MarketWatch First Take: Overstock founder tried to squeeze short sellers, then sold out when the SEC cracked down

One of Patrick Byrne’s last acts at Overstock.com Inc. appears to have forced a short squeeze that warranted the attention of the Securities and Exchange Commission, and the sell-off of his entire stake over the last three days is now raising questions about whether he tried to manipulate the market.

Byrne, the controversial founding chief executive of Overstock OSTK, -3.85% who has long been at open war with short sellers and Wall Street at large, left the company last month amid some of the strangest circumstances and stories from a tech executive since John McAfee fled Belize. Before he left, though, he installed plans for a “digital dividend” for Overstock shareholders that appears designed to be a shot of pure poison for the people Byrne appears to hate only as much as “the Deep State,” short sellers.

As in all things associated with Overstock, the dividend is not normal. As designed by Byrne, shareholders would receive one share of Series A-1 Preferred Stock for every 10 shares of Overstock common shares, but they would have to set up an account with Dinosaur Financial Group to access an alternative trading system called PRO Securities that is operated by Overstock’s blockchain subsidiary, tZero.

Byrne explained the genius behind his digital dividend in another blog post on his DeepCapture website, at the same time writing a post to Overstock employees about his sudden departure from the company last month and his controversial stock sell-off.

“By issuing OSTK shareholders a digital token, they would have a reason to open digital wallets with tZERO,” Byrne wrote Wednesday from Asia, where he said he is scuba diving. “There is a wonderful business reason, a way to create an incentive for 40,000 people to open accounts with tZERO: if each customer is worth $10,000 (which is about where some brokerages are valued, I am told), that would bring $400 million of economic value into the tZERO firm.”

What Byrne is saying is that the digital dividend is a way to force investors to open a digital wallet and help his blockchain-exchange experiment. What he is not saying is that the scheme would also force investors to recall their shares that were loaned out to short sellers, forcing some to buy to cover their position.

None of this is going over well with investors, especially hedge funds who typically short stocks that they borrow, hoping to repay the borrows after a price decline and make money on the difference. In the last two weeks, Overstock’s shares have been on a roller-coaster ride, as investors started to realize that the digital dividend presented a problem for short sellers.

“The entire dividend is a gimmick conceived by the company’s board to engineer a short squeeze by designing an operational impossibility by short sellers to deliver the digital dividend,” Willem de Vocht, founder of Netherlands hedge fund Mayflower Capital Partners, said in an email earlier this week.

De Vocht said at the time he was covering part of his short position. “There is very little transparency from most brokers, the SEC, the OCC how they are going to deal with the dividend,” he said, referring to the Securities and Exchange Commission and the Options Clearing Corporation.

The SEC appeared to eventually step in, however. On Wednesday, Overstock announced a big change: that investors would not have to hold the dividend for 6 months, as was initially required, but could immediately begin trading the instrument. Overstock also postponed the record date for the dividend, and said it will announce a new distribution date, while suggesting that questions from unnamed “regulators” helped lead to the decision.

Overstock officials did not respond to an email for further comment.

Just hours later, Byrne disclosed that he had sold his entire stake in Overstock for $90 million over the prior three days. Amazingly, he admitted that he did so because he caught wind that the SEC was looking to smack down his convoluted but brilliant scheme.

“They leaked that they were going to Bazoomba our digital dividend,” Byrne wrote in a post directed to his former colleagues at Overstock. “Once that started getting back to me, I realized this: Whenever I have had any question about whether the SEC would or would not do something totally outrageous in order to hurt our company to benefit their clients on Wall Street, they never let me down: they always did the evil thing.”

Evil is in the eye of the beholder, though, and many investors — especially short sellers — are pointing that accusation at Byrne, along with a couple of other loaded words: Market manipulation.

“If Byrne had intent to engineer a short squeeze then profited from selling into the price spike, that seems to be clear-cut market manipulation,” Nathan Anderson, founder of Hindenberg Research, which published a scathing report on Bloom Energy BE, -6.48% earlier this week, said Wednesday afternoon. “I’ve been both long and short Overstock in the past and frankly given these latest events I intend to be short tomorrow.”

“For years, Patrick Byrne has complained about short sellers and has insinuated that they are criminals or nearly so,” said one hedge-fund manager who asked not to be named. “Today we learned that he tried to engineer a short squeeze and when it appeared to be failing, he sold every share of stock he owned. And it’s the shorts who are criminals? Hogwash.”

Beyond market manipulation accusations, there is also the question of insider trading. Byrne said in his blog post that he has not spoken with any Overstock executive since Aug. 23, and as long as he heard that the SEC was poking around from someone outside the company, he is probably in the clear on that front.

“Byrne was out of the company so it is not clear whether he was in possession of non-public information,” said Stephen Diamond, an associate professor of law at Santa Clara University School of Law, in an email. “His comments seem to indicate that HE thinks he had information unknown to the market but unless an insider tipped him, that may not in fact have been the case.” He added, “If an insider did tip him both of them could be in legal jeopardy.”

Byrne, who did not respond to an email requesting further comment, was prepared for his detractors. He said that he saw the digital dividend as a litmus test for the SEC, to determine whether they are in the business of protecting “American retail investors, or are they still protecting Wall Street cronies.” Byrne said the digital dividend was a well-planned instrument, and it has been carefully vetted by a high powered white collar crime lawyer, who has also worked with the Drug Enforcement Agency.

“I did not just dream this up on a whim,” he wrote. “I designed it carefully (and if there be any criminal liability associated with it, let me stipulate right now that I am 100% responsible for this: come after me).

Even if Byrne escapes charges of market manipulation or insider trading, this is still a horrible look: Amid an ongoing investigation by the SEC’s enforcement division into Overstock’s TZero platform and its token offering, the chief executive quit and sold his entire stake while seemingly hiding out in an unidentified Asian country, with plans to invest the money in ways that it may not be recoverable by U.S. authorities. Anyone who was still supporting Byrne as an eccentric, misunderstood genius before this final episode in his bizarre soap opera needs to change their tune: We understand what he is doing, and it is shockingly brazen.