CMKM Diamonds Inc. (fka CMKX)

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SEC Chairman Cox confirms Naked Short Selling is a Serious Problem

Dave Patch

This past Wednesday the Securities and Exchange Commission approved the first step in the proposal to amend 18-month old Regulation SHO and finally address the issues of naked short selling abuses. The Commission approved the Division of Market Regulation proposal for public comment.

In the opening remarks to this segment of the public hearing Chairman Cox set the tone very early on where he stood on this issue and never wavered throughout the remainder of his remarks.

In his opening remarks on the Regulation SHO amendments the Chairman started by informing the Commission Staff, attorneys, and listening public that “the next item on our agenda is the serious problem of abusive naked short sales.”

We went from naked shorting being a figment of investor imaginations prior to 2004, to a small problem in 2004, and finally a “serious problem” in 2006. How life transforms itself.

Cox did not stop in just calling this a serious problem however; he spoke about how and why it was a serious problem.

“We are particularly concerned about the potential negative effect that substantial and persistent fails to deliver may be having on the market in some securities. Specifically, these fails to deliver can deprive shareholders of the benefits of ownership - voting, lending, and dividends from issuers. Moreover, they can be indicative of abusive naked short selling, which could be used as a tool to drive down a company's stock price. They may also undermine the confidence of investors who may believe that the fails to deliver are evidence of manipulative naked short selling in the stock. In turn, issuers may be harmed, as investors may be reluctant to commit capital to a stock that they believe is subject to abusive naked short selling.”

Finally we have a Chairman in place that is willing to speak the truth in public. Something Cox’s’ most recent predecessors did not have the courage to do. Former Chairman William Donaldson smugly smirked when confronted by Senator Bennett in the 2005 Senate Hearings on Capital Markets when naked shorting and SHO was brought to the table and former Chairman Harvey Pitt, who now speaks against this practice, never broached the subject matter while in position to correct it.

Now with a legacy of the Commission to downplay any type of egregious market abuses, for the Chairman to publicly cite a “serious problem” exists here must mean it is really a serious problem.

What made this an even greater monumental moment was how the members of the Division of Market Regulation and the remaining Commissioners presented this amendment. They did so as if new revelations had been made.

Under a forum of accolades and back slapping the Commissioners applauded the efforts of the Division of Market Regulations in honoring their commitment to monitor the 18-month old regulation and make necessary changes as was promised back in June of 2004. This 18-month review and reversal of the grandfather clause was in fact a delay tactic by the Commission to aid the most blatant violators to clean up their act free of charge. That free pass is now coming to an end.

A little history here folks…

In October 2003 the SEC submitted Regulation SHO for public comment and by June 2004 the Commission staff approved the rule. The staff allotted a six-month window for the industry to come in full compliance bringing us to January 2005 before industry compliance began.

In the period between October 2003 and June 2004 the public was afforded the opportunity to write comment letters to the SEC while the SEC was meeting privately with the congressional oversight committees and members of Wall Street to openly discuss option. What resulted from these private meeting would blow away the hopes of the investing public.

Despite the concerns raised by aides for the House Financial Services Committee, and despite a proposal submitted by the NASD in March 2004, the SEC Division of Market Regulation created an alteration to the proposal submitted for public comment. The alteration was a “grandfather clause” that was inserted into the rule making which allowed all prior settlement failures to be immune from the new closeout provision of SHO. The alterations came at the benefit of, and most likely the bequest of, Wall Street.
The final draft served notice to the investing public that their rights would take a back seat to the rights of broker-dealers and certain clients.

Fast-forward to today and the same Division of Market Regulations, with much of the same individuals involved; have identified this grandfather clause as a loophole that now needs to be closed. Repeal of the grandfather clause part of the modifications presented to the Commission staff.

In the 18-months that this provision existed however the members of Wall Street were able to slowly and methodically work through a large portion of the pre-existing fails as the SEC claims that the fails have been reduced some 50% on daily average from when SHO was first enacted in January 2005. Members of the staff of market regulation claiming SHO to be a success as few market disruptions associated with volatile short squeezes occurred while the fails were being eliminated.

In July 2005 and again Wednesday the SEC making serious claims that the grandfather clause had one sole purpose – insure short squeezes due to trade settlements did not occur.

Ironically, a glance at how these fails were removed from the market highlights an opposite impact to a short squeeze. While short squeezes were not prevalent, Bear Raids were. Data provided by the SEC under the Freedom of Information Act indicate that companies with excessive fails in the trading were methodically being driven down by Wall Street to cover these fails at lower prices and higher profits. Only when the fails were eradicated could these stocks begin to see positive price responses.

Was that just coincidence? Hardly.

While the SEC takes a myopic view of SHO success looking only at the reduction in the number of fails to deliver registered for any given security, success is really to be measured by how these fails were eliminated from the system and how many enforcement cases came against those the Commission admits entered into abusive trading practices.

I believe no enforcement cases have been brought to term as of yet.

Wednesday was the start of the new administration at the SEC. Chairman Cox has already exposed himself for gaffes made (Derailing Journalist Subpoenas) but Wednesday he began the process of making amends by addressing what no other has been willing to tackle. Time will tell how the remainder of the Commission staff responds.

As for the financial press and allegations of bias, consider this. The Chairman of the SEC states publicly that a “serious problem” exists in the markets and in the same sentence uses the word “abusive” and barely a word is mentioned the next day.

This is the same financial press that berates the SEC on a regular basis for failing to take action until the State regulators beat them to the punch. Now, on a subject matter the financial media claims does not exist, the SEC claims it is serious problem based on their thorough analysis and the financial press refuses to cover it. Go figure.

Senate Judiciary Hearings, State changes to laws, State task forces, SEC admissions of abuse and the financial press has suddenly swallowed their keyboards. What better reason to re-issue those subpoenas and find out where their alliances are.

There will be more to come on this issue and an opportunity for yet another round of public comment.

For now, lets just give our special thanks to Senator Hatch, Senator Bennett, Senator Specter, and Connecticut Director of Securities Ralph Lambiase for following through on their promise to put the interests of the people first.

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