Before starting Overstock.com (NASDAQ: OSTK), the closeout e-tailer whose annual revenue has grown from $1.8 million to $760.2 million in just eight years, Patrick Byrne earned a doctorate in philosophy, founded 19 schools, beat cancer, and cycled across the country—four times. But Wall Street’s former golden boy is better known for launching a controversial public campaign against illegal short selling, an initiative that’s made him the subject of intense media scrutiny, lengthy legal battles, and an SEC investigation. Despite accusations of playing the blame game to detract from the negative parts of Overstock’s history, Byrne is more determined than ever to spotlight financial corruption and bring his company back to profitability. He spoke to EQUITIES about challenges in the online space, the future of our economy, and his fight for reform on Wall Street.
EM: What gave you the idea for
Overstock.com?
Byrne: I’ll give you the street version. I had a friend in high school named Charlie who was a badda-bing-badda-boom type of guy. You know, I got a cousin at the warehouse who can get it for you real cheap. Charlie was part of this fringe world called jobbing, cleaning up excess inventories and canceled orders for retailers. So my idea for Overstock was to have a few dozen Charlies bringing products into a central warehouse and selling them online. When you’re a jobber, you don’t get the selection of the mass-market guys, but what you do have can be offered for much less.
EM: What challenges face an online platform?
Byrne: For nine years, I’ve felt like Sisyphus. You roll the boulder to the top of the hill, then sometimes you trip and it rolls back 50 yards, and you’ve got to go back and start again. Getting website traffic is a big challenge. Building clientele is harder than it is for a physical store because there you have a neighborhood or a town with limited choices. But on the Internet, the options are endless. So you really have to offer quality. Even one disappointment in the online space can cause you to lose customers.
EM: Many Internet start-ups fail within the first year. What have you done differently?
Byrne: For four years, we didn’t spend a penny unless it was in a measurable marketing channel. If we spent a dollar, we knew how much revenue it generated. We didn’t put any stock in the idea of branding. We just counted on satisfying customers and word of mouth advertising.
Then in 2003, we started advertising on television because there was more competition coming into our space. It had a rather dramatic effect, so we stayed with it until 65% of Americans recognized our name. Then we cut advertising by two-thirds.
Also, we never really cared about going public. Now that we have, we get to focus on building the right long-term value. We haven’t chased some of the fads that other online platforms did, and I think that’s made a difference.
After visiting Southeast Asia in 2001, Byrne began Worldstock.com, a socially responsible marketplace for handcrafted products created by artisans from developing nations and rural areas of the United States. The artisans receive 60% of the sales price.
EM: What has Worldstock added to your site?
Byrne: It’s often the fastest growing part of the company. Before I became a rapacious capitalist, I was involved in development economics as an academic. I became convinced that development came down to two things: rule of law and women. Development is all about increasing the incomes of women. During a trip to Cambodia, I saw that many landmine survivors were being re-trained as potters and weavers. I realized that their goods could fit into our supply chain and that Overstock would work perfectly for artisan production. It was the single best idea of my life.
EM: Online retailers are expected to benefit as consumers look to spend less at the gas pump. Have Overstock’s sales reflected this trend?
Byrne: We do see ourselves growing rather nicely. In the first half of the year, we grew at 27%. I think the economy’s problems have begun to give us some tailwind, both on the demand side and the supply side. We’re getting more inventory offers, which tells me that others have excess inventory. An analyst once wrote that the people who do discount shopping tend to be either poor or wealthy; the middle class drives to the mall and pays full retail. But during a recession, the middle class tries to hang onto its standard of living by shopping smarter. There’s definitely going to be less driving to the malls and more shifting disposable income online.
EM: Do you think the slowdown will continue?
Byrne: I’m incredibly pessimistic. I think we’re entering a ditch that’s going to take a generation to get out of. Our republic worked pretty well for about 150 years. Then we found that we could organize politically, go to [Washington] D.C., and write checks from the bank accounts of other people. After 50 years, people got smart enough to protest against this. Then we all found one group that can’t protest when we write checks from their bank accounts: the group of future people. One way or another, politics today are shifting costs onto the backs of future Americans, whether it’s education, the environment, Social Security, or Medicare.
Right now, the Feds are reflating the economy with cheap money. Greenspan did it in the 1990s to buffer Y2K, and it gave us the tech bubble and subsequent crash, but we reflated our way out of that. Then we had 9/11, but we reflated our way out of that and got the housing bubble. That crashed, and now we’re trying to reflate our way out of it. I’m surprised as hell that it seems to be working again. It may crack, or it may hold together for another year or two. But I’m incredibly pessimistic about our political institutions. I call this “creeping old fartism,” but I think we may be nearing the end of a 230-year experiment.
In 2005, Byrne publicly alleged that various hedge funds, analysts, and journalists were practicing aggressive illegal short selling in an attempt to profit by driving down the share prices of numerous public companies, including Overstock.com. He filed suit against hedge fund Rocker Partners and equities research firm Gradient Analytics, which filed a countersuit for libel.
EM: Tell us about your fight against naked short selling.
Byrne: Naked short selling isn’t really about short selling. It’s about a crime, just like sexual harassment isn’t fundamentally about sex. And my fight isn’t about Overstock. Everyone says, ‘Oh, this is just a guy in Utah who’s pissed off that his stock went down. Blah, blah, blah.’ Forget me and forget Overstock. Somebody has to dig into this. If you understand the naked shorting problem, then you understand the systemic risks and what it’s doing to America.
EM: It’s gotten a lot of press recently.
Byrne: Well, much of [Washington] D.C. is on our side now. They’ve woken up because they’re between a rock and a hard place. We spent nearly three years going back and forth to D.C., and at first we were educating staffers, but now we’re sitting with senators. It’s over. Stick a fork in it. There are six bulge-bracket banks, and one of them, Bear Stearns, has imploded. The CEO has come out and said that it was destroyed by illegal manipulative short selling. The SEC has launched an investigation into illegal short selling and has had to testify before the Senate. The intellectual battle has been won.
EM: What’s the real issue behind naked short selling?
Byrne: Under our current stock settlement system, you buy stock from me and I deliver it to your broker three days later. But there’s loophole in the system, so that when the time comes for me to deliver that stock, if I don’t have it—maybe I made a mistake, miscounted, double-sold, screwed up some paperwork—I can deliver you an IOU and spend a day or two getting things fixed. You and I can’t take advantage of that loophole, but the big hedge funds, prime brokers, and market makers can.
These guys have figured out how to use that loophole to take down a company like Bear Stearns by flooding the market with IOUs that don’t get cleaned up. These IOUs persist for months or years—in Overstock’s case it was three years. They get traded like real stock, which creates an artificial supply of phantom shares and enables a group of big hedge funds to flood the market with fake shares. If they pick the right company, they can make it disappear and may never have to pay off the IOUs.
EM: What role does the Depository Trust & Clearing Corporation play in naked shorting?
Byrne: It’s a very strange organization. It’s owned by broker-dealers and other industry players, but it’s as if they’ve carved out this black box and moved it outside so they can keep their hands clean. I’ve had state regulators tell me that when they go to the DTCC to try to look into it, the DTCC says, ‘I’m federally regulated. You can’t ask me questions.’ But I’ve had SEC people tell me that when they go to the DTCC, they’ve been told, ‘We’re not regulated by you. You regulate the folks who own us—go talk to them.’
So in the middle of our capital market, there’s this black box that’s regulated by the Feds except on the days it doesn’t want to be. More than a quadrillion dollars passes through the DTCC each year and it’s not clear what the hell goes on inside. We’re talking about a situation that would make our founding fathers roll over in their graves.
I think a lot of stuff goes on in there, but it’s brilliantly conceived, so there’s really not one pair of dirty hands. There’s a dirty finger here and there, but the dirt is spread in this very clever way, so it’s difficult to pinpoint one dirty place.
EM: So regulating the DTCC is key. What else needs to be done?
Byrne: They’ve already eliminated the grandfather clause. Now the option market-maker exemption loophole must be closed. Also, we have to go to a system of real locates. Right now, a short seller can say, ‘Yeah, I’ll short 30,000 shares and yeah, I’ve got a locate because I looked at an easy-to-borrow list.’ But the record of how they found that stock is incredibly flimsy. It’s kind of a nudge and a wink. There needs to be a pre-borrower requirement where the stock is actually borrowed before short selling it. Finally, exchanges must disclose the failure-to-deliver positions for every threshold list company.
EM: The SEC dropped its investigation of Overstock.com for alleged stock manipulation. Did you consider this a victory?
Byrne: Absolutely. We know it was started by the hedge funds. I knew there was nothing behind it. I was going on television and radio, saying, ‘Not only do I welcome this investigation, but I will meet the SEC in court and put them on trial.’ I think their behavior on this issue has been a disgrace to our country. They’ve forgotten their job. They are what’s called a captured regulator. I think [the investigation] was intended to make me back down.
EM: There’s been talk of a merger between the SEC and the Fed. Would that be an appropriate move?
Byrne: I’ve been saying for three years that they should disband the SEC. There’s no way to reform it—you just have to unplug it. But I disagree that it should all go to Treasury. I think that the crime-fighting function should be moved to the Department of Justice. When Roosevelt came up against Wall Street, he said that of all the reforms he tried to make in American society, the fight to reform Wall Street was the hardest. The SEC was born out of a compromise he made, and it only has civil authority.
Nothing scares these guys but an orange jumpsuit. They know that they can make hundreds of millions of dollars naked shorting based on fake locates—and if they’re caught, all they have to do is pay a million-dollar fine.
In 2007, Byrne filed suit against investment banks Morgan Stanley and Goldman Sachs, alleging the firms used naked short selling to manipulate Overstock.com’s share price and seeking $3.48 billion in damages. The case remains in litigation.
EM: You’ve challenged some sizeable financial players. What has it been like?
Byrne: The last three years have been life altering. The manager of a large hedge fund once told me that I’ve become the most hated man on Wall Street. I’ve been told that this is way too big, that I can’t stop what’s going on. I’m going to get Overstock fixed and on track, and then I think I’m going to get out of business. I still want to do the right thing and see this fight through, but I feel despondent that it’s taken three years to convince America that we need a stock settlement system that settles stock. All I’ve said is let’s close these loopholes so people can’t generate endless supplies of fake shares. You would think that wouldn’t be a contentious proposition, but I came out and start saying this and immediately became the target of an incredible amount of criticism. It’s convinced me of how deeply bent the system is.
EM: Where do you see yourself in 10 years?
Byrne: Sitting in a cave or on a 10,000-acre ranch where I can see them coming from all directions.
email to a friend
digg this
