Listening to the Shorts: A Book Note

I've been reading Richard C. Sauer's fascinating new book, SELLING AMERICA SHORT: THE SEC AND MARKET CONTRARIANS IN THE AGE OF ABSURDITY (2010). Sauer was with the SEC for 12 years, and what he said he learned in that time was that short sellers are a valuable resource, whom the agency ignores at its own cost. And at the cost of the public.

Some fascinating material here concerns the case of the Belgian software company Lernout & Hauspie Speech Products NV. The two named gentlemen, Jozef Lernout and Pol Hauspie, founded that firm in 1987, and they took it public in 1995. They specialized, as the name suggests, in speech recognition, text-to-speech conversion, and digital speech compressions.

Sauer writes, "As a foreign company with a U.S. listed stock, Lernout was subject to relatively loose reporting standards....We allow foreign companies to file stale and incomplete information because otherwise they might not grace our markets with their securities, depriving the NYSE of a revenue source, and denying our investors the opportunity to make ill-informed investments in companies they probably can't sue if things go wrong."

It was Marc Cohodes, of Rocker Partners -- and Herb Greenberg, of MarketWatch -- who raised the possibility that something was funny with the company numbers. While looking into the matter, the SEC wanted the help of Belgian authorities so they could get information from L&H's auditor, KPMG Belgium, which was not responding to a nice pretty-please request.

"In the United States, auditors are prohibited from releasing client files without a subpoena or the consent of the client. We badgered Lernout management into providing a letter of consent. KPMG Belgium, however, claimed that wasn't enough to protect it from liability....We asked a Belgian law firm for its opinion and were told the law was unclear. I would eventually form the opinion that all Belgian law was unclear and therefore there is little to be gained from hiring local attorneys." That will be sufficient as a sample of the style in which the book is written.

Many of you probably know the upshot. L&H turned out to be one of the biggest frauds in Europe's financial history: the biggest fraud, until Parmalat came along to take the crown. Cohodes, in short, was vindicated.