Mutual Fund Director
From TheStreet.com - The Last Honest Man?
Investing
Why Does Failure to Deliver Go Unpunished?
By Arne Alsin
RealMoney.com Contributor
There is a systemic problem in the equity market, but the magnitude of the problem is impossible to gauge because the parties involved refuse to answer a simple question: Why?
My mutual fund purchased five blocks of stock in Overstock (OSTK:Nasdaq) during the first quarter. There was a failure to deliver shares in four out of the five purchases, with delays for delivery lasting as long as three weeks. Nobody can tell me why shares were not delivered within the requisite three-day settlement period -- the so-called T+3 requirement.
This is not a single isolated occurrence, or a one-in-a-million bookkeeping bump in the road. The Securities and Exchange Commission recently acknowledged that $6 billion in stock have failed deliveries each day. Out of 6,000 publicly traded stocks, over 300 are currently experiencing significant delivery problems.
There are two common ingredients to every financial scandal that has rocked Wall Street over the years.
The first is that the perpetrators have power or influence that the average investor does not have. While small investors have to play by the rules, market players with power or influence work around the rules or simply break them.
For some sellers of stock, it appears that property can be delivered at a time of their choosing. It's not T+3. It's T plus when they get around to it. In one of my purchases of Overstock, it was T+21. The vast majority of investors do not have the luxury of delivering stock that they sell at a time of their choosing. A market is unfair when some market participants can ignore rules that others have to follow.
The second common ingredient to past scandals is greed. Greed causes market participants to break the rules. Implicit in the failure to deliver shares to my fund is this: Delivery was delayed because it was financially advantageous to the seller. The seller, in effect, grants himself a free option to take extra time for delivery. The seller's unilateral modification to our agreement (giving the seller as much as three weeks for delivery) is made without my prior notice and consent.
If this implication is correct, that the only logical rationale to delay delivery is because it financially benefits the seller, then any gain to the seller is an ill-gotten gain.
It is an either/or situation for the sellers that failed to deliver Overstock shares to my fund: Either they had my property in their possession and decided to keep it for awhile, or they sold the shares to me without having possession. While the first possibility is a serious infringement of the rules, the second possibility is particularly disturbing.
Selling shares without possession is known as a "naked short". That is, naked shorting is selling shares that are not owned and haven't been borrowed. While market makers are granted the flexibility to naked-short in order to maintain liquidity, that exception should not apply here. Overstock shares have plenty of liquidity. The entire float of Overstock turns over every 13 days. By comparison, it takes 50 days for the entire float of Amazon.com (AMZN:Nasdaq) to turn over.
More importantly, the market-maker exception is not available when a company has had repeated problems in share delivery. Companies with share-delivery problems are placed on a "Threshold List" per regulation SHO, promulgated by the SEC in 2005. If a company has been on the Threshold List for 13 consecutive days, the market maker-exception is no longer available. When I bought Overstock for my fund it had been on the Threshold List for more than 200 days.
Why Is Naked Shorting A Problem?
The problem with naked shorting is that it represents an attack on the fundamental fairness of the market. At the heart of a fair market is a respect for supply and demand. Once the supply component of supply and demand is tinkered with, all bets are off as to the fairness of the marketplace. If there is no cap on the supply of shares -- because market participants are able to sell stock that they don't have -- prices are subject to manipulation.
Manipulation occurs when sellers sell large chunks of stock -- stock that they don't own and haven't borrowed -- in order to drive down the price. Increased supply overwhelms buyers and the stock price is crushed. Sellers then can profit handsomely by buying back the stock at low prices to cover their short position.
For the most part, the fail-to-deliver problem is largely hidden from the average investor.
Investors are generally not informed by their broker when there are delivery problems. The bank that has custody of my mutual fund's assets readily provides me with the information when there are delivery problems. But not my brokers. I bought Overstock shares simultaneously for my mutual fund and for privately managed brokerage accounts. So far, I can't get delivery information from the brokers.
I can't gauge the magnitude of the problem because I can't get answers to some simple questions:
* Why can't I get delivery of Overstock shares on time?
* Why is T+3 not uniformly enforced?
* Why are sellers of Overstock shares keeping my property for a few weeks, or, alternatively, selling me property that they do not have?
* How is it possible for Overstock to have more shares sold short than actually exist in the float?
When evidence suggests problems at the heart of the market involving supply and demand, manipulation of prices, or unevenly applied or unenforced rules, then it is reasonable to say that there is a systemic problem in the market that requires attention.
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At time of publication, Alsin and/or ACM was long OSTK, although holdings can change at any time.
Arne Alsin is the founder and principal of Alsin Capital Management, an Oregon-based investment advisor, and portfolio manager of The Turnaround Fund, a no-load mutual fund. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Alsin appreciates your feedback; click here to send him an email.
AI
