FEDS PROBE SHORT-SELLERS : WALL STREET FIRMS' DEMISE PRODUCES INQUIRY BY SEC.

Byline: Diana B. Henriques The New York Times

For years, the promoters of small public companies have complained about ``bear raids'' by short-sellers, investors who strive to profit from declining stock prices. But despite tales of bears who go even further, illegally conspiring to drive prices down, actual evidence of such misbehavior has been scarce.

That may be about to change. According to a letter and an affidavit filed with a bankruptcy judge in Manhattan, federal prosecutors are conducting a criminal investigation of whether illegal short-selling on a massive scale caused the collapse of two Wall Street firms last year.

The Securities and Exchange Commission and the enforcement unit of the National Association of Securities Dealers also are examining whether the short-selling violated market rules, the documents submitted to the court show.

These inquiries all focus on the collapse in February 1995 of Hanover Sterling and Co., a penny-stock firm, and the consequent failure of Adler, Coleman Clearing Corp., a firm that guaranteed and processed trades for Hanover and 41 other small retail brokers.

The assets of Adler, Coleman are now being liquidated in bankruptcy court.

Firms like Hanover Sterling that deal in inexpensive and typically unseasoned securities known as penny stocks collapse with dreary regularity. The unexpected collapse of Adler, Coleman, however, strained the Wall Street safety net: Adler is the first major clearing firm to fail in the 25-year history of the Securities Investor Protection Corp., the industry-financed agency that insures brokerage customer accounts.

With some 66,000 accounts affected, it is one of the largest liquidation cases the SIPC has ever faced, and the fund's potential losses run as high as $40 million.

The case is crucial to the small but important community of professional short-sellers. Though almost always controversial, many of these investors buttress their skeptical attitude with thorough research; their contrary trades often provide a check on the hyperbole and euphoria of the marketplace.

Only a few small brokerage firms in the short-selling community are involved in the Adler case. Those short-sellers have denied any misbehavior and have, in fact, gone into bankruptcy court to accuse the trustee unwinding the mess for SIPC - Edwin Mishkin, a partner in the law firm of Cleary, Gottlieb, Steen & Hamilton - of improperly shifting SIPC's losses onto their backs.

If their challenge fails, the risks of being contrarian may rise. And if any of them are later found to have committed a crime, the pressure to curb all short selling may intensify.

Luckily for the future law students who will have to study this complicated case in years to come, the players in the Adler, Coleman bankruptcy are fighting over these critical issues with all the decorum of the folks who organized the gunfight at the OK Corral.

In a deposition, John Fiero, owner of Fiero Brothers Inc., one of the short-sellers challenging the trustee, recalled threats he said he had received from the officers of Hanover before it collapsed.

John Moran, who pleaded guilty in 1991 to securities fraud but who was nevertheless an adviser to Hanover in its final days, testified that he was offered a bribe to withhold his testimony from Mishkin. And, Mishkin said, the officers of Adler, Coleman had received anonymous warnings against cooperating with his efforts to liquidate the firm's estate.

For their part, in legal complaints filed in the bankruptcy case, the short-sellers have accused Mishkin of securities fraud for his handling of the estate. And Mishkin has responded with a blistering counterclaim that accuses the short-sellers of using ``unlawful and criminal acts of extortion, economic coercion, threats of physical violence and destruction of business'' and various other means to deliberately kill Hanover and Adler.

The criminal investigation detailed in the court documents was discussed this week by lawyers at a hearing before the bankruptcy judge, James Garrity Jr., who is handling the Adler case.

At the hearing, lawyers for short-sellers had asked the judge to order that information gathered in the bankruptcy case not be shared with federal investigators or market regulators. After the judge balked, they withdrew the request.

Eric Hershmann, a lawyer for Fiero Brothers, said Wednesday that he has had no direct contact with law enforcement.

He said, however, that he is convinced that there is a continuing investigation of the events that had caused the collapse of Hanover Sterling.

``Is Fiero probably one of the parties being investigated? Yes,'' he said. ``Do I think there are numerous others? Yes.''

But, he said, ``our client has done nothing whatsoever wrong to warrant those investigations.''

The seeds of the case were planted late in 1994, when prices were soaring for Hanover's ``house stocks,'' shares of the flimsy companies the firm aggressively marketed to retail customers.

Regulators already have charged that at least one of the stocks - All-Pro Products Inc., founded by Lawrence Taylor, the former football star - was illegally manipulated by Hanover. Then the bears started to sell those shares short in huge amounts.

Anyone who thinks a stock is headed for a fall can bet on that prospect by selling short.

CAPTION(S):

Photo, Box

Photo: (Color) Flanked by lawyers, Edwin Mishkin is in a bankruptcy battle that is illuminating the role of short-sellers, investors who gain from falling stocks.

The New York Times

Box: The Cascade Effect 

When a penny-stock promoter failed in February 1995, the resulting mess unexpectedly claimed its clearing agent as well, leaving stock speculators and a bankruptcy trustee at war over the wreckage, and the blame.

The New York Times