AI
Saturday, July 08, 2006 8:09:31 PM
Chapter 1, book 3, of Dr. Jim DeCosta's work on the naked short selling crisis and its causes
CHAPTER 1
THE “BALANCE” MODEL FOR NAKED SHORT SELLING
If the Senate Banking Committee, the House Financial Services Committee, the SEC that they oversee, the Senate Judiciary Committee, the SROs like the DTCC, NASD, and NYSE, the DOJ, the IRS, the Department of Homeland Security, the State Legislatures and especially INVESTORS understood naked short selling (NSS) better, then the prognosis for the eradication of this massive “Fraud on the market” being perpetrated daily against unknowing Mom and Pop investors by abusive DTCC participants and hedge fund managers would be greatly enhanced. The absolutely heinous nature of this particular form of securities fraud/racketeering, once understood, would have to lead to its rapid removal from any society that favors law and order over blatantly fraudulent activity. This 3rd book of mine on naked short selling is being written to help advance these parties and others along the steep learning curve of naked short selling. Trust me, after studying this discipline non-stop for the last 25 years I have never been more confident that a thorough understanding of this particular form of securities fraud will lead to its demise.
In my experience the “Balance” analogy is the single best learning tool to allow students of naked short selling to get their arms around the important concepts in regards to the effect of naked short selling upon share price “Discovery” dynamics. In my second book on NSS I pictured the clearance and settlement atrocities as being similar to a scale or “Balance” with 2 trays. See Figure 1. The right tray is labeled “Corporate failure” and the left tray is labeled “Corporate success”. Under the right tray is the “Corporate vitality” candle burning brightly.
Since the formation of the DTCC in the early 1970s, our clearance and settlement system has been based upon incredibly easy to counterfeit “Electronic Boon Entries” – unfortunately representing either paper-certificated legitimate shares usually held in a DTCC vault, or not-so-legitimate share entitlements that the DTCC management and participants can, and do, refuse to allow the exercising of.
Our system is no longer based upon the use of difficult-to-counterfeit paper-certificated shares. This change was deemed necessary due to the 1969 “Paperwork Crisis” associated with increased trading volumes, and the resultant difficulty Wall Street’s back offices had with processing transactions involving paper certificates, as opposed to the much-easier-to-deal-with computerized electronic book entries theoretically representing paper-certificated shares held in a DTCC vault.
The underlying premise of this entire new and more efficient system was the assumption that those empowered to convert paper-certificated shares into electronic book entries (DTCC management) would do so in good faith, and not access the incredible amount of leverage over U.S. corporations and investors, by simply placing bets against the corporations, no matter their merits, by selling mere “Share Entitlements” or “Share Look-Alikes” and then continuing to do with unbridled aggression in an effort to flood their markets with electronic book entries, grossly in excess of the number of paper-certificated share held in DTCC vaults. With approximately $90 trillion worth of investor dollars currently in play on Wall Street, this acting-in-good-faith presumption turned out to be misplaced, in the case of certain DTCC management members, DTCC participants, Canadian B/Ds, prime brokers, and their co-conspiring unregulated hedge fund funds.
The result has been this enormous “Industry within an industry” driven in large part by the $1.3 trillion currently being held in secrecy-obsessed hedge funds, with their $10 billion + in annual commission flow available to the prime brokers, market makers, and clearing firms that can be the most “accommodative” to the hedge funds’ needs, I.e. access to the money put into play by retail investors via non-stop naked short selling into their buy orders.
Going back to Book #2, recall that a “Naked short sale” is a sale of share “Look-alikes” made by a non-owner of legitimate shares that refused to make the mandatory “Borrow” of legitimate shares prior to executing a “Short sale”. Without this “Borrow” of legitimate shares having been made then “Good form delivery” cannot be attained by settlement day (T+3) which prevents the legal “Settlement” of the trade resulting in a “Delivery failure”. Note that legitimate “Borrows” might be time consuming, they need to be paid back, might be expensive to execute and might be entirely unavailable. Recall that “Settlement” is defined by the SEC as “the conclusion of a securities transaction; a b/d buying securities pays for them; the selling broker DELIVERS (emphasis added) the securities to the buyer’s broker.” In short, “Settlement” equals “DVP” or “Delivery Versus Payment”.
Recall from Book #2 that the much less important “Clearance” of a trade involves the buyer and seller agreeing on the date of the execution of the transaction, the settlement date of the transaction, the price level of the transaction, which b/d acted as the buying party and which acted as the selling party and in what capacity the b/d operated i.e. as an “Agent” or as a “Principal”. I believe that there is a common misperception of the “Clearance” of a trade involving payment or a check “Clearing”. At the DTCC payment is made via Fedwire involving entities known as “Settlement banks” and the debiting and crediting of “Participant accounts”.
The prompt “Settlement” of a trade which necessitates “Good form delivery” aligns perfectly with the old Mission Statement of the SEC and provides “Investor protection” and “Market integrity” - whereas the “Clearance” of a trade involves only housekeeping matters related to efforts to minimize clerical errors and misunderstandings. One might naively think that the SEC might be a little more interested in the prompt “Settlement” of trades than they appear to be due to their Mission Statement’s contents. The question arises as to why the apparent “Disconnect” between their actions and their reason for existence i.e. providing “Investor protection” and “Market integrity”?
Section 17 A was a Congressional Mandate determining that it was the DTC that was in charge of “Promptly settling all trades”. They were to do this under the direct supervision of the SEC, which is in charge of enforcing the 1934 Securities Exchange Act – of which Section 17A is an integral part. This is especially critical with this direct alignment between “Investor protection” and “Market Integrity” – the mantra of the SEC – and the prompt “Settlement of Trades,” which is by far the key factor that provides the aforementioned protection and integrity. After reading the SEC’s Mission Statement one might think that the SEC would be all over any market frauds involving the lack of “Prompt Settlement” of trades caused by the lack of prompt “Good form delivery” due to its absolutely catastrophic effect on “Investor protection” and “Market integrity”.
Note that the mere “Locate” of theoretically “Borrowable” shares without their DELIVERY on settlement date is also a naked short sale involving a “Delivery failure” even though the ILLUSION of an effort having been made to execute a “Borrow” (hopefully implying “Legitimacy” to any overseeing regulators interested in providing “Investor protection” and “Market integrity”) has been cleverly concocted. The mere “Having reasonable grounds to believe that shares are borrowable” is, of course, a poor substitute for a legitimate “Borrow” resulting in delivery on “Settlement day”. The supposed “Borrowing” of shares from the self-replenishing lending pools of the DTCC’s SBP (Stock Borrow Program) is, of course, an absurdity from the onset when the buying b/d receiving the “Borrowed” shares is allowed to place these borrowed shares right back into the same lending pool from whence they just came, AS IF THEY NEVER LEFT IN THE FIRST PLACE. We’ll soon see how each and every one of these wishy-washy “Honor System Arrangements” that fail to result in “Good form delivery” on settlement day does extreme damage to targeted issuers and the investments made therein. A “Delivery failure” on Settlement day, while not of much importance to the SEC and openly welcomed by abusive DTCC participants, is a very significant event to a U.S. Corporation whether it is of a “Legitimate” short term nature or not.
When even “Mandated” buy-ins of archaic delivery failures are universally ignored in 99.875% of the time by DTCC participants (Evans, Geczy, Musto and Reed 2003) then ANY delivery failure becomes a huge issue. Peter Chepucavage, an ex-SEC attorney, did a wonderful job of describing the history of the “Locate” and “Reasonable grounds” issues and how Reg SHO inadvertently opened the door to more fraud in this “Pre-Trade” regulatory arena (6/23/06 Legal and compliance update at www.iasbda.com). Suffice it to say that throughout history the “Locate” and “Reasonable grounds” measures associated with making a “Borrow” theoretically made in an effort to maintain “Market integrity” and “Investor protection” while not bogging down the speed of the clearance and settlement system have now “Devolved” to our current sad state of affairs involving needing only “Reasonable grounds” to believe that shares were “Borrowable” in time for delivery on T+3. The lobbying for this “Loophole you could drive a truck through” was intense by certain Wall Street “Professionals” and Reg SHO represents a huge step backwards in regards to the “Pre-trade” regulatory structure.
Why are these concepts of faking a “Borrow” via bogus “Locates”, bogus “Reasonable grounds” and SBP “Pseudo-borrows” (a bogus “Borrow” made from a self-replenishing source) such a big deal? There is a gigantic line in the sand, actually more like a canyon, on midnight of T+3 or “Settlement day”. If the fake “Borrow” does not result in “Delivery” by midnight of T+3 then a “Delivery failure” results. Due to the way the DTCC is structured one single “Delivery failure” can be very damaging to an issuer. Why? Because once that “Delivery failure” has found safe refuge within a DTCC “D” sub-account DTCC management will predictably claim to be “Powerless” to “Cure” it via buying it in - which is the only way in existence to “Cure” a delivery failure by a party that continues to refuse to deliver the missing shares. That’s why Dr. Boni, after being the first outsider allowed to shine a light in the darker corners of the DTCC found what she did, in the form of her research findings of a 56-day average age of a delivery failure. So much for “Prompt settlement” necessitating prompt “Good form delivery”.
A legitimate “Borrow” resulting in delivery of the borrowed shares by midnight of T+3 is a world apart from a bogus borrow that missed this critical deadline. The “Locate” and “Reasonable grounds” options create the ILLUSION of a good faith effort having been made but the fraudsters know that they just need to get that delivery failure safely into the DTCC to pull off the heist of unknowing investors’ money and DTCC policies are meticulously designed to see to this. It’s almost as if that at 12:01 on T+4 the champagne corks can be heard popping because the crooks have bought an average of 56 days for “Father Time” and the new addition of these now readily sellable “Share entitlements” assuming their position on the “Corporate failure” tray to do their damage via dilution to the issuer under attack (see Fig. 1).
This “Reasonable grounds” wording which is now incorporated into the text of Reg SHO drastically decreased the “Intended” effectiveness of Reg SHO from its inception and amounts to no more than an engraved invitation to commit fraud via abuses of what are known as “Hard to borrow” and “Easy to borrow” lists. Without casting aspersions on the hard work of ethical SEC employees, the reason the word “Intended” is highlighted above is that since the final draft of Reg SHO provided what could arguably be construed as a “BLANKET AMNESTY” for prior acts of blatant securities fraud as well as humongous loopholes in the form of the “Locate” and “Reasonable grounds” options of tremendous utility to fake a legitimate “Borrow” then one might question the “INTENTION” of some of the participants in the drafting process. The perception is that if a security is on an “Easy to borrow” list or NOT on a “Hard to borrow” list then there must automatically be “Reasonable grounds” to believe it is “Borrowable” and can and will be delivered by settlement day. Noteworthy is the fact that the SEC has neither the resources nor the manpower to monitor obviously bogus “Hard and easy” lists - and of course the DTCC will claim that although it is mandated as an SRO to “Monitor the business conduct of its participants” this is one particular “Business conduct” of its participants that should be monitored by some other entity.
What the SEC seems to forget is that whether a short seller makes a legitimate “Locate” or has “Reasonable grounds” to believe the shares are borrowable, the short seller is still mandated to DELIVER or have delivered for him by a lender the borrowed shares by settlement day. That’s why it’s called “Settlement day” - because the 2 components of legal “Settlement”, delivery and payment, are to be accomplished by that date. This lack of delivery has always been treated, although rarely via enforcement actions, by the NASD as an infraction UNTIL Reg SHO “Accidentally” removed even this.
As we’ll soon see, DTCC policies have surgically removed the “Settlement” from “Settlement day”. In the overall scope of things whether the phraseology used is a “Locate”, having “Reasonable grounds” of borrowability, or making “Bona fide borrowing arrangements” (for “Threshold list” securities) it really doesn’t matter IF the punishment for getting caught is being allowed to keep the stolen money and paying a fine of 1% of the money stolen, and the need to sign off on an NASD “Acceptance, waiver and consent” form (an “AWC” form) stating that “I didn’t do it and I won’t do it again”. These AWC’s are an industry wide “Courtesy” being extended to DTCC “Fraternity brothers” which allows a crooked Wall Street participant to “Sort of” plead guilty in a civil manner - but not in a criminal manner - to performing criminal activity. Isn’t that thoughtful! As mentioned many times, Wall Street watches out for its own.
One might naively think that if a significant percentage of these THEORETICALLY LEGITIMATE “Locates” and “Reasonable grounds” STILL resulted in delivery failures on settlement day then the DTCC, SEC and NASD would notice that certain DTCC participants were “Gaming” the system, and just not up to the “Acting in good faith” presumption involved in utilizing “Locates” and “Reasonable grounds” instead of firm “Borrows”. The research conducted by Dr. Leslie Boni (2003) indicating that the AVERAGE age of a “Delivery failure” at the DTCC was an astonishing 56 days should have resulted in a DEAFENING noise from the alarms going off and the SEC, NASD and DTCC employees scurrying around in a mad frenzy to plug the holes in this regulatory dyke that had obviously been breached. The proponents of these wishy-washy attempts to create the ILLUSION of the legitimacy of a “Borrow” will proffer that things are so busy on Wall Street that there just isn’t time to execute legitimate “Borrows,” which are both time consuming and expensive - while the market integrity proponents that are the purchasers of these “Share facsimiles” being sold would strongly beg to differ i.e. let’s either make “Settlement day” a “Settlement day” or call it something else to keep it from being misrepresentative.
Recall from Book #2 the legal definition of Misrepresentation: THE STATUTORY CRIME OF OBTAINING MONEY OR PROPERTY BY MAKING FALSE REPRESENTATIONS OF FACT. For instance, on monthly brokerage statements after a share dividend distribution wherein DTCC participants MISREPRESENT to their clients to whom they owe a duty, that real dividend shares with their attendant package of rights have safely landed from the Transfer Agent’s office, and were placed into your account. That reads so much better than “The DTCC participant that sold you your original “Share facsimiles” STILL hasn’t delivered them, so we’re going to reward him by not making him go into the market and buy for your account the “Real” dividend shares that he owes you (as per UCC Article 8) - over and above the original shares he owes you, which we won’t make him buy-in either. Instead, we’ll just add these new dividend shares owed to the other bill he never paid and credit your account with yet more often unexercisable “Share entitlements” - and hope you don’t notice”.
Notice how these NSS related issues start to straddle that fence between securities law and criminal law and why many think that if the DTCC, SEC and NASD don’t get their act together quickly AND START “SETTLING” THE TRADES INVOLVED IN THESE CURRENT “OPEN POSITIONS” then the DOJ is going to create a turf war with much more dire consequences for the perpetrators of these frauds, their co-conspirators and those in regulatory positions that failed to reign them in - especially after their existence was irrefutably proven.
I’ve noticed over the last 25 years of studying this discipline that NSS has metamorphosed from being a good old battle between the shorts and the longs or between the “Pump and dumpers” and those that despise them, to mostly just flat out thievery being committed by the agents of the mostly ultra-wealthy i.e. hedge fund managers or those billion dollar behemoth prime brokers on Wall Street (with a superior “KAV” factor or Knowledge of, Access to and Visibility of the clearance and settlement system of the U.S.) against the average Joe. I think the lesson learned in those earlier battles is just how easy it really is to kill a U.S. Corporation no matter its merits when the DTCC management predictably acts like they do, and the SEC predictably acts like they do. You don’t really have to diagnose WHY they act like they do, you just need to be able to recognize the pattern (which isn’t very difficult) and then place your naked short selling “Bets” accordingly.
The ultra-wealthy who invest in hedge funds demand (and when factoring in “Economies of scale,” perhaps actually deserve) better returns than somebody investing .01% of what they invest. An unregulated hedge fund manager working out of the Cayman Islands who has the ability to spread around hundreds of millions of dollars in commissions and who earns his salary based on 2% of committed funds and 20% of the profits (“2 and 20”) is pretty well incentivised to assume a “Take no prisoners” approach on Wall Street. Perhaps he really does earn those exorbitant fees if he is risking his rear end going to jail if things break down. His wealthy investors, of course, can’t be touched. When you get right down to it, when an investor is responsible for all losses and has to give 2% of committed funds as a fee and 20% of all earnings, then he’d better hope that his fund manager has access to a non-level playing field and some extremely “ACCOMODATIVE” DTCC participants somewhere - because he’s counting on it and paying for it!
When market makers recently lost a good source of their income to “Decimalization” (wherein the ETHICAL MMs now must make their income off of razor thin “Spreads”) all of a sudden their best asset UP FOR BID became their immunity from borrowing before executing a short sale - accorded to THEORETICALLY “Bona-fide” MMs only (wink, wink). The marriage between MMs trying to leverage their immunity from the “Borrow,” and secrecy-obsessed and unregulated hedge fund managers well-incentivised to perform, became inevitable. Throw in a couple dozen prime brokers with a superior “KAV” factor, a “Powerless” DTCC and a few regulators trying to secure better paying jobs on Wall Street, and you’ve got the perfect wedding party.
Let’s go back to Book #2 for a couple of definitions taken from UCC Article 8. A “Securities entitlement” is defined as: the rights and property interest of an “Entitlement holder” - and an “Entitlement holder” is defined as: a person identified in the records of a “Securities intermediary” (DTCC, a clearing agency, Fed. Res. Bank, a broker) as the person having a “Security entitlement” against the “Securities intermediary”.
Notice that the “Rights” or “Package of rights” that a “Securities entitlement” is SUPPOSED TO entail is conspicuously missing from what abusive DTCC participants are naked short selling to unknowing investors. Recall also that for our purposes a “Share” is a unit of equity ownership made up of this “Package of rights” attached to a particular corporation domiciled in a particular U.S. State.
The readily-sellable “Share entitlements” above and beyond the number of “real” paper-certificated shares which result from each and every naked short sale as evidenced by unaddressed “Delivery failures” held in 1 of 3 different repositories (more about those later) stack up on an issuer’s “Corporate failure” tray like lead weights. Note that the triangular shaped “Share entitlements” pictured in Figure #1 are not legitimate “Shares” as there are no “Packages of rights” attached to them - and it is important to keep in mind that a “Share” IS the “Package of rights”. Electronic book entries and paper certificates are mere FORMATS to account for legitimate “Share” ownership but the mere FORMAT has no intrinsic value.
Section 17A mandated the change of the FORMAT for accounting for share ownership; it did not mandate nor approve the change in the definition of a “Share” which DTCC policies have resulted in. For some not so mysterious reason the existence of mere “Share entitlements” without the “Package of rights” which makes a “Share” a “Share” is kept as a tightly held secret from prospective investors as well as a corporation’s management team - BOTH of which are in desperate need of this very “MATERIAL” information regarding the “CHARACTER” of these securities, as the secrecy around their existence allows their levels to expand well beyond the number of paper-certificated shares held in DTCC vaults and elsewhere. The problem though is that the fundamental purpose of the 1933 Securities Act (“33 Act”) as expressed in its preamble is: “To provide full and fair disclosure of the CHARACTER of the securities sold in interstate commerce and through the mails, and to prevent fraud in the sale thereof.”
When the actions of the DTCC and the SEC are 180-degrees antipodal to the 2 “Fundamental purposes” (“Disclosure,” and preventing fraud during the sale of shares) of the parent of all of the Securities Acts - the 1933 Securities Act (or “The Disclosure Act”), then I would proffer that there are some issues that need to be promptly addressed in regards to naked short selling. When the fundamental purposes of the ’33 Act itself and the mission statement of the SEC BOTH literally SCREAM for the addressing of naked short selling frauds, and the SEC doesn’t respond, and the DTCC management chooses to continue on its path of denying the existence of any problems despite irrefutable evidence to the contrary, then one can just feel the SYSTEMIC RISK levels being allowed to build to a crescendo - in order to actively cover up previous crimes and to satisfy the insatiable greed of the abusive DTCC participants operating in the regulatory vacuum created by BOTH the SEC and the DTCC management’s voluntary “DEAFNESS” to these screams.
The question that obviously begs to be asked is, if these admittedly counterfeit “Share entitlements” really are necessary for our clearance and settlement system to function EFFICIENTLY, and their numbers are not totally out of control (as is constantly being proffered by the DTCC) then why isn’t a prospective investor or an issuer’s management team entitled to the “DISCLOSURE” of the number of these dilution-causing “Corporate assassins” that are in existence? One might think that in these days of “Enhanced disclosure” mandates like Reg FD, Reg SHO, and Sarbanes-Oxley that our regulators and SROs like the SEC, NASD, NYSE and the DTCC might join in on these efforts to increase TRANSPARENCY in our markets - but in fact just the opposite has happened. As our regulators and SROs push for increased transparency on the part of corporations and their management teams, these same regulatory bodies and SROs have headed in the other direction, towards actively concealing “Material” information related to “The “CHARACTER” of the securities sold in interstate commerce and through the mails,” which is so pertinent to investors and management teams.
This is a very disturbing pattern from the “Securities cops” whose mission statement centers on the provision of “Investor protection” and “Market integrity”. What could possibly be more “Material” to a prospective investor then the existence of an embarrassing (to the DTCC) amount of unaddressed delivery failures, i.e. mere “Share entitlements” that have basically preordained many of the issuers unfortunate enough to have become chosen as a target of these “Bear raids” to an early death? Why the active cover-up and the willingness to allow more U.S. investors and corporations unaware of their existence to join the list of the victimized? From the DTCC’s point of view the reasons are obvious. They want to avoid criminal prosecutions for past fraudulent behavior, and from a financial point of view their abusive participants would just as soon keep the funds irrefutably STOLEN from investors in their wallet, then to deploy them into the market in an effort to buy back and finally “DELIVER” that which they already sold. The SEC’s reticence to act is a little bit more complicated and we’ll develop that thesis in future chapters.
These extremely dilutive “Share entitlements” are basically “Electronic book-entries” whose creation was admittedly allowed by the “Immobilization and Dematerialization” mandates of Section 17 A of the ’34 Exchange Act; but only for “Legitimate” i.e. relatively short term “Delivery failures” as per Addendum C to the rules and regulations of the DTCC - and only in very minute amounts above the number of paper-certificated shares in existence, i.e. 10,000 shares and 0.5% of the “Outstanding” number of paper-certificated shares. Note that the buy-in of any excessive amount above this critical “Metric” was MANDATED (NASD Rule 11830 and its successor Reg SHO).
Thus “Congressional intent” was that 100 million paper-certificated shares would be “Immobilized” in a DTCC vault and “Dematerialized” into no more than 100.5 million, easier-to-deal-with “Electronic book entry” shares. Simple, right? The reality is that now their numbers have grown completely out of control due mainly to the DTCC management’s claim to be “POWERLESS” to perform 8 simple tasks that they actually have a CONGRESSIONAL MANDATE (via Section 17A’s “Prompt and accurate clearance and SETTLEMENT of trades”) to perform, and that they have all of the power in the world to perform, but VOLUNTARILY CHOOSE (to steal a phrase from Dr. Robert Shapiro, the Under secretary of Commerce under President Clinton) not to. The most important of these being ignored is to effect the “MANDATED” buy-ins of the excessive numbers of “Share entitlements” above the 0.5% “Metric” - necessary to “PROMPTLY SETTLE ALL TRADES” as per Section 17 A of the ’34 Exchange Act, which gave birth to the then “DTC”. The DTCC management, however, has the audacity to claim to be “Powerless” to buy-in the failed deliveries of their bosses no matter how old, DESPITE THE FACT that this simple action is the ONLY way to “Promptly SETTLE” these trades (involving a “Delivery failure” that may have slipped through the cracks provided by bogus borrowing efforts [“Locates”, “Reasonable grounds” and the SBP] and not-so bona-fide market making activity). Thus, the age of the delivery failure becomes critical, when the Congressional mandate specifies PROMPT “Settlement”.
Was Section 17 A of the ’34 Exchange Act a total faux pas on the part of Congress? No, it was a very well written and timely document. The problem seems to be that the DTCC management and participants have trouble deciphering 17 A (a) (2) (A) which addresses the FOUNDATION upon which this expedited clearing process was to be based - i.e. based upon showing “Due regard for the public interest and the protection of investors”. Recall also that the 1934 Securities Exchange Act mandated that this new “SEC” “purge the markets of short selling abuses” especially in light of those abuses’ role in the recent 1929 market sell off involving “Unregulated pools” of money similar to today’s hedge funds. As a side note, if the current SEC Commissioners can’t see this train barreling down the tracks at us ONCE AGAIN, then we all are going to need some help.
http://www.thesanitycheck.com/Blogs/DrJimDeCostasBlog/tabid/99/EntryID/374/Default.aspx
CHAPTER 1
THE “BALANCE” MODEL FOR NAKED SHORT SELLING
If the Senate Banking Committee, the House Financial Services Committee, the SEC that they oversee, the Senate Judiciary Committee, the SROs like the DTCC, NASD, and NYSE, the DOJ, the IRS, the Department of Homeland Security, the State Legislatures and especially INVESTORS understood naked short selling (NSS) better, then the prognosis for the eradication of this massive “Fraud on the market” being perpetrated daily against unknowing Mom and Pop investors by abusive DTCC participants and hedge fund managers would be greatly enhanced. The absolutely heinous nature of this particular form of securities fraud/racketeering, once understood, would have to lead to its rapid removal from any society that favors law and order over blatantly fraudulent activity. This 3rd book of mine on naked short selling is being written to help advance these parties and others along the steep learning curve of naked short selling. Trust me, after studying this discipline non-stop for the last 25 years I have never been more confident that a thorough understanding of this particular form of securities fraud will lead to its demise.
In my experience the “Balance” analogy is the single best learning tool to allow students of naked short selling to get their arms around the important concepts in regards to the effect of naked short selling upon share price “Discovery” dynamics. In my second book on NSS I pictured the clearance and settlement atrocities as being similar to a scale or “Balance” with 2 trays. See Figure 1. The right tray is labeled “Corporate failure” and the left tray is labeled “Corporate success”. Under the right tray is the “Corporate vitality” candle burning brightly.
Since the formation of the DTCC in the early 1970s, our clearance and settlement system has been based upon incredibly easy to counterfeit “Electronic Boon Entries” – unfortunately representing either paper-certificated legitimate shares usually held in a DTCC vault, or not-so-legitimate share entitlements that the DTCC management and participants can, and do, refuse to allow the exercising of.
Our system is no longer based upon the use of difficult-to-counterfeit paper-certificated shares. This change was deemed necessary due to the 1969 “Paperwork Crisis” associated with increased trading volumes, and the resultant difficulty Wall Street’s back offices had with processing transactions involving paper certificates, as opposed to the much-easier-to-deal-with computerized electronic book entries theoretically representing paper-certificated shares held in a DTCC vault.
The underlying premise of this entire new and more efficient system was the assumption that those empowered to convert paper-certificated shares into electronic book entries (DTCC management) would do so in good faith, and not access the incredible amount of leverage over U.S. corporations and investors, by simply placing bets against the corporations, no matter their merits, by selling mere “Share Entitlements” or “Share Look-Alikes” and then continuing to do with unbridled aggression in an effort to flood their markets with electronic book entries, grossly in excess of the number of paper-certificated share held in DTCC vaults. With approximately $90 trillion worth of investor dollars currently in play on Wall Street, this acting-in-good-faith presumption turned out to be misplaced, in the case of certain DTCC management members, DTCC participants, Canadian B/Ds, prime brokers, and their co-conspiring unregulated hedge fund funds.
The result has been this enormous “Industry within an industry” driven in large part by the $1.3 trillion currently being held in secrecy-obsessed hedge funds, with their $10 billion + in annual commission flow available to the prime brokers, market makers, and clearing firms that can be the most “accommodative” to the hedge funds’ needs, I.e. access to the money put into play by retail investors via non-stop naked short selling into their buy orders.
Going back to Book #2, recall that a “Naked short sale” is a sale of share “Look-alikes” made by a non-owner of legitimate shares that refused to make the mandatory “Borrow” of legitimate shares prior to executing a “Short sale”. Without this “Borrow” of legitimate shares having been made then “Good form delivery” cannot be attained by settlement day (T+3) which prevents the legal “Settlement” of the trade resulting in a “Delivery failure”. Note that legitimate “Borrows” might be time consuming, they need to be paid back, might be expensive to execute and might be entirely unavailable. Recall that “Settlement” is defined by the SEC as “the conclusion of a securities transaction; a b/d buying securities pays for them; the selling broker DELIVERS (emphasis added) the securities to the buyer’s broker.” In short, “Settlement” equals “DVP” or “Delivery Versus Payment”.
Recall from Book #2 that the much less important “Clearance” of a trade involves the buyer and seller agreeing on the date of the execution of the transaction, the settlement date of the transaction, the price level of the transaction, which b/d acted as the buying party and which acted as the selling party and in what capacity the b/d operated i.e. as an “Agent” or as a “Principal”. I believe that there is a common misperception of the “Clearance” of a trade involving payment or a check “Clearing”. At the DTCC payment is made via Fedwire involving entities known as “Settlement banks” and the debiting and crediting of “Participant accounts”.
The prompt “Settlement” of a trade which necessitates “Good form delivery” aligns perfectly with the old Mission Statement of the SEC and provides “Investor protection” and “Market integrity” - whereas the “Clearance” of a trade involves only housekeeping matters related to efforts to minimize clerical errors and misunderstandings. One might naively think that the SEC might be a little more interested in the prompt “Settlement” of trades than they appear to be due to their Mission Statement’s contents. The question arises as to why the apparent “Disconnect” between their actions and their reason for existence i.e. providing “Investor protection” and “Market integrity”?
Section 17 A was a Congressional Mandate determining that it was the DTC that was in charge of “Promptly settling all trades”. They were to do this under the direct supervision of the SEC, which is in charge of enforcing the 1934 Securities Exchange Act – of which Section 17A is an integral part. This is especially critical with this direct alignment between “Investor protection” and “Market Integrity” – the mantra of the SEC – and the prompt “Settlement of Trades,” which is by far the key factor that provides the aforementioned protection and integrity. After reading the SEC’s Mission Statement one might think that the SEC would be all over any market frauds involving the lack of “Prompt Settlement” of trades caused by the lack of prompt “Good form delivery” due to its absolutely catastrophic effect on “Investor protection” and “Market integrity”.
Note that the mere “Locate” of theoretically “Borrowable” shares without their DELIVERY on settlement date is also a naked short sale involving a “Delivery failure” even though the ILLUSION of an effort having been made to execute a “Borrow” (hopefully implying “Legitimacy” to any overseeing regulators interested in providing “Investor protection” and “Market integrity”) has been cleverly concocted. The mere “Having reasonable grounds to believe that shares are borrowable” is, of course, a poor substitute for a legitimate “Borrow” resulting in delivery on “Settlement day”. The supposed “Borrowing” of shares from the self-replenishing lending pools of the DTCC’s SBP (Stock Borrow Program) is, of course, an absurdity from the onset when the buying b/d receiving the “Borrowed” shares is allowed to place these borrowed shares right back into the same lending pool from whence they just came, AS IF THEY NEVER LEFT IN THE FIRST PLACE. We’ll soon see how each and every one of these wishy-washy “Honor System Arrangements” that fail to result in “Good form delivery” on settlement day does extreme damage to targeted issuers and the investments made therein. A “Delivery failure” on Settlement day, while not of much importance to the SEC and openly welcomed by abusive DTCC participants, is a very significant event to a U.S. Corporation whether it is of a “Legitimate” short term nature or not.
When even “Mandated” buy-ins of archaic delivery failures are universally ignored in 99.875% of the time by DTCC participants (Evans, Geczy, Musto and Reed 2003) then ANY delivery failure becomes a huge issue. Peter Chepucavage, an ex-SEC attorney, did a wonderful job of describing the history of the “Locate” and “Reasonable grounds” issues and how Reg SHO inadvertently opened the door to more fraud in this “Pre-Trade” regulatory arena (6/23/06 Legal and compliance update at www.iasbda.com). Suffice it to say that throughout history the “Locate” and “Reasonable grounds” measures associated with making a “Borrow” theoretically made in an effort to maintain “Market integrity” and “Investor protection” while not bogging down the speed of the clearance and settlement system have now “Devolved” to our current sad state of affairs involving needing only “Reasonable grounds” to believe that shares were “Borrowable” in time for delivery on T+3. The lobbying for this “Loophole you could drive a truck through” was intense by certain Wall Street “Professionals” and Reg SHO represents a huge step backwards in regards to the “Pre-trade” regulatory structure.
Why are these concepts of faking a “Borrow” via bogus “Locates”, bogus “Reasonable grounds” and SBP “Pseudo-borrows” (a bogus “Borrow” made from a self-replenishing source) such a big deal? There is a gigantic line in the sand, actually more like a canyon, on midnight of T+3 or “Settlement day”. If the fake “Borrow” does not result in “Delivery” by midnight of T+3 then a “Delivery failure” results. Due to the way the DTCC is structured one single “Delivery failure” can be very damaging to an issuer. Why? Because once that “Delivery failure” has found safe refuge within a DTCC “D” sub-account DTCC management will predictably claim to be “Powerless” to “Cure” it via buying it in - which is the only way in existence to “Cure” a delivery failure by a party that continues to refuse to deliver the missing shares. That’s why Dr. Boni, after being the first outsider allowed to shine a light in the darker corners of the DTCC found what she did, in the form of her research findings of a 56-day average age of a delivery failure. So much for “Prompt settlement” necessitating prompt “Good form delivery”.
A legitimate “Borrow” resulting in delivery of the borrowed shares by midnight of T+3 is a world apart from a bogus borrow that missed this critical deadline. The “Locate” and “Reasonable grounds” options create the ILLUSION of a good faith effort having been made but the fraudsters know that they just need to get that delivery failure safely into the DTCC to pull off the heist of unknowing investors’ money and DTCC policies are meticulously designed to see to this. It’s almost as if that at 12:01 on T+4 the champagne corks can be heard popping because the crooks have bought an average of 56 days for “Father Time” and the new addition of these now readily sellable “Share entitlements” assuming their position on the “Corporate failure” tray to do their damage via dilution to the issuer under attack (see Fig. 1).
This “Reasonable grounds” wording which is now incorporated into the text of Reg SHO drastically decreased the “Intended” effectiveness of Reg SHO from its inception and amounts to no more than an engraved invitation to commit fraud via abuses of what are known as “Hard to borrow” and “Easy to borrow” lists. Without casting aspersions on the hard work of ethical SEC employees, the reason the word “Intended” is highlighted above is that since the final draft of Reg SHO provided what could arguably be construed as a “BLANKET AMNESTY” for prior acts of blatant securities fraud as well as humongous loopholes in the form of the “Locate” and “Reasonable grounds” options of tremendous utility to fake a legitimate “Borrow” then one might question the “INTENTION” of some of the participants in the drafting process. The perception is that if a security is on an “Easy to borrow” list or NOT on a “Hard to borrow” list then there must automatically be “Reasonable grounds” to believe it is “Borrowable” and can and will be delivered by settlement day. Noteworthy is the fact that the SEC has neither the resources nor the manpower to monitor obviously bogus “Hard and easy” lists - and of course the DTCC will claim that although it is mandated as an SRO to “Monitor the business conduct of its participants” this is one particular “Business conduct” of its participants that should be monitored by some other entity.
What the SEC seems to forget is that whether a short seller makes a legitimate “Locate” or has “Reasonable grounds” to believe the shares are borrowable, the short seller is still mandated to DELIVER or have delivered for him by a lender the borrowed shares by settlement day. That’s why it’s called “Settlement day” - because the 2 components of legal “Settlement”, delivery and payment, are to be accomplished by that date. This lack of delivery has always been treated, although rarely via enforcement actions, by the NASD as an infraction UNTIL Reg SHO “Accidentally” removed even this.
As we’ll soon see, DTCC policies have surgically removed the “Settlement” from “Settlement day”. In the overall scope of things whether the phraseology used is a “Locate”, having “Reasonable grounds” of borrowability, or making “Bona fide borrowing arrangements” (for “Threshold list” securities) it really doesn’t matter IF the punishment for getting caught is being allowed to keep the stolen money and paying a fine of 1% of the money stolen, and the need to sign off on an NASD “Acceptance, waiver and consent” form (an “AWC” form) stating that “I didn’t do it and I won’t do it again”. These AWC’s are an industry wide “Courtesy” being extended to DTCC “Fraternity brothers” which allows a crooked Wall Street participant to “Sort of” plead guilty in a civil manner - but not in a criminal manner - to performing criminal activity. Isn’t that thoughtful! As mentioned many times, Wall Street watches out for its own.
One might naively think that if a significant percentage of these THEORETICALLY LEGITIMATE “Locates” and “Reasonable grounds” STILL resulted in delivery failures on settlement day then the DTCC, SEC and NASD would notice that certain DTCC participants were “Gaming” the system, and just not up to the “Acting in good faith” presumption involved in utilizing “Locates” and “Reasonable grounds” instead of firm “Borrows”. The research conducted by Dr. Leslie Boni (2003) indicating that the AVERAGE age of a “Delivery failure” at the DTCC was an astonishing 56 days should have resulted in a DEAFENING noise from the alarms going off and the SEC, NASD and DTCC employees scurrying around in a mad frenzy to plug the holes in this regulatory dyke that had obviously been breached. The proponents of these wishy-washy attempts to create the ILLUSION of the legitimacy of a “Borrow” will proffer that things are so busy on Wall Street that there just isn’t time to execute legitimate “Borrows,” which are both time consuming and expensive - while the market integrity proponents that are the purchasers of these “Share facsimiles” being sold would strongly beg to differ i.e. let’s either make “Settlement day” a “Settlement day” or call it something else to keep it from being misrepresentative.
Recall from Book #2 the legal definition of Misrepresentation: THE STATUTORY CRIME OF OBTAINING MONEY OR PROPERTY BY MAKING FALSE REPRESENTATIONS OF FACT. For instance, on monthly brokerage statements after a share dividend distribution wherein DTCC participants MISREPRESENT to their clients to whom they owe a duty, that real dividend shares with their attendant package of rights have safely landed from the Transfer Agent’s office, and were placed into your account. That reads so much better than “The DTCC participant that sold you your original “Share facsimiles” STILL hasn’t delivered them, so we’re going to reward him by not making him go into the market and buy for your account the “Real” dividend shares that he owes you (as per UCC Article 8) - over and above the original shares he owes you, which we won’t make him buy-in either. Instead, we’ll just add these new dividend shares owed to the other bill he never paid and credit your account with yet more often unexercisable “Share entitlements” - and hope you don’t notice”.
Notice how these NSS related issues start to straddle that fence between securities law and criminal law and why many think that if the DTCC, SEC and NASD don’t get their act together quickly AND START “SETTLING” THE TRADES INVOLVED IN THESE CURRENT “OPEN POSITIONS” then the DOJ is going to create a turf war with much more dire consequences for the perpetrators of these frauds, their co-conspirators and those in regulatory positions that failed to reign them in - especially after their existence was irrefutably proven.
I’ve noticed over the last 25 years of studying this discipline that NSS has metamorphosed from being a good old battle between the shorts and the longs or between the “Pump and dumpers” and those that despise them, to mostly just flat out thievery being committed by the agents of the mostly ultra-wealthy i.e. hedge fund managers or those billion dollar behemoth prime brokers on Wall Street (with a superior “KAV” factor or Knowledge of, Access to and Visibility of the clearance and settlement system of the U.S.) against the average Joe. I think the lesson learned in those earlier battles is just how easy it really is to kill a U.S. Corporation no matter its merits when the DTCC management predictably acts like they do, and the SEC predictably acts like they do. You don’t really have to diagnose WHY they act like they do, you just need to be able to recognize the pattern (which isn’t very difficult) and then place your naked short selling “Bets” accordingly.
The ultra-wealthy who invest in hedge funds demand (and when factoring in “Economies of scale,” perhaps actually deserve) better returns than somebody investing .01% of what they invest. An unregulated hedge fund manager working out of the Cayman Islands who has the ability to spread around hundreds of millions of dollars in commissions and who earns his salary based on 2% of committed funds and 20% of the profits (“2 and 20”) is pretty well incentivised to assume a “Take no prisoners” approach on Wall Street. Perhaps he really does earn those exorbitant fees if he is risking his rear end going to jail if things break down. His wealthy investors, of course, can’t be touched. When you get right down to it, when an investor is responsible for all losses and has to give 2% of committed funds as a fee and 20% of all earnings, then he’d better hope that his fund manager has access to a non-level playing field and some extremely “ACCOMODATIVE” DTCC participants somewhere - because he’s counting on it and paying for it!
When market makers recently lost a good source of their income to “Decimalization” (wherein the ETHICAL MMs now must make their income off of razor thin “Spreads”) all of a sudden their best asset UP FOR BID became their immunity from borrowing before executing a short sale - accorded to THEORETICALLY “Bona-fide” MMs only (wink, wink). The marriage between MMs trying to leverage their immunity from the “Borrow,” and secrecy-obsessed and unregulated hedge fund managers well-incentivised to perform, became inevitable. Throw in a couple dozen prime brokers with a superior “KAV” factor, a “Powerless” DTCC and a few regulators trying to secure better paying jobs on Wall Street, and you’ve got the perfect wedding party.
Let’s go back to Book #2 for a couple of definitions taken from UCC Article 8. A “Securities entitlement” is defined as: the rights and property interest of an “Entitlement holder” - and an “Entitlement holder” is defined as: a person identified in the records of a “Securities intermediary” (DTCC, a clearing agency, Fed. Res. Bank, a broker) as the person having a “Security entitlement” against the “Securities intermediary”.
Notice that the “Rights” or “Package of rights” that a “Securities entitlement” is SUPPOSED TO entail is conspicuously missing from what abusive DTCC participants are naked short selling to unknowing investors. Recall also that for our purposes a “Share” is a unit of equity ownership made up of this “Package of rights” attached to a particular corporation domiciled in a particular U.S. State.
The readily-sellable “Share entitlements” above and beyond the number of “real” paper-certificated shares which result from each and every naked short sale as evidenced by unaddressed “Delivery failures” held in 1 of 3 different repositories (more about those later) stack up on an issuer’s “Corporate failure” tray like lead weights. Note that the triangular shaped “Share entitlements” pictured in Figure #1 are not legitimate “Shares” as there are no “Packages of rights” attached to them - and it is important to keep in mind that a “Share” IS the “Package of rights”. Electronic book entries and paper certificates are mere FORMATS to account for legitimate “Share” ownership but the mere FORMAT has no intrinsic value.
Section 17A mandated the change of the FORMAT for accounting for share ownership; it did not mandate nor approve the change in the definition of a “Share” which DTCC policies have resulted in. For some not so mysterious reason the existence of mere “Share entitlements” without the “Package of rights” which makes a “Share” a “Share” is kept as a tightly held secret from prospective investors as well as a corporation’s management team - BOTH of which are in desperate need of this very “MATERIAL” information regarding the “CHARACTER” of these securities, as the secrecy around their existence allows their levels to expand well beyond the number of paper-certificated shares held in DTCC vaults and elsewhere. The problem though is that the fundamental purpose of the 1933 Securities Act (“33 Act”) as expressed in its preamble is: “To provide full and fair disclosure of the CHARACTER of the securities sold in interstate commerce and through the mails, and to prevent fraud in the sale thereof.”
When the actions of the DTCC and the SEC are 180-degrees antipodal to the 2 “Fundamental purposes” (“Disclosure,” and preventing fraud during the sale of shares) of the parent of all of the Securities Acts - the 1933 Securities Act (or “The Disclosure Act”), then I would proffer that there are some issues that need to be promptly addressed in regards to naked short selling. When the fundamental purposes of the ’33 Act itself and the mission statement of the SEC BOTH literally SCREAM for the addressing of naked short selling frauds, and the SEC doesn’t respond, and the DTCC management chooses to continue on its path of denying the existence of any problems despite irrefutable evidence to the contrary, then one can just feel the SYSTEMIC RISK levels being allowed to build to a crescendo - in order to actively cover up previous crimes and to satisfy the insatiable greed of the abusive DTCC participants operating in the regulatory vacuum created by BOTH the SEC and the DTCC management’s voluntary “DEAFNESS” to these screams.
The question that obviously begs to be asked is, if these admittedly counterfeit “Share entitlements” really are necessary for our clearance and settlement system to function EFFICIENTLY, and their numbers are not totally out of control (as is constantly being proffered by the DTCC) then why isn’t a prospective investor or an issuer’s management team entitled to the “DISCLOSURE” of the number of these dilution-causing “Corporate assassins” that are in existence? One might think that in these days of “Enhanced disclosure” mandates like Reg FD, Reg SHO, and Sarbanes-Oxley that our regulators and SROs like the SEC, NASD, NYSE and the DTCC might join in on these efforts to increase TRANSPARENCY in our markets - but in fact just the opposite has happened. As our regulators and SROs push for increased transparency on the part of corporations and their management teams, these same regulatory bodies and SROs have headed in the other direction, towards actively concealing “Material” information related to “The “CHARACTER” of the securities sold in interstate commerce and through the mails,” which is so pertinent to investors and management teams.
This is a very disturbing pattern from the “Securities cops” whose mission statement centers on the provision of “Investor protection” and “Market integrity”. What could possibly be more “Material” to a prospective investor then the existence of an embarrassing (to the DTCC) amount of unaddressed delivery failures, i.e. mere “Share entitlements” that have basically preordained many of the issuers unfortunate enough to have become chosen as a target of these “Bear raids” to an early death? Why the active cover-up and the willingness to allow more U.S. investors and corporations unaware of their existence to join the list of the victimized? From the DTCC’s point of view the reasons are obvious. They want to avoid criminal prosecutions for past fraudulent behavior, and from a financial point of view their abusive participants would just as soon keep the funds irrefutably STOLEN from investors in their wallet, then to deploy them into the market in an effort to buy back and finally “DELIVER” that which they already sold. The SEC’s reticence to act is a little bit more complicated and we’ll develop that thesis in future chapters.
These extremely dilutive “Share entitlements” are basically “Electronic book-entries” whose creation was admittedly allowed by the “Immobilization and Dematerialization” mandates of Section 17 A of the ’34 Exchange Act; but only for “Legitimate” i.e. relatively short term “Delivery failures” as per Addendum C to the rules and regulations of the DTCC - and only in very minute amounts above the number of paper-certificated shares in existence, i.e. 10,000 shares and 0.5% of the “Outstanding” number of paper-certificated shares. Note that the buy-in of any excessive amount above this critical “Metric” was MANDATED (NASD Rule 11830 and its successor Reg SHO).
Thus “Congressional intent” was that 100 million paper-certificated shares would be “Immobilized” in a DTCC vault and “Dematerialized” into no more than 100.5 million, easier-to-deal-with “Electronic book entry” shares. Simple, right? The reality is that now their numbers have grown completely out of control due mainly to the DTCC management’s claim to be “POWERLESS” to perform 8 simple tasks that they actually have a CONGRESSIONAL MANDATE (via Section 17A’s “Prompt and accurate clearance and SETTLEMENT of trades”) to perform, and that they have all of the power in the world to perform, but VOLUNTARILY CHOOSE (to steal a phrase from Dr. Robert Shapiro, the Under secretary of Commerce under President Clinton) not to. The most important of these being ignored is to effect the “MANDATED” buy-ins of the excessive numbers of “Share entitlements” above the 0.5% “Metric” - necessary to “PROMPTLY SETTLE ALL TRADES” as per Section 17 A of the ’34 Exchange Act, which gave birth to the then “DTC”. The DTCC management, however, has the audacity to claim to be “Powerless” to buy-in the failed deliveries of their bosses no matter how old, DESPITE THE FACT that this simple action is the ONLY way to “Promptly SETTLE” these trades (involving a “Delivery failure” that may have slipped through the cracks provided by bogus borrowing efforts [“Locates”, “Reasonable grounds” and the SBP] and not-so bona-fide market making activity). Thus, the age of the delivery failure becomes critical, when the Congressional mandate specifies PROMPT “Settlement”.
Was Section 17 A of the ’34 Exchange Act a total faux pas on the part of Congress? No, it was a very well written and timely document. The problem seems to be that the DTCC management and participants have trouble deciphering 17 A (a) (2) (A) which addresses the FOUNDATION upon which this expedited clearing process was to be based - i.e. based upon showing “Due regard for the public interest and the protection of investors”. Recall also that the 1934 Securities Exchange Act mandated that this new “SEC” “purge the markets of short selling abuses” especially in light of those abuses’ role in the recent 1929 market sell off involving “Unregulated pools” of money similar to today’s hedge funds. As a side note, if the current SEC Commissioners can’t see this train barreling down the tracks at us ONCE AGAIN, then we all are going to need some help.
http://www.thesanitycheck.com/Blogs/DrJimDeCostasBlog/tabid/99/EntryID/374/Default.aspx
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