Prime Broker’s Defense; The SEC Made Us Do It - July 24, 2007
Dave Patch
As first reported last week, the case of Overstock.com v. Wall Street Prime Brokers has progressed to the next phase of trial after Judge John Munter of the Superior Court of California; County of San Francisco denied the defendants motion for dismissal. Court transcripts of the hearing are now available to the public and it appears Wall Street’s most prestigious firms will be rallying around a common defense.
Don't blame us, the SEC made us do it.
In the court transcripts it was Merrill Lynch Attorney James E. Lyons, Esg. of Skadden, Arps, Slate, Meagher & Flom who plead the case for the defendants and opined on several occasions that the activities of the prime brokerage firms were based on what the SEC has allowed them to do over the years. From the trading of unlimited quantities of naked shorts to the lack of compliance to existing settlement rules, the industries limited interpretation of recent SEC comments, and the lack of regulatory enforcement justified whatever actions the firms engaged in.
Under a twisted arrangement of half truths Lyons informed the Judge that "Reg SHO doesn't say you can't have a fail to deliver and even an intentional fail to deliver, and the SEC has said even naked short sales can provide benefits to the marketplace." Lyons limiting his definitions of intentional fails to deliver and naked shorts to only those legal trades he wishes to discuss leaving out the illegal trades the SEC has openly voiced concern over. Trades only a member of Wall Street can participate in by representing either the buy side, sell side, or both sides of the executed trade.
Lyons courtroom bait and switch denied the very existence of the SEC commentary imbedded in the 2003 SHO proposal where the SEC identified that "Naked short selling can have a number of negative effects on the market, particularly when the fails to deliver persist for an extended period of time and result in a significantly large unfulfilled delivery obligation at the clearing agency where trades are settled." With the SEC following up those remarks by saying that "naked short sellers enjoy greater leverage than if they were required to borrow securities and deliver within a reasonable time period, and they may use this additional leverage to engage in trading activities that deliberately depress the price of a security."
Wall Street ultimately failed to honor the concessions the SEC provided them in the 2005 release of SHO leading the SEC to quickly respond with new reforms only 2 years later. Chairman Cox, in his opening remarks to the 2007 changes revealed "Changes to our short selling rules we consider today are aimed squarely at abusive short-selling and market manipulation - and promoting fair, efficient, and orderly markets."
Those changes introduced by the Commission included the elimination of the controversial grandfather clause used almost extensively by market makers and member firms to sell these unlimited naked shorts into the public markets, doing so with great financial advantage. The industry ultimately abused the privilege provided and the SEC responded to the abuse. In rare form, the Prime Brokers continued to show little remorse for their actions again blaming company financials for the intentional fails executed into the market as if the two can ever be directly related.
Lyons: "They have both [Novastar and Overstock] reported dreadful financial performance and they have a terrible outlook for the future. It's no wonder their stock prices declined, and it's no wonder that people have engaged in short selling activity."
Did I miss a law somewhere? Where in our securities laws or rules does it say that it is acceptable to abuse, using illegal trading practices, a struggling company? I even have to question where Lyons received his analyst training to accurately depict the future outlooks of either public company. I thought Mr. Lyons was just one of those high priced ambulance chasers we all speak so highly of.
Lyons could not even keep his lines of reasoning straight as one minute he was arguing that the fails in these companies were related to legal naked shorts associated with market making activities. I must point out that in a collapsing stock there is no need for bona fide market making as the stock already has an imbalance on the sell side. And then in the next breath Lyons appears to be linking the fails to short sellers taking advantage of the poor fundamentals in the company. To that argument, Prime Brokers cannot legally execute orders for short selling clients where the intention is to fail the trade. Such trades would be in violation of SEC Rule 15c6-1 which demands 3-day settlement on trades.. Either way, his clients are involved.
Lyons really minces his words however when he summarizes on how intentional fails to deliver and naked short sales are good for the market place.
A good analogy to the Lyons propaganda would be to take the medicinal belief that "a glass of wine a day is healthy for you" and expand it to a grander scale leading to such conclusions that "binge drinking is a healthy habit if you just stick to drinking wine." Luckily the Judge did not take a sip from the Kool-Aid, or wine, Lyons was serving up.
Lost by Lyons in his translation are the scales of moderation vs. abusive levels. Even the SEC has been drawn to the conclusion that binge trading of sales that result in settlement failures is not healthy for our markets and could be used to manipulate the securities involved.
While Lyons portrayal to the courts that naked shorting is standard industry practice, the SEC and SRO rules do not follow such lines of reasoning and each has placed extreme limits on the use of intentional fails to deliver (naked shorts). Those limited exceptions apply to bona fide market making activities when necessary to create liquidity and are totally off limits to any retail or institutional client not registered as a market maker in a particular issue.
The bona fide market making exemption, in itself carries limitations in that these naked shorts used to create liquidity are to be temporary and would require that the market maker demonstrate a patterns of equilibrium in representing both the buy side and sell side of a market. Sell side only market making is not market making.
NASD Rule 5100 offers guidance on market making citing that "Disproportionate short selling in a market making account to effectuate such strategies will be viewed by the Association as inappropriate activity that does not represent bona fide market making and would therefore be in violation."
Thus where market making activities may have been responsible for the persistence of failures equal to and exceeding threshold levels for a period of no less than 18 trade days, 8 days of qualification to reach threshold level and 10 days of failure thereafter, there can be nothing legal about such activities. Eighteen trade days have never been considered a temporary measurement of time.
The only other option would be that those naked shorts were not market making failures, which would make them illegal except under some extreme and unusual circumstance. Such responsibility for the illegal trades would fall upon those responsible for the execution and timely close out of the failed trade.
By my read of Lyons commentary the Industry misinterpreted SHO and came to their own conclusion that the grandfather clause allowed market makers to short hard-to-borrow stocks without fear they would have to close out losing positions. As soon as the SEC recognized that the members were abusing the clause reforms were being drafted to stop the abuse.
‘Without fear they would have to close out losing positions.’ When did Wall Street become a riskless operation?
Ultimately, the case of Overstock.com v. Wall Street Prime Brokers will be settled in a Superior court in the state of California where the SEC will have no jurisdiction and little influence over the Judge and Jury who will be presented the facts in the case.
What will be interesting when those days come upon us will be how quickly and easily the Attorneys for Wall Street will throw the SEC under the bus after all these years of the SEC protecting these firms’ illegal actions. It will be fun to watch the SEC feel the pain that so many investors have felt over these past decades. Usually it is the investing public thrown under the bus by the SEC and now turn around will be fun to watch.
Neither the SEC nor the Prime Brokers will have a place to hide.
In December 2005 the General Counsel to Bear Stearns admitted in a conference call that "For the past few years we have been hearing from many different regulators regarding their concerns about the increase in the level of fails that they are seeing. They believe, and they have stated on numerous occasions, that one of the primary causes of the high level of fails was that various participants in the short sale process, prime brokers, executing brokers, clients, were not following already established rules."
This week these same Prime Brokers identified above spoke before a state Superior Court Judge and demanded a dismissal on the grounds that they did no wrong because the SEC has never taken an enforcement action against them. It was never about legal or illegal, it was about what the SEC has identified as acceptable behavior by these firms, legal or otherwise.
Request for comment from the Commission Staff at SEC was denied. The Chairman and his staff have seen the documents but have once again gone into silent mode as if possibly they have something of significance to hide.
A full copy of the transcripts will be located at www.investigatethesec.com soon so continue to check out the site for the link.
Later, Stockgate Today will discuss how market makers have and will continue to manipulate our markets through the use of abusive and intentional naked short selling when close out requirements come calling on losing positions.
