Shorting America
By Walter Cruttenden
It is widely agreed that excessive short sale activity can cause sudden price declines,
which can undermine investor confidence, depress the market value of a company’s
shares and make it more difficult for that company to raise capital, expand and create
jobs. This is particularly aggravating for entrepreneurial companies; the engines of new
job creation. In the crash of 2008 short sale activity reached record levels and
exacerbated the market turmoil, leading to one of the most severe economic declines in
modern history.
Job formation is highest among pioneering companies, such as those in the computer,
biotech and emerging growth industries. Studies show that approximately 80% of all new
jobs come from small businesses or new companies in their fast growth phase; those that
grow the fastest hire the most. However, because research, development and new product
innovation are risky and often require multiple rounds of equity financing, short sellers
often target these companies, to the detriment of America.
Short sellers are essentially traders that are hoping a company will experience problems
(such as product delays or the inability to raise financing) so they may profit from the
setbacks. These traders or trading machines make the most if a company struggles and
goes out of business, and some short sellers actively work to make that happen.
Aggressive shorters, and short selling pools, will sometimes hire stock “bashers”, people
paid to post negative articles on blogs and message boards. Their goal is to put out
negative news on a company or its products in an effort to cause the company problems
and insure the stock declines so their negative bets pay off. Others will put up “flash
orders” advertising to sell a large number of shares in an effort to drive down the price.
Thus entrepreneurial companies not only need to fight the battles of developing new
products and markets, they have to stave off the short sellers in the meantime. This
growing culture of betting against a company for the sake of short-term trading profits
(regardless of economic consequences) has negative economic repercussions. This trend
has been fostered by:
• Technology that allows trader anonymity without consequence. Short sellers, like
private hedge funds do not have to disclose their negative bets, whereas mutual
funds and most institutions are required to publicly report their holdings.
• Brokerage firm procedures that make it easy for short sellers to borrow stock
without informing the shareowner of the transaction or potential consequences.
• Internet forums and message boards that allow traders to quickly publish negative
comments about a company, thus forcing down prices.
• The repeal of the uptick rule, which had required traders to only short when it
wouldn’t hurt a company’s stock price, and now allows shorting regardless of the
company’s current stock price direction, enabling “piling on” trading.
As asset prices decline people feel less wealthy and spend less, which in turn causes real
economic contraction. Economists recognize that investor confidence determines
economic activity and Fed Chairman Bernanke recently commented that the economy
could avoid a “double dip recession” as long as markets stayed healthy. Governments
around the world are now struggling with how to stop the proliferation of short sellers
that bet against the economic well being of their nation. This past summer Germany
banned short sales outright in an attempt to quiet its markets during a run on the Euro.
How did things get this way?
Short Sale History
Originally there was no short selling. People that owned shares of a business rarely traded
those shares and would never loan their shares out to a third party to bet against them.
Short selling began as a way to accommodate buyers and sellers. Market makers (such as
the brokers that originally met under the buttonwood tree which became the NYSE) knew
people that wanted to sell their shares if the price reached a certain level. If a buyer
showed up and wanted to purchase a security when that seller was physically unavailable,
the market maker would stand in for the seller and “short” the shares. The outstanding
short rarely lasted more than a few days. Thus there were no actual short sale investors,
just brokers that were temporarily shorting a stock to accommodate a real seller. And
these short sales generally took place when there was demand, meaning at favorable
prices, or at an “uptick” (increase to the prior sale price) and were triggered by the fact
the stock traded up to a certain level. It was a win-win transaction for all parties. In these
early days, traders did not bet against companies, and there was no ability to artificially
drive down the price of a stock.
Share ownership was originally represented by a physical certificate in the shareholders
name kept by the owner in a safe deposit box, or sometimes under the mattress. With the
prosperity of the post World War I economic boom, more people became invested in the
markets, and as trading frequency increased, investors began to leave their shares with a
brokerage firm for convenience purposes.
At first the certificates were kept in the name of the individual shareholder but as trading
volume increased the brokerage firm simply kept the shares in “street name”, meaning
the name of one of the brokerage firms on the street, with an accounting entry to trace the
ownership. This made it easy for the brokerage firms to get into the business of making
“margin” loans against the securities. The securities (collateral for the margin loan) were
already in the brokers name and possession so they did not have to worry about having to
foreclose on the collateral if that became necessary. As margin loans became common
trading volume further increased.
Short selling first came into vogue with the crash of 1929 when certain investment pools
realized it was easy to bet against a company, especially with so many margin loans
outstanding. The market was declining rapidly and shares could be borrowed from
brokerage firms, and the brokerage would get paid for lending those shares.
This historic first wave of large scale short selling probably exacerbated the market
decline, and in some cases, may have gone hand in hand with stock manipulation. Short
sellers realized that if they could force down the price of a stock they could force a
margin call. This effectively forced a sale of the shares allowing the unscrupulous trader
to make money on their short. The severe decline of so many companies in 1929 through
the early 1930’s forced the regulators to study the matter. Finally in 1938 the “uptick”
rule was adopted. This required any investor that wanted to short a stock to sell only on
an uptick (thus returning to the original de facto practice), and greatly reduced the
amount of short selling activity. Prosperity soon returned to America.
By allowing short sales only on price strength, the rule mitigated the “piling-on effect”
and the self-fulfilling prophesy that short selling can bring about when left unrestricted
(short selling causes price declines which in turn shake the confidence of long term
holders who then sell and prolong the downward price trend regardless of underlying
fundamentals, eliminating the company’s ability to raise new capital, causing a vicious
cycle). Thanks in large part to the “uptick rule”, short selling was held to a minimum.
Consequently, short sale activity and market volatility remained relatively quiet during
the 69 years the rule was in effect until its repeal in 2007. To the student of history it is
no coincidence that the repeal of the uptick rule was followed by one of the worst market
declines in recent memory.
Since 2007 there has been a marked increase in short sale activity. Aggressive short
selling not only hurt small companies, it aggravated the 2008 run on Lehman Brothers,
Bear Stearns, Merrill Lynch, WaMu and other long standing financial institutions, that
depended on stable equity values while they worked out their financial problems. Short
selling effectively reduced the duration of the workout window and the result was a
domino effect of economic decline. While the big names captured the headlines many
emerging growth companies suffered similar attacks on their stock and were forced to
downsize or otherwise curtail job creation efforts. As the securities of the unstable
companies, large and small, became worth less many companies found it suddenly
impossible to exchange equity for debt, raise new financing or otherwise restructure in a
normal manner. Rampant short selling causes adverse economic consequences on a scale
that quickly gets out of hand yet its full ramifications are still not widely recognized.
Aggressive short selling was a major contributor to the recent economic troubles as
evidenced by the fact that more large companies have gone into bankruptcy or closed
their doors in the three years since the repeal of the uptick rule, than at any other time
since before the uptick rule. During this period short selling activity became almost a
mainstream activity as new short selling funds proliferated. Many of these so called
“Bear Funds” now leverage their investments whereby ever dollar put up results in two
or three dollars of shorted stock. Jim Cramer and other market pundits have called for a ban
on such funds.
This economically contracting behavior has been accompanied by an increase in market
volatility, evidenced by the rise in the “VIX” (the CBOE volatility index), which has
reached historical levels over the last three years. Needless to say, these larger than
normal market swings spook long-term investors, and drive people out of the equity
markets. This not only shakes investor confidence, but it is bad for the capital formation
process as it restricts financing for innovation and exacerbates economic difficulties.
Fed Chairman Ben Bernanke, Morgan Stanley CEO John Mack, Congressman Gary
Ackerman, Former SEC Commissioner Chris Cox and others have called for a review of
the decision to lift the uptick rule. However, there are now many traders that have an
interest in large short selling funds and as of this date there has been no agreement to
bring back the uptick rule. The SEC did recently adopt Rule 201, which bans short selling
if a stock has fallen more than 10% in a single day. But the fact is if a stock does decline
10% in a single day it has already spooked investors in that company. While it is a
laudable effort it does nothing to address the underlying operational issues that enable
large scale short selling. The easiest and most natural way to rein in aggressive short
sellers is a return to a permission-based system that involves the investors who shares are
being borrowed. In other words, require the approval of the person whose shares are
being loaned to the shorts before short sales can be implemented.
The Genesis of the Problem
Anyone that would like to short a stock must first arrange to borrow those shares, because
stock clearing rules require delivery of the shares to be made within three business days.
If stock certificates were still held by individuals, and these individuals therefore had to
approve the loan of their certificates to would be short sellers, there would likely be very
little shorting activity. After all, what long-term investor would actually loan his or her
shares to someone that wants to bet against his or her economic interests?
Since the 1960’s, technology, record keeping and trading activity have advanced to the
point where not only do most investors find it more convenient to keep their securities
with their broker, but many opt for full featured accounts that give the account holder the
right to borrow against the market value of the account, use a credit card against the
account, or enjoy other borrowing privileges. This means the investor has signed a
margin and hypothecation agreement with a brokerage firm and therefore that brokerage
firm can now freely lend those shares in the account to prospective short sellers without
the investor-owner’s knowledge or permission.
The original purpose of the hypothecation agreement was to give the brokerage firm
access to the client’s securities simply so they could put these securities up as collateral at
a bank to borrow the funds they were loaning to the client. But eventually the brokerage
industry realized the broadly written hypothecation agreement would also allow them to lend
the securities to prospective short sellers, and generate additional income for the firm.
Most shareowners are completely unaware they have given up such extensive rights
under these margin or “hypothecation”agreements. As they are now written, even if an
investor has a minimal loan balance outstanding, the brokerage firm can lend out shares
in that investors account. This practice has evolved so that most brokerage firms now
maintain “Stock Loan Departments” and they get paid well for loaning those certificates
out to short sellers, yet rarely do these proceeds make it to the individual investor. Many
investors have no idea they are effectively aiding the short sellers that are betting against
them. The ease of borrowing such shares nowadays, without an investor’s specific
knowledge, is a major factor in the increase in short sale activity.
Investor Rights Violated
If shareholders knew that their shares were being loaned to prospective short sellers,
whose purpose is to effectively bet against the owner of the securities, few of the stock
loans to short sellers would be made. There is currently no required disclosure to the
rightful owner that provides the owner with right to say yes or no. This lack of
transparency is the root of the issue.
While it is justifiable that a brokerage firm should have the right to borrow against the
shares of anyone they make a margin loan to, they should not be able to loan these shares
to a third party that has an economic interest opposite the shareowner s without specific
approval of that shareholder. But current margin agreements, written by the brokerage
firms to include blanket hypothecation language, do not differentiate between legitimate
borrowing to accommodate a margin loan, and the loaning of shares to short sellers. Thus
current procedures effectively allow the borrowing of shares from one party to be loaned
to another party that bets against the economic interests of the first party, without specific
disclosure.
Unauthorized Share Issuance
Another related problem, that occurs with significant short selling, is the lack of
disclosure that the float is effectively being increased without conveying that information
to the public. The creation of phantom shares, by loans of existing shares to short sellers,
boosts the float (number of freely traded outstanding shares) by artificial means even
though no such increase in shares was ever authorized by the company or the SEC. For
example, one company we have studied has 40 million shares outstanding and a 6 million
short position. Thus investors think they own 46 million shares, even though neither
management nor the SEC ever authorized the extra 6 million shares. In truth there are
only 40 million shares outstanding and the extra shares have been created out of thin air
by the shorts. Far from the original purpose of the practice these shorted shares often stay
outstanding in virtual perpetuity.
But worse than the issuance of phantom shares is the fact this is happening on a large
scale with many investors being taken advantage of without their knowledge. Again, this
is because most investors are effectively loaning their shares to short sellers without
realizing they are helping these short sellers to degrade the value of their securities. The
ability to borrow shares to short, which has become relatively easy, works to the
detriment of long-term investors and the capital formation process.
Solution
The present system lacks transparency. Investors should never be put in a position where
their investments are used to bet against them without their specific knowledge.
Fortunately, it is an easy fix:
Brokerage firms should be required to modify their hypothecation clause in new account
and margin agreements to specifically inform investors that their shares may be loaned to
short sellers that are betting against them, and only allow this practice with an investor’s
knowledge and express permission. This would only require a few sentences to be
changed and should include a check box where an investor is required to give permission.
This would not preclude the brokerage firm from legitimate borrowing against these
shares, it would only preclude the loaning of such shares to short sellers without an
investors knowledge.
The effect of this action would be that if a brokerage firm wants to loan out the shares on
its books (for short sale purposes) it could only do so if the investor has given permission,
whether or not those shares are held in street name or margined or otherwise obfuscated
by commingled ownership. Some brokerage firms would argue that if they have made
margin loans against those securities they should have the right to loan those shares to
other investors. But this is not a valid argument, as loaning shares to a bank for
borrowing purposes has no negative economic consequence to the owner of the shares,
whereas loaning shares to a short seller has direct negative consequences to the owner of
said shares. The two situations should therefore be bifurcated: investors should have the
right to approve any loans of their shares to short sellers, and brokerage firms should
retain their rights to the collateral for legitimate borrowing and collection purposes.
As long as investors are responsible for paying interest and paying back the margin loans
they should have the right to determine what is done with the underlying shares. They
should not forfeit this right under any circumstances. Giving investors this basic right in
no way diminishes the brokerage firm’s ability to liquidate such shares if for any reason
the investor is unable to pay his margin balance. In fact, it could be argued that the
collateral value of the underlying shares will hold “more” value if they are NOT being
loaned out to short sellers.
The result of such a rule (which could be adopted by the SEC or passed as a law by
Congress) would be to once again return short selling to its original purpose. This would
naturally limit the number of people that could bet against investors’ interests, as very
few investors would allow such activity if they were aware that it might directly impact
the value of their securities held. Indirectly it would also reduce the number of “flash
orders” and “machine trades”, which are both highly dependent on the easy borrowing of
shares to short. Furthermore, it would help out entrepreneurial companies, by returning
confidence to the long-term investor, the backbone of America’s job creating capital
markets system.
Summary
In summary, investor rights were slowly usurped by the advance of technology that did
away with the investors name on specific certificates of ownership. This obfuscated the
rights of the certificate holder and led to an increase in the transfer of those securities for
short sale purposes, against the investor’s best interest. The potential damage of increased
short sales was held at bay by the uptick rule that effectively limited the amount of shares
that could be shorted but this rule was repealed. By returning to a permission based
system, whereby the holder of the securities regains the full right to determine the fate of
those securities, a natural balance will be returned to the short sale market (whether or not
the uptick rule is reinstituted). The rightful owner of the securities will once again be in a
position to determine if he or she wants to loan their securities to a third party.
The result of full disclosure and the return of this basic investor right will be reduced
market volatility, an economic system that does not penalize innovation, and a level
playing field for all investors.
Walter Cruttenden, 60, is a financial markets entrepreneur having founded and served
as CEO of two innovative investment banking and brokerage firms; Cruttenden Roth
(now Roth Capital, one of the largest providers of equity capital to emerging growth
businesses), and E*Offering, formerly part of E*Trade Securities. Cruttenden is also an
author of books and films on history and astronomy.
Email: Walter@CruttendenPartners.com
Phone: 949-399-0300
original post courtesy of z
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