On August 7th, Sharesleuth.com released their first investigative report. The blog, written by Chris Carey and backed by billionaire Mark Cuban, chose Xethanol Corp. (AMEX:XNL) as its first target.
Xethanol is a small New York company whose stock has been riding the ethanol wave. Carey alleges that Xethanol is in no condition to meet the aggressive production schedules proposed in their recent press releases. Furthermore, Carey disputes Xethanol’s technology and ability to build a profitable process for converting waste into ethanol. Perhaps most damagingly, Carey points out the shady pasts of many of the executives and investors close to the company.
While the Xethanol story is an interesting one, what’s more interesting to me is ShareSleuth itself. The writing, billed as investigative journalism, has much more meat to it than your average financial analysis report. And the site’s business model, where Mark Cuban publicly shorts the stock of the companies covered in the reports, has stirred up quite a debate around the ethics and legality of financial reporting.
The Report
The report itself is a damning piece of writing. It seems that investors and executives involved with Xethanol had as much of a criminal resume as they did business resumes. Many of the people close to the company had been investigated by the SEC in the past. Some had even done jail time. Their business resumes weren’t actually that accurate anyway, as Carey writes that two of Christopher d’Arnaud-Taylor’s (Xenthanol’s chairman and CEO) previous employers “could find no information confirming his employment, in any capacity”.
Add to this the articles allegations that Xethanol is in no way ready to meet the production schedules they’ve been hyping. Carey cites the lack of scientists in the company and lack of R&D spending relative to other waste-to-ethanol hopefuls. The article also states the following about Xethanol’s alleged “testbed for evaluating potential feedstocks and technologies”:
When we paid a visit to the operation June 30, we found the doors locked, the building dark and no employees present. A large filtration unit sat on a grassy patch outside the plant, and an air system serving the building was in obvious disrepair.
Sounds like the type of company one would love to short. Which brings us to…
The Business Model
Here is a quote from the section titled “What We’re About” from the blog’s initial post:
We’re looking for companies that were built for fraud, for executives who are enriching themselves at shareholder expense, and for businesses whose behavior runs counter to their stated objectives or to the public interest.
It seems the site is planning to make money mostly on the investments made based on the information gathered from the reports (other money-making possibilities include using the investigated material for future HDNet shows or Magnolia Pictures films, a la Enron: The Smartest Guys in the Room). Mark Cuban, the majority partner of ShareSleuth, owner of the Dallas Mavericks, HD-Net, and the popular blogmaverick blog, will sometimes short the stock of the companies investigated. Here is the disclosure which was made along with the Xethanol piece:
Disclosure: Mark Cuban, the majority member of Sharesleuth.com LLC, sold short 10,000 shares of Xethanol’s stock at a time when the price was around $12.65. Cuban also has sold short about 25,000 shares of UTEK Corp.(UTK: AMEX), a Florida company that is a large Xethanol shareholder.
The order of operations at ShareSleuth is as follows:
(1) Chris Carey investigates.
(2) Mark Cuban makes investments based on the research.
(3) The research is released on the blog.
Some allege that this is the reverse of a pump-and-dump scheme. The reports released by ShareSleuth have the ability to move the price of a stock greatly, and Mark Cuban stands to gain on the short term sell off. However, Cuban states:
My intention is not to cover based on any short-term swing in the price of either stock. I will stay short until there is a material change in the operations of either company. My goal is to never have to cover.
While I believe him, I would encourage him to formalize his trading rules in a way similar to Jim Cramer’s Action Alerts Plus rules/restrictions. Cramer’s rules are stated during every television and radio show. They clearly state, among other things, that Jim “must hold all securities in the Action Alerts PLUS Portfolio for at least one month, and is not permitted to buy or sell any security he has spoken about on television or on his radio program, for five days following the broadcast.” So far, I don’t see any terms of use or similar policy document on the ShareSleuth site other than what’s stated in their first post.
ShareSleuth did delay the release of their first publication to include 3rd-party fact checking and supposedly get their legal ducks in a row. Without an ironclad legal position, Carey and Cuban could be getting into some controversial business. But then, that’s what Mark Cuban does. He is so far no less controversial in the basketball world or the movie industry world as he will potentially become in the financial world.
The Bigger Picture
Besides a possible SEC investigation against Cuban and Co., I think there is potential for ShareSleuth and its work to have a larger effect on the financial world. Cuban wrote a follow-up post at blogmaverick.com, Business Journalists should be thankful, in which he proposes that Hedge Funds and other large institutional investors will be inspired to take on more journalist-types for their research. Perhaps the financial media outlets will pick up on the trend as well and include more fact-based reporting in their broadcasts. Perhaps we’ll see more sites like ShareSleuth and StockLemon (a similar site which has been around much longer) crop up.
Back to Ethics
Even if the business model setup by Cuban is in fact legal, is it ethical? Some of the commenters on ShareSleuth and Cuban’s blog have pointed out that while Cuban is shorting the stock, he is in effect backing the bad guys while hoping for the stock to go down. Here is part of a comment made by elvistcb35_77:
In the report D’Arnaud-Taylor and his wife are demonized for selling the company shares into the open market, and maybe rightly so. But how are the buyers of Mr. Cuban’s short sell any less a victim than the buyers of D’Arnaud-Taylor sells? If both are aware that the underlining business that the shares represent to be a perversion of truth are they not each participants? (though Mr. Cuban on lower level understandably so). Is not the instrument of the fraud the stock itself?
Of course, Mark Cuban himself taught us that the stock market is for suckers and there is always someone else on the other end of your trade. Even when you are going long a stock, there must be someone to buy it. Why are they buying it? Are they really less smart than you are?
But then robbing someone of the potential profits they would have had by holding on to the stock they sold you (when you go long) seems like less of an offense than selling short to a guy who stands to lose money outright. Selling short is like playing the “don’t pass” line in craps, where you bet that the casino is going to win. While it is often a good play mathematically, it will never sit right with some people. You will always be seen as someone betting against the rest of the players.
The folks at Zangani hit the nail on the head:
While critics and investors are quick to attack short sellers feeding the market negative information, even if it is true, it’s rare that anyone complains about people unleashing positive information into the market, even when there’s no corroboration from the company.
Investing is a zero-sum game. Someone must be on the losing end of every winning trade, and that goes for both long and short positions.
Conclusion
ShareSleuth is an interesting site. The writing should prove to be informative and entertaining. The site’s business model and high-profile backing should drum up some controversy that will also be informative and entertaining. We’ll have to wait to see what kind of effect the site has on the investing world. But if Cuban’s forays into basketball and movies are any indicator, we should be in for some fun.
Further Reading
Cuban acuses Gary Weiss of editing Mark’s Wikipedia entry at blogmaverick.com
Gary Weiss’ response to the above at Gary-Weiss.com
A good place to start for all of Gary’s cricism of Mark and ShareSleuth at Gary-Weiss.com
Xethanol Responds to ShareSleuth Posting at Zangani.com