Hannaian
WebLine Notes
An
Introduction To Naked Short Selling - Failing To Deliver
(FTD) *
Naked Short
Selling / Failing to Deliver
Naked short selling occurs when a seller sells a share of
stock, and then fails to deliver it.
In a legitimate short sale, the seller first borrows a share
of stock, and THEN sells it, hoping to buy it at a lower
price before he returns it to the lender, his profit being
the difference between the sale price, and his later buy
price. It is a bet on a price decline, and legal as
described. Sell high, buy low.
A naked short sale is a manipulative trading technique. It
takes advantage of a structural deficiency in the system
that allows a transaction to occur, and all moneys to be
paid, before delivery occurs.
So a transaction goes by on the tape - a sale - and it is
processed, and has an effect on the price of the stock, but
the delivery portion of the transaction is left for days
later. Meanwhile, the depressive effect of thousands of
these sales extracts it toll on the price - the naked sales
are still sales, and are treated as legitimate by the
system.
At some point after the checks have been cashed and the
commissions distributed and the fees paid, the share never
shows up.
Illegal In Most Instances
Naked short selling is illegal as described - it can be
legal in certain limited circumstances: for a market maker
that needs to provide shares in a fast moving market for a
thinly traded security, but in that instance it will buy the
share back a few cents below where it sold it - Sell at
$4.20, buy at $4,00 - which is part of legitimate market
making. Or an options market maker will do so to hedge its
sale of put options. These are legal, limited-time frame
exceptions. All other instances are illegal.
The industry term for a naked short sale is a Fail to
Deliver (FTD), because the seller fails to deliver.
The FTD is handled by the clearing and settlement system
(the DTCC, a for-profit company wholly owned by Wall Street
- the brokers) in two ways:
1) The stock borrow program at the NSCC (a subsidiary of the
DTCC) enables that entity to borrow shares from an anonymous
pool, and effect delivery to the buyer. The NSCC then
creates a debit in the seller's account, and holds the cash
from the sale (minus commissions, of course) as collateral.
It charges a fee to do that, and the program was designed to
accommodate "temporary" delivery failures - but has been
abused over the years, as "temporary" has no fixed
definition, and some unscrupulous hedge funds think
"temporary" means years.
2) The non-CNS (Continuous Net Settlement) system, or
ex-clearing (ex- meaning outside of) system, which allows
the NSCC to handle the cash for the brokers and pay
everyone, but leaves the delivery portion of the transaction
outside of the system, between the two brokers, on the honor
system. The brokers ALL have a ledger in their back offices
where they keep track of the IOU's from each other, and this
has resulted over time in a ghost, or phantom, float of
electronic book entries in the system, with no stock
existent to support the transactions - just IOU's.
The DTCC reports that the FTD problem amounts to $6 billion
a day, marked to market. It is unclear whether that includes
the ex-clearing transactions or not - the language used is
ambiguous, and allows for different interpretations. Many
have asked for clarification, and none has been offered -
the DTCC doesn't like to talk about this, to anyone,
including the regulators.
Critics of the DTCC charge that the Stock Borrow Program
creates more book entries/FTD's/IOU's than there are shares
of stock issued, which the DTCC has denied in carefully
parsed language that actually doesn't deny the direct
accusation. These critics maintain that the lending pool is
replenished as shares are borrowed, delivered to the buyer's
broker, then put right back into the pool by the new broker
to be lent out again, thereby giving birth to IOU after IOU.
The DTCC carefully argues that it never lends more shares
than there are in customer accounts. This is technically
true, as Lender A's account has no share in it once it is
lent to Buyer B, but when Buyer B re-deposits the lent share
into his DTCC account, available for loan, it then gets lent
to Buyer C, leaving a nice little trail of IOU's as it worms
its way through the system. The DTCC never addresses this,
and instead answers questions that weren't asked, in the
best tradition of politicians and bureaucrats
everywhere.
The DTCC has said that only 20% of the transactions are
handled via the Stock Borrow Program. That leaves the
question of how the remaining 80% are handled. The answer is
via the ex-clearing system.
How can the SEC allow this chronic failure to deliver to
occur, creating a de facto phantom float of book
entries/IOU's with no shares to support them? Aren't those
in actuality counterfeit shares, falsely represented to the
buyers as real? If they are treated by the system as
equivalent to genuine shares for the purpose of creating a
transaction, I would argue they are.
The system tells the buyer that all is well, and doesn't
differentiate between a legitimately delivered share and an
IOU. Thus, the buyer sees that he bought 1000 shares of ABC
on his brokerage statement or on his screen - but there is
no way of knowing how many are real shares and how many are
IOU's without obtaining paper certificates, which cannot be
counterfeited with the ease of an electronic book
entry/tick/IOU. The brokers will tell you that of course
there's shares there, or alternatively, that it is a
non-issue, as the ticks can be sold at any time, getting the
buyer's cash out of the trade. These explanations
deliberately ignore that there is no attendant share to back
up the IOU.
A share is a specific thing, a parcel of rights, from the
issuing company. Among these rights are the right to vote,
and the right to legal redress (you can sue them as an owner
of the company), and the right to any dividends, cash or
stock.
An electronic book entry without a share to back it up has
none of these rights.
The lack of differentiation between real shares and IOU's
has resulted in a market where we are trading claims on
shares, rather than genuine shares, and oftentimes there are
many more claims than there are shares. That is not the way
the market is supposed to work.
Systemic Problem of Critical Scope - Rule 17A Sought
to Prevent This
Congress mandated in Rule 17A of the 1934 Securities
Exchange Act that our markets have prompt, accurate
clearance and delivery. It reads, "The prompt and accurate
clearance and settlement of securities transactions,
including the transfer of record ownership and the
safeguarding of securities and funds related thereto, are
necessary for the protection of investors and persons
facilitating transactions by and acting on behalf of
investors.”
That seems pretty clear. BOTH clearing (booking the sale and
paying for it) and settling (delivery) need to happen
promptly, and further, the transfer of record ownership
needs to occur. The rule makers understood the temptation to
come up with a way to game this, so were clear on the
necessary predicates. Clear AND Settle, including transfer
of ownership.
FTD's violate that mandate. No record ownership is
transferred on a stock share via an IOU. Further, none is
transferred via a Stock Borrow Program "loaned" share -
because if it were, then the lender would lose his
ownership, which would be a sale, not a loan - so either the
"loan" is a disguised sale in which record ownership IS
transferred, in which case the NSCC appears to be
deliberately disguising a sale by erroneously calling it a
loan, or no record ownership is being transferred, in which
case it violates 17A. Those are the only two choices.
Neither is pretty, nor legal.
So how does the SEC allow this to go on?
They typically cite Addendum C of the NSCC's rules, which
allows for the stock borrow program to loan stock to cover
TEMPORARY settlement failures - the kind resulting from lost
certificates. The "temporary" caveat has been ignored, and
it has instead become a long-term device to create an
unlimited number of electronic book entries.
They also take the position that the ex-clearing
transactions are the province of contract law, as the
agreements to deliver are a contractual agreement, and the
SEC doesn't mediate contractual disputes. A nice way to step
out of the role of regulator of the markets, and create
instant deniability. The NSCC takes the same position,
leaving things up to the brokers, on the honor system.
So the back offices create an unknown number of IOU's,
predictably resulting in depressed prices for the afflicted
securities, and the regulators say it isn't any of their
business.
Systemic Risk
Because of this unbridled FTD manufacturing, a tremendous
contingent liability for the industry has been created over
time, as the large float of FTD's represents stock that
needs to be bought back at some point in the future, but for
which there is no guarantee that stock is readily available.
In some instances there are reports of companies where FTD's
represent multiples of the issued genuine shares.
The collateral used to secure the FTD at the NSCC is cash,
but it is marked to market against the price of the stock at
the end of the day, and any overage is available to the
seller. This means that if the FTD was created at $20 per
share, and the stock has been run down to $5 per share, the
seller gets to withdraw the $15 dollar difference. This
creates a dangerous situation where the system is hopelessly
under-collateralized for the true risk - the shares will
cost far more than their current depressed price to cover,
as the depressed price is often a function of massive
selling of FTD's. This is the contingent liability risk. It
is likely considerable, and is ignored by the system.
This risk creates a situation where the brokerage community
has a vested interest in seeing the prices of victim
companies stay down once they are down, as their best
customers (hedge funds) have taken out the
over-collateralization dollars over the years from the
FTD's, and used them to collateralize other securities -
many times, more FTD's.
The most obvious way to keep the price depressed and enable
everyone to continue to make money is to issue more FTD's
whenever the price of a victim security starts to rise. This
creates a self-fulfilling prophecy of chronic price
manipulation via the issuance of FTD's.
It is likely that there is a severe leverage crisis with the
hedge funds that use FTD's, as they have used borrowed funds
to collateralize the initial FTD, and then used the
over-collateralization to create yet more FTD's. If one of
these funds was to unwind it could vaporize the assets of
the fund involved virtually overnight, and create yet more
systemic problems for other hedge funds as their positions
rise in value, triggering more de-leveraging.
It is the classic derivative risk de-leveraging scenario
wherein one or two larger funds can cause a meltdown, a la
Long Term Capital Management (LTCM) in 1998, where one
highly leveraged hedge fund with $2.2 billion in assets
caused the entire US credit markets to shut down. LTCM was
not naked short selling - they are mentioned to illustrate
how one leveraged fund can endanger an entire market.
The SEC is likely aware of this risk, as it heretofore
inexplicably violated SEC Rule 17A, and grandfathered in all
FTD's prior to 2005, even though long term FTD's were
illegal for many years prior to that date, and even though
it is in violation of their Congressional mandate. Further,
and perhaps more disturbing, the grandfathering rules
grandfathers current FTD's below the threshold once a stock
hits the Reg SHO Threshold list - market manipulators still
get one free bite of the apple even on new SHO entrants -
all the fails up until the company lands on the list are
inexplicably grandfathered as well, even if they happened
today. Wild? It's fact.
SEC Forgives Past Larceny With No Penalty -
Why?
Why would the SEC grandfather all prior fails, as well as
current fails below the threshold, and knowingly violate
their Congressional mandate? It is akin to allowing bank
robbers keep the proceeds of all prior bank robberies. There
are two logical explanations available to us:
1) The SEC knows about the
systemic risk FTD's cause, it is terrified of the
implications, and it wanted to, at the stroke of a pen,
eliminate that risk from the system, even if it violated the
law and was at the expense of shareholders who had been
financially decimated by the practice.
A choice was made to allow the brokers and hedge funds to
keep the proceeds of their ill-gotten gains, and not require
them to ever buy in the shares they had printed whole
cloth.
The SEC admits it, in their own bureaucrat-ese. From the
February, 2005 Euromoney article on the controversy:
The SEC's Brigagliano says the commission made a choice.
"We were concerned about generating volatility where there
were large pre-existing open positions, and we wanted to
start afresh with new regulation, not re-write
history."
Substitute the words "not enforce existing, decade-old laws"
for "not re-write history" and you have the plain English
version. The SEC violated 17A, knowingly, because they were
worried about causing "volatility" - SEC-speak for short
squeezes, where stocks with millions of FTD's go through the
roof as they are bought in - essentially a return of capital
to those damaged by the FTD's, as their cash is returned to
them, in return for selling their genuine shares. That would
be the fair way equitable markets would work - those who had
made untold billions using FTD's would have to pay most or
all of it back in short squeezes, as legitimate supply and
demand are returned to an unbalanced market (because of the
current artificial supply of FTD's).
The SEC was apparently so
concerned about that "volatility", that their solution was
to give the violators a free pass, and allow the damaged
shareholders and companies to remain damaged in perpetuity,
never settling nor having record ownership transferred. This
decision underscores the likelihood that the SEC understands
the systemic risk years of FTD creation have created, and
will go to great lengths to avoid triggering an event that
would cause the violators to have to settle the trades.
A more cynical interpretation is that the SEC didn't want to
cause undue financial hardship for the more politically and
financially important violators (the violators would likely
be both, as they had years of selling non-existent shares
with which to build and solidify their financial importance
- and to spread the wealth by supporting their elected
officials with contributions), choosing instead to lock in
the industry's illegally generated profits, rather than have
the violators pay it back - the SEC favored the hedge funds
and brokers that had violated the law, over the shareholders
and companies that had been brutalized by the
practice.
2) The far more ominous
logical explanation is that the SEC grandfathered not out of
concern for the system, but rather to limit its own
liability under the law - that after
years of permitting felony short selling/securities fraud
manipulation, the SEC ultimately came to realize that it had
committed collateral crimes, and could be held accountable -
as accessories to the felonies. This explanation posits that
in passing Regulation SHO, the SEC wasn’t just
grandfathering the previous illegal short selling to protect
the short sellers, but rather it was, much more importantly,
protecting the SEC itself. And it focused the ire of the
victims on the rule violators who financially benefitted,
rather than upon the regulator that had permitted the
felonious activity for years.
The
legal argument would go like this (simplified): The felony
committed and suborned in this situation is USC 18, Title
514, the commission of counterfeiting of a commercial
security, a Class B Federal Felony. By permitting this
felony to be an endemic part of the modern market system,
and by knowingly failing to enforce rules designed to
prevent counterfeiting of a commercial security, the SEC
aided and abetted those who have done so, subjecting it to
risk of civil and criminal redress. The permission of a
large float of FTD's to be part of the markets is a de facto
permission of counterfeiting (wherein the bogus IOU/Markers
are represented as and have the effect of legitimate stock
shares, on the auction price of the security as well as on
the long term size of the float), and thus creates an
accessory risk for the Commission. Arguments have been
advanced that, as in the Elgindy case, naked short selling
was used for money laundering for Middle Eastern arms
dealers, thus constituting treason during a time of war
(according to the Patriot Act), a Class A Felony - that the
Commission was ignorant of the outcome of its permitting the
counterfeiting does not absolve it of the legal jeopardy
arising from that outcome, any more than the driver of a
getaway car in a bank robbery is absolved of the murder of a
teller during the robbery - even though he was ignorant of
the ultimate crime committed. That is not how the law works.
Note that I take no
position as to the likelihood of this second explanation
being correct. It is a credible explanation advanced by
several experts familiar with the legal ramifications of
allowing FTD's to remain in the system in perpetuity, and
failing to enforce rules designed to stop larcenous action,
nothing more.
FWIW, it is far more
likely that the SEC folks understand that upon retirement
they will receive $700 per hour jobs with top lawfirms
representing Wall Street, and that knowing this they are
much more likely to favor Wall Street's interests. Most
agencies of the Government have the conceit that comes from
unbridled power, and it is hard to imagine Federal employees
actually afraid of liability for anything. Thus, the second
explanation is a hard one to swallow.
But whatever the
motivation, charitable or cynical, you arrive at the same
effective point: Years of lawless predation were pardoned
(in violation of 17A's Congressional mandate), the profits
kept by the criminals, with no penalty or sanctions imposed
- leaving investors and the victimized companies out of
luck, and money.
So what about now?
Since the new FTD rule was passed (Regulation SHO, for
SHOrt) and went into effect January, 2005, more companies
have gone onto the Threshold list (a list of companies whose
FTD's exceed a "threshold" of 10,000 shares AND 1/2% of
their total issued shares), and more FTD's have been
created. The industry can't help itself (and truthfully why
would they?) - it is just too lucrative to ignore the
un-enforced rules, and continue to manufacture IOU's. The
systemic risk continues to build, and the regulators that
hoped the industry would heal itself are left unwilling or
unable to act - the imperative to create fair markets is
clearly subordinate to pandering to the financial well being
of the violators.
The DTCC and the SEC take the position that information
about this crisis is proprietary and secret, and that our
elected officials and companies and we shareholders have no
need or right to know the true parameters of the problem.
The workings of the machine are opaque, and transparency is
derided as an unnecessary invasion of the industry's
privacy.
Again, the charitable
explanation for this stance is because they want to avoid a
potentially damaging meltdown (albeit of their own
creation). The cynical explanation is that investors would
riot in the streets or abandon the market if they understood
what was being done to them, and would hold the SEC
accountable for their role in it. Regardless of the
explanation that one feels best explains the SEC and the
DTCC's actions, what is unarguable is that the size, scope,
and ongoing treatment of the crisis is top secret.
This is very much like the way the regulators handled the
S&L crisis, allowing a large systemic problem to develop
into a catastrophic systemic problem that wound up costing
hundreds of billions of dollars, and every man, woman and
child in the US about $2K in taxes. We are still paying for
it today.
In that episode, the
S&L's accounted for about a third of all the business
Wall Street did in the 80's, and every big house stuffed the
most larcenous of the S&L's with untold billions of junk
bonds and options and precarious loans, knowing and
understanding that the American taxpayer would ultimately
have to pay the freight via secured deposits. Wall Street
was assisted in this wholesale looting of the financial
system by every major accounting firm in existence, and the
most prominent attorneys in the country. Fraud of a mind
boggling scale was perpetrated and perpetuated by that
industry, and one of the primary beneficiaries was Wall
Street, who that time also got to keep the money, laying off
the blame on the S&L's. This time around we have hedge
funds comprising over 50% of Wall Street's action, and we as
a nation seem to have learned nothing from our prior
fleecing. One can't understand that catastrophe and not draw
striking parallels to this situation.
In fact, the entire FTD crisis is very similar to the
S&L crisis, in the sense that staggering amounts of
money are in play, private interests are operating in an
unregulated environment (hedge funds and ex-clearing),
leverage is being employed to compound the risk, Wall Street
wunderkind are making preposterous profits, phenomenally
wealthy players are receiving preferential treatment even as
they knowingly violate the law, Greenspan is saying that no
restrictive regulation is required, the industry is
protesting that there is no problem, and the entire affair
is taking place shrouded in secrecy.
That didn't end well.
The above is simplified, and is conceptual, as in reality
there is no single share followed through the system - there
are debits and credits to participant accounts at the NSCC,
which are netted against total long positions, further
obfuscating the mechanisms. But the fundamentals are
accurate, if lacking in a certain specificity that could
fill volumes. Hopefully it is enough for the reader to grasp
the issue and the scope thereof.
* From "Symphony of
Greed - Financial Terrorism and Super-Crime on Wall Street",
by Bob O'Brien, in progress. Interested literary agents or
publishers are encouraged to contact Bob at
NCANS.mgr@gmail.com
Who's
Behind Naked Shorting?
http://www.fool.com/investing/high-growth/2005/03/30/whos-behind-naked-shorting.aspx
Karl
Thiel
March 30, 2005
Last week, when
I
wrote about naked
short sellers and Regulation SHO, I suggested none too
subtly that the new rules seem to deal pretty lightly with
any bad guys operating outside the law. If the Securities
and Exchange Commission is acknowledging a problem, as it
seems to be, then Reg SHO seems like a pretty weak tool for
controlling it.
But that was last week's
subject. Having gotten to that point, I was left wondering
how extensive the problem really is. As I said then, I'm
deeply skeptical of some conspiracy theories that suggest
that short selling is not only rampant, but also a part of a
coordinated scheme involving brokers, media, and regulators
trying to bring down targeted companies. In fact, let me say
at the outset that after spending many hours looking at this
issue, I remain unconvinced of the larger conspiracy
theories and agnostic on how extensive naked short selling
is or how exactly it happens. There is no shortage of
theories -- some of which I'll discuss here -- but little in
the way of concrete answers. So the first and most obvious
question is, how much of this is going on?
Rare or everywhere?
Unfortunately, nobody seems to know. The Depository
Trust & Clearing Corporation (DTCC), a holding company
that clears and guarantees almost all trades in the U.S.,
very recently posted an interesting
Q&A on naked
short selling, an article well worth reading if you're at
all interested in the subject. "While naked short selling
occurs," says DTCC First Deputy General Counsel Larry
Thompson in the document, "the extent to which it
occurs is in dispute." Ain't that the truth.
Nevertheless, the DTCC has
a good reason to say something public about the issue. The
subject of naked short selling has gained some momentum with
the introduction of Reg SHO early this year and a rising
tide of complaint from companies like Overstock.com (Nasdaq:
OSTK) and
others. But in addition to this general attention, 12
separate lawsuits have accused the DTCC itself of
engineering naked short-selling schemes. Nine of these,
according to Thompson, have been dismissed or withdrawn,
while three are still pending.
The basic accusation is
that the DTCC itself counterfeits shares through its stock
borrow program. This program has been around for more than
20 years and helps guarantee transactions when one party
fails to produce promised shares. While the DTCC itself
doesn't own shares, a network of participating
broker-dealers lists shares available for borrowing with the
program, and these are called on to complete failed
transactions.
Lawsuits have claimed that
the DTCC loans out shares it never collects from
participants. These, in turn, presumably show up as new
"fails to settle" transactions, but from the point of view
of the market, they appear to be new shares floating around
-- in electronic form, that is, without stock certificates
to back them up. These can then be relisted, the theory
goes, as available for borrowing, and the process repeats
itself, allowing the folks manipulating the system to
essentially manufacture any number of phantom
shares.
Thompson calls these
accusations "either an intentional misrepresentation of the
SEC-approved system, or a profoundly ignorant
characterization of this component of the process of
clearing and settling transactions." I want to stress that
I'm not supporting these accusations -- I mention them
because they describe one popular theory of how naked short
sellers operate.
Something's going on
here
But if we rule this out, how does one explain the
suspicious volumes and consistent, ongoing settlement
failures experienced by companies like
BioLaseTechnology (Nasdaq:
BLTI),
Netflix, or
Rule Breakers pick
Taser (Nasdaq:
TASR)
on the Threshold Security lists? Thompson, while
acknowledging that naked shorting does happen, suggests that
many settlement failures are innocent. "An investor can get
a physical certificate to his broker too late for
settlement," he suggests. "An investor might not have signed
the certificate, or signed in the wrong place. There may
have been human error, in that the wrong stock (or CUSIP)
was sold, so the delivery can't be made. Last year, 1.7
million physical certificates were lost," he continues, "and
sometimes that isn't discovered until after an investor puts
in an order to sell the security. There are literally dozens
of reasons for a 'fail to deliver,' and most of them are
legal. Reg SHO also allows market makers to legally 'naked
short' shares in the course of their market making
responsibilities, and those obviously result in
fails."
But can unsigned
or lost certificates really explain why some companies have
lingered on the list for weeks, meaning that more than
10,000 shares per day or over 0.5% of the company's entire
float is subject to failed settlement on a daily basis? If
that's the root cause, it would certainly seem to point to
some pretty shoddy settlement practices among
broker-dealers. If that's really all there is to this, then
maybe Reg SHO will serve its greatest purpose in
embarrassing some brokers into improving their settlement
procedures.
Who's making
the market?
Yet, as I noted last week, it is the
market-making exemption that still seems to me like a source
of potential trouble. Market makers don't have to locate
shares before executing short sales in most circumstances.
Their role is to keep an inventory of readily available
stock, to smooth volatility, and to manage their own risk,
and this sometimes requires them to short shares. A prime
example of why this is sometimes a valuable function and
even protects investors can occasionally be seen with
companies emerging from bankruptcy.
When
US Airways (OTC BB:
UAIRQ.OB) was planning to re-emerge from bankruptcy in 2003,
for instance, its old common stock, trading on the OTC BB,
rallied -- apparently because some investors mistakenly
thought the news was somehow good for shareholders in the
old common stock. But the plan called for the issuance of
new stock, and the old shares were to become worthless.
Market makers, by shorting the old common shares, could
burst a speculative mini-bubble in the making and stop more
ill-informed investors from losing their shirts. (Of course,
one wonders why stocks are allowed to trade at all in these
situations, but that's another matter). In any case, this is
an extreme example of one function legitimate market makers
serve by shorting stock and why they are given an exemption
to the rules.
The potential
problem is that unscrupulous folks could potentially
register as market makers to take advantage of the
exemptions. (Do you
want to be a market maker? Go here
for an application! It's not a rubber-stamp process, but
it's not as hard as you might think.) Right now, "bona fide"
market making is judged by the individual transaction rather
than by the individual market maker, so no market maker gets
a blanket exemption, but any market maker -- even the ones
posting $0.001 bid/$10,000 ask spreads -- get a pass in the
right circumstances. It's a situation that seems to hold
potential for mischief.
Overseas
intrigue?
And here is a final source of potential trouble
I'll suggest. Say the broker placing the order to short a
stock is in an offshore location where naked short selling
is legal. This would seem to open up the same opportunities
purportedly exploited to naked short the stock of companies
that have issued floorless convertible debt.
A floorless convertible
bond (a vehicle of what is sometimes called the "convertible
death spiral") is a debt instrument issued by desperate or
dishonest companies to raise cash; the bondholder can
convert the debt into stock at variable, below-market
prices.
It's not a deal a
responsible company should enter into. When a company does a
floorless convertible, its stock, not surprisingly, drops.
The new bondholders have every reason to short the stock
unmercifully, and as the price drops further, they get more
shares upon conversion because the conversion rate changes.
Thus, the original shareholders lose virtually all their
stake in the company. Meanwhile, the bondholders simply
short all the shares they can, take their profit, and then
hope the stock price continues to drop until they get more
than enough shares upon conversion to cover the original
short.
As long as the bondholders
are using legitimately borrowed shares and not engaging in
unscrupulous tactics to manipulate share price lower, this
is a legal strategy -- although it is hard to see why such
floorless converts, devastating for existing shareholders,
are in fact legal. But if the bondholders are in an offshore
location where they can legally naked short, they might
theoretically short more shares than they can get their
hands on. After all, the shares they have coming back to
them are multiplying as the price drops, so why
not?
At the root of the
conspiracy theory?
There are folks out there who believe this is the main
source of naked short selling in the market. Certainly, in
this scenario the bondholder has an incentive to naked short
the stock, and one could expect to see massive issuance of
new shares as the debt is converted to stock at a
rock-bottom price. Failed settlement and suspicious volume
in one neat package, right?
Maybe. But since most of
the companies on the Threshold Security List haven't issued
toxic convertibles, of what relevance is this? Only this: If
an offshore concern can naked short the shares of a company
to which they've issued a convertible loan, why can't a
foreign broker naked short a company for which there is
simply high demand for borrowed shares?
When I look at the
Threshold Security List, even ignoring the penny stocks, I
see companies that a lot of investors want to short (OK,
that's pretty much true by definition). The very appearance
of these companies means that not everyone is getting to
borrow the shares they want -- you won't see
Microsoft (Nasdaq:
MSFT) or
General Electric (NYSE:
GE) on the
list. Couldn't an enterprising broker in some foreign
location be executing naked short sales to satisfy some of
this demand? Wouldn't this cause persistent settlement
failure?
I have no way of proving
this -- it is just surmise. But notice that this scenario
does not suggest that the naked shorts are
successfully pushing down the price of the threshold stocks
to any significant degree. It only suggests that the
real demand for shares to short is being satisfied by
extra-legal means -- brokers who have set up shop to
transact shares of a popular short target. Investors who see
value and want to take a long position in these same stocks
should naturally balance out the shorts, absent some highly
organized conspiracy to spook the market. Thus, I don't
think investors in threshold companies should necessarily
believe that their stock is artificially depressed to any
substantial degree.
More unanswered
questions
This may only go part of the way toward explaining
unusual volume, however. Last week, I mentioned Global
Links (OTC BB: GLKCE.OB), a penny stock that has a
listed float of a little over 1 million shares but traded
many times that volume in a single day despite there being
one shareholder who claimed to own the entire float. I
mentioned that particular company because it came up by name
at the March 9 Senate Banking Committee hearing, and the
story makes a good illustration of the kinds of absurdities
showing up on the Threshold Security List.
But in fairness, I should
point out that in this particular case, there are other
factors that might explain the volume. Among other things,
the company has a huge overhang of preferred shares
convertible to common stock. It's impossible to tell from
the SEC filings alone exactly what's going on here, and
while it's an interesting story, a smoking gun it ain't.
This is part of what makes penny stocks really bad
investment ideas for nearly everyone.
But while Global Links is
a strange and perhaps poor example of suspicious trading
volume, there are other examples out there. Overstock CEO
Patrick Byrne has noted seeing four or five times his
company's float trade hands in a day. The same thing has
happened to other threshold companies. What explains
this?
I'm afraid I still don't
know. Is it day traders on steroids, frantically trading
back and forth? Perhaps. Could it be a few hedge funds
painting the tape, hoping to make it look like the sky is
falling? Maybe. Could it be huge numbers of phantom shares
out there, making the reported float inaccurate? I guess
it's possible.
Unfortunately, Reg SHO
appears to raise more questions than it answers. As the DTCC
is quick to point out, its job is simply to report the
failed settlements. It is up to the SEC to actually do
something about it.
By the way, I'll look at
some more of the specifics of naked shorting and what they
mean to investors in the next issue of the Rule
Breakers
newsletter.
Karl
Thiel is a
member of the Rule Breakers newsletter team. Click
here for a
free trial.
He does not own stock in any companies mentioned in this
article. The Motley Fool has a disclosure
policy.
Cale Smith, Senior Associate
Hawk Associates, Inc.
The drama surrounding
naked shorting has all the elements of a John Grisham
novel. Sly, blue blood institutions conspire with shadowy
hedge fund cowboys to unmercifully assault a well-meaning
but outgunned CEO in his quest for shareholder value.
Offshore accounts and corrupt foreign officials veil the
crimes for decades, until finally being thrust into the
open through the hyper-caffeinated efforts of hundreds of
message board denizens throughout cyberspace.
As with most Grisham
novels, however, liberties may have to be taken with the
original story to romanticize an otherwise bland topic.
After all, its hard to make CUSIP numbers and stock
certificates sound sexy, but thats really the heart
of the naked shorting controversy.
Due largely to concerns
raised by microcap CEOs and their shareholders, naked
shorting is a hot topic on message boards. Opinions range
widely on how common it is. Those claiming it pervades
the markets and foreshadows a systemic meltdown are met
with equally fervent arguments calling it an over-hyped,
isolated problem that is becoming the grassy knoll
conspiracy theory of Wall Street.
Everyone agrees,
however, that risks of naked shorting are heightened in
the microcap world. The sheer number of small public
companies, combined with high volatility and an almost
inevitable need for financing, make detecting this
hard-to-prove crime that much more difficult for the
microcap CEO. Although the odds seem small that a
particular company will be victimized, there is no
authoritative data indicating how many microcaps are
being naked shorted.
Keeping those odds in
perspective, then, this primer is for microcap CEOs
curious about the naked shorting fuss. On the off chance
that a company attracts naked shorts, CEOs should
recognize that there is despairingly little that can be
done to stop it from occurring. Due to the nature of the
crime, legal expertise may not help.
Although there seem to
be few bulletproof ways to stop naked shorts, there are a
handful of things a proactive CEO can do to reduce the
odds of being blindsided by this notorious lot. This
primer includes a rough sketch of how naked shorting
works and a brief familiarization with the main players.
A worst-case scenario of what it means to be targeted by
naked shorts is presented, as are suggestions for wary
CEOs. The final section contains a list of links with
more about the intriguing world of naked shorting.
In its simplest terms,
naked shorting involves selling shares of stock that
dont exist. Its performed routinely by
market-makers to keep an orderly market, but it is
illegal when done to manipulate a companys stock
price. Only when someone intends to drive down the stock
price is naked shorting breaking the law. Throughout the
rest of this overview, any reference to naked shorting
will refer to the illegal variety.
Its also worth
noting the important distinction between shorting and
naked shorting. The former is perfectly legal and occurs
extensively as either a way for an investor to mitigate
risk or as a bet that a companys share price will
decrease (i.e. the short-seller or short
believes the company is overvalued). Despite the wary
glances often cast upon them, shorts are an essential
part of a robust market and are often the first to
discover financial fraud, as in the case of
Enron.
A short will sell
borrowed shares as a bet against a company because he
believes the price will eventually drop. These borrowed
shares come from his broker, which loans the short a
certain number of shares (not dollars). As soon as the
short receives the borrowed shares in his account, he
sells them immediately for cash, which goes to his
brokerage account. The short still has that pesky loan to
pay back, though, and does so by waiting for the price of
the stock to drop. Then he buys some cheaper shares using
money from the same pool of cash he received after the
original sale, gives the broker his shares back, and
keeps whatever cash is left in his account.
Naked shorts, in
contrast, are much more manipulative they sell
short shares that dont exist and then attempt to
actively lower the companys share price through
constant short-selling pressure. By using pretend shares,
of which there is an unlimited supply, naked shorts can
effectively control the share price through this constant
pressure, eventually driving the price of a
companys shares into the basement.
Where do these fake
shares come from? Naked shorts can create them out of
thin air, depending on your point of view, due to either
(a) glaring inefficiencies in the back-office world of
certificate transfers, or (b) institutionalized fraud on
a massive scale. Either way, the effects can be
disastrous for companies who are victimized.
Naked shorting is
typically done by hedge funds with arms length
support from several other parties. The extent of active
assistance provided to the fund by these related groups
is unclear but hotly debated. One player is the
Depository Trust & Clearing Corp. (DTCC), which
tracks the stock certificates of traded shares between
brokerages. When a fund sells short a share of stock, the
funds brokerage (another prominent player) has a
settlement period of three days to deliver those shares
to the buyers broker. If the transfer doesnt
occur, the DTCC notifies the funds broker that it
has FTDd (Failed to Deliver). The DTCC
is required by the SEC to enforce delivery of missing
shares. While waiting to account for shares, the DTCC may
charge the brokerage to borrow similar shares from its
own inventory.
The obvious conflict of
interest here is that DTCC is policing its own customers
- the brokerages. In response to complaints, the SEC
required all exchanges to comply with Regulation SHO in
January of 2005. Reg SHO establishes several requirements
aimed at broker-dealers, but it does not specifically
address the manipulative aspects of naked shorting, which
fall under existing securities law.
Regulation SHO
specifically requires the major exchanges to provide a
daily list of Threshold Securities, defined as those that
(1) have an aggregate fail to deliver position of over
10,000 shares (2) equal to 0.5% of the issuers
total shares outstanding for (3) greater than five days.
Reg SHO also requires a broker-dealer to close out any
open fail position once it has been included
on an exchanges Threshold Security list for 13
consecutive days. The ironic effect of this policy, as
noted by its detractors, is that it effectively requires
shorts to cover (buy back shares) after theyve had
two weeks to drive the price down - meaning they profit
from the trade. Needless to say, the effectiveness of
such a regulation is often called into question among the
cyberspace crowd.
Links to the Threshold
Security list for each primary exchange are included at
the conclusion of this article. Its important to
remember that seeing a company included on the Threshold
Securities list does not mean that company is being naked
shorted nor that its share price is artificially
depressed. It means shares in that company are failing to
deliver on time for what may be legitimate reasons,
including simple human error. Even shares bought long
could FTD and show up on the Threshold list. A daily
presence on the Threshold list for more than 13 days at a
time, however, might signal the need for deeper
digging.
Based on the accounts
of CEOs who believe they have been the target of naked
shorts, here is how the worst-case scenario might play
out using an ill-intentioned hedge fund (Fund
Malicious) as an example.
Fund Malicious first
identifies a target in the microcap world for naked
shorting, most likely an obscure company in the
development stage or having otherwise questionable
fundamentals. The hedge fund gets that firm listed on a
foreign exchange in, say, Berlin, via a request funneled
through a complicit broker or official in that country.
Malicious then sells short shares it doesnt have
(naked shorts them), waits three days for the DTCC to
call and ask for the shares, and then replies either,
I borrowed them on the Berlin exchange, and
theyll take some time to get here, or
Im a market-maker for that companys
shares in Berlin and naked shorting rules dont
apply there. The DTCC then loans the fund shares
from its inventory and charges the broker a fee until the
stock loan is repaid. Malicious, in the meantime,
continues to drive the price of the targets shares
down as long and as aggressively as possible. In the
event the fund does cover to pay off the stock loan, it
doesnt take much effort to begin the naked shorting
cycle again.
Other theories exist as
to how the hedge fund might skirt additional rules. To
prevent piling on, exchange rules mandate
that a stock cannot be shorted on a downtick or decrease
in stock price. In other words, Malicious must wait for
the stock price to increase briefly before shorting the
company. Rather than wait passively for an uptick,
though, Fund Malicious can create an uptick in the stock
itself by purchasing a few shares through a small
offshore account. The hedge fund is then free to short
(or naked short) the company with both barrels at
home.
Malicious may get
additional leverage out of the original naked short by
choosing to target an ugly, obscure microcap company. By
driving the price down, the fund hopes to scare existing
shareholders into selling their shares, too, out of fear
that something is going on that they dont know
about (i.e. the fund can paint the tape).
This, of course, drives the price even lower while
further obscuring the role of Fund Malicious.
There is plenty of room
for additional mischief in the above scenario. According
to the most vocal critics of naked shorting, funds like
Malicious have relationships with reporters and/or
message board regulars who are compensated to distribute
negative news about the company in order to exaggerate
the selling. There is also plenty of irony possible, in
that a CEO can be her shareholders worst enemy by
merely uttering the words naked shorting.
Investors may panic, the stock might dive further and
legitimate short-sellers could begin to circle.
Given the mysterious
nature of hedge funds and the convoluted nature of this
crime, its easy to get carried away with paranoid
scenarios regarding naked shorting. The skeptics,
however, have some unanswered questions of their own. For
instance:
Whats in it for the brokerages? Are they
supposed to take all the risk just to get a few more
commissions or under-the-table money? Since when have
they been that desperate?
Has anyone ever
been found guilty of naked shorting?
Where is the
proof? Are there other pieces of evidence that would
suggest a crime is being committed?
Why arent
more companies making noise about it? Where are the
whistleblowers?
Wouldnt
the unintentional buyers of naked-shorted shares voice
their concerns when they did not receive proxy
votes?
Why is there no
outrage from legitimate funds and brokerages?
How much
regulatory burden should the SEC and other publicly
traded companies have to bear to resolve the questionable
problems of a few companies?
Both camps raise
legitimate issues that simply cannot be addressed
definitively yet. Reg SHO is not the deterrent the
problem seems to demand. There have been numerous calls
on the SEC to increase the scope of data provided in the
daily Threshold Securities lists, which may help better
gauge the seriousness of this problem. Until those issues
are resolved, the SEC continues to consider the
surveillance and enforcement of trading activity as the
primary responsibility of the markets and exchanges. The
DTCC considers its role to be reporting the FTDs.
Brokerages are doing all they can to win commissions from
hedge funds. Detection is difficult, accusations are
nearly impossible to prove, and nobody has figured out a
foolproof way to stop this crime.
So whats all that
mean for the microcap CEO? When it comes to naked
shorting, you are your own best watchdog.
A well-intentioned CEO
can fulfill his own prophecy by going public with
accusations of naked shorting. Investors may flee the
stock, further lowering the share price. Meanwhile, other
funds may hover, waiting for an uptick to begin shorting
your company themselves.
If youre seeing
four or five times your companys float trade hands
in an otherwise ordinary day, and you have no large share
overhangs, pay attention. Start documenting those
patterns.
Your stock price is not
declining exclusively due to naked shorting. Weakness in
the business, industry, model, communications or
management team exists well before naked shorting begins
and allows it to continue. In most cases, the best
deterrent for shorts of any kind is consistent execution
and credible communications with your
shareholders.
By maintaining absolute
secrecy before good news, you give yourself the best
chance to catch the shorts off guard and maybe even
squeeze them. Be conscious of unintended signals you may
send when in public appearances, conference calls and
analyst meetings before a particularly good quarter or
other surprising good news. Keep your cards close to your
chest and save those glowing press releases for the
middle of the trading day.
By communicating with
your investors as often as possible, you remove some of
the mystery surrounding a company that a naked shorter
typically targets. In the absence of any company news, a
continuously dropping stock price is the only
communication your investors are hearing. Sales of stock
by legitimate owners are sure to follow.
A floorless convertible
bond (also known as a convertible death
spiral) is an open invitation for its owners to
short the stock as aggressively as possible. A constant
decline in share price means the convertible owners will
get more shares because the initial rate of conversion
will change. While the original shareholders may very
well lose their entire stake in the company, the
convertible owners can continue to short the stock until
they can effectively cover the original short with new
shares created by a new rate. Should those convertibles
be held offshore where naked shorting is not illegal, the
potential for price depression becomes even greater.
Ensuring you have a floor on those converts will prevent
the worst case scenario.
If your firm
unexpectedly turns up on the Berlin-Bremen stock exchange
and you, the CEO, did not request a listing there, that
might be a sign of a problem. Request the removal of your
company from that exchange immediately, and keep asking
until its done.
In addition to
floorless convertibles, PIPEs may also attract undue
attention from potential funders. Since shares in a PIPE
are sold for below market price, the provider could short
the stock down to that level with no risk of capital loss
on his part. When issuing warrants with the deal,
youre also effectively pushing the price lower
through increased dilution of existing shareholders.
While its true that sometimes beggars cant be
choosers when it comes to raising funds, go into those
negotiations with your eyes wide open.
Links to the lists at
each exchange are below. Keep in mind that inclusion on
that list does not mean naked shorting or any other
improper activity is occurring, just that some shares
meet the three requirements mentioned above. An extended
presence on the Threshold list, however, in combination
with other signals may be an important sign.
Youll drive
yourself nuts, waste a ton of time and eventually
convince yourself youre a victim of someones
ill wishes, naked shorts or otherwise. If youre
that compelled to monitor the boards, ask your IR team to
send you weekly summaries of any cogent posts.
Consider your choice of
an investor relations firm as your first line of defense.
Does the company have expertise in dealing with naked
shorting? Does the price of your stock mysteriously rise
or fall between the time you send your draft press
releases and when they hit the wires? Do they have
long-term clients willing to vouch for their integrity?
And do they have processes in place to handle sensitive
information?
Given that the process
of naked shorting begins at the brokerage level,
theres not much your companys transfer agent
can do with regards to those shares. The responsibility
for tracking them lies with the brokerage. It is
theoretically possible, however, for a corrupt transfer
agent to conceal the true float and otherwise manipulate
the shares themselves.
Both your transfer
agent and IR firm should be able to advise you on the
effectiveness of combating naked shorts by changing CUSIP
numbers, reverse mergers, and/or reverse splits. Although
the long-term effectiveness of these strategies is
questionable, it may be useful as part of a larger
strategy to deter naked shorting. After changing your
companys CUSIP number, for instance, all existing
stock certificates must be exchanged for new ones. All
issued and outstanding certificates from old shares will
no longer represent an interest in the company until
exchanged. This may be more trouble than its worth,
however. Once the new shares are in circulation,
theres nothing to stop a new round of naked
shorting by determined parties. Such tactics may
represent a small part of an overall strategy to reduce
naked shorting interest in your company.
Questions?
Please feel free to contact Cale Smith at Hawk Associates
at either csmith@hawkassociates.com
or (305) 451-1888 with any questions or comments.
Links:
The
SEC on Key Points About Regulation SHO
DTCC
on Naked Short Selling and the Stock Borrow Program
Professor
John Finnerty of Fordham University on "Short Selling,
Death Spiral Convertibles, and the Profitability of Stock
Manipulation."
The
CEO of Overstock.com explains naked shorting
An
open letter from the CEO of Eagletech to the DTCC
Naked
Shorts What I Have Learned. By Mark Cuban
Motley
Fool: The Naked Truth on Illegal Shorting
Motley
Fool: Whos Behind Naked Shorting
The
National Coalition Against Naked Shorting
NASDAQ
Threshold Securities List (for NASDAQ, OTCBB and OTC
issues)
NYSE
Threshold Securities List
AMEX
Threshold Securities List
Chicago
Stock Exchange
ArcaEx
Berlin-Bremen
Stock Exchange
To report alleged abusive naked short selling
activity: enforcement@sec.gov
For more information on how to submit potential
violations of Federal securities laws: http://www.sec.gov/complaint.shtml
or by calling 1-800-SEC-0330
Home |
CEO
Resources Center
Naked Short Selling
and the Stock Borrow Program
In recent months, there has been a fair amount of media
coverage of naked short selling, Regulation SHO and even
DTCC’s role in that via the Stock Borrow program
operated by DTCC subsidiary National Securities Clearing
Corporation (NSCC). Because there has been much confusion
about these issues, and much misinformation, @dtcc
sat down with DTCC First Deputy General Counsel Larry
Thompson to discuss these issues.
@dtcc:
Let’s start with the question, what is naked short
selling and why has it suddenly become an issue?
Thompson:
Short selling is a trading strategy where a
broker/dealer or investor believes that a stock is
overvalued and is likely to decline. It is an integral part
of the way our capital market system works. Basically, it
involves borrowing stock that you don’t own and
selling it on the open market. You then buy it back at a
later date, hopefully at a lower price, and as a result,
making a profit.
Naked short
selling is selling stock you don’t own, but
not borrowing it and making no attempt to do so. While naked
short selling occurs, the extent to which it occurs is in
dispute.
@dtcc:
DTCC and some of its subsidiaries have been sued over naked
shorting. What has been the result of those
cases?
Thompson:
We’ve had 12 cases to date filed against DTCC or one
of our subsidiaries over the naked shorting issue. Nine of
the cases have been dismissed by the judge without a trial,
or withdrawn by the plaintiff. The other three are pending,
and we have moved to dismiss all those cases as well. While
the lawyers in these cases have presented their theory of
how they think the system works, the fact is that their
theories are not an accurate reflection of how the capital
market system actually works.
@dtcc:
One of the allegations made in some of the lawsuits is that
the Stock Borrow program counterfeits shares, creating many
more shares than actually exist. True?
Thompson:
Absolutely false. Under the Stock Borrow program, NSCC only
borrows shares from a lending member if the member actually
has the shares on deposit in its account at the DTC and
voluntarily offers them to NSCC. If the member doesn’t
have the shares, it can’t lend them.
Once a loan is made, the
lent shares are deducted from the lender’s DTC account
and credited to the DTC account of the member to whom the
shares are delivered. Only one NSCC member can have the
shares credited to its DTC account at any one
time.
The assertion that the
same shares are lent over and over again with each new
recipient acquiring ownership of the same shares is either
an intentional misrepresentation of the SEC-approved system,
or a profoundly ignorant characterization of this component
of the process of clearing and settling
transactions.
@dtcc:
Another allegation is that the Stock Borrow program has
become “a reliable source of income” for NSCC?
Some articles have said we make almost $1 billion from
it.
Thompson: This
statement is purposely misleading. One billion dollars
represents our total revenue from all our operations of all
subsidiaries. The fact is that there are NO separate fees
for transactions processed through the Stock Borrow program.
There is just the normal fee for delivery of the shares,
which is 30 cents per delivery. If you assume we make an
average of 22,000 deliveries through Stock Borrow a day,
there would be about $6,600 extra a day in revenue over 253
trading days, or about $1.67 million a year in additional
revenue, out of $1 billion.
All of our members know
that DTCC and all its subsidiaries operate on a “not
for profit” basis. What that means is that we aim to
price our services so that our revenues cover our
expenses.
@dtcc:
Just how big is the fail to delivers, and how much of those
fails does the Stock Borrow program address?
Thompson:
Currently, fails to deliver are running about 24,000
transactions daily, and that includes both new and aged
fails, out of an average of 23 million new transactions
processed daily by NSCC, or about one-tenth of one percent.
In dollar terms, fails to deliver and receive amount to
about $6 billion daily, again including both new fails and
aged fails, out of just under $400 billion in trades
processed daily by NSCC, or about 1.5% of the dollar volume.
The Stock Borrow program is able to resolve about $1.1
billion of the “fails to receive,” or about 20%
of the total fail obligation.
The Stock Borrow program
was created in 1981 with the approval of the SEC to help
reduce potential problems caused by fails, by enabling NSCC
to make deliveries of shares to brokers who bought them when
there is a “fail to deliver” by the delivering
broker. However, it doesn’t in any way relieve the
broker who fails to deliver from that obligation. Even if a “fail
to receive” is handled by Stock Borrow, the “fail
to deliver” continues to exist, and is counted as part
of the total “fails to deliver.” If the total
fails to deliver for that issue exceeds 10,000 shares, it
gets reported to the markets and the SEC.
@dtcc: If
the volume in the Stock Borrow program is so small, why are
these companies suggesting it is a major issue?
Thompson: Frankly,
we believe that the allegations are attempting to purposely
mislead those who are not familiar with this program. A
number of small OTCBB and so-called “pink sheet”
companies have contended that this practice is driving down
the price of their shares and driving them out of
business.
According to their own 10K
and 10Q reports financial auditor’s disclosure
statements, many of these firms have admitted that “factors
raise substantial doubt about the company’s ability to
continue as a going concern.” They have had little or
no revenue, according to their financial reports, and
substantial losses, for periods of seven or eight years. One
of these companies has been cited for failing to file
financial statements since 2001. Another has been cited by
the SEC for press releases that misled investors on
expanding business contracts that didn’t exist. They
will do anything they can do that takes people’s
attention off that kind of record, especially if they can
convince a law firm to take the case on a contingency basis,
which is what has happened.
@dtcc:
Who are the law firms bringing these suits?
Thompson: The main
law firms engaged in these lawsuits, and they have been
behind virtually all of them, were principally involved with
the tobacco class action lawsuit. They like to bring suits
in multiple jurisdictions in an attempt to find any
jurisdiction where they might be successful in winning large
judgments.
@dtcc:
What causes a fail to deliver in a trade? Is it all naked
short selling?
Thompson: There can
be any number of reasons for a “fail to deliver,”
many of them the result of investor actions. An investor can
get a physical certificate to his broker too late for
settlement. An investor might not have signed the
certificate, or signed in the wrong place. There may have
been human error, in that the wrong stock (or CUSIP) was
sold, so the delivery can’t be made. Last year, 1.7
million physical certificates were lost, and sometimes that
isn’t discovered until after an investor puts in an
order to sell the security. There are literally dozens of
reasons for a “fail to deliver,” and most of
them are legal. Reg SHO also allows market makers to legally
“naked short” shares in the course of their market making
responsibilities, and those obviously result in fails. We
can’t do anything about them but what we are doing:
that is, report all fails of more than 10,000 shares in any
issue to the marketplaces and the SEC for their
action.
@dtcc:
What happens then?
Thompson: The
markets check to see if the amount of fails to deliver is
more than 1/2 of 1% of the total outstanding shares in that
security. If it is, then it goes on a “Threshold List.”
If it is then on the Threshold List for 13 consecutive
settlement days, restrictions on short selling then apply.
The “close-out” requirement forces a participant
of a registered clearing agency to close out any “fail
to deliver” position in a threshold security that has
remained for 13 consecutive settlement days by purchasing
securities of like kind and quantity. If the participant
does not take action to close out the open fail to deliver
position, the participant is prohibited from making further
short sales in that security without first borrowing or
arranging to borrow the security. Even market makers are not
exempt from this requirement.
@dtcc: So
Reg SHO doesn’t force them to close out the position,
but if they don’t, they are prohibited from making any
additional short sales without borrowing the shares
first?
Thompson: That’s
right.
@dtcc:
Does DTCC have a regulatory role in naked short selling?
What authority does it have to force companies to settle a
fail?
Thompson: Naked
short selling, or short selling, is a trading activity. We
don’t have any power or legal authority to regulate or
stop short selling, naked or otherwise. We also have no
power to force member firms to close out or resolve fails to
deliver. That power is reserved for the SEC and the markets,
be it the NYSE, Nasdaq, Amex, or any of the other markets.
The fact is, we don’t even see whether a sale is short
or not. That’s something only the markets see. NSCC
just gets “buys” and “sells,” and it’s
our job to try and clear and settle those trades.
@dtcc:
Why won’t you reveal the number of fails to deliver in
each position to the issuer of the security?
Thompson: There are
a couple of reasons. First, we provide that information to
regulators and the SROs so they can investigate fails and
determine whether there are violations of law going on.
Releasing that information might jeopardize those
investigations, and we feel they are the appropriate
organizations to get that information since they can act on
it. Second, NSCC rules prohibit release of trading data, or
any reports based on the trading data, to anyone other than
participant firms, regulators, or self-regulatory bodies
such as the NYSE or Nasdaq. We do that for the obvious
reason that the trading data we receive could be used to
manipulate the market, as well as reveal trading patterns of
individual firms.
@dtcc:
How does DTCC respond to claims that shares from cash
accounts and/or retirement accounts and/or institutional
accounts are being put into the lending pool of the Stock
Borrow program?
Thompson: It is our
broker and bank members who control their DTC accounts. They
can and do segregate shares that they are not permitted to
lend out. Neither NSCC nor DTC monitor or regulate that
activity. It is done by the SROs and the SEC. However, there
is no requirement that brokers or banks participate in the
Stock Borrow program, and neither DTC nor NSCC can take
shares from an account unless those shares are voluntarily
offered by the broker or bank member.
@dtcc: Do
you think there is illegal naked shorting going
on?
Thompson: Certainly
there have been cases in the past where it has, and those
cases have been prosecuted by the SEC and other appropriate
enforcement agencies. I suppose there will be cases where
someone else will try to break the law in the future. But I
also don’t believe that there is the huge, systemic,
illegal naked shorting that some have charged is going on.
To say that there are trillions of dollars involved in this
is ridiculous. The fact is that fails, as a percentage of
total trading, hasn’t changed in the last 10 years.
@
Naked Shorting --
Why not just ignore the law?
LINKS
So who and what is
responsible for creating all the naked shorts? Market makers
abusing their short-selling exemption? Brokers in foreign
markets where naked shorting is legal? Hedge fund managers
manipulating the market? Has this been facilitated over the
last couple of decades, by the shift to the vast majority of
shares being held in street name? The creation of, flaws in,
or abuses of, the DTCC's stock-borrow program?
In case you weren't aware
of it, the SEC is in the process of phasing out paper
certificates, totally. In a 2004 Concept
Release: Securities Transactions
Settlement, the
SEC called for comment on methods to improve the safety and
operational efficiency of the U.S. clearance and settlement
system and to help the U.S. securities industry achieve
straight-through processing. You can read the resulting
comments
here.
The SEC's paper blithely
assumes they are trying to shorten the settlement time for a
trade from 3 days to 1 or even less. It does not address the
fact that the present system sometimes fails totally and any
new system should be designed to eliminate the flaws in the
old one.
Read more via the links,
below.
For recent developments
and discussion, go to the
CEO Council website
and click on "Council Initiatives", then read the
section on "Predatory Trading".
Key
Points About Regulation SHO
from the SEC. Includes links to Threshold Security
Lists.
Buyins.net
-- compiles the data on the Threshold Lists and expands upon
them. Finds out at what prices these stocks have been
shorted, what amounts have been shorted and with enough
investigation, who is illegally shorting the
stocks.
- Motley Fool
Articles:
- The
Naked Truth on Illegal Shorting
- Who's
Behind Naked Shorting?
- By Cale Smith at Hawk
Associates
- Eat
My Shorts! -- A Naked Shorting Primer for
CEOs. -- A
must-read!
- Kevin Kelleher
Articles at TheStreet.com:
- Naked
Truth Dressed to Baffle
- Naked
Before Byrne
- Naked
Shorts' Long Shelf Life
- Naked
Shorts Eye Internet Japan
Short
Selling, Death Spiral Convertibles, and the Profitability of
Stock Manipulation
by John D. Finnerty, Professor of Finance, Fordham
University. Note: This paper is in PDF format.
To get more information
that that included in Reg. SHO, Pink Sheets petitioned the
SEC to cause the amendment of NASD Rule 3360 and require
NASD broker dealers to maintain a record of total "short"
positions in all customer and proprietary firm accounts in
all publicly traded equity securities as well as report this
information to the NASD for public dissemination of the
short positions by security. (At the present time OTCBB and
Pink Sheet companies are not included in this type of
reporting.) Here is the letter
from R. Cromwell Coulson,
Chairman of The Pink Sheets, asking you to support the
petition. Subsequently the SEC did, indeed, propose
such a rule change.
Regulation
SHO and the New Short Sale Locate and Delivery
Requirements By
the National Society of Compliance Professionals. Spells out
the SEC regulations. Note: This article is in PDF
format.
National
Coalition Against Naked Shorting
(NCANS).
Online
PetitionAgainst Naked
Shorting.
Investrend's
FinancialWire Search Page
where you can type in "naked" to get the many articles Gayle
Essary has written on the subject. And here's a quick link
to the
reason you won't see these
articles at Yahoo
Finanance, MarketWatch, or Investor's Business Daily. (Note:
to access FinancialWire archives you'll have to do a free
sign-up.)
The
DTCC Responds on Naked Short
Selling.
You can see a summary of
key legislators concerned about the issue at
America
Needs To Know.
Here is a position
paper from the
Advanced Small Business Alliance (ASBA).
Links to more
articles on the subject
at RGM.
- Blogs Featuring
Relevant Comments
- Relevant
Articles at
Mark
Faulk's Blog.
- Bob
O'Brien's Blog.
- Jeff
Matthews' Blog.
- Patrick
Byrne's Blog.
- Relevant
Articles at
Mark
Cuban's Blog.
- Discussions
- Illegal
Naked Short Selling
Thread at Eliot
Spitzer's Website.
- SS
funds invested in Manipulated Markets
Thread at Eliot
Spitzer's Website.
- 12
Questions Thread
on Silicon Investor.
- On
Cellar Boxing
at Raging Bull.
- Fuego
Entertainment's "Counterfeit
Conspiracy"
blog and discussion.
- Media
- On November 30, 2005,
the North
American Securities Administrators Assn. (NASAA)
held a forum on
naked short selling. Go to their Website to register to
hear the audio Webcast of that forum.
- Video media.
The
Christian Financial Radio
Network has a
video feature called "Where's My Stock?".in their "Buyer
Beware" section.
- At buyins.com look on
the left-hand menu for a link to the Naked
Short Video segment of CNBC's "StreetSigns"
Program where
Patrick Byrne discusses naked shorting.
Below are
extremely truncated excerpts from a very
interesting conversation posted on a discussion board. An
investor decided to experiment by trying to buy a shorted
stock from 2 different sources. Here's what happened.
Read
the whole exchange
for many more details.
Dennis Smith Posted: "I
thought it might be interesting to prove a short position
first hand by purchasing shares in (GLKC) a company that
reportedly already had over 100% of it's shares sold (and
"legally" documented).... Just after settlement date (three
days later), I requested certificates from both brokers. The
cert ordered through Ameritrade appeared in three
weeks....
Getting the Wells Fargo
cert however has become predictably (and almost amusingly)
problematic....":
From Wells
Fargo: ...We are researching your request and will
contact you directly as soon as we have completed our
investigation....
From Dennis
Smith: ...It's been five days. What kind of
"investigation" are you doing?
From Wells
Fargo: ... We were awaiting full delivery of the
shares from the transfer agent. Unfortunately, due to
some unusual circumstances, this took longer than we
expected.
From Dennis
Smith: What exactly are the "unusual
circumstances"?
From Wells
Fargo: ...The broker/dealer from whom your shares
were purchased is short 5,000,000 shares versus the
street. A broker/dealer is allowed to sell shares which
they do not own, which they will buy at a later date and
deliver.
From Dennis
Smith: Exactly how later is "later"? Is not a
5,000,000 short position cause for alarm? Who is the
subject "broker/dealer" from whom you acquired my
"shares" and what is that dealer telling you about his
apparent failure to deliver? As I understand it, a
shareholder is entitled to physical certificates in every
event, assuming the buy was legitimate.
From Wells
Fargo: ...The other broker/dealer who is short shares
of your security is E*Trade. Though this type of activity
makes it difficult to issue physical certificates, it is
legal and within regulations. There is no definite date
by which E*Trade would have to purchase the shares....
According to our trading desk, E*Trade was the only
broker/dealer offering shares of GLKC yesterday. This has
been the case since you originally requested your
certificate.
From Dennis
Smith: You stated there is no definite date by which
E-Trade has to purchase the "short" shares that they sold
you and that in turn you sold me. How can this be
"legal"? What is to prevent them from continuing to sell
what they don't own while subsequently refusing to buy
the shares back if there are no time
constraints?...
My bottom line is this.
I demand the physical GLKC certificate(s) representing
the shares I purchased.
From Wells
Fargo: ...We have received your request for physical
certificates. As soon as we are able to order a physical
certificate for you, we will do so.
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