Want the news summarized?
Subscribe to The Morning Report.

Looking to make some extra bucks during this recession?

Here’s an idea: Investigate a public company and find some damaging dirt about its operations. Make a bet that the company will go down the tubes. Publish a report that convinces the company’s investors to dump their stock. And then rake in the dough.

If it sounds like a plan, keep this in mind: It’s been done. This is the strategy used by San Diego’s Barry Minkow, the onetime swindler behind a massive Ponzi scheme who now investigates corporate fraud. He’s also a senior pastor at an evangelical church.

I interviewed him late last year and followed up this month as he launched an investigative journalism site and got sued for a cool $270 million by the weight-loss company Medifast. It accuses him of defamation and stock manipulation.

So wait a minute. Is what Minkow is doing legal? And could he lose that lawsuit? Here’s a rundown on what he does, how he does it and how he — at least up until now — has avoided landing in the slammer.

Minkow’s Fraud Discovery Institute starts by investigating a company it thinks is up to no good. Then what happens?

The institute releases reports about companies (and will publish stories through its new investigative journalism outfit). The media — including the financial blogosphere — pays attention to Minkow and often publicizes its findings.

Investors seem to be paying attention. After he released a report about Medifast, the company’s stock fell drastically.

At the same time, the institute may “short-sell” the stock of the company under investigation, betting that it will fall in price.

What does “short-selling” mean?

That means Minkow is reversing the old advice that says “buy high, sell low.” He’s tries to buy high and sell low, which is more complicated than simply buying a stock and hoping its price will go up.

Let’s imagine a company called Flowtap Waterfine Inc., which sells faucets. Its stock is worth $10 a share, but you think it will go down in price because there’s some funny business going on with its accounting.

You borrow 10 shares of Flowtap from a broker. Then you sell them at $10 a share, the current price. You just made $100.

In a few months, Flowtap’s chief financial officer gets convicted of embezzlement and goes to the hoosegow. The stock dives to $2 a share. That’s when you buy 10 shares at $2 and return them to the broker, making good on the loan.

Your profit — $100 minus the $20 you spent on the shares — is $80. (You’ll owe the broker something too.)

Why is this a gamble? Because you’ll be in the hole if the stock price goes up beyond $10.

It’s legal to short-sell a stock of a company that you’re bashing in public?

Yes.

Minkow “is like any other investor who gets information from public sources. If he forms a judgment that this company is going down the drain, he may short sell,” said Tamar Frankel, a law professor at Boston University School of Law. “It’s just as if he decides that this company is going to be the best in the world. He can buy it and hold it.”

Minkow does make sure to disclose that he has a financial interest in the fates of the companies investigated by his institute.

Do other people investigate corporate fraud and make money like Minkow tries to do?

Yes. Sharesleuth.com also investigates companies, and its owner, sports mogul Mark Cuban, may benefit if their stock prices decline. A Wired Magazine story in 2007 said the site had “become required reading for a small but influential cadre of securities analysts, stockbrokers, money managers, and journalists.”

But isn’t it ethically questionable to profit off a company’s demise, especially if you had something to do with it?

Plenty of people are critical of short-sellers, including those like Minkow who publicize their thoughts about a company’s failings. Some accuse them of being bottom-feeders with obvious conflicts of interest.

But Gary Weiss, a financial journalist and author, said that can be a case of shooting the messenger.

“A short seller comes by and says the emperor has no clothes,” said Gary Weiss, a financial journalist and author. “How can you blame the short seller when it’s really the emperor who’s at fault?”

And consider this: Why would it be wrong to publicize a company’s failings when it’s OK to say a company is great and everyone should go buy its stock?

So Minkow is in the clear when it comes to the Medifast lawsuit accusing him of defamation and stock manipulation?

Not necessarily. The key will be whether Minkow’s allegations are true, Frankel said. Medifast “will have to show that he had the intention to mislead the public in the sense of affecting the price.”

There’s another factor to consider. Journalists, among others, like to say that the truth is the ultimate defense in a libel or defamation suit. But even if a defendant wins such a suit, he or she may face huge costs in terms of legal fees and lost revenue due to hours spent developing a defense case.

Contact Randy Dotinga directly at rdotinga@aol.com and follow him on Twitter: twitter.com/rdotinga.

Leave a comment

Your email address will not be published.

This site uses Akismet to reduce spam. Learn how your comment data is processed.