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Washington Examiner
May 31, 2005

Courthouse insiders sell short and sue

Just when you think you've heard all the tricks of the trial lawyer's trade, you flip over a rock and behold a new species of lowlife scuttling around.

That's what The Wall Street Journal did in a 2003 story. It began in 2000 when Donald Reilly, a Florida pharmacist with Eckerd Drug Stores, told state and federal authorities the drug chain was overcharging on Medicaid prescriptions.

Late in 2001, stock analysts and traders heard rumors about Eckerd and began phoning Reilly. Being in a whistleblower frame of mind, he was happy to unburden himself. About then, the stock of J.C. Penney, Eckerd's parent company, began to slide. Was a puzzlement!

Reilly said an analyst at Rocker Partners, a New York hedge fund, asked him to call a private investigator who worked with law firms that specialize in class-action securities litigation. Why, oh why, no one can divine.

The pharmacist also received 30 or 40 calls from Clifford Murray, a Florida stock analyst. According to Reilly, Murray said he was in touch with lawyers planning to sue Eckerd, and he was keeping Reilly posted on the timing and progress. (When asked about this by The Journal, Murray's boss did a Sgt. Schultz routine: We knew nothing, nothing!)

On Friday, Feb. 1, 2002, Rocker Partners went short on J.C. Penney shares. The same day, four law firms filed suit against Eckerd. Bracketing that date, from Jan. 15 to Feb. 15, short-selling of Penney stock increased 43 percent, and the price went south.

The Florida attorney general investigated Eckerd but found no evidence of overcharging on prescriptions. By then, short-sellers had hit and run.

In 2003 The San Francisco Chronicle unfolded an even more elaborate story of a class-action securities fraud lawsuit against Terayon Communications Co. The lead plaintiffs were Cardinal Investment Co., of Dallas, and Marshall Payne, a Cardinal vice president.

The Chronicle reported that Cardinal "sought profit by bad-mouthing Terayon until its stock dropped. They then sought damages through a shareholder class-action [suit] filed because, in essence, the stock had dropped."

In disqualifying Cardinal and Payne as lead plaintiffs, Chief Judge Marilyn Patel of the U.S. District Court in Northern California noted that it wasn't the first time the stock traders had been in cahoots with their attorney, the Milberg Weiss firm, in short-selling schemes.

"As in the Fields case [another securities fraud suit]," wrote Judge Patel, "evidence in the record indicates that counsel had been working with plaintiffs Cardinal and Payne significantly in advance of the filing of the complaint."

Short-selling schemes, which often include seeding the news with bad (and sometimes false) news, create enormous pressure for defendant corporations to settle lawsuits. And settling is big business for plaintiffs' lawyers. Last year Forbes listed 15 securities cases Milberg Weiss had settled between 1998 and 2003. The firm collected $848 million in fees.

Who profits from short-selling, and by how much, only the chosen few know. But cases like these show how easily plaintiffs' lawyers and short-sellers working together can bilk the market. This is an open field for abusing the law, and there's no reasonable doubt that some trial lawyers and short-sellers are playing in it.

The problem is how to close it down. A House subcommittee heard testimony two years ago, and the Securities and Exchange Commission has received two formal complaints from the Washington Legal Foundation, a public interest law firm. So far, nothing has been done. That may be in part because the legal problem is still unclear. This doesn't appear to be insider trading, because plaintiffs aren't insiders (as, for instance, corporate officers are).

What's needed now is a legal theory that points toward a solution. A good start in that direction is made in an article forthcoming in the Suffolk University Law Review by Moin A. Yahya, a law professor at the University of Alberta.

One of Yahya's arguments is especially interesting: This kind of short-selling is fraudulent. He cites the widely recognized duty of a seller to disclose information that might dissuade a potential buyer from buying. Example: A man sells a mobile home but doesn't disclose that the mobile home park is about to be sold, which will force homeowners to move out.

"While everyone who buys a stock takes on the risk of a drop in its price," Yahya says, "no one would purchase shares in a company that is about to be sued by the [short] seller." Put yourself in a buyer's place and you see the point. The old rule of caveat emptor won't do here.

Judge Patel apparently agrees. In disqualifying Cardinal and Payne as lead plaintiffs in the Terayon case, she said: "Indeed, Cardinal and Payne appear to have participated, if not perpetrated, a fraud of their own on the market. Other class members who were not parties to or aware of their scheme may find they have a claim against their purported class representatives."

Yahya outlines several ways the courts, the Congress or the SEC could construe the practice of short-selling the target of a lawsuit. We'll leave it to the legal experts to decide which theory is best. But Yahya's conclusion is dead on: "Plaintiffs and their attorneys should not be allowed to trade in the stocks of their targets and, by extension, anyone who receives such information from either of the parties should also be prohibited from trading."

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