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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.

Eat My Shorts!
A Naked Shorting Primer for CEOs.

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, it’s hard to make CUSIP numbers and stock certificates sound sexy, but that’s 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.

WHAT IS NAKED SHORTING, AND WHY SHOULD A CEO CARE?

In its simplest terms, naked shorting involves selling shares of stock that don’t exist. It’s performed routinely by market-makers to keep an orderly market, but it is illegal when done to manipulate a company’s 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.

It’s 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 company’s 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 don’t exist and then attempt to actively lower the company’s 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 company’s 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.

WHO IS INVOLVED?

Naked shorting is typically done by hedge funds with arm’s 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 fund’s brokerage (another prominent player) has a settlement period of three days to deliver those shares to the buyer’s broker. If the transfer doesn’t occur, the DTCC notifies the fund’s broker that it has “FTD’d” (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 issuer’s 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 exchange’s 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 they’ve 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. It’s 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.

HOW DOES NAKED SHORTING ACTUALLY WORK?

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 doesn’t 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 they’ll take some time to get here,” or “I’m a market-maker for that company’s shares in Berlin and naked shorting rules don’t 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 target’s shares down as long and as aggressively as possible. In the event the fund does cover to pay off the stock loan, it doesn’t 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 don’t 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.

KEEPING THINGS IN PERSPECTIVE

Given the mysterious nature of hedge funds and the convoluted nature of this crime, it’s easy to get carried away with paranoid scenarios regarding naked shorting. The skeptics, however, have some unanswered questions of their own. For instance:

• What’s 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 aren’t more companies making noise about it? Where are the whistleblowers?

• Wouldn’t 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 what’s all that mean for the microcap CEO? When it comes to naked shorting, you are your own best watchdog.

WHAT TO DO IF YOU THINK YOU MAY BE TARGETED

Above all else, be discrete with your public accusations.

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.

Watch your trading volume.

If you’re seeing four or five times your company’s float trade hands in an otherwise ordinary day, and you have no large share overhangs, pay attention. Start documenting those patterns.

Keep your focus on operations.

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.

Always surprise on the upside.

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.

Maintain a steady stream of news.

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.

Put floors on your convertibles.

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.

Monitor small international exchanges.

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 it’s done.

Realize your choice of financing vehicle may attract naked shorting interest.

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, you’re also effectively pushing the price lower through increased dilution of existing shareholders. While it’s true that sometimes beggars can’t be choosers when it comes to raising funds, go into those negotiations with your eyes wide open.

Check the Threshold Security lists.

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.

Don’t read the message boards.

You’ll drive yourself nuts, waste a ton of time and eventually convince yourself you’re a victim of someone’s ill wishes, naked shorts or otherwise. If you’re that compelled to monitor the boards, ask your IR team to send you weekly summaries of any cogent posts.

Know your IR company.

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?

Know your transfer agent.

Given that the process of naked shorting begins at the brokerage level, there’s not much your company’s 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 company’s 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 it’s worth, however. Once the new shares are in circulation, there’s 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: Who’s 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.

Eat My Shorts! A Naked Shorting Primer for CEOs.

Cale Smith, Senior Associate

Hawk Associates, Inc.

Naked Shorting -- Why not just ignore the law?

LINKS

Eat My Shorts!
A Naked Shorting Primer for CEOs.