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The big short: How a National Bank analyst found himself in the crosshairs of a group of short-sellers

Marc Cohodes, the former head of Copper River Management and an aggressive short-seller, is seen on his a farm in Sonoma County, Calif. Manitoba-based Exchange Income Corp. saw it's stock price fall 6.3 per cent after Mr. Cohodes's placed the company on his hit list in July.

Thor Swift/The New York Times

Three guys walk into a bar and start talking about investing.

It sounds like the beginning of a joke. But when three men met at Earl's in Toronto's financial district one night this summer, one of the men was secretly recording what was being said. That conversation has now become a flashpoint in an intriguing battle between a Manitoba company and a band of critics who are trying to drive down its share price.

The party of three included Trevor Johnson, an analyst at National Bank Financial who has been a long-time booster of Exchange Income Corp., a Winnipeg-based industrial company with a market capitalization of $1-billion. The other two men were short-sellers who had bet against the stock in the belief that Mr. Johnson's investment case is wrong.

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During the conversation, Mr. Johnson spent the bulk of the time explaining his bullish case for Exchange Income. But he also offered some unvarnished views of his employer – "greedy," he said, for the interest rates it was charging short-sellers – and of the potentially sharp downside to owning Exchange Income shares if the company were to lose the ability to raise new capital.

Exchange Income runs a number of aviation and manufacturing businesses in North America, including air services that serve Canada's north. A former income trust, the company has a following among many retail investors, thanks to a large and growing dividend that pays 17.5 cents a share every month.

It also has an aggressive strategy of deal-making, and has funded its expansion with frequent trips to the equity and debt markets. The company has raised more than $630-million from debt, finance leases and new shares since the beginning of 2015. Much of that money has been raised with the help of National Bank Financial, which was the lead underwriter on two big equity deals in the past three years, according to Bloomberg data.

Asked by the short-sellers what would happen if Exchange Income lost its access to the capital markets, Mr. Johnson responded: "It's ten bucks." Exchange Income currently trades for $33.17, and the analyst's price target is $42.

In the conversation, Mr. Johnson also suggested that National Bank Financial, in an attempt to please Exchange Income and its chief executive Michael Pyle, was moving Exchange Income stock out of brokerage customers' margin accounts, where they could easily be lent to short-sellers, and into cash accounts. By doing this, a brokerage firm can squeeze the supply of shares available to short-sellers – and drive up their cost of borrowing stock.

Short-sellers borrow shares they don't own and sell them in order to profit if the price goes down. But as with any loan, they must pay interest, which varies widely depending on the security. If there is not much stock available to be borrowed, the price can be high. The Globe and Mail has seen data from multiple short-sellers that show their borrowing costs on Exchange Income skyrocketed over the summer.

National Bank says its management didn't direct anyone to support Exchange Income in this way – but says two of its financial advisers participated in what might be a broader Bay Street effort to prop up the shares.

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The firm and its analyst have now become the targets of Marc Cohodes, an aggressive short-seller from California who added Exchange Income to his hit list in July after a long-running campaign against mortgage lender Home Capital Group Inc.

Mr. Cohodes took the squabble public when he featured Mr. Johnson at a New York City investment conference in October. He compared the National Bank analyst with former Merrill Lynch analyst Henry Blodget, who was barred from the securities industry in 2003 after it emerged that he had privately expressed strongly negative opinions on stocks that, in public, he was telling investors to buy. (Mr. Johnson declined to comment for this story.)

"The people and firms involved in this manipulation are all underwriters or bankers of Exchange Income and have a vested interest," Mr. Cohodes said.

He said his cost of shorting Exchange Income has soared, with investment banks charging 2 per cent on the lent shares in June to 32 per cent in September. (Mr. Cohodes says he's currently paying 22 per cent interest to borrow the shares; his attorney sent a letter to National Bank in October, claiming the bank may be violating U.S. securities laws that govern "market manipulation.")

Another investment firm that is shorting the stock provided The Globe with data showing the interest rates it paid at each of two banks were around 1 per cent to 2 per cent as of the beginning of June. That rate climbed to double digits at both by early August, and spiked to roughly 30 per cent in late August.

Brian Davis, co-CEO of National Bank Financial, said: "There is absolutely and has been absolutely no strategy on the part of National Bank's management to try and systematically transfer [Exchange Income] shares from margin accounts to cash accounts to somehow curtail availability of stock for short-sellers."

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Mr. Davis said, however, that National Bank has determined that "a couple of advisers" moved "about 200,000 shares" of Exchange Income from margin accounts to cash accounts. The National Bank clients were long-term Exchange Income shareholders, and the moves were made in consultation with the clients, Mr. Davis said.

"If you are long-term holder of [Exchange Income] I can understand why an investment adviser would recommend this to his or her clients – because if you're a long-term holder, wouldn't you want to support the stock in some manner? There's nothing illegal or in my view inappropriate when an investment adviser in consultation with his or her clients do something like that."

National Bank never stopped lending Exchange Income shares to short-sellers, Mr. Davis said, and "we were not pressured to do so" by the company. "They might have preferred that we not participate [in stock lending], but we have an obligation to other clients who actually want us to do that activity for them and so we carried on."

However, he said, "we are aware that there were efforts by people outside the firm not under our oversight." Mr. Davis says the two National Bank investment advisers "responded to an initiative" driven by investment advisers at other retail brokerage firms to move shares out of margin accounts. He would not name the other firms.

A spokeswoman for Exchange Income declined to comment.

The company has been the target of short-sellers and other critics before. In the summer of 2014, Veritas Investment Research Corp. published a report questioning the viability of the company's cellphone-tower business and suggested the company's dividend was at significant risk. Exchange Income sold off the U.S. part of the tower business, used the proceeds to add to its aviation business, and saw its shares post strong gains in 2015 and 2016. It is down 21 per cent so far this year.

Mr. Cohodes's attack, however, has raised the stakes. The short-seller argues the company's cash flow has never covered its dividend, pointing to operating cash flow minus all the company's capital expenditures. Exchange Income, in presenting its results, says the bulk of its capital expenditures are for growth initiatives, not the maintenance of its business, and therefore should not be considered in evaluating the viability of its dividend.

The difference is significant: Exchange Income said Wednesday that its "free cash flow," defined by excluding all capital expenditures, was up 22 per cent to $55.8-million, and its dividend payout of 45 per cent of that was "the strongest level in a decade," Mr. Pyle said in an earnings call in which he also called this "the best third quarter in our history." Free cash flow minus "maintenance" capital expenditures was just less than $36-million.

Mr. Cohodes argues the company's free cash flow was actually negative, when $55.8-million in total capex is considered. While the company was able to net $15.3-million against that total capex by selling assets, Mr. Cohodes notes that accounts payable swelled by $23.6-million in the quarter, as Exchange Income paid fewer bills.

"You could never find an accounting book or a professor who agrees with what they say free cash flow is," he says.

In the recording from Earl's, the short-sellers ask Mr. Johnson, "Why would the borrow be so expensive?" referring to the rates banks charge the short-sellers to borrow shares.

"The borrow will be as expensive as how greedy my bank wants to be," he replies. Some time later, as they return to the topic, Mr. Johnson says: "My bank makes so much money on this stock. They want every single broker to recall their margin account. What's happened is that they sent an internal memo to all the brokers … they don't want to see it in the margin account."

Mr. Davis of National Bank says it has searched its records and the banks cannot find any memo that matches that description. "We used search terms, and no system is perfect, but we use search terms that would help us identify electronic communications that we think might be relevant to a review … I may be ultimately wrong, and if I am, then I will correct the record, and I will apologize. But we couldn't find whatever this is."

Mr. Cohodes has also seized on Mr. Johnson's comments about the shares being worth "ten bucks" if Exchange Income loses its ability to access the capital markets, and argues it directly conflicts with his published target price of $42.

"Trevor was responding to a hypothetical risk," Mr. Davis says. "If you assume that as the fact, then I think that people will broadly agree on the consequence. But Trevor does not regard this as the right hypothetical to apply to his recent analysis. And he said to us that it has not affected his views that had been published in his research and he stands by his research."

The "casual" nature of the bar conversation led to a "lack of precision" by Mr. Johnson, Mr. Davis says. Mr. Johnson is still employed by National Bank and continues to cover Exchange Income shares. "There is, in our view, no reason to see any change in any of that."

Tax expert Kim Moody says structuring investment clubs as a partnership is a good approach. Investment clubs allow members to pool their money and invest in markets. The Canadian Press
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