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Naked Shorting Problem info:

The Naked Shorting Problem
by Dr. Patrick Byrne



The issue of “naked shorting” seems to be becoming a news item, and is even (perhaps) a scandal in the making.


The majority of what follows is taken From the Overstock Message Board - 3/13/05


Certain areas have been expanded upon or new ideas and concerns have been added


Shorting Stock

This is a legal and honorable method of investing.

I make a bet that the price of a stock is going to decline.

I borrow and sell the borrowed share at the going market price of $50.00

The stock price goes down to $40.00 - I buy the stock back three days later at market price

I return the borrowed stock with the stock I purchased and pocket $10.00 profit.

Failure-to-Deliver (“FTD”)
The American stock market runs on a “T+3” system. This means that when I sell a share of stock, I have 3 days to deliver that share. If I do not deliver within 3 days, I have, “failed to deliver,” or “FTD’ed”. Think of this like someone who posts auctions on E-Bay, accepts a bid, receives the funds from the successful bidder, but does not deliver the goods.



Depository Trust and Clearing Corporation (DTCC )


This is the back-office of Wall Street. Rather than have people run around with paper stock certificates, the DTCC keeps electronic records of who owns which stock at which brokerages, and settles the trading of stocks. If you “FTD” (“Fail to Deliver”), the DTCC are the folks whose books don’t match.

MARKET MAKERS
On Wall Street there exists a job known as a “market maker,” someone who is charged with maintaining an orderly market in a stock by continuously buying and selling to create liquidity.

Strategic Failures to Deliver
Not all FTD’s are Illegal
Someone may forget to get shares of stock out of her sock draw and deliver them to her broker within three days of a sale, yet this does not make her a criminal.

Market makers are allowed (on a good faith basis) to buy and sell stock that does not exist, temporarily, just to keep liquidity in a stock. Again, this is expected and allowed.

IT IS ILLEGAL FOR INVESTORS OR ANY TRADER TO SELL AND FAIL-TO-DELIVER PURPOSEFULLY

Doing so in an attempt to manipulate the price of a stock, is a “strategic” failure-to-deliver.

Regulations against it since 1933

Regulations which provide for criminal and civil penalties

The slang term for “Strategic Failure to Deliver” is, “naked shorting.”



THE ECONOMICS OF NAKED SHORTING


when a hedge fund pretends to short a stock (I say, “pretends” because it is stock that it does not really own, and which it does not really borrow)

It sells those made-up shares into the marketplace, and collects the money just as though it sold real shares (note that this is “counterfeiting,” more or less, though with electrons rather than paper)



THE ECONOMICS OF NAKED SHORTING - Continued


If it is stock in a small company, and does not trade with much liquidity, then the hedge fund can keep “selling” its made-up shares and drive the stock price down to wherever it wants it to go.

If naked shorting is allowed, then there is no limit on how many bogus shares hedge funds can create.

they can drive a stock’s price down close to $0



THE ECONOMICS OF NAKED SHORTING - Continued


This practice destroys peoples’ savings

Some folks believe companies have been driven out of business by this

if given the right to create an unlimited number of new shares, essentially out of thin air, not limited by the number of shares “in the borrow” as legal shorting requires, these hedge funds can always drive the price down and always cover for a profit. That is why it’s, “illegal.”



How can Naked Shorting Occur in Our Regulated Markets?


The lazy explanation


The sleazy explanation



The lazy explanation
One theory is that the DTCC (and some brokers) look the other way for “favored” clients

Large clients enjoy such favored relationships and, because they have deep pockets, the DTCC and the brokers assume they can trust those clients to operate like this and true things up later

This lackadaisical attitude, however, gives dishonest hedge funds opportunity to “sell” stock that does not exist

as the stock gets driven down it reaches the point that other owners lose confidence and dump their stock, and as it gains downward momentum, the naked shorts can cover their shorts and move on



The Sleazy Explanation


Imagine that a sleazy hedge fund chooses a small, illiquid company to attack
• Often that company is in a poorly understood sector
• or is a company with some accounting complexities so it will be possible to create “where there’s smoke there’s fire” skepticism about its books


The Sleazy Explanation- Continued
Here is what happens:
• The hedge fund gets that US firm listed on foreign exchanges.
• That hedge fund then “sells” shares it neither has nor borrows.
• When the DTCC calls after three days and says, “Where are those shares?” The hedge fund replies, “I borrowed them on the German exchange, they will take a few weeks to show up,” or “I am a market maker for the German Exchanges in that stock, and thus excluded from the no naked shorting rules.”


The sleazy explanation-Continued
Here is what happens – Continued:
• With a nudge and a wink the DTCC says, “OK, we’ll loan you from our own reserves of that stock.”
• The hedge fund has relationships with a few compliant reporters, who are called
• The combination of bad publicity coupled with the selling of an unlimited number of shares drives the stock down to the point either that the hedge fund covers and moves on, making a quick $20 - $50 million, or the company goes bankrupt, or simply remains a penny stock


The Regulatory Environment


After years of pressure, in 2004 the SEC promulgated Reg SHO (for “SHORT”)

directs the exchanges (NYSE, NASDAQ, etc.), to start publishing early in 2005 lists of companies whose FTD’s exceed a reasonable amount

This list is called, “The Reg SHO Threshold List.”
• It does not list the amounts of FTD’s, just the names of companies that are experiencing them.


The way Reg SHO is supposed to work

A company crosses beyond the threshold of a reasonable amount of FTD’s

Company stays there for 5 days without crossing back under the threshold

Company name goes on the Reg SHO list

After 13 more days on the list, brokers are to tell those hedge funds that are failing to deliver that they must stop failing to deliver

Those brokers are not supposed to take any more short sale orders from those accounts for those stocks.



Reg SHO is Flimsy
So flimsy, in fact, it set folks scratching their heads - does the SEC not get it? Here is why it is flimsy:
• Telling the hedge funds after 13 days, “You are not supposed to do any more naked shorting in this stock,” is meaningless - they weren’t supposed to be naked shorting it in the first place.
• There are no sanctions for violators.
• Why grandfather violations that have been illegal for 71 years?


HOW BIG IS THE PROBLEM
TWO THEORIES:
• Tame theory: This is a problem for a small percent of companies, just those that find themselves on the Reg SHO list.
• Extreme Theory: This problem is so endemic that if the SEC tried to fix it the system would crack.
• Which theory is correct? I don’t know. No one knows outside the DTCC, SEC, and maybe the NASDAQ and NYSE. And they are not telling.


The Party Line On Wall Street


The “Pay-No-Attention-To-The-Man-Behind-The-Curtain” Responses
• “There is no naked shorting”:
• “Reg SHO will address this problem”:
• “CEO’s who make an issue of this are just mad that their stock is down.”
• “The folks who make a big deal about this are crazies who line their hat with tinfoil.”


HOW ARE THEY DOING


To perhaps over-dramatize the point, the Reg SHO list is the financial equivalent of the police watching a series of rapes on closed circuit television, and saying they will publish a list of the rape victims, and they will start reminding people that it is not OK to be rapists, but they will grandfather in all rapes that occurred up to some date, and they will not publish the names of the rapists, or reveal how much actual raping is going on. Would we accept that from our police? So why should we from the SEC?



WHO IS RESPONSIBLE



WITHOUT A DOUBT – THE UNITED STATES SECURITIES EXCHANGE COMMISSION IS CHARGED WITH PROTECTING INVESTORS


NO DISTINCTION IS MADE IN THEIR MISSION STATEMENT BETWEEN FUTURE INVESTORS AND CURRENT INVESTORS.



Questions for the SEC

Does SEC receive daily data from the DTCC/NSCC on Fail to Delivers?
• If not, why not?
• How can the SEC regulate without this?


Questions for the SEC – Cont.

How large is the fail to deliver problem? Does the SEC even know?
• Why won’t the DTCC tell anyone how large the problem is?
• Why won’t the DTCC tell the SHO companies how large their FTD problem is?


Questions for the SEC – Cont.
How can firms remain on the threshold list if Reg SHO is enforced?



Questions for the SEC – Cont.

Why grandfather - pardon - all violations prior to January 7, 2005?
• Wasn’t it against the rules (10(a)2, 15(c)6-1, 17(a)) since 1934?
• Why won’t the SEC enforce rules on the books for 71 years?
• What logic supports pardoning flagrant, regular violation of rules?


Questions for the SEC – Cont.

Who are the biggest violators of the Failure to Deliver rules?
• Who benefits the most from the past fails being pardoned?
• Why reward these hedge funds for systematically violating the rules?


Questions for the SEC – Cont.


How can private SS accounts be considered while this is going on?



The Securities and Exchange Act of 1934, Section 17A, Paragraph 2

The congressional mandate the SEC is not fulfilling


The Commission is directed, therefore, having due regard for the public interest, the protection of investors, the safeguarding of securities and funds, and maintenance of fair competition among brokers and dealers, clearing agencies, and transfer agents, to use its authority under this title–
• to facilitate the establishment of a national system for the prompt and accurate clearance and settlement of transactions in securities…” (emphasis added)


Other Issues to Consider
NSCC’s stock borrow program

Vague SEC Statements such as: : “Naked short-selling is not necessarily a violation of the federal securities laws or the Commission's rules.“

why the DTCC “freezes” delivering paper certificates when they are demanded by beneficial owners on heavily shorted stocks

Current initiative of the DTC and NSCC to Dematerialization versus Immobilization of paper stock certificates




What Are The Potential Tax Implications


Seller pockets millions of dollars in profit from naked short sales of stock and never completes the sale by delivering the stock to the buyer. No sale occurs = no taxable income reported.

No money trail to follow on ill-gotten gains

Stock issuer is bankrupted or stock issues are revoked from the market as worthless stock = tax deduction for holders of that stock applied against any gains that are otherwise taxable

Possibly other tax advantages to the bad guys that I am not smart enough to understand



What Must Be Done

Make the SEC enforce the rules that were written and designed to protect investors from Failing To Deliver the stock they bought. No exceptions, no back-room sweetheart deals, no looking the other way while America is fleeced.

Make the DTCC disclose the number of shares in violation - "Fail to Delivers" - for each company on the list, on a daily basis.

Force the Transfer Agents to make outstanding share figures available in daily real time for any company not exempt from registration and reporting.



What Must Be Done – Cont.


Eliminate the grandfathering "vacation from the rule of law" on an illegal abuse that has been ongoing.

Enforce the buy-in provisions on ALL Fail To Deliver positions, not just the latest violations. Don’t reward criminal behavior. Punish it.

Demand accountability for how this violation of the public trust occurred, and fix it, rather than covering it up.




YOUR TASK – FIND A WAY
UNILATERAL RECOGNITION THAT A PROBLEM EXISTS

RECOGNITION THAT A BILATERAL COMMISSION MUST BE APPOINTED TO FIX THIS PROBLEM

CLOSE ALL LOOPHOLES THAT ALLOW THIS PRACTICE TO THRIVE

PUNISH THE PERPURTRATORS

PRESERVE THE SIMPLE INTENTION OF THE SECURITIES AND EXCHANGE ACT OF 1934 TO ESTABLISH AND MAINTAIN A LEVEL PLAYING FIELD FOR INVESTORS
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