Watch Out, They Bite!

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Brokers are required to ask a client the nature of a stock sale. If it's a short sale, the broker must ascertain if the client has been able to borrow the stock. "I have seen evidence that links Badian and/or Refco to more than 50 stocks that were driven into the ground," says Wes Christian, part of a legal team headed by billionaire Texas tobacco litigator John O'Quinn, who is amassing a case against Badian, other hedge funds and now possibly Refco. Refco declined to comment. Badian didn't come to the door when a TIME reporter rang his bell. His lawyer in the civil cases, Perrie Weiner, says that the suits against Badian have "not a shred of merit" and that courts have consistently dismissed such cases.

After high-profile alleged frauds like Refco's and another this summer at hedge fund Bayou Management, where managers shut down the firm without notice, the call for strict oversight is growing. Largely unregulated investment pools for institutions and the wealthy, hedge funds make big bets--up or down--on stocks, bonds, commodities and currencies. Officials are investigating trading records at 35 institutions as part of their probe into naked short selling. And starting in February, hedge-fund advisers must register with the SEC.

Usually the victims of hedge-fund excesses are their rich customers, who lose when the hedge fund makes a bad bet. But through naked short selling, hedge funds can stir up trouble for any publicly traded firm. In the case of Pet Quarters, the suit alleges that Badian's hedge fund lent the firm sorely needed operating capital on terms that allowed the hedge fund to convert the debt to shares at any time. Through naked short selling, Badian then pushed Pet Quarters stock from $4 to just pennies. Badian balanced his massive short selling with cheap shares obtained after he converted the loan to stock.

Meanwhile, with its stock sinking, Pet Quarters couldn't raise the funds it needed to keep operating, and shut down. CEO Steve Dempsey and an executive who had invested with him wound up filing for personal bankruptcy. "There was nothing wrong with our business," says Dempsey. "We fell prey to the perfect crime." Weiner counters that "most of these companies" that blame short sellers when their stock falls are financially "barely skating by."

SEC data show that such relatively big firms as Overstock.com and Martha Stewart Living Omnimedia have been targets too. Overstock CEO Patrick Byrne has launched a crusade against naked short selling, charging that an unnamed criminal "mastermind" is conspiring against his company. Byrne says the attacks have "put limits on the amount of capital we can raise, how fast we can grow and how many people we can employ." His company's stock, at $76 in January, has tumbled into the low $30s. Byrne filed an unfair-practices suit in August against Rocker Partners, which specializes in short selling. Rocker says the suit is "frivolous" and blames Overstock's disappointing results for the stock slide.