Transparency of Short Sale Reporting
By: jcline
13 Feb 2007, 09:50 AM EST Msg. 337546 of 337559
Transparency of Short Sale Reporting
Peter J. Chepucavage
Presentation for “The Changing Business of Securities Lending”
NY, NY September 18,2006
This analysis is based on a two part comment letter by Thomas Reilly on the proposed amendments to Reg. SHO dated 9/6 and 9/7.I have added certain insights where applicable and attached the disclosure sections of H.R. Rep102-414-, December 6,1991 which recommended daily short sale reporting and stated the following with respect to the SEC’S approach to short selling:
“Accurate and timely information for investors is essential for a fair and efficient securities market. The unchallenged and unpunished circulation of false or misleading reports about company affairs is very destructive of fair markets. It discourages long-term investors from committing their funds to companies that have been made the targets of information distortions, and in this way it impairs and may even destroy these companies access to the equity market for new capital.
The SEC does not take an evenhanded and balanced approach toward information integrity in the equity market. The SEC vigorously investigates suspected cases of misleading or false information released by company officials about their own companies, which is entirely proper regulatory scrutiny, but the SEC does not employ equal vigor on the other side. The SEC has not committed itself to a policy of suppressing false or manipulative rumor circulation by parties seeking to discredit a company or its officers or products, and it has not displayed any such commitment in practice through its enforcement program.
Small companies are especially vulnerable to campaigns of intentional distortion about their company affairs, for two reasons. First, they lack the resources usually available to a larger company to conduct an expensive information campaign to combat false rumors directly. Second, knowledge of their affairs among the financial press and among securities professionals, who may be able to evaluate false charges critically and render a constructive independent judgment, is generally much less widespread than in the case of large companies.
The SEC should adopt a formal policy and administrative program for improving the integrity of information flows about public companies, especially smaller companies. This program should include a commitment of resources to vigorous investigation of suspected cases of dissemination of false information or of unverifiable information under false pretenses (such as impersonation of company officers or regulatory authorities). The SEC should also evaluate the adequacy of the enforcement authority at its disposal for controlling information distortions about public companies, and should advise Congress of its recommendations for additional authority, if needed.
This commitment by the SEC is needed in part to provide greater confidence to investors that they can commit their funds to investments in small company stocks without excessive vulnerability to abusive information distortion by short sellers. A commitment of this nature by the SEC is needed to dissipate the unhealthy psychological atmosphere, referred to above, that adversely affects the markets for many stock issues in which there is substantial short-selling activity. “
As noted by Mr. Reilly, there remains 15 years later, a unique vacuum in the disclosure of short sales at a time when the public is extremely concerned about naked short sales. Recent estimates suggest that short sales account for over 25% of total volume and that the large investment banks get 25-50% of their profits from hedge funds. Yet the current disclosure is misleading when it excludes arbitrage shorts and fails to disclose naked shorts. It is arguably the sole area where the SEC and Congress choose not to force disclosure of material information. Indeed the Commission did not ask for comment on disclosure in the concept release and proposed rule leading up to Reg SHO. It is only the state of Utah that has ventured into disclosure territory. There is little explanation for non-disclosure of the naked shorts occurring for each issuer especially when they are available thru an FOIA request and to industry insiders. Furthermore there is no recent SEC discussion to explain their reluctance to do so. The Commission’s last word was a concept release in 1991 as a result of the the above referenced House Report. Also attached is a dialogue from last year’s NASSA conference that addresses disclosing naked shorts. See attached transcript at pp.41-47. Reilly notes as follows;
FTD/naked shorts data -
The fact that the SEC selectively releases FTD data through the FOIA process clearly indicates there is a problem both the SEC and the Industry want to shield. It is high time some transparency entered the fray letting investors in on the issue at hand. All FTD data should be released per security. Furthermore, while the SEC pats itself on the back for a reduction in FTD's (shares) there is no mention of the monetary value of those FTD's (shares). If the monetary value of fails does not decline with a 30+% reduction in fails on a share basis then you have allowed the industry to game your regulation. Any analysis of FTD data, and SHO's effectiveness, without a monetary component is absurd.
Monthly Short Interest Reporting -
The fact that these figures are issued without explanatory notices is a disservice to the investing public. The figures released by the NYSE and Nasdaq on a monthly basis are NOT, let me repeat, NOT all of the short positions in the market. Not by a longshot. The short interest figures are pure unadulterated half-truths sold as whole-truths and Wall Street has been pulling the wool over everyone’s eyes, including some of the top academics in the country. Let me explain.
Every month the Nasdaq requires its members to report short interest under NASD Rule 3360 - Short interest Reporting:
a) Each member shall maintain a record of total "short" positions in all customer and proprietary firm accounts in securities included in The Nasdaq Stock Market
and in each other security listed on a registered national securities exchange and not otherwise reported to another self-regulatory organization and shall regularly report
such information to NASD in such a manner as may be prescribed by NASD. For the purposes of this rule, the term "customer" includes a broker/dealer. Reports shall be
made as of the close of the settlement date designated by NASD. Reports shall be received by NASD no later than the second business day after the reporting settlement date designated by NASD.
(b) For purposes of this Rule, "short" positions to be reported are those resulting from "short sales" as that term is defined in SEC Rule 200 of Regulation SHO, with
the exception of positions that meet the requirements of Subsections (e)(1), (6), (7), (8), and (10) of SEC Rule 10a-1 adopted under the Act.
In addition, every month the NYSE requires its members to report short interest under NYSE rule 421.10 Periodic reports
Short positions.—Member organizations and individual direct clearing members for which the Exchange is the designated examining authority are required to report "short" positions, including odd lots, in each stock or warrant listed on the Exchange, and in each other stock or warrant not listed on the Exchange which is not otherwise reported to another United States securities exchange or securities
association, using such automated format and methods as prescribed by the Exchange. Such reports must include customer and proprietary positions and must
be made at such times and covering such time period as may be designated by the
Exchange.
Members and member organizations for which the Exchange is not the designated examining authority must report "short" positions to the self-regulatory exchange which is its designated examining authority if such DEA has a requirement for such reports. If the DEA does not have such a reporting requirement, then such member or member organization must comply with the provisions of Rule 421.
The term "designated examining authority" means the self-regulatory organization which has been assigned responsibility for examining a member or member
organization for compliance with applicable financial responsibility rules. (See Rule 17d-1 under the Securities
Exchange Act of 1934.)
"Short" positions to be reported are those resulting from "short" sales as defined in the Securities and Exchange Commission's Regulation 240.3b-3, but excluding
positions resulting from sales specified in clauses (1), (6), (7), (8), (9) and (10) of paragraph (e) of the Commission's Regulation 240.10a-1. Also to be excluded are
"short" positions carried for other members and member organizations reporting for themselves.
Only one report should be made for each stock or warrant in which there is a short position. If more than one "account" has a short position in the same stock or warrant, the combined aggregate should be reported.
The rules above contain a number of reporting exceptions that most investors do not know exist including, but not limited to the enormous arbitrage short positions. When investors check the short interest of a stock they do not see a notice telling them the short interest may not represent all of the short positions in the stock. We are supposed to have a market operating on transparency, where all participants are on equal footing. It seems to me this
is a serious breach of that market principal. In fact when I researched the rules pertaining to short interest reporting I found it downright misleading. The average investor should not have to investigate the rules, as I have presented above, to ascertain that the short interest data is incomplete and contains many exceptions to reporting.
In March, 2005 SEC Chairman William Donaldson testified before the House Financial Services Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises on The Long and Short of Hedge Funds: Effects of Strategies for Managing Market Risk. In that testimony Chairman Donaldson had some revealing testimony in which he stated:
"While the Commission's rules generally do not require the disclosure of most short sales or short security positions, rules of self-regulatory organizations require their
members to report once a month aggregate short positions in exchange-listed and Nasdaq securities to all customer (including hedge fund customers) and proprietary
accounts. This information is publicly available."
The SEC should take another look at this statement. "The SEC does not require the disclosure of most short sales". Yes, thats true, as I have pointed out above, there are numerous exceptions provided by the SEC and there is no requirement to include them on Form 13(F). However Chairman Donaldson goes on to state that "the NYSE and Nasdaq require their members to report once a month aggregate short positions in exchange-listed and Nasdaq securities to all customer (including hedge fund customers) and proprietary accounts. This information is publicly available." The problem is Chairman Donaldson failed to mention the publicly
available information excepts the same information that led Chairman Donaldson to make the observation that most short sales are not reported.
Chairman Donaldsons testimony perfectly illustrates how information is available to Wall St and unavailable to the small investor. Chairman Donaldson further stated that the SEC reasoned in 1991 that requiring public reporting of material short security positions in publicly traded companies should not be adopted because:
"SROs require members to report short positions in all customer and proprietary accounts and aggregate information, by security, is published monthly. Issuers, through their industry contacts, probably have little difficulty in identifying very large short sellers."
So, what Chairman Donaldson essentially said is unless you have INDUSTRY CONTACTS (Securities lending desks),you will not be able to find out who is hiding behind the exemptions provided in the SEC, NASD and NYSE rules and in effect know the real short position in a security. That is not transparency, it is information rigged in favor of Wall St, hedge funds and institutions. The folks with "INDUSTRY CONTACTS."
The arbitrage exception to reporting short interest mentioned above is a very peculiar aspect of this dissemination of half truths sold as whole truths. Why? Because it wasn’t always in the rules and because arbitrageurs (risk,convertible etc) are some of the biggest
short sellers in the market. In 1986, the NASD issued Notices to Members 86-4 and 86-15 requiring all NASD members to maintain a record of their total "short" positions in NASDAQ securities in all customer and proprietary firm accounts and to report aggregate "short" positions
to the NASD on a monthly basis beginning in February 1986. The notice specifically required "Short positions created as a result of arbitraged transactions are required to be included in the reported aggregate "short" positions. Apparently that rule requirement has been changed by the SEC since then. The question is why?
The exception for arbitraged positions is so peculiar, in fact, that many heavyweights in the world of academia have been snookered over the past years. Finance professors from the likes of MIT, Harvard, Yale... have done studies and written working papers on short interest thinking the arbitrage shorts were included in the short interest figures. Some even going so far to come up with elaborate calculations and assumptions to nullify the impact on their studies.
The bottom line here is investors of all stripes deserve the full, complete picture when they examine short interest. An investor should not need "industry contacts" to determine the extent of the short interest in a particular security. Short interest is important and can have serious implications on a stocks performance. As Paul Asquith and Lisa Meulbroek of Harvard Business School pointed out in a working paper, there is a strong correlation between short interest and subsequent negative corporate returns:
"Using data on monthly short interest positions for all New York Stock Exchange and American Stock Exchange stocks from 1976-1993, we detect a strong negative relation between short interest and subsequent returns, both during the time the stocks are heavily shorted and over the following two years. This relationship persists over the entire 18 year period, and the abnormal returns are even more negative for firms which are heavily shorted for more than one month."
The following Freedom of Information Act request was filed in 2005 in an attempt to see if the SEC had any idea what the total, complete short interest was in the stock market:
Under the Freedom of Information Act (FOIA), please send me the aggregate common stock short interest in the NYSE and Nasdaq, including positions that meet the requirements of Subsections (e)(1), (6), (7), (8), and (10) of SEC Rule 10a-1. Please provide the most recent available aggregate data for each exchange separately. If the commission does not maintain or monitor the aggregate data,
including exceptions provided above, please state so in your response.
The response from the SEC was straightforward. The SEC does not have the information. The total short interest in the stock market is an unknown. Its unknown because its not required to be reported.
The last study on short selling was done by Congress in 1991 and made numerous findings.H.R.Rep.No.102-414(1991) Two of the findings regarding disclosure were as follows:
a.) a method for collecting daily short-selling activity and weekly short interest data from broker-dealers should be developed and this information should be available electronically to the market in aggregate form
b.) Congress should enact a reporting requirement for large individual short positions.
Neither of those recommendations were enacted and I submit that a third should be added to eliminate the aforementioned exceptions or require an explanatory notice any short interest report that is disseminated to the public. Its time the SEC and Congress revisited the issue. The current disclosure is deficient and misleading. The true short interest in the market is unknown. As for individual security short interest. Nobody knows those answers either.
The "Short Squeeze" red herring
The SEC needs to discontinue their use of a "short squeeze" risk as an excuse for not providing transparency regarding FTD data. Not only is it pure bunk, refuted by the industry itself, it is an insult to the intelligence of all investors.
As I mentioned in part one of my comments the real short interest or borrowing availability of all securities can be identified through, as Chairman Donaldson stated, INDUSTRY CONTACTS. Those "industry contacts" are the securities lending desks and organizations that compile, provide and make available a plethora of short interest and borrowing information to Wall St., hedge funds and institutions. In essence, the folks who have the capacity to execute a short squeeze already have all of the information they need.
As the CFA Institute, formerly the Association for Investment Management, stated in its comment letter to the FSA (UK's version of the SEC) concerning the lack of transparency in short selling and responding to a naked short selling scandal in that country:
"professional investors use stock lending information from securities lenders to determine the level of short selling in a security. They can determine whether a large percentage of a company’s shares are already sold short by checking the borrowing costs. By charging more for stocks with significant short interest, lenders provide these investors with information that enables them to determine the risk of a market squeeze."
AND
"reporting by subject stock achieves transparency without putting institutions that enable or engage in short selling at risk of market squeezes."
