Watch Out, They Bite!

(3 of 3)

But small companies are especially vulnerable because even modest trading can move the stock. Naked short selling "has got to push the price down," says James Angel, associate professor of finance at Georgetown University. He says the rate of short selling has nearly doubled in the past five years, to 36% of all trades. In the same period, assets held in hedge funds, which are active short sellers, more than doubled, to more than $1 trillion.

Illegal naked short selling, according to Robert Shapiro, a former Under Secretary of Commerce, has cost investors $100 billion and driven 1,000 companies into the ground. Shapiro is on O'Quinn's legal team, which has brought 16 cases against hedge funds and other traders. For their part, the hedge funds say that they have done nothing illegal, that the stocks they sell short ultimately drop because the companies are not doing well.

Papers filed in the Sedona case offer a rare glimpse into the cut-throat nature of naked short selling. Federal prosecutors, in a case that remains open against Thomas Badian but has been dropped against his brother Andreas, charge in the complaint that Andreas ordered brokers to sell Sedona shares short with "unbridled levels of aggression." After the stock had "collapsed," according to the complaint, he congratulated the brokers on a "good job" and instructed them to be "merciless" in selling the stock a day later.

Around that time, Thomas Badian was living the high life. Registered in his name was a two-seat 1998 Aston Martin. "He told me he liked to put the top down and take a long drive," recalls Pet Quarters' Dempsey. "I asked him if he'd like to drive out to Humboldt [Pa.] to take a look at our distribution center. For a guy who had just loaned us money, he seemed strangely detached. He never did make the drive." He had other plans for Pet Quarters. Just not the ones Dempsey had imagined.