Subject: SEC Criticized by US Chamber
SEC Criticized For Delaying Short-Selling ChangesBy Judith BurnsOf DOW JONES NEWSWIRES459 words29 March 200712:30Dow Jones News ServiceEnglish(c) 2007 Dow Jones & Company, Inc.WASHINGTON (Dow Jones)--
The U.S. Securities and Exchange Commission iscoming under criticism for delaying action on persistent problemsinvolving short selling abuses, an area where SEC Chairman ChristopherCox has said existing rules have been inadequate.The SEC announced this week that it is reopening the public commentperiod on changes it proposed last summer to tighten its 2004 rule,known as Regulation SHO. Although the comment period closed inmid-September, the SEC said a new, 30-day extension is warranted inlight of the "continuing public interest" in the matter and concernsraised by a handful of groups and individuals who complained the agencyhad not issued data it referenced when proposing the changes."There's really no reason why they should delay," U.S. Chamber ofCommerce chief operating officer David Chavern said in a telephoneinterview Thursday. "The things they're proposing make perfect sense."The proposed changes aimed to bolster the SEC's earlier efforts tocombat "naked" short sales. Unlike short sellers who borrow shares inhopes of replacing them later and profiting from a price decline, nakedshort sellers don't borrow shares they sell short, a practice somecompare to counterfeiting.Although Regulation SHO imposed new restrictions and stock deliveryrequirements, it contained an exception for options market makers andexcluded pre-existing failures to deliver stocks sold short. Cox told aHouse subcommittee Tuesday that the rule proved "inadequate" because ofthe so-called "grandfather" protections for prior delivery failures.Last July, faced with chronic failures to deliver certain stocksborrowed for short sales, the SEC proposed ending those protections.Eliminating the "grandfather loophole" and market maker exception are"no-brainers," according to Chavern, who urged the SEC to "move aheadexpeditiously with the reforms that they've proposed."The SEC said it is reopening the proposal for comment after releasingdata sought by the American Bar Association and others, including by CTCLLC, which specializes in options trading."We provided additional data because the commenters asked for it, and welook forward to considering their views," said SEC spokesman JohnNester.The SEC had previously referenced the data from the National Associationof Securities Dealers, but didn't release it because it contained"confidential, company-specific" findings. An edited version of the NASDfindings showed many of the stock-delivery failures over a 10-monthperiod in 2005 had pre-existing delivery failures and may have beenexempt under the "grandfather" treatment, while others appear to havebeen covered by the option market maker exemption.
Friday, March 30, 2007
Tuesday, March 13, 2007
SB-979 Passes Oklahoma Senate
Oklahoma State Senate Passes Anti Naked Short Legislation
SB-979 Now moves to the House Calendar
SB-979 Now moves to the House Calendar
Thursday, March 1, 2007
Overstock and Patrick Byrne Continue Naked Short Selling Jihad
Overstock and Patrick Byrne Continue Naked Short Selling Jihad
Thomas J. Catino November 8, 2005
Overstock.com (Nasdaq: OSTK) President, Dr. Patrick Byrne, has continued to up the ante in his vocal public battle against a coordinated campaign of short sellers who have allegedly targeted his company's shares. After appearing over the summer on a CNBC Street Signs segment with anchor Ron Insana, Byrne continued to emphasize that "what's at stake here is innovation and entrepreneurship in America." With strong words, Byrne said that his "company has been attacked and I'm not going to take this lying down."
Overstock.com, which launched its website in 1999 to sell products at wholesale prices, now has annual revenues of approximately $500 million. In the financial world, however, the company is not as well known for its business, but the controversy surrounding an alleged campaign to denigrate the company. Towards the end of the summer, Overstock.com filed suit against Rocker Partners and Gradient Analytics, alleging that the hedge fund and research company conspired to drive down the company's stock in a scheme known as naked short selling. Generally speaking, naked short selling is defined as selling a security short without borrowing the necessary securities to make a delivery, thus resulting in a failure to deliver the securities to the rightful owner. The main goal of naked shorting is to engage in harmfully affecting the stock price of a company in order to manipulate and create downward pressure on the security, affecting a company's ability to raise money on the open market, and ultimately profit from the downward movement in the company's shares.
In the civil complaint against Gradient Analytics, Inc., Rocker Partners LP., David Rocker, Marc Cohodes, and others, Overstock filed on the basis of unfair business practices. It was filed by John O'Quinn and his legal consortium, which has been instrumental in helping other naked short embattled companies in the past. The complaint alleges that Gradient Analytics, Inc., an influential company that sells reports and analyses on publicly traded companies to hedge funds, traditional mutual funds, and provides them to financial commentators such as MSNBC, is closely aligned with various stock hedge funds. The complaint goes on further by alleging that the Gradient and Rocker Partners LP, which is owned and controlled by David Rocker and Michael Cohodes, individually or through Rocker Offshore or Rocker Management, conspired to denigrate Overstock's business in order to reap personal profits for themselves.
While the financial press has been slow to document this, media coverage of this scandal gained momentum with another spirited Byrne conversation, this time on Fox News' Your World Today, with market veteran Neil Cavuto. During his appearance, Byrne claimed that there were "at least twelve Refco's buried in the system" that could result due to this ongoing problem of continuing fails to deliver, or naked short sales. According to the Financial Times, Refco (NYSE: RFXCQ) has over ten billion dollars worth of securities sold, that have not yet been purchased. It is rumored that these dollar amounts represent massive naked short sales, currently under review by major regulatory bodies.
When looking into the Securities and Exchange Commission legislation that should be able to enforce naked short sales, Regulation SHO, with its threshold security list, appears to be a miserable failure. This can be shown through Overstock's presence on the list for well over 100 straight days. In an exclusive interview that Ant & Sons conducted with the President of Overstock.com, Dr. Patrick Byrne, said that he agreed.
When discussing why the SEC had not initiated a buy-in or taken any enforcement action against those failures to deliver, he stated that the SEC is plagued by the fact that they are in an especially difficult situation because they are a "captured regulator." In other words, Byrne believes that "this is not a hard problem to solve," yet "it is just a hard problem to solve without a couple hundred guys on Wall Street getting their asses handed to them." While this may be considered blunt and extreme, it is Byrne's way of calling things as he sees them. However, intelligent investors could argue that Byrne's opinion on the lack of enforcement is quite accurate and is often seen as the unspoken truth on Wall Street. When asked about a potential solution to the problem, Byrne said in his plain spoken style that all that simply needed to be done was to "force settlements."
A while back, Ant & Sons spoke with Eagletech's CEO, Rodney Young, about his company's battle and ultimate downfall because of its inability to raise funds due to naked short selling. At the time, Young was labeled as being out of touch with reality because he claimed that there were potentially thousands of companies that have been "manipulated out of business" due to naked short selling. It now appears though that the problem is much more far reaching than previously thought, even though it has not gotten the appropriate attention in the financial press.
Although this may be the case, Byrne is quick to point out that an investor should first differentiate between the general problem of naked short selling, and his fight of battling against an orchestrated short selling campaign. Still, he admits that there are "hundreds, and historically, perhaps thousands" of cases where naked short selling has led to the downfall of many publicly traded corporations.
In response to this, naysayers tend to believe that Overstock's share price troubles are its own fault, due in part mostly to disappointing earnings results and its lack of a successful business model. Overstock has had many critics on Wall Street, including Jeff Matthews, an internet blogger and General Partner at Ram Partner Capital. He contends, like numerous other critics, that Overstock's allegations of a naked short selling conspiracy is only a cover up for the fact that Overstock's financial performance has not gotten better.
Byrne defended his company by speaking the truth, saying that "Q3 was rough" and it was "(his) bad." Last week, earnings came in below analyst expectations. Not shying away from the tough questions, Byrne said honestly that the company "bit off more technology projects than my colleagues could chew" and the "last bite, an ERP implementation, was one bite too many, and we choked on it."
He also acknowledged the intense criticism "for taking my eye off the ball to pursue a jihad" with his deluge of complaints and lawsuits against Rocker Partners and Gradient Analytics. Some financial journalists have targeted Byrne for going off into the deep end. In a past conference call, he stated that he started to realize that ".there was actually some more orchestration here being provided, by what I am calling here the Sith Lord, or mastermind" that was apart of a conspiracy to manipulate Overstock shares. Filing a lawsuit against Rocker Partners and Gradient is evidence that Byrne and company have confidence in their ability to expose the short selling "Sith Lord" and help to put to rest that these allegations are not just another stock market conspiracy.
For now, the bottom line is that Overstock will have to continue to rely on its own proactive approach and legal team to combat its naked short selling woes. Even with Chris Cox's public statement that the SEC is a "regime for law enforcement," there seems to be no follow through in action to his tough public words. The SEC has merely taken a back seat in all of this, failing to take any enforcement action when necessary, highlighting the continued ineffectiveness and regulatory failure of the SEC. However, with increasing evidence that naked short selling is not just a myth or fantasized market scandal, the pressure will only increase for regulatory bodies to do something meaningful about naked short selling.
Thomas J. Catino November 8, 2005
Overstock.com (Nasdaq: OSTK) President, Dr. Patrick Byrne, has continued to up the ante in his vocal public battle against a coordinated campaign of short sellers who have allegedly targeted his company's shares. After appearing over the summer on a CNBC Street Signs segment with anchor Ron Insana, Byrne continued to emphasize that "what's at stake here is innovation and entrepreneurship in America." With strong words, Byrne said that his "company has been attacked and I'm not going to take this lying down."
Overstock.com, which launched its website in 1999 to sell products at wholesale prices, now has annual revenues of approximately $500 million. In the financial world, however, the company is not as well known for its business, but the controversy surrounding an alleged campaign to denigrate the company. Towards the end of the summer, Overstock.com filed suit against Rocker Partners and Gradient Analytics, alleging that the hedge fund and research company conspired to drive down the company's stock in a scheme known as naked short selling. Generally speaking, naked short selling is defined as selling a security short without borrowing the necessary securities to make a delivery, thus resulting in a failure to deliver the securities to the rightful owner. The main goal of naked shorting is to engage in harmfully affecting the stock price of a company in order to manipulate and create downward pressure on the security, affecting a company's ability to raise money on the open market, and ultimately profit from the downward movement in the company's shares.
In the civil complaint against Gradient Analytics, Inc., Rocker Partners LP., David Rocker, Marc Cohodes, and others, Overstock filed on the basis of unfair business practices. It was filed by John O'Quinn and his legal consortium, which has been instrumental in helping other naked short embattled companies in the past. The complaint alleges that Gradient Analytics, Inc., an influential company that sells reports and analyses on publicly traded companies to hedge funds, traditional mutual funds, and provides them to financial commentators such as MSNBC, is closely aligned with various stock hedge funds. The complaint goes on further by alleging that the Gradient and Rocker Partners LP, which is owned and controlled by David Rocker and Michael Cohodes, individually or through Rocker Offshore or Rocker Management, conspired to denigrate Overstock's business in order to reap personal profits for themselves.
While the financial press has been slow to document this, media coverage of this scandal gained momentum with another spirited Byrne conversation, this time on Fox News' Your World Today, with market veteran Neil Cavuto. During his appearance, Byrne claimed that there were "at least twelve Refco's buried in the system" that could result due to this ongoing problem of continuing fails to deliver, or naked short sales. According to the Financial Times, Refco (NYSE: RFXCQ) has over ten billion dollars worth of securities sold, that have not yet been purchased. It is rumored that these dollar amounts represent massive naked short sales, currently under review by major regulatory bodies.
When looking into the Securities and Exchange Commission legislation that should be able to enforce naked short sales, Regulation SHO, with its threshold security list, appears to be a miserable failure. This can be shown through Overstock's presence on the list for well over 100 straight days. In an exclusive interview that Ant & Sons conducted with the President of Overstock.com, Dr. Patrick Byrne, said that he agreed.
When discussing why the SEC had not initiated a buy-in or taken any enforcement action against those failures to deliver, he stated that the SEC is plagued by the fact that they are in an especially difficult situation because they are a "captured regulator." In other words, Byrne believes that "this is not a hard problem to solve," yet "it is just a hard problem to solve without a couple hundred guys on Wall Street getting their asses handed to them." While this may be considered blunt and extreme, it is Byrne's way of calling things as he sees them. However, intelligent investors could argue that Byrne's opinion on the lack of enforcement is quite accurate and is often seen as the unspoken truth on Wall Street. When asked about a potential solution to the problem, Byrne said in his plain spoken style that all that simply needed to be done was to "force settlements."
A while back, Ant & Sons spoke with Eagletech's CEO, Rodney Young, about his company's battle and ultimate downfall because of its inability to raise funds due to naked short selling. At the time, Young was labeled as being out of touch with reality because he claimed that there were potentially thousands of companies that have been "manipulated out of business" due to naked short selling. It now appears though that the problem is much more far reaching than previously thought, even though it has not gotten the appropriate attention in the financial press.
Although this may be the case, Byrne is quick to point out that an investor should first differentiate between the general problem of naked short selling, and his fight of battling against an orchestrated short selling campaign. Still, he admits that there are "hundreds, and historically, perhaps thousands" of cases where naked short selling has led to the downfall of many publicly traded corporations.
In response to this, naysayers tend to believe that Overstock's share price troubles are its own fault, due in part mostly to disappointing earnings results and its lack of a successful business model. Overstock has had many critics on Wall Street, including Jeff Matthews, an internet blogger and General Partner at Ram Partner Capital. He contends, like numerous other critics, that Overstock's allegations of a naked short selling conspiracy is only a cover up for the fact that Overstock's financial performance has not gotten better.
Byrne defended his company by speaking the truth, saying that "Q3 was rough" and it was "(his) bad." Last week, earnings came in below analyst expectations. Not shying away from the tough questions, Byrne said honestly that the company "bit off more technology projects than my colleagues could chew" and the "last bite, an ERP implementation, was one bite too many, and we choked on it."
He also acknowledged the intense criticism "for taking my eye off the ball to pursue a jihad" with his deluge of complaints and lawsuits against Rocker Partners and Gradient Analytics. Some financial journalists have targeted Byrne for going off into the deep end. In a past conference call, he stated that he started to realize that ".there was actually some more orchestration here being provided, by what I am calling here the Sith Lord, or mastermind" that was apart of a conspiracy to manipulate Overstock shares. Filing a lawsuit against Rocker Partners and Gradient is evidence that Byrne and company have confidence in their ability to expose the short selling "Sith Lord" and help to put to rest that these allegations are not just another stock market conspiracy.
For now, the bottom line is that Overstock will have to continue to rely on its own proactive approach and legal team to combat its naked short selling woes. Even with Chris Cox's public statement that the SEC is a "regime for law enforcement," there seems to be no follow through in action to his tough public words. The SEC has merely taken a back seat in all of this, failing to take any enforcement action when necessary, highlighting the continued ineffectiveness and regulatory failure of the SEC. However, with increasing evidence that naked short selling is not just a myth or fantasized market scandal, the pressure will only increase for regulatory bodies to do something meaningful about naked short selling.
Naked Shorting - The Real Bad Guys
Naked Shorting - The Real Bad Guys
Feb 15th 2006 12:49AM
I got a very interesting email a few minutes ago. I cant say I have fact checked it exhaustively. I havent. Im sure the Naked Shorting Sithmeisters will weigh in with their comments about any perceived or real inaccuracies. Facts can never get in the way of a war, so every side and every word will be spun by all those with something at stake.
Personally, the only thing I have at stake is the ongoing entertainment value of all of this. My 20k shares short of Overstock will continue to do just fine. ( Patrick Byrne, if you want to lend me any of the shares you own and have taken possession of, I would be happy to borrow them and short them).
But I digress. Here is the information I received. You can do your own research before coming to any conlusions. Im sure the comments to this blogpost will be very, very interesting.
Ive been following your blog and have been particularly amused by your postings about Patrick Byrne, Overstock.com and the mysterious people behind the anti-naked shorting movement.
Ive spent quite a bitof time tracking a vast network of corrupt executives, financiers and brokers who route discounted shares of obscure U.S. companies overseas through sham private placements and venture capital deals and then resell them to foreign investors at marked up prices, through unlicensed securities boiler rooms
A few weeks ago, I learned that shares of one such company, Private Trading Systems Inc. of Scottsdale, Ariz. (Pink sheets: PVTM), were being offered to European investors by an apparently fictitious brokerage calling itself Anglo Swiss Consulting (fictitious in the sense that it is not registered with any nations regulatory agency and that its Internet site is something of a Potemkin storefront.)
When I looked into Private Trading Systems, I noted that its chairman, chief executive, treasurer and corporate secretary is none other than C. Austin Bud Burrell, whose dire warnings about naked shorting have been featured at NCANS.net, on the Bob OBrien blog and similar Internet sites.
Burrell also has been a litigation consultant for John OQuinn, the Texas lawyer representing Overstock.com in its suit against Rocker Partners, Gradient Analytics and other defendants who allegedly undermined the companys stock through nefarious shorting activities.
Its worth noting that shares of Endovasc Inc., another company that is part of the anti-naked shorting coalition, also were sold by a foreign boiler room known as Bellador Advisory Services.
Theres another interesting aspect to Private Trading Systems. According to the Form 10-12 that Private Trading filed earlier this month with the SEC, its biggest shareholder, with a 43.2 percent equity stake, is T.P. Ramsden.
The filing said Ramsden controlled the rights to the technology behind the trading system that the company is developing to allow institutional investors to privately trade securities, instruments, or any financial asset that is capable of being converted to electronic form.
What Private Trading Systems SEC filing did not say is that T.P. Ramsden is Terry Ramsden, once a highflying British bond trader, who pleaded guilty to investment fraud in the 1990s and later was convicted of bankruptcy fraud. He was sentenced to 21 months in prison, and served 10.
Ramsden is making a comeback of sorts, and has raised eyebrows in British investment circles by taking positions in several small public companies whose shares have moved upward after his arrival (Hansard Group is one example).
I offer this tale as yet another example of the kinds of activities that members of the anti-naked shorting coalition have been engaging in, while claiming that it is their detractors who are involved in dishonest undertakings.
Feb 15th 2006 12:49AM
I got a very interesting email a few minutes ago. I cant say I have fact checked it exhaustively. I havent. Im sure the Naked Shorting Sithmeisters will weigh in with their comments about any perceived or real inaccuracies. Facts can never get in the way of a war, so every side and every word will be spun by all those with something at stake.
Personally, the only thing I have at stake is the ongoing entertainment value of all of this. My 20k shares short of Overstock will continue to do just fine. ( Patrick Byrne, if you want to lend me any of the shares you own and have taken possession of, I would be happy to borrow them and short them).
But I digress. Here is the information I received. You can do your own research before coming to any conlusions. Im sure the comments to this blogpost will be very, very interesting.
Ive been following your blog and have been particularly amused by your postings about Patrick Byrne, Overstock.com and the mysterious people behind the anti-naked shorting movement.
Ive spent quite a bitof time tracking a vast network of corrupt executives, financiers and brokers who route discounted shares of obscure U.S. companies overseas through sham private placements and venture capital deals and then resell them to foreign investors at marked up prices, through unlicensed securities boiler rooms
A few weeks ago, I learned that shares of one such company, Private Trading Systems Inc. of Scottsdale, Ariz. (Pink sheets: PVTM), were being offered to European investors by an apparently fictitious brokerage calling itself Anglo Swiss Consulting (fictitious in the sense that it is not registered with any nations regulatory agency and that its Internet site is something of a Potemkin storefront.)
When I looked into Private Trading Systems, I noted that its chairman, chief executive, treasurer and corporate secretary is none other than C. Austin Bud Burrell, whose dire warnings about naked shorting have been featured at NCANS.net, on the Bob OBrien blog and similar Internet sites.
Burrell also has been a litigation consultant for John OQuinn, the Texas lawyer representing Overstock.com in its suit against Rocker Partners, Gradient Analytics and other defendants who allegedly undermined the companys stock through nefarious shorting activities.
Its worth noting that shares of Endovasc Inc., another company that is part of the anti-naked shorting coalition, also were sold by a foreign boiler room known as Bellador Advisory Services.
Theres another interesting aspect to Private Trading Systems. According to the Form 10-12 that Private Trading filed earlier this month with the SEC, its biggest shareholder, with a 43.2 percent equity stake, is T.P. Ramsden.
The filing said Ramsden controlled the rights to the technology behind the trading system that the company is developing to allow institutional investors to privately trade securities, instruments, or any financial asset that is capable of being converted to electronic form.
What Private Trading Systems SEC filing did not say is that T.P. Ramsden is Terry Ramsden, once a highflying British bond trader, who pleaded guilty to investment fraud in the 1990s and later was convicted of bankruptcy fraud. He was sentenced to 21 months in prison, and served 10.
Ramsden is making a comeback of sorts, and has raised eyebrows in British investment circles by taking positions in several small public companies whose shares have moved upward after his arrival (Hansard Group is one example).
I offer this tale as yet another example of the kinds of activities that members of the anti-naked shorting coalition have been engaging in, while claiming that it is their detractors who are involved in dishonest undertakings.
Who's Behind Naked Shorting?
Who's Behind Naked Shorting?
By 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 hereBut 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 questionsThis 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.
By 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 hereBut 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 questionsThis 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.
DTCC Responds on Naked Short Selling
DTCC Responds on Naked Short Selling
Let’s start with the question, what is naked short selling and why has it suddenly become an issue?
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.
FAQs
SEC Updates Q&A on Short Selling and Reg SHO
From the Division of Market Regulation: Responses to Frequently Asked Questions Concerning Regulation SHO (May 6, 2005)
SEC Issues Q&A on Short Selling and Reg SHOFrom the Division of Market Regulation: Key Points About Regulation SHO (April 11, 2005)
Naked Short Selling and the Stock Borrow ProgramAn interview with DTCC First Deputy General Counsel Larry Thompson (@dtcc newsletter, March 2005)
LITIGATION
SEC Files Amicus Brief in Nanopierce Appeal (February 7, 2006)
Status of Litigation against DTCCThe current status of litigation against DTCC involving naked short selling. (October 26, 2006)
PRESS RELEASES & STATEMENTS
August 31, 2006 - Media Statement on Global Links
June 28, 2006 - MEDIA STATEMENT: DTCC Clarification on Fails to Deliver
June 2, 2006 - Federal Court Dismisses Lawsuit Against DTCC
March 15, 2006 - Media Statement on Robert Shapiro’s Report on Naked Short Sales
March 14, 2006 - DTCC Clarifies Work Experience of Former DTC Employee
February 17, 2006 - DTCC and the State of Connecticut Issue Joint Statement
January 24, 2006 - Critique of Prof. John Finnerty's paper - A critique by DTCC of Prof. John Finnerty's recent paper, "Short Selling, Death Spiral Convertibles and the Profitability of Stock Manipulation" as it relates to DTCC and its subsidiaries. This critique was offered at the FMA conference where Prof. Finnerty's paper was presented.
January 23, 2006 - Regulators Say Reg SHO is Working - Regulators at the SEC, NYSE and NASD say Reg SHO is working on cutting down fails. May 3, 2005 - DTCC Applauds Court Decision to Dismiss Nanopierce Lawsuit
March 31, 2005 - DTCC Calls Euromoney Article on its Stock Borrow Program and Naked Short Selling 'Sloppy Journalism'
March 30, 2005 - DTCC Announces Effort to Correct Record on its Stock Borrow Program and Naked Short Selling
January 23, 2003 - Media Statement: DTCC Statement On Alleged Short Selling And Issuers Withdrawal From DTC
RECENT NEWS ARTICLES ON NAKED SHORT SELLING
January, 2006 - Regulators Say Reg SHO is Working - @dtcc newletter article.-"While there may be instances of abusive short slling, 99% of all trades in dollar value settle on time without incident..."[more]
May, 2005 - Nevada Court Dismisses Nanopierce Lawsuit Against DTCC On Naked Short Selling - Follows series of nine other failed suits
"A Nevada court has dismissed a lawsuit brought by Nanopierce Technologies, Inc. against DTCC and its subsidiaries that sought to hold DTCC responsible for the drop in Nanopierce’s stock price ..." [more]
March 30, 2005 - Who's Behind Naked Shorting? - By Karl Thiel, The Motley Fool
"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 ..." [more]
February 18, 2005 - A New S.E.C. Rule Fails to Raise Share Prices, and Some Are Angry - By Floyd Norris, The New York Times
"It's a criminal conspiracy when stocks move the wrong way, and the government should do something about it. That is the cry these days of some investors in stocks that have been heavily shorted even after a new rule from the Securities and Exchange Commission took effect ..." [more]
COMMENTARY
Letter to EuromoneyDTCC’s Reaction to April 2005 Article.PDF, 85KB, March 31, 2005
PRODUCT FACT SHEETS
NSCC's Stock Borrow Program - The Stock Borrow Program allows participants to lend NSCC available stocks and fixed income securities from their account at The Depository Trust Company (DTC), to cover temporary shortfalls in NSCC's Continuous Net Settlement (CNS) System.
NSCC's Continuous Net Settlement (CNS) System - CNS is an automated book-entry accounting system that centralizes the settlement of compared security transactions and maintains an orderly flow of security and money balances.
Let’s start with the question, what is naked short selling and why has it suddenly become an issue?
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.
FAQs
SEC Updates Q&A on Short Selling and Reg SHO
From the Division of Market Regulation: Responses to Frequently Asked Questions Concerning Regulation SHO (May 6, 2005)
SEC Issues Q&A on Short Selling and Reg SHOFrom the Division of Market Regulation: Key Points About Regulation SHO (April 11, 2005)
Naked Short Selling and the Stock Borrow ProgramAn interview with DTCC First Deputy General Counsel Larry Thompson (@dtcc newsletter, March 2005)
LITIGATION
SEC Files Amicus Brief in Nanopierce Appeal (February 7, 2006)
Status of Litigation against DTCCThe current status of litigation against DTCC involving naked short selling. (October 26, 2006)
PRESS RELEASES & STATEMENTS
August 31, 2006 - Media Statement on Global Links
June 28, 2006 - MEDIA STATEMENT: DTCC Clarification on Fails to Deliver
June 2, 2006 - Federal Court Dismisses Lawsuit Against DTCC
March 15, 2006 - Media Statement on Robert Shapiro’s Report on Naked Short Sales
March 14, 2006 - DTCC Clarifies Work Experience of Former DTC Employee
February 17, 2006 - DTCC and the State of Connecticut Issue Joint Statement
January 24, 2006 - Critique of Prof. John Finnerty's paper - A critique by DTCC of Prof. John Finnerty's recent paper, "Short Selling, Death Spiral Convertibles and the Profitability of Stock Manipulation" as it relates to DTCC and its subsidiaries. This critique was offered at the FMA conference where Prof. Finnerty's paper was presented.
January 23, 2006 - Regulators Say Reg SHO is Working - Regulators at the SEC, NYSE and NASD say Reg SHO is working on cutting down fails. May 3, 2005 - DTCC Applauds Court Decision to Dismiss Nanopierce Lawsuit
March 31, 2005 - DTCC Calls Euromoney Article on its Stock Borrow Program and Naked Short Selling 'Sloppy Journalism'
March 30, 2005 - DTCC Announces Effort to Correct Record on its Stock Borrow Program and Naked Short Selling
January 23, 2003 - Media Statement: DTCC Statement On Alleged Short Selling And Issuers Withdrawal From DTC
RECENT NEWS ARTICLES ON NAKED SHORT SELLING
January, 2006 - Regulators Say Reg SHO is Working - @dtcc newletter article.-"While there may be instances of abusive short slling, 99% of all trades in dollar value settle on time without incident..."[more]
May, 2005 - Nevada Court Dismisses Nanopierce Lawsuit Against DTCC On Naked Short Selling - Follows series of nine other failed suits
"A Nevada court has dismissed a lawsuit brought by Nanopierce Technologies, Inc. against DTCC and its subsidiaries that sought to hold DTCC responsible for the drop in Nanopierce’s stock price ..." [more]
March 30, 2005 - Who's Behind Naked Shorting? - By Karl Thiel, The Motley Fool
"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 ..." [more]
February 18, 2005 - A New S.E.C. Rule Fails to Raise Share Prices, and Some Are Angry - By Floyd Norris, The New York Times
"It's a criminal conspiracy when stocks move the wrong way, and the government should do something about it. That is the cry these days of some investors in stocks that have been heavily shorted even after a new rule from the Securities and Exchange Commission took effect ..." [more]
COMMENTARY
Letter to EuromoneyDTCC’s Reaction to April 2005 Article.PDF, 85KB, March 31, 2005
PRODUCT FACT SHEETS
NSCC's Stock Borrow Program - The Stock Borrow Program allows participants to lend NSCC available stocks and fixed income securities from their account at The Depository Trust Company (DTC), to cover temporary shortfalls in NSCC's Continuous Net Settlement (CNS) System.
NSCC's Continuous Net Settlement (CNS) System - CNS is an automated book-entry accounting system that centralizes the settlement of compared security transactions and maintains an orderly flow of security and money balances.
Naked Short Selling and the Stock Borrow Program
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.
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.
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