.

The Securities and Exchange Commission said Tuesday it had discovered 23 firms it believes shorted stock of companies before buying shares of the same firms in public offerings.

That's a big no-no. There's a specific regulation -- Rule 105 of Regulation M -- that prohibits shorting a stock right before purchasing shares in a public offering.

When companies make secondary public offerings, it typically takes the investment banker awhile to find buyers and determine a price. During that time, investors could sell shares short at the current market price and then buy the secondary offering, which typically price lower than the market.

The investor would end up with a neutral position, but since the short sale produced larger proceeds than the cost of the purchase, the investor makes money. In many cases, the investing firm wouldn't cover all the purchased shares, but the ones that were covered with a short were essentially risk free (assuming the public offering priced lower than the market price).

A Brazilian firm, JGP Global Gestao de Recursos, for instance, allegedly shorted 721,823 shares of Arcos Dorados in 2009 and then bought 1 million shares of the offering a few days later, netting more than $1 million. JGP is also accused of shorting Citigroup before buying its 2009 public offering and shorting CEMEX  before buying its 2011 public offerings. All told the investment firm made more than $2.5 million on the three investments, according to the SEC.

All but one of the 23 firms have agreed to settle the charges to the tune of $14.4 million in monetary sanctions. In addition to disgorging their profits, the investment firms agreed to pay interest and penalties. JGP, for instance, owes interest of $129,310 and a penalty of $514,000.

A victimless crime?
Much like insider trading, the main argument for the regulation is that it's unfair to take advantage of information available to only a small number of people. Interestingly, while the SEC tends to go after inside traders, often seeking jail time, there doesn't seem to be any individuals at the firms being accused of wrongdoing. Must be nice to have your boss cover your butt.

You could argue that shorting right before the offering drove down the share price, which resulted in a lower price for the public offering, hurting the company and its diluted shareholders.

I'd counter that the investors were able to accept higher prices for the public offerings because they knew they were already short. If the investors were just purchasing the shares, they'd need a large enough discount to fair value to believe they were getting a deal worthy of the risk of owning unhedged stock.

Keep in mind that many companies often make secondary offerings out of desperation. At the time of the offerings, Citigroup was down 45% from the previous year and CEMEX was down 28% from the previous year. Arcos Dorados was up but had only been listed on the NYSE for a few months when it raised more cash. The capital raise helped Citigroup, which is up substantially from its 2009 offering, but the other two currently trade lower than when they raised capital.

I don't know how widespread this practice is, but if it's a common practice that the SEC crackdown eventually stops, companies desperate for cash may find it harder to raise funds.

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Fool contributor Brian Orelli has no position in any stocks mentioned. The Motley Fool owns shares of Arcos Dorados and Citigroup. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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