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Sunday, 06/13/2004 11:43:22 AM

Sunday, June 13, 2004 11:43:22 AM

Securities Act of 1934, Naked Shorting, and Regulatory Negligence
June 10, 2004

Friends,

In past dialogues, I addressed naked shorting from a personal perspective without direct evidence of fact. Below, I will connect a series of dots that will put into question the actions of Congress and the Securities Regulators as it pertains to the Securities Act of 1934. The Congressional Charter and mandate to all Securities Law.

The Securities act of 1934, as a basis of law, requires that the market be regulated to provide for the highest levels of investor protection possible. In no uncertain terms, the protection of the investor comes above any financial benefits to the institutions that participate in the industry process.

In recent weeks and months, the SEC and DTCC have both used the Securities Act of 1934 to try to address the actions of some public companies to place restrictions on their stock and to trade with what is now known as “Custody-Only” settlement. The DTCC sought, and achieved, approval of the SEC to restrict companies from exiting the National Clearance and Settlement System and from reverting back to physical certificate trading citing, section 17A of the Securities Act. Then, last week, the SEC, again citing the Securities Act of 1934, proposed further rules restricting any and all efforts by transfer agents to clear trades on companies that imposed restrictions on the transfer of their stock.

So with all this attention on the Securities Act of 1934, let’s take a closer look at the Act itself and use it against the very data that the SEC and NASD have provided us regarding naked shorting.

Let’s start with the facts as presented by the SEC and NASD regarding naked shorting.
NASD Rule 3370, as changed effective April 1, 2004, has identified a loophole used by offshore firms that allows naked shorting to enter our markets. The NASD claims specifically that naked shorting can be abusive in nature.
SEC proposed rule SHO has identified that naked shorting can be abusive and be used to manipulate our markets. The SEC claims at that time that the settlement failures of trades exceed the public floats of some securities.
NASD proposes a 10-day settlement rule and states that naked shorting can be abusive to investors. The NASD also claims that settlement failures can exceed the entire public float of companies and further claims that certain rights, including voting rights and rights to dividends, could have a negative affect on investor rights.
So what does the Securities Act of 1934 have to say about naked shorting and investor protection? http://www.law.uc.edu/CCL/34Act/index.html

I. section 17A of the securities act is very specific about the mandate to facilitate:

a. The prompt and accurate clearance and settlement of securities transactions, including the transfer of record ownership and the safeguarding of securities and funds related thereto, are necessary for the protection of investors and persons facilitating transactions by and acting on behalf of investors.
b. The Commission shall use its authority under this title to assure equal regulation under this title of registered clearing agencies and registered transfer agents. In carrying out its responsibilities set forth in subparagraph (A)(ii) of this paragraph, the Commission shall coordinate with the Commodity Futures Trading Commission and consult with the Board of Governors of the Federal Reserve System.

But the present mandate by Congress is not close to being met even though recent claims by the SEC and DTCC assert that it is. The prompt settlement of our securities’ transactions is not presently taking place, as the SEC and DTCC have not facilitated a process that works for all companies and all investors. This Securities Act does not state that this only has to apply to NYSE Large Caps or, excluding penny and micro-cap stocks, it covers all securities under equal regulation. Equal regulation as referred to here is directly linked to the “Equal Protection” clause of the US Constitution.

Regulation SHO and the background dialogue on naked shorting provide substantial evidence of the SEC and DTCC’s failure to establish a prompt and accurate settlement system that protects the investors from abuse. The fact that Congress has not acted upon this admission is concerning. The SEC and DTCC are in direct violation of their mandated charters. Importantly, the failure of Congress to act on the information provided to them about this topic constitutes a gross failure of “Oversight” that is their direct responsibility.

II. Section 18 of the securities Act focuses on the impacts of false and misleading information, and the rights to cure of affected parties.

a. Persons liable; persons entitled to recover; defense of good faith; suit at law or in equity; costs, etc.

Any person who shall make or cause to be made any statement in any application, report, or document filed pursuant to this title or any rule or regulation thereunder or any undertaking contained in a registration statement as provided in subsection (d) of section 15, which statement was at the time and in the light of the circumstances under which it was made false or misleading with respect to any material fact, shall be liable to any person (not knowing that such statement was false or misleading) who, in reliance upon such statement, shall have purchased or sold a security at a price which was affected by such statement, for damages caused by such reliance, unless the person sued shall prove that he acted in good faith and had no knowledge that such statement was false or misleading. A person seeking to enforce such liability may sue at law or in equity in any court of competent jurisdiction. In any such suit the court may, in its discretion, require an undertaking for the payment of the costs of such suit, and assess reasonable costs, including reasonable attorneys' fees, against either party litigant.

The actions of naked shorting settlement failures create several reported documents that contain false and/or misleading information.

The Settlement failure must be covered with a net capital reserve set aside to “protect the liabilities” of that failure. That capital reserve is published in the Broker-Dealers’ quarterly audited filings but is calculated improperly to intentionally hide from the investors of these Broker-Dealers the true nature of their liabilities. In one or more cases, Broker-Dealers and/or Clearing firms have been put out of business upon regulatory actions that required these firms to “settle-up” on their unsettled trades. The capital reserve only represents mark-to-market values and does not take into consideration the requirements to assume settlement of all outstanding shares at a single interval in time.
The trade statements delivered to the buying investor have dates identified on the statement called the “settlement date”. By the definition of settlement according to the NASD, settlement is the conclusion of the transaction in which money is delivered to the seller upon delivery of a registered share to the buyer. In the case of a settlement failure, delivery of the certified share to the buyer did not take place and thus the Statement, mailed to the Investor, contains false and misleading information. This is information that is highly pertinent to the investors’ awareness of their investment risks.

The failure of the SEC and other regulatory agencies in continuing to ignore the false accounting statements is in violation with the mandates of Congress to enforce the accuracy of the statements being presented to the investing public. The SEC is therefore facilitating in the fraud.

III. Finally, Section 20 of the securities Act of 1934 addresses the involvement of those that aid and abet in the facilitation of securities fraud.

e. Prosecution of persons who aid and abet violations

For purposes of any action brought by the Commission under paragraph (1) or (3) of section 21(d), any person that knowingly provides substantial assistance to another person in violation of a provision of this title, or of any rule or regulation issued under this title, shall be deemed to be in violation of such provision to the same extent as the person to whom such assistance is provided.

I contend that the overall actions of the Broker-Dealers, as well as the SEC and SRO’s is in perfect harmony with what the Congress considers to be aiding and abetting the crime of stock manipulation through naked shorting.

To facilitate a naked short there cannot simply be an illegal short sale, there needs to be an orchestrated conspiracy that supports that illegal trade. The Buying Broker-Dealer must ignore their fiduciary duty to enforce delivery for settlement in seeking out the protection of the investors’ best interests. The Buying Broker-Dealer in fact perpetuates the facilitation of that crime when they themselves initiate the false trade statement/confirm identifying settlement had occurred.

The National Clearance and Settlement System, which is mandated by Congress to provide, prompt and accurate clearance and settlement, has failed in its obligations as they process the trade with a continuing settlement failure. The NSCC, with logged data on the magnitude of the settlement failure, has full knowledge and awareness of the continued growth in failures by issuers and fails to enforce any level of “Buy-In” to amend the growing issue.

The DTCC, as an SRO, is in direct violation of the Congressional Mandate and has tried to cover-up their fraud in this conspiracy by placing restrictions on those seeking to remedy the failures. They have co-opted the support of the SEC in trying to shut down companies who have engaged in actions described by Annette Nazareth of the SEC as “Self-Help” efforts, saying that whatever good they might do was in conflict with the greater needs of electronic settlement.

The Securities regulators, NASD and SEC, have participated in the fraud by not addressing these issues of failures as they were brought to the attention of the Commission. It is not expected that the Commission would act immediately but the SEC has had full awareness of the settlement failure issues for over a decade. Instead of meeting the mandates of The Securities Act’s law for prompt settlement, the SEC ignores their obligations to certain issuers because of the pedigree of those companies.

When the SEC fined Rhino Advisors for securities fraud in the manipulation of Sedona Corp in February 2003, they validated all my accusations. Rhino Advisors manipulated a stock through a shorting process that resulted in settlement failures. These are settlement failures that Congress mandated would not take place, as it would have overall adverse affects on our markets. These failures could only take place with participation of the securities industry, and thus, the securities industry aided and abetted the crime as defined by the Securities Act of 1934.

It is time we stopped playing games and started really looking at the evidence quietly provided by the SEC. Congress has set up a mandate on how Investors must be protected and the SEC is ignoring certain aspects of them for the financial protection of those involved in the crimes. Congress must act now and address these issues or our markets will never be safe. The SEC’s primary and singular mission is to protect the individual investor, and not a corrupt industry and its corrupt or incompetent regulators.

Part II--Securities Act of 1934 Part II, When Liquidity becomes Manipulation

The Securities Regulators have created a very fine line between the efficiencies of sufficient market liquidity and market manipulation through the sale of unregistered shares. That fine line is marked when there is a determination of trade settlement. Unfortunately, it appears that we have allowed that fine line to be crossed and instead of addressing those that cross it improperly, we have simply moved the line so that it now affects investor protection to the favor of stock manipulators.

The Industry created settlement loopholes in their guidelines in order to create needed liquidity with tighter spreads in the market in the supposed interests of investor protection and of “Efficient Markets”, the latter being defined as markets that trade with an optimal mix of spread and liquidity. These loopholes specifically addressed:
The allowance for settlement failures arising from “day trading” activities or quick flips by Investors. In cases where a buyer of a security wants to sell that same security within the normal settlement period, the overall settlement of the total trade activities would fail as the buyer was selling a security they have yet to take ownership of. This allowable settlement failure should result in short term delays only and provides the opportunity to an investor to quickly get into and out of a security as needed.
The allowance for settlement failures associated with Bona-Fide Market Making activities. Market Makers were allowed to create liquidity in the market by selling shares they either did not own or could not borrow for delivery to maintain an orderly market. The intent was to offset sudden heavy buying or selling volumes so that there were not wild fluctuations in the price of our securities. In other words, it was intended to maintain tight spreads that could support trading liquidity. Again, the intent was for only short term settlement failures as the Market Makers were required to close out such positions within a short duration of time for settlement. These exceptions were particularly intended for securities where the public float was considered small and illiquid.

The allowance for settlement failures when trading against a fully hedged or arbitrage position. If you were to sell a security against a long position you were holding or as part of an “arbitrage” trade, the settlement was provided a grace period of 5 days beyond the normal settlement period. The presumption here is that this was a short-term bet and that the long share could easily be used for settlement at the termination of the additional grace period.

All of these exemptions, however, had restricted time limits on how long settlement failures could exist in the markets. The Industry instead set up its own guidelines that allowed manipulation to enter the market using the settlement failure as its mechanism. The Industry simply ignored the timeline instructions for delivery and extended an indefinite timeframe for settlement on executed trades. The industry floated (meaning left unsettled) huge percentages of a company’s public float, up to and exceeding 100% in hundreds of cases, as settlement failures and they allowed that dilution to abuse and manipulate the long investor in the securities. Efforts originally intended to improve short-term liquidity became long-term wholesale price manipulation.

When the SEC and NASD admitted that settlement failures exceeded the entire public float of companies they did so quietly and without compassion or explanation. Why? Did the SEC explain how long these settlement failures had to exist for the accumulated totals to exceed the public floats? For companies that trade 1-2% of the public float daily, that would be 50 – 100 trading days just to trade the entire float. If as many as 75% fail to go to settlement daily, it would take 67 – 133 days of trading to fail 100% of the float. These timelines fall way outside the boundaries of prompt settlement as defined by Section 17A of the Securities Act of 1934 and far outside the guidelines necessary to support short-term liquidity. At some point, the settlement failures co-exist in the settlement and clearance system in a manner similar to counterfeit dollars co-existing in our domestic and world economies. Neither is good.

So, what impacts do settlement failures have to the marketplace? From what I can surmise, there are three certain negative impacts.
Settlement failures dilute the investments of all long shareholders who buy these securities with the purpose of holding them long term. Shareholders who invested in a stock in January of 2004 and who has watched additional supply dilute their security by 100% since January has lost their investment to the perils of an imbalance between supply and demand. Regardless of whether the stock has lost value or gained value, the overall investment opportunity has been diminished by the impacts of dilution that is both Long term and continual. In almost all cases, the securities that have been “kited” do not gain value, as it is hard to under these conditions.

Settlement Failure impose risk to the financial markets due to Capital reserve Liabilities and proper accounting of required reserves. In 1995 a clearing firm operating under the name of Adler Coleman went insolvent due to insufficient capital to cover unsettled long positions. The issue was brought to a head when the NASD took enforcement actions against the Fiero Brothers and Hanover Sterling for stock manipulation associated with short selling. Part of the enforcement action required the short sales to be settled leaving Adler Coleman short net capital to cover the short sales. These short sales creating unsettled long positions in client accounts. This case showed that with a growing number of settlement failures entering our markets, forced settlement can and will create insolvency. The extent is based on the magnitude of the settlement problems. We do know, however, that the SEC is aware of several companies as a minimum where the settlement failures exceed the entire public floats of those companies.

Settlement failures have made basic fundamentally-driven virtually meaningless, as the core number of shares used to analyze such ratios as “Float”, “Earnings Per Share”, “Net Asset Value”, “Outstanding Shares”, and more are rendered meaningless. After the recent scandals surrounding conflicts of interest in Research activities of major firms, here we see the worst scandal yet, one that could affect fundamental confidence in markets.

The logical conclusion to jump to here is; With all the risks that come from extended “Long Term” settlement failures, why do regulators continue to let the problem grow? Could it be that they have let it grow to such proportions that they fear the magnitude of insolvency that could come from correcting the problem? Could it be that the regulators have now justified putting individual investor protection on the back burner to corporate solvency for the bigger picture? Does the Securities Act of 1934 even allow the regulators to consider such thoughts?

Section 17A of the Securities Act of 1934 is very specific as to what it requires from the Securities Regulators. Congress mandates that a National Clearance and Settlement system be created that provides for prompt and accurate clearance and settlement of our securities in order to provide protection to the investor. The regulators, in complying with this Law, have set up rules that require prompt settlements with subtle exemptions. These exemptions, however, have timelines that are slightly beyond the definitions of “prompt” settlement and delivery. “Indefinite” was never a word considered in the enabling legislation that created the Securities Act of 1934, nor could it have been.

In the admission that they have allowed indefinite timelines for settlements, Regulators and the Industry have placed themselves into the same criminal liability as the manipulators that created the unsettled shares. They have aided and abetted the crime of stock manipulation and put investor protection and the overall safety of our financial markets in harms way. The Regulators allowed the greed of Broker-Dealers and Clearing Firms to risk their solvency status and have thus risked our market integrity. So, instead of addressing the issue, the Regulators maintain their silence and allow for the financial collateral damage to the individual investor to take place. If this is proven to be the case, as I expect, the Regulators are in violation of Section 20 of the Securities Act of 1934 and should be held criminally liable.

When the Enforcement and Market Regulation Divisions of our regulators consider the solvency of those Wall Street Operations (B/D’s, Clearing firms, Market Makers, etc…) that have taken advantage of settlement failures, they take action that approaches criminal liabilities. The solvency of illegal operations is not to be placed ahead of even a single investor let alone an entire class of investors and/or corporation. There has never been a “Class status” differentiation in the Securities act and certainly our government would be somewhat conflicted if we started to impose one now. Such an action would be in direct violation of the “Equal Protection” clause of our Constitution.

The challenge that lies ahead is difficult. The regulators certainly are at a crossroads where they must decide the fate of investors and companies they have chosen to ignore for some time now. Will the regulators force Wall Street to suck it up and settle out the trades that exist far past the allowable guidelines or will they provide relief at the expense of long shareholders across this country? This should be a question every media person seeks the answer to as it puts the integrity of our government in question.

This is not war, and friendly fire is not supposed to be accepted as a risk in the securities market. Today the collateral damage of friendly fire has been devastating to many on the lower end of the economic scale. It is time to turn that around. Wall Street executives taking in 7 and 8 figure salaries must not be provided the luxury of continued salary expectations at the expense of additional friendly fire. If these firms suffer due to their failures, it must happen. The Securities Act of 1934 is clear about that. Individual Investor Protection is the backbone to the entire act. And that means all investors, not just the wealthy and institutional.

by Dave Patch
http://www.investigatethesec.com

We'll Get there. Just you wait and see....
(Posting news is what I do. It DOESN'T mean I own it!!:-)

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