Tuesday, December 06, 2005 8:13:10 PM
An open letter to the NASAA ...
North American Securities Administrators Association, Inc. (NASAA) 2005-11-24
750 First Street, N.E., Suite 1140
Washington, D.C. 20002
To the members of NASAA:
Ladies and Gentlemen of NASAA, thank you for taking the critical step of holding a conference focused on Naked Short Selling (in Washington, D.C. on Nov. 30). I am pleased that there is recognition at the state level of a pervasive, dangerous problem in our markets, and that NASAA is taking the lead in addressing this issue with this groundbreaking meeting, featuring an august panel of authorities. I have no doubt that it will be productive.
As I read your news release, I noted verbiage congratulating the SEC on their passage of Reg SHO. I presume that was a gracious tip of the hat to that agency, rather than a statement of the States' sentiment on the efficacy of Reg SHO. As I am sure you will hear during your meeting, the position of many outside of Federal regulatory chambers is less positive when discussing the agency's performance on this issue.
With that in mind, let me offer an observation or two about the SEC and Reg SHO, from the perspective of a shareholder advocate immersed in the subject.
Reg SHO A Provable Failure
My first observation is that Reg SHO has been a provable failure in curtailing this illegal and destructive manipulation tactic.
Provable, as naked short selling continues to be rampant - one glance at the infamous Reg SHO Threshold List turns up quite a few companies that have been on that list for approaching the entire year it has been published - a virtual impossibility if Reg SHO's rules were being adhered to or enforced, or if the rules themselves actually achieved any desirable effect.
To make matters confusing for many, all naked short selling is not illegal - some naked short selling is actually permitted under Reg SHO, which specifically allows many different entities to do so, with the SEC’s full support - even for companies on the Reg SHO List. As an example, NYSE specialists can not only naked short sell, but can maintain the unsettled trade for months, with the Exchange's blessing. Of course this blessing is given in secret, and nobody is told that it has taken place.
How can naked short selling be eliminated with loopholes like this? How do ordinary investors or victim companies benefit from these sweetheart deals and exceptions, which literally enable a host of participants to print an endless supply of stock at will? With specialists and market makers and foreign financial institutions all able to naked short sell legally, what real obstacle does Reg SHO present for a motivated fraudster with decent resources?
I think it is safe to say, after almost a year of ineffectiveness, that Reg SHO is worse than useless. I have yet to see a shred of evidence that it has achieved anything positive for investors, or the companies naked short sellers (market manipulators, really) target. On the contrary, it has created an environment where the practice is officially condoned and protected by federal regulators - via the numerous exceptions to the anti-naked short selling rules, the non-penalties for violation of the rules, and perhaps most onerous, Reg SHO's grandfathering provision. Which brings me to the second observation I'd like to tender:
What Does Grandfathering Accomplish In Reg SHO?
My second observation is that the "grandfathering" provision of Reg SHO violates Rule 17A - the Congressional mandate to clear and settle ALL trades in a prompt manner (including transfer of record ownership). While the SEC can apparently choose to disregard Congressional mandates, a fair question is what useful purpose is served by grandfathering, and who benefits/is protected?
The SEC's James Brigagliano admitted that the SEC grandfathered unsettled trades due to volatility concerns, which is a euphemism for wanting to avoid short squeezes - legitimate run-ups in price caused by unsettled trades being bought-in, returning the victimized stocks to levels consistent with genuine supply and demand. Why this upside volatility is to be avoided, and yet the downside volatility arising from naked short selling is rewarded by being grandfathered, is unclear, other than that it would place a financial hardship on naked short sellers.
Why it is acceptable for investors to be subjected to downside volatility from these "bear raids", and yet those violating the rules should be protected from upside volatility, remains a mystery. Perhaps Mr. Brigagliano can speak to this double standard, as well as help us all understand the desirability of limiting upside volatility/return to fair value, and protecting downside volatility/perpetually depressed prices by sanctioning a pool of failed trades which can remain undelivered in perpetuity.
Need For Clear Language and Clear Thinking
My third observation is that the language used by Wall Street to describe the offense is a deliberate obfuscation, designed to confuse the issue and make it less understandable for the layman. I think that is wrong, and needs to end. I'm not talking about rare episodes where certificates get lost, or the dog ate them, or someone died after making a trade and failed to mail their cert. When most investors use the term naked short selling, or failing to deliver, we mean deliberate selling of stock without delivering, in order to manipulate the price.
Stock manipulation is a time honored Wall Street tradition. In the 1900's to 1930's, stock manipulation "pools" were common, and share counterfeiting was well understood - the term for it was "watered stock" - unscrupulous manipulators then, as now, used share counterfeiting and naked short selling to create drops in stock prices, creating windfalls from their short positions. Some attribute much of the 1929 Crash's precipitous severity to this practice. Back then everyone understood that counterfeiting a stock certificate and delivering it in place of the genuine article was fraud - nobody argued that. Everyone also understood that taking money for a trade, and never delivering the stock, was also fraud. It is only recently that our moral compass was knocked out of kilter, and the terms failing to deliver and naked short selling were offered as descriptors. This less specific language was introduced and put into play, and soon selling something you didn't own was a delivery failure, a niggling little oversight, a licentious-sounding faux pas, a forgivable speed bump on a fast moving road.
Enough is enough. Let's start using appropriate terms for the acts that are being discussed, not flowery euphemisms devoid of any meaning for the average person.
The act of illegal naked short selling is simple fraud. Money is exchanged for shares, which aren't delivered. It is actually very straightforward at its essence - sales transactions are processed in order to cap or depress a stock's price, money changes hands, the participants are all paid their commissions, but the product is not delivered.
Why does our system, and our regulatory mechanism, have a lexicon of special terms which serve to disguise the nature of this fraud? Why don't we stop calling it naked short selling, or failing to deliver, and call it what it actually is: Fraudulent Stock Trades?
And why is the size and scope of this fraudulent activity kept secret? Who is served by this other than the fraudsters? Why does an entire system conceal the extent of the fraud, and why do our regulatory bodies accommodate this sham? Would we keep the number of bank robberies secret? The number of currency counterfeiting incidences secret? Why do we keep the number of Fraudulent Stock Trades secret, and why can't investors and companies get straight answers as to the number of transactions in their stocks that are fictions - frauds designed to depress their stock's price?
I think that if we use simple, accurate terminology, everyone can better appreciate what is occurring. When you advertise something for sale, take money for it, lower the selling price in the market by artificially creating an illusion of supply, and then don't deliver the item, that is fraud - and the motive is profit. Everyone can understand that. No need to soften it up so it is less repellent or ugly. We all understand defrauding folks for profit, and that it is illegal in every instance we can think of.
So let's just call it what it is: Fraudulent Stock Trades - FST.
Reg SHO Is Ineffective As A Prophylactic
Reg SHO is useless for protecting investors and victim companies. Gentlemen like Dr. Patrick Byrne and his father can't get confirmation of delivery of their shares for months, due specifically to fraudulent stock trades in OSTK, and neither Reg SHO nor the SEC have done a thing to protect them, nor any other shareholders, from those who knowingly and willfully abuse the rules (Dr. Byrne, and his father, purchased shares in the open market in August, 2005, while OSTK was on the SHO list – as it remains today – and it took approximately 60 days for Dr. Byrne to receive delivery of his shares, and almost 90 days for his father to receive his, during which time the price dropped by $10).
Because of the Byrnes' profile, this travesty receives visibility, but if not for their willingness to expose the hypocrisy and lack of enforcement that is the SEC's norm in this area, shareholders would continue to be routinely violated in silence. That is deplorable.
Reg SHO has failed in its essential purpose, and sections of it violate Congressional mandates, so it is inappropriate to view it as any sort of a solution.
The number of FSTs has remained in the centi-million per day range before and after SHO (per multiple FOIA disclosures cited in The Pipes Report, September 15, 2005), proving that the rule has had no measurable deterrent effect in curtailing this threat to our markets. The conceit that a pilot program is required to measure this lack of effect while investors continue to be robbed by unscrupulous participants who use FSTs as a trading strategy is insulting - the SEC fights any disclosure of the size of the problem, delays and stalls any meaningful reform by killing effective rules (like the NASD amendment intended to replace NASD rules 11830 and 3210, which WAS having an effect when implemented in early 2004, until supplanted by Reg SHO), and in general behaves more like an agency attempting to run interference for the industry it is chartered with regulating, rather than an agency attempting to make a good faith effort to address a crisis with the markets. This begs a critical and mystifying question:
Why All The Secrets?
The cult of secrecy surrounding the relatively mundane task of clearing and settling stock trades is alarming, and one must question the requirement for the existent opacity in the system, and ask who is served by this lack of transparency? Why is it desirable or necessary to keep the level of FSTs in a specific stock secret? Why does the plumbing of the system require the cloak of darkness to operate? What is being covered-up with self-important rules mandating secrecy? If millions of shares of a particular stock are being FST'd, who besides the market manipulators are shielded by keeping the information hidden from public view? Since when did understanding how many investors have been defrauded out of their funds, thinking they had purchased and received shares but instead received nothing, become something that investors shouldn't be told?
Exactly how big is the problem? And why is it so dangerous for the public to know? We are discussing delivery of shares that have been paid for, not the secret to building the A-bomb, so why is it all so shrouded in mystery? If investors and CEO's don't have the right to understand how many of the transactions in a given stock are fictions designed to depress the price, why not?
Some market observers state that thousands of companies have been put out of business by FSTs, their access to capital squashed in their infant or growth stage. Others reasonably assert that the amount of tax revenue lost from companies being de-listed or going out of business, the FSTs remaining open in perpetuity and thus never triggering a taxable event, numbers in the many billions. Why not put the speculation to rest and give investors a straight answer?
While we are on the topic of interrogatives the SEC avoids like the plague, here's my all time favorite simple, easy and reasonable Reg SHO question: How many FSTs were grandfathered in Reg SHO, representing what total dollar value of transactions (not current mark to market - actual cash exchanged for non-existent shares at the time of the transactions)?
Every FST grandfathered represents hard cash that was pulled out of the market, with no product ever delivered, leaving the rubes who paid their life savings for the sham FSTs holding nothing - the ultimate fraud. Why won't anyone tell us how many billions of dollars Wall Street manipulators took from the markets, delivering nothing in return? Where is the harm in investors knowing? The only answer I have been able to arrive at is that the number is so egregious, so much of a palpable violation to our reason, that there would be a full scale investor revolt if the number was known.
I have yet to hear a coherent or reasonable answer to these questions, so perhaps NASAA can obtain better responses. I am cautiously optimistic.
I applaud NASAA's willingness to tackle the FST problem, and sincerely hope that this is the commencement of a new era of understanding and genuine effort to curtail a destructive, illegal practice. In the interest of offering up some discussion points for the group's meeting, I'd like to comment on where I believe the major offenses in the FST process occur. It seems that the SEC prefers to ignore these, thus I thought it would be useful to review what is so studiously ignored - that way we can all understand the logic to selective enforcement, or rather complete non-enforcement, of the agency's own rules and regulations.
Anatomy Of A Fraudulent Stock Trade
When an FST occurs, a number of steps in the clearing and settlement process take place, and there are violations of rules/laws at every stage. Note that there are two offenders in an FST:
First offender : Selling broker, who has no shares to deliver.
Second offender : Buying broker, who posts shares into customer accounts (cash and margin) - despite having insufficient shares on hand, thus violating SEC 15c3-3.
Here is a list of the violations and a rough chronology of the sequence:
1) The Seller (or Seller's broker) fails to locate shares. This is a clear violation of NASD Rule 3370(b)(2)(B).
2) The Seller's broker fails to deliver shares to the NSCC (the contra party in all CNS trades) at T+13 (T+3 +10). This is a violation of 17A, and Reg SHO.
3) Alternatively, in the case of non-CNS system trades ("ex-clearing"), the Seller's broker fails to deliver shares to the Buying broker at T+13. Again, a violation of 17A, and Reg SHO.
4) The Buying broker treats these unsettled trades as delivered (rather than canceling the transaction and returning the funds, or buying in the FST Seller), and claims settlement to clients with IRA, 401k and other types of cash accounts (instead of advising them that he's failed to receive the shares, and that he has insufficient shares on hand to match the number of shares in cash accounts). Violation of 15c3-3[1]. Additionally, this misrepresentation on account statements of settlement to cash and retirement account customers constitutes mail and wire fraud, breach of fiduciary duty, and a breach of honest dealings.
5) If handled ex-clearing, there is a failure to tell the shareholder/buyer that nothing was delivered (by the buyer's broker). Also a 15c3-3 violation, and mail and wire fraud.
6) At the 10,000 foot level, the use of FSTs as described above as a manipulative trading strategy by unscrupulous hedge funds/brokers is a violation of 10(B)5, as it constitutes violating a host of rules and laws for the sole purpose of depressing the share price of the victim company - a nice definition of one type of stock manipulation, and a clear 10(B)5 violation.
A Crisis Of Catastrophic Proportions
My perspective is that the FST problem represents a systemic crisis for the U.S. equity markets. The combination of the SEC's non-enforcement of its own rules (as indicated above) along with its passage of Reg SHO, complete with loopholes large enough to drive a truck through and meaningless non-penalties for violations, creates an environment of lawlessness wherein investors are preyed upon by ever-bolder predators. What is the financial penalty to FST practitioners for violating the rules? What are the meaningful disincentives for defrauding investors in this manner? What is the SEC's track record of enforcement for this type of stock fraud? The answers to these questions are disturbing - there are no financial disincentives of note, and the SEC stands idly by as a nation is fleeced, making pretend rules and mouthing platitudes as the predators steal their next billion with impunity.
This situation cannot continue. The flagrant violation of 17A that Reg SHO's grandfathering represents (and its attendant concern that the problem is large enough to warrant grandfathering), combined with the cult of secrecy that characterizes the SEC's approach to the issue, leads me to conclude that years of ignoring the violations have resulted in a buildup of FSTs in the system that could devastate any faith in the market's integrity. The only possible explanations for grandfathering are:
A) The SEC recognizes that the scope of the problem represents a contingent liability of catastrophic proportions, and that any requirement that all the trades actually settle and shares get delivered would cause financial chaos; or,
B) The SEC is protecting the illegally generated profits of those who have been using FSTs as a trading strategy.
If A, the agency is making the classic mistake of hoping that the same industry that created the problem will fix it over time - a tactic that proved fatal in the S&L crisis. If B, the agency is acting as a protector of the industry versus protector of the investor, and requires the strongest possible censure, if not dismantlement and restructuring.
A Thought About "Ex-Clearing"
When the topic of FSTs comes up, generally what is being discussed is the trackable float of failure to delivers recorded by Reg SHO's Threshold List. The omission of the non-Continuous Net Settlement (CNS) system fails - the notorious "ex-clearing system" fails - from this discourse does everyone a disservice, as that system's FSTs likely eclipses the number that are existent within the official system.
For the casual reader, the DTCC (Depository Trust Clearing Corporation) has a mechanism at their subsidiary, the NSCC (National Stock Clearing Corporation), wherein the NSCC will process the clearing (exchange of moneys, including payment of commissions) portion of the trade, and leave the settlement portion (the actual delivery of the stock) out of the system, as an obligation to be handled between the selling and buying brokers. These off-balance sheet delivery obligations don't show up as FSTs on Reg SHO - the DTCC and the SEC take the position that they represent private contractual arrangements between two consenting adults, and they trust that the two parties will settle their trades honorably, in a timely manner.
The obvious problem here is that Wall Street's history is one wherein the participants have been known to behave in a less than honorable manner, especially when money is involved. Witness the analyst scandal, the specialist scandal, the mutual fund front-running scandal, REFCO, etc. etc. By allowing the ex-clearing system to create its own float of IOUs, which freely trade and are treated as genuine between the brokers involved, the SEC and DTCC have compounded the FST problem, and quite literally afforded the clearing brokers an opportunity to print the equivalent of shares of stock (without the annoying cost of goods that buying genuine shares entails), with no real restrictions or oversight. Nobody knows the number of FSTs that are floating around in ex-clearing. I've never seen any accounting for them. And yet we know they exist, as there is a mechanism for handling them at the NSCC, and the General Counsel for Bear Stearns references them in an ominous manner during his Reg SHO conference call (Fall, 2004).
Consider these questions, and you will understand the potential catastrophe lurking beneath the surface of Wall Street, residing in the ledgers in the back offices of the clearing brokers.
1) What is the size of the non-CNS system FST fail to delivers?
2) How are they accounted for by the participants? To whom are they accounted? What mechanism exists to ensure timely settlement? How is delivery tracked and verified? Who administers and regulates this?
3) If NASAA doesn't know how large the problem is (with verifiable data), and can't get access to the numbers, how can it regulate the markets effectively? How can it protect investors?
4) Does anyone know how large this contingent liability of undelivered stock is? If so, who, what data is being collected, and why isn't it being reported? If nobody knows how large it is, why not? Wouldn't this then represent a potentially cataclysmic liability, a float of IOUs of unknown size, collateralized in presumably vastly inadequate ways - essentially an unofficial stock counterfeiting scheme, carried on in Wall Street's back offices?
5) If this is the case, wouldn't that mean that nobody could ever be sure that they own genuine stock, and not just some IOU between brokers?
6) Wouldn't the existence of an undocumented, unregulated float of ex-clearing IOUs represent an industry-wide fraud perpetrated against investors, wherein their cash is exchanged, not for shares of stock, but for bogus markers of questionable actual value?
7) And wouldn't this result in an environment wherein Wall Street has powerful motivation to maintain depressed stocks at depressed levels, given that it is in the industry's best interests to never strain the inadequate collateralization of the ex-clearing FSTs?
8) Why is this NEVER discussed in an open manner, by any regulator? Is it so frightening in its implications that nobody wants to touch it? I've had private discussions where regulators admitted that they had been "told" that it wasn't "that big" a problem, but that they had never seen any data, nor been told exactly how big the problem was. Isn't that scary? If our regulators can't get access to how large the problem is, who is watching the store?
The non-CNS system FSTs could be many orders of magnitude larger than the Reg SHO FSTs, and it is disturbing in the extreme that nobody has any hard data on how pervasive or large the problem is. My belief is that the non-CNS system FSTs are the real iceberg, and the Reg SHO FSTs are simply the tip floating above the surface. Any regulator that chooses to ignore the implications of the 8 questions outlined above shouldn't be a regulator, IMO. Thusfar the SEC won't touch this. Now it is NASAA's opportunity to turn over the rocks, or follow in the SEC's footsteps, and ignore the problem entirely.
Contingent Liabilities
Finally, there is the logistical question of where the money will come from to cover the FSTs failed trades when they are forced to settle, as 17A, and any semblance of a reasoned system, mandates they eventually must. If many years of abuse have truly resulted in a secondary market of non-shares trading in the system, treated by the participants as genuine, then we could well be looking at the financial crisis of our lifetime, as the leverage inherent in hedge fund operations creates a situation where there isn't enough ready liquidity to settle the trades in an auction market.
Given that the difference in cash between the sale price of the FST and the current mark to market price of that undelivered share is available for use by the violator, and given that the cash was likely used to perform more of the same sort of highly profitable, albeit illegal, trades, it is likely that brokers are holding inadequate collateral for most or all the FSTs on their books, should the shares be required to be delivered (prices go up when artificial depressions due to artificial supply end, and the ten cents of collateral now in the account for the shares that will cost $20 tomorrow after steady buy-ins commence, is inadequate to truly settle the trades without damaging the broker or annihilating the violator.) This creates an environment wherein the industry has a vested interest in never settling the trades, and maintaining depressed stocks at depressed prices.
The fraudulent stock trading parties, their brokers, and the clearing and settlement agencies likely have enormous contingent liabilities arising from years of abusing the system, and from permitting unsettled trades to build with inadequate capital collateralizing the obligations. This might well explain the grandfathering, cloak and dagger secrecy, and the multitude of exempted parties - if the rules were enforced, most of the participants would be insolvent or badly damaged once the shares were bought in, thus new nonsense rules and a perpetual vacation from prompt settlement mandates were required - hence Reg SHO.
The question of whether the SEC understands the contingent liability issue, and has been forced to write ineffective rules in order to safeguard the survival of the worst offenders, or is merely protecting their illegally generated profits, is not necessarily a meaningful distinction for investors and companies victimized by this fraudulent practice. Either way, investors lose, and the fraudsters keep their ill-gotten gains.
Proposed Solutions
NASAA is in a unique situation to rectify the deficiencies in Reg SHO, by introducing rules and requrements at the state level which would then drive reasoned rulemaking at the federal level. Here are a list of proposed solutions which could eliminate the Fraudulent Stock Trade problem:
1. Eliminate partial settlement, and prohibit the release of any funds to non-delivering sellers (regardless of what the share price does), until all shares of the trade involved are delivered to the original buyer. This eliminates the current mark to market release of funds to Fraudulent Stock Traders, and prohibits them from using any portion of the proceeds until the shares are delivered. That terminates a large part of the financial reward for FSTs.
2. Hold back all commissions until the shares have been delivered.
3. Force buying brokers to inform their customers when delivery has failed.
4. Upon notification of delivery failure, give the buying customer the option to cancel the trade, and have his money returned.
5. If a customer decides not to cancel trade (presumably because the price has changed in his favor), require the broker to implement a buy-in.
6. Create a "Brokers With Current Delivery Violations" master list, itemized by security - brokers who have current unsettled trades for Reg SHO Threshold List stocks.
7. Implement a financial penalty for delivery violations for SHO Threshold List securities – 33% of the trade value would likely eliminate delivery failure as a trading strategy.
In Closing
Regardless of the motivations of the agency, as protectors of the investing public go, the SEC has failed with Reg SHO. Now it is NASAA's turn to fulfill its obligation to protect investors. I sincerely hope that NASAA will accept the challenges presented in taking responsible, meaningful and swift action, and return our markets to some semblance of the fair system we all hope to participate in.
Thank you for the opportunity to have the FST issue addressed by your group. It is reassuring that someone is willing to tackle this. Investors owe you a tremendous debt of gratitude for your efforts - I hope that they bear meaningful fruit.
Respectfully,
Bob O'Brien
NCANS.net
North American Securities Administrators Association, Inc. (NASAA) 2005-11-24
750 First Street, N.E., Suite 1140
Washington, D.C. 20002
To the members of NASAA:
Ladies and Gentlemen of NASAA, thank you for taking the critical step of holding a conference focused on Naked Short Selling (in Washington, D.C. on Nov. 30). I am pleased that there is recognition at the state level of a pervasive, dangerous problem in our markets, and that NASAA is taking the lead in addressing this issue with this groundbreaking meeting, featuring an august panel of authorities. I have no doubt that it will be productive.
As I read your news release, I noted verbiage congratulating the SEC on their passage of Reg SHO. I presume that was a gracious tip of the hat to that agency, rather than a statement of the States' sentiment on the efficacy of Reg SHO. As I am sure you will hear during your meeting, the position of many outside of Federal regulatory chambers is less positive when discussing the agency's performance on this issue.
With that in mind, let me offer an observation or two about the SEC and Reg SHO, from the perspective of a shareholder advocate immersed in the subject.
Reg SHO A Provable Failure
My first observation is that Reg SHO has been a provable failure in curtailing this illegal and destructive manipulation tactic.
Provable, as naked short selling continues to be rampant - one glance at the infamous Reg SHO Threshold List turns up quite a few companies that have been on that list for approaching the entire year it has been published - a virtual impossibility if Reg SHO's rules were being adhered to or enforced, or if the rules themselves actually achieved any desirable effect.
To make matters confusing for many, all naked short selling is not illegal - some naked short selling is actually permitted under Reg SHO, which specifically allows many different entities to do so, with the SEC’s full support - even for companies on the Reg SHO List. As an example, NYSE specialists can not only naked short sell, but can maintain the unsettled trade for months, with the Exchange's blessing. Of course this blessing is given in secret, and nobody is told that it has taken place.
How can naked short selling be eliminated with loopholes like this? How do ordinary investors or victim companies benefit from these sweetheart deals and exceptions, which literally enable a host of participants to print an endless supply of stock at will? With specialists and market makers and foreign financial institutions all able to naked short sell legally, what real obstacle does Reg SHO present for a motivated fraudster with decent resources?
I think it is safe to say, after almost a year of ineffectiveness, that Reg SHO is worse than useless. I have yet to see a shred of evidence that it has achieved anything positive for investors, or the companies naked short sellers (market manipulators, really) target. On the contrary, it has created an environment where the practice is officially condoned and protected by federal regulators - via the numerous exceptions to the anti-naked short selling rules, the non-penalties for violation of the rules, and perhaps most onerous, Reg SHO's grandfathering provision. Which brings me to the second observation I'd like to tender:
What Does Grandfathering Accomplish In Reg SHO?
My second observation is that the "grandfathering" provision of Reg SHO violates Rule 17A - the Congressional mandate to clear and settle ALL trades in a prompt manner (including transfer of record ownership). While the SEC can apparently choose to disregard Congressional mandates, a fair question is what useful purpose is served by grandfathering, and who benefits/is protected?
The SEC's James Brigagliano admitted that the SEC grandfathered unsettled trades due to volatility concerns, which is a euphemism for wanting to avoid short squeezes - legitimate run-ups in price caused by unsettled trades being bought-in, returning the victimized stocks to levels consistent with genuine supply and demand. Why this upside volatility is to be avoided, and yet the downside volatility arising from naked short selling is rewarded by being grandfathered, is unclear, other than that it would place a financial hardship on naked short sellers.
Why it is acceptable for investors to be subjected to downside volatility from these "bear raids", and yet those violating the rules should be protected from upside volatility, remains a mystery. Perhaps Mr. Brigagliano can speak to this double standard, as well as help us all understand the desirability of limiting upside volatility/return to fair value, and protecting downside volatility/perpetually depressed prices by sanctioning a pool of failed trades which can remain undelivered in perpetuity.
Need For Clear Language and Clear Thinking
My third observation is that the language used by Wall Street to describe the offense is a deliberate obfuscation, designed to confuse the issue and make it less understandable for the layman. I think that is wrong, and needs to end. I'm not talking about rare episodes where certificates get lost, or the dog ate them, or someone died after making a trade and failed to mail their cert. When most investors use the term naked short selling, or failing to deliver, we mean deliberate selling of stock without delivering, in order to manipulate the price.
Stock manipulation is a time honored Wall Street tradition. In the 1900's to 1930's, stock manipulation "pools" were common, and share counterfeiting was well understood - the term for it was "watered stock" - unscrupulous manipulators then, as now, used share counterfeiting and naked short selling to create drops in stock prices, creating windfalls from their short positions. Some attribute much of the 1929 Crash's precipitous severity to this practice. Back then everyone understood that counterfeiting a stock certificate and delivering it in place of the genuine article was fraud - nobody argued that. Everyone also understood that taking money for a trade, and never delivering the stock, was also fraud. It is only recently that our moral compass was knocked out of kilter, and the terms failing to deliver and naked short selling were offered as descriptors. This less specific language was introduced and put into play, and soon selling something you didn't own was a delivery failure, a niggling little oversight, a licentious-sounding faux pas, a forgivable speed bump on a fast moving road.
Enough is enough. Let's start using appropriate terms for the acts that are being discussed, not flowery euphemisms devoid of any meaning for the average person.
The act of illegal naked short selling is simple fraud. Money is exchanged for shares, which aren't delivered. It is actually very straightforward at its essence - sales transactions are processed in order to cap or depress a stock's price, money changes hands, the participants are all paid their commissions, but the product is not delivered.
Why does our system, and our regulatory mechanism, have a lexicon of special terms which serve to disguise the nature of this fraud? Why don't we stop calling it naked short selling, or failing to deliver, and call it what it actually is: Fraudulent Stock Trades?
And why is the size and scope of this fraudulent activity kept secret? Who is served by this other than the fraudsters? Why does an entire system conceal the extent of the fraud, and why do our regulatory bodies accommodate this sham? Would we keep the number of bank robberies secret? The number of currency counterfeiting incidences secret? Why do we keep the number of Fraudulent Stock Trades secret, and why can't investors and companies get straight answers as to the number of transactions in their stocks that are fictions - frauds designed to depress their stock's price?
I think that if we use simple, accurate terminology, everyone can better appreciate what is occurring. When you advertise something for sale, take money for it, lower the selling price in the market by artificially creating an illusion of supply, and then don't deliver the item, that is fraud - and the motive is profit. Everyone can understand that. No need to soften it up so it is less repellent or ugly. We all understand defrauding folks for profit, and that it is illegal in every instance we can think of.
So let's just call it what it is: Fraudulent Stock Trades - FST.
Reg SHO Is Ineffective As A Prophylactic
Reg SHO is useless for protecting investors and victim companies. Gentlemen like Dr. Patrick Byrne and his father can't get confirmation of delivery of their shares for months, due specifically to fraudulent stock trades in OSTK, and neither Reg SHO nor the SEC have done a thing to protect them, nor any other shareholders, from those who knowingly and willfully abuse the rules (Dr. Byrne, and his father, purchased shares in the open market in August, 2005, while OSTK was on the SHO list – as it remains today – and it took approximately 60 days for Dr. Byrne to receive delivery of his shares, and almost 90 days for his father to receive his, during which time the price dropped by $10).
Because of the Byrnes' profile, this travesty receives visibility, but if not for their willingness to expose the hypocrisy and lack of enforcement that is the SEC's norm in this area, shareholders would continue to be routinely violated in silence. That is deplorable.
Reg SHO has failed in its essential purpose, and sections of it violate Congressional mandates, so it is inappropriate to view it as any sort of a solution.
The number of FSTs has remained in the centi-million per day range before and after SHO (per multiple FOIA disclosures cited in The Pipes Report, September 15, 2005), proving that the rule has had no measurable deterrent effect in curtailing this threat to our markets. The conceit that a pilot program is required to measure this lack of effect while investors continue to be robbed by unscrupulous participants who use FSTs as a trading strategy is insulting - the SEC fights any disclosure of the size of the problem, delays and stalls any meaningful reform by killing effective rules (like the NASD amendment intended to replace NASD rules 11830 and 3210, which WAS having an effect when implemented in early 2004, until supplanted by Reg SHO), and in general behaves more like an agency attempting to run interference for the industry it is chartered with regulating, rather than an agency attempting to make a good faith effort to address a crisis with the markets. This begs a critical and mystifying question:
Why All The Secrets?
The cult of secrecy surrounding the relatively mundane task of clearing and settling stock trades is alarming, and one must question the requirement for the existent opacity in the system, and ask who is served by this lack of transparency? Why is it desirable or necessary to keep the level of FSTs in a specific stock secret? Why does the plumbing of the system require the cloak of darkness to operate? What is being covered-up with self-important rules mandating secrecy? If millions of shares of a particular stock are being FST'd, who besides the market manipulators are shielded by keeping the information hidden from public view? Since when did understanding how many investors have been defrauded out of their funds, thinking they had purchased and received shares but instead received nothing, become something that investors shouldn't be told?
Exactly how big is the problem? And why is it so dangerous for the public to know? We are discussing delivery of shares that have been paid for, not the secret to building the A-bomb, so why is it all so shrouded in mystery? If investors and CEO's don't have the right to understand how many of the transactions in a given stock are fictions designed to depress the price, why not?
Some market observers state that thousands of companies have been put out of business by FSTs, their access to capital squashed in their infant or growth stage. Others reasonably assert that the amount of tax revenue lost from companies being de-listed or going out of business, the FSTs remaining open in perpetuity and thus never triggering a taxable event, numbers in the many billions. Why not put the speculation to rest and give investors a straight answer?
While we are on the topic of interrogatives the SEC avoids like the plague, here's my all time favorite simple, easy and reasonable Reg SHO question: How many FSTs were grandfathered in Reg SHO, representing what total dollar value of transactions (not current mark to market - actual cash exchanged for non-existent shares at the time of the transactions)?
Every FST grandfathered represents hard cash that was pulled out of the market, with no product ever delivered, leaving the rubes who paid their life savings for the sham FSTs holding nothing - the ultimate fraud. Why won't anyone tell us how many billions of dollars Wall Street manipulators took from the markets, delivering nothing in return? Where is the harm in investors knowing? The only answer I have been able to arrive at is that the number is so egregious, so much of a palpable violation to our reason, that there would be a full scale investor revolt if the number was known.
I have yet to hear a coherent or reasonable answer to these questions, so perhaps NASAA can obtain better responses. I am cautiously optimistic.
I applaud NASAA's willingness to tackle the FST problem, and sincerely hope that this is the commencement of a new era of understanding and genuine effort to curtail a destructive, illegal practice. In the interest of offering up some discussion points for the group's meeting, I'd like to comment on where I believe the major offenses in the FST process occur. It seems that the SEC prefers to ignore these, thus I thought it would be useful to review what is so studiously ignored - that way we can all understand the logic to selective enforcement, or rather complete non-enforcement, of the agency's own rules and regulations.
Anatomy Of A Fraudulent Stock Trade
When an FST occurs, a number of steps in the clearing and settlement process take place, and there are violations of rules/laws at every stage. Note that there are two offenders in an FST:
First offender : Selling broker, who has no shares to deliver.
Second offender : Buying broker, who posts shares into customer accounts (cash and margin) - despite having insufficient shares on hand, thus violating SEC 15c3-3.
Here is a list of the violations and a rough chronology of the sequence:
1) The Seller (or Seller's broker) fails to locate shares. This is a clear violation of NASD Rule 3370(b)(2)(B).
2) The Seller's broker fails to deliver shares to the NSCC (the contra party in all CNS trades) at T+13 (T+3 +10). This is a violation of 17A, and Reg SHO.
3) Alternatively, in the case of non-CNS system trades ("ex-clearing"), the Seller's broker fails to deliver shares to the Buying broker at T+13. Again, a violation of 17A, and Reg SHO.
4) The Buying broker treats these unsettled trades as delivered (rather than canceling the transaction and returning the funds, or buying in the FST Seller), and claims settlement to clients with IRA, 401k and other types of cash accounts (instead of advising them that he's failed to receive the shares, and that he has insufficient shares on hand to match the number of shares in cash accounts). Violation of 15c3-3[1]. Additionally, this misrepresentation on account statements of settlement to cash and retirement account customers constitutes mail and wire fraud, breach of fiduciary duty, and a breach of honest dealings.
5) If handled ex-clearing, there is a failure to tell the shareholder/buyer that nothing was delivered (by the buyer's broker). Also a 15c3-3 violation, and mail and wire fraud.
6) At the 10,000 foot level, the use of FSTs as described above as a manipulative trading strategy by unscrupulous hedge funds/brokers is a violation of 10(B)5, as it constitutes violating a host of rules and laws for the sole purpose of depressing the share price of the victim company - a nice definition of one type of stock manipulation, and a clear 10(B)5 violation.
A Crisis Of Catastrophic Proportions
My perspective is that the FST problem represents a systemic crisis for the U.S. equity markets. The combination of the SEC's non-enforcement of its own rules (as indicated above) along with its passage of Reg SHO, complete with loopholes large enough to drive a truck through and meaningless non-penalties for violations, creates an environment of lawlessness wherein investors are preyed upon by ever-bolder predators. What is the financial penalty to FST practitioners for violating the rules? What are the meaningful disincentives for defrauding investors in this manner? What is the SEC's track record of enforcement for this type of stock fraud? The answers to these questions are disturbing - there are no financial disincentives of note, and the SEC stands idly by as a nation is fleeced, making pretend rules and mouthing platitudes as the predators steal their next billion with impunity.
This situation cannot continue. The flagrant violation of 17A that Reg SHO's grandfathering represents (and its attendant concern that the problem is large enough to warrant grandfathering), combined with the cult of secrecy that characterizes the SEC's approach to the issue, leads me to conclude that years of ignoring the violations have resulted in a buildup of FSTs in the system that could devastate any faith in the market's integrity. The only possible explanations for grandfathering are:
A) The SEC recognizes that the scope of the problem represents a contingent liability of catastrophic proportions, and that any requirement that all the trades actually settle and shares get delivered would cause financial chaos; or,
B) The SEC is protecting the illegally generated profits of those who have been using FSTs as a trading strategy.
If A, the agency is making the classic mistake of hoping that the same industry that created the problem will fix it over time - a tactic that proved fatal in the S&L crisis. If B, the agency is acting as a protector of the industry versus protector of the investor, and requires the strongest possible censure, if not dismantlement and restructuring.
A Thought About "Ex-Clearing"
When the topic of FSTs comes up, generally what is being discussed is the trackable float of failure to delivers recorded by Reg SHO's Threshold List. The omission of the non-Continuous Net Settlement (CNS) system fails - the notorious "ex-clearing system" fails - from this discourse does everyone a disservice, as that system's FSTs likely eclipses the number that are existent within the official system.
For the casual reader, the DTCC (Depository Trust Clearing Corporation) has a mechanism at their subsidiary, the NSCC (National Stock Clearing Corporation), wherein the NSCC will process the clearing (exchange of moneys, including payment of commissions) portion of the trade, and leave the settlement portion (the actual delivery of the stock) out of the system, as an obligation to be handled between the selling and buying brokers. These off-balance sheet delivery obligations don't show up as FSTs on Reg SHO - the DTCC and the SEC take the position that they represent private contractual arrangements between two consenting adults, and they trust that the two parties will settle their trades honorably, in a timely manner.
The obvious problem here is that Wall Street's history is one wherein the participants have been known to behave in a less than honorable manner, especially when money is involved. Witness the analyst scandal, the specialist scandal, the mutual fund front-running scandal, REFCO, etc. etc. By allowing the ex-clearing system to create its own float of IOUs, which freely trade and are treated as genuine between the brokers involved, the SEC and DTCC have compounded the FST problem, and quite literally afforded the clearing brokers an opportunity to print the equivalent of shares of stock (without the annoying cost of goods that buying genuine shares entails), with no real restrictions or oversight. Nobody knows the number of FSTs that are floating around in ex-clearing. I've never seen any accounting for them. And yet we know they exist, as there is a mechanism for handling them at the NSCC, and the General Counsel for Bear Stearns references them in an ominous manner during his Reg SHO conference call (Fall, 2004).
Consider these questions, and you will understand the potential catastrophe lurking beneath the surface of Wall Street, residing in the ledgers in the back offices of the clearing brokers.
1) What is the size of the non-CNS system FST fail to delivers?
2) How are they accounted for by the participants? To whom are they accounted? What mechanism exists to ensure timely settlement? How is delivery tracked and verified? Who administers and regulates this?
3) If NASAA doesn't know how large the problem is (with verifiable data), and can't get access to the numbers, how can it regulate the markets effectively? How can it protect investors?
4) Does anyone know how large this contingent liability of undelivered stock is? If so, who, what data is being collected, and why isn't it being reported? If nobody knows how large it is, why not? Wouldn't this then represent a potentially cataclysmic liability, a float of IOUs of unknown size, collateralized in presumably vastly inadequate ways - essentially an unofficial stock counterfeiting scheme, carried on in Wall Street's back offices?
5) If this is the case, wouldn't that mean that nobody could ever be sure that they own genuine stock, and not just some IOU between brokers?
6) Wouldn't the existence of an undocumented, unregulated float of ex-clearing IOUs represent an industry-wide fraud perpetrated against investors, wherein their cash is exchanged, not for shares of stock, but for bogus markers of questionable actual value?
7) And wouldn't this result in an environment wherein Wall Street has powerful motivation to maintain depressed stocks at depressed levels, given that it is in the industry's best interests to never strain the inadequate collateralization of the ex-clearing FSTs?
8) Why is this NEVER discussed in an open manner, by any regulator? Is it so frightening in its implications that nobody wants to touch it? I've had private discussions where regulators admitted that they had been "told" that it wasn't "that big" a problem, but that they had never seen any data, nor been told exactly how big the problem was. Isn't that scary? If our regulators can't get access to how large the problem is, who is watching the store?
The non-CNS system FSTs could be many orders of magnitude larger than the Reg SHO FSTs, and it is disturbing in the extreme that nobody has any hard data on how pervasive or large the problem is. My belief is that the non-CNS system FSTs are the real iceberg, and the Reg SHO FSTs are simply the tip floating above the surface. Any regulator that chooses to ignore the implications of the 8 questions outlined above shouldn't be a regulator, IMO. Thusfar the SEC won't touch this. Now it is NASAA's opportunity to turn over the rocks, or follow in the SEC's footsteps, and ignore the problem entirely.
Contingent Liabilities
Finally, there is the logistical question of where the money will come from to cover the FSTs failed trades when they are forced to settle, as 17A, and any semblance of a reasoned system, mandates they eventually must. If many years of abuse have truly resulted in a secondary market of non-shares trading in the system, treated by the participants as genuine, then we could well be looking at the financial crisis of our lifetime, as the leverage inherent in hedge fund operations creates a situation where there isn't enough ready liquidity to settle the trades in an auction market.
Given that the difference in cash between the sale price of the FST and the current mark to market price of that undelivered share is available for use by the violator, and given that the cash was likely used to perform more of the same sort of highly profitable, albeit illegal, trades, it is likely that brokers are holding inadequate collateral for most or all the FSTs on their books, should the shares be required to be delivered (prices go up when artificial depressions due to artificial supply end, and the ten cents of collateral now in the account for the shares that will cost $20 tomorrow after steady buy-ins commence, is inadequate to truly settle the trades without damaging the broker or annihilating the violator.) This creates an environment wherein the industry has a vested interest in never settling the trades, and maintaining depressed stocks at depressed prices.
The fraudulent stock trading parties, their brokers, and the clearing and settlement agencies likely have enormous contingent liabilities arising from years of abusing the system, and from permitting unsettled trades to build with inadequate capital collateralizing the obligations. This might well explain the grandfathering, cloak and dagger secrecy, and the multitude of exempted parties - if the rules were enforced, most of the participants would be insolvent or badly damaged once the shares were bought in, thus new nonsense rules and a perpetual vacation from prompt settlement mandates were required - hence Reg SHO.
The question of whether the SEC understands the contingent liability issue, and has been forced to write ineffective rules in order to safeguard the survival of the worst offenders, or is merely protecting their illegally generated profits, is not necessarily a meaningful distinction for investors and companies victimized by this fraudulent practice. Either way, investors lose, and the fraudsters keep their ill-gotten gains.
Proposed Solutions
NASAA is in a unique situation to rectify the deficiencies in Reg SHO, by introducing rules and requrements at the state level which would then drive reasoned rulemaking at the federal level. Here are a list of proposed solutions which could eliminate the Fraudulent Stock Trade problem:
1. Eliminate partial settlement, and prohibit the release of any funds to non-delivering sellers (regardless of what the share price does), until all shares of the trade involved are delivered to the original buyer. This eliminates the current mark to market release of funds to Fraudulent Stock Traders, and prohibits them from using any portion of the proceeds until the shares are delivered. That terminates a large part of the financial reward for FSTs.
2. Hold back all commissions until the shares have been delivered.
3. Force buying brokers to inform their customers when delivery has failed.
4. Upon notification of delivery failure, give the buying customer the option to cancel the trade, and have his money returned.
5. If a customer decides not to cancel trade (presumably because the price has changed in his favor), require the broker to implement a buy-in.
6. Create a "Brokers With Current Delivery Violations" master list, itemized by security - brokers who have current unsettled trades for Reg SHO Threshold List stocks.
7. Implement a financial penalty for delivery violations for SHO Threshold List securities – 33% of the trade value would likely eliminate delivery failure as a trading strategy.
In Closing
Regardless of the motivations of the agency, as protectors of the investing public go, the SEC has failed with Reg SHO. Now it is NASAA's turn to fulfill its obligation to protect investors. I sincerely hope that NASAA will accept the challenges presented in taking responsible, meaningful and swift action, and return our markets to some semblance of the fair system we all hope to participate in.
Thank you for the opportunity to have the FST issue addressed by your group. It is reassuring that someone is willing to tackle this. Investors owe you a tremendous debt of gratitude for your efforts - I hope that they bear meaningful fruit.
Respectfully,
Bob O'Brien
NCANS.net
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