By David Dayen
Penny stock gadfly Chris DiIorio tells the SEC about his suspicion that Knight Capital is tanking penny stocks on purpose and racking up unsustainable balance-sheet liabilities. But that leads to another mystery: Why don’t they seem to care?
CHRIS DIIORIO SUSPECTED major broker-dealer Knight Capital of tanking penny stocks on purpose and racking up massive, unsustainable balance-sheet liabilities based on all the stocks it “sold” that it never really had.
It had taken him five years to reach these conclusions — five years of digging through reams of financial data in search of answers to how and why his particular penny stock investment was so brutally crushed. Knight never answered DiIorio’s questions, nor, during the reporting of this story, any of The Intercept’s.
In April 2011, DiIorio decided he had to alert the Securities and Exchange Commission. He reached out to the SEC through its Office of the Whistleblower.
“The core business at Knight has always been naked shorting penny stocks,” DiIorio asserted.
Shorting a stock is betting it will drop in price: You borrow a share, sell it, hope the stock price drops, then buy another share to pay back your loan, hopefully for less than you borrowed it for.
In naked shorting, you sell a share that doesn’t exist and cash the proceeds. Do that enough and you bet the price will drop. Set it up so that it looks like you really sold the share to everyone except an obscure middleman, and the only toxic byproduct is a liability on your balance sheet representing shares you have sold but not yet purchased.
DiIorio believed this represented the secret of Knight’s success. “I told the SEC, ‘If you don’t believe me, ask Knight!’ If their penny stock volumes went to zero, what would happen to their trading profits?”
DiIorio filed a TCR (tip, complaint, or referral) form. Under Section 922 of the Dodd-Frank Act, the SEC has the authority to provide substantial monetary awards to eligible whistleblowers who inform the agency of securities law violations, if the subsequent enforcement actions exceed $1 million. But DiIorio says he wasn’t trying to win back his losses by filing a whistleblower complaint; he just wanted to see the ongoing fraud of investors like him put to a stop.
He also pointed to the threat to the markets from Knight’s thinning capital compared to the billion-dollar-plus “sold not yet purchased” liability. “I said, ‘Knight is insolvent, and this is how I know.’”
Indeed, the firm’s own second-quarter 2011 report to the SEC clearly showed $1.9 billion in “sold, not yet purchased” liabilities — up from $1.3 billion just six months earlier. By contrast, it reported “net current assets, which consist of net assets readily convertible into cash less current liabilities, of $105.1 million.”
Other than a perfunctory acknowledgement of receipt, the SEC did not respond to the TCR. DiIorio sent personal emails to top officials at the agency. One still exists on the SEC’s website, an October 2011 letter to Robert Khuzami, then the SEC’s head of enforcement. “Why won’t [then-Knight CEO Thomas] Joyce disclose to the investing public the nearly [$2 billion] sold not yet purchased liability is where he moves aged fails,” DiIorio wrote. “It is a structural liability and does not in fact ‘fluctuate with volumes’ as [Joyce] has said in several public filings.”