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States Weigh In On Naked Shorts
Liz Moyer, 10.16.06, 6:00 AM ET

By This Author

Liz Moyer

Let the mudslinging begin!

State securities regulators have asked their federal counterparts to force the disclosure of more data on securities transactions, and to tell the clearing firm that collects this data to stop hiding behind privacy and other claims as its excuse for not doing so.

This is all part of the debate on whether aggressive short-sellers are gaming market rules on stock borrowing and trade settlement to drive down the shares of targeted stocks (the "short and distort" trick), reaping big profits in the process.

The U.S. Securities and Exchange Commission is considering ways to close loopholes in the regulations governing short-sales, especially so-called naked shorting. But some say the amendments don't go far enough, and the rhetoric is heating up.

In an Oct. 4 comment letter, the North American Securities Administrators Association takes direct aim at the Depository Trust & Clearing Corp. (DTCC), a brokerage-owned private company that handles the bulk of the clearing and settlement of U.S. securities.

NASAA, an organization representing all the state securities regulators and others, describes the DTCC as being "obstructionist" in the movement to make more data available on trade settlement--and, more precisely, on trade settlement failures.

Stock trades are supposed to settle in three days, with the shares being transferred from seller to buyer. Trades "fail to deliver" when that settlement deadline is breached. There are various reasons why that can happen, but high incidences of trade settlement failures in a stock can indicate manipulation.

That explains why regulators and a growing list of publicly traded companies are demanding more and earlier disclosure of trade settlement failure data, some even asking for the disclosure of the brokerages through which many of the fails are occurring. Their view is that more disclosure would ferret out the manipulators.

"The paucity of information available to investors and issuers in the short-selling market is surprising, and contrary to the SEC traditionally disclosure-oriented public policies," complains Barry McCarthy, chief financial officer of Netflix (nasdaq: NFLX - news - people ), in a Sept. 19 letter to the SEC.

Netflix has been on the threshold list of stocks with high and persistent trade settlement failures for over a year. Several other stocks have been on that list for much longer than the SEC ever intended, such as Overstock.com (nasdaq: OSTK - news - people ), Fairfax Financial Holdings (nyse: FFH - news - people ), Novastar Financial (nyse: NFI - news - people ), Krispy Kreme (nyse: KKD - news - people ) and Martha Stewart Living Omnimedia (nyse: MSO - news - people ).

But the DTCC, which collects all of this data and gives it to the SEC and the stock exchanges, guards it from public consumption and has thrown up confidentiality and federal pre-emption claims against releasing it, even to state regulators.

The DTCC "cannot be allowed to hide behind jurisdictional claims or assert that privacy concerns preclude it from sharing information about broker-dealer transactions with state regulators," says the NASAA's letter, which is signed by Joseph Borg, director of the Alabama Securities Commission.

Of course, the DTCC doesn't quite see it that way. In its own comment letter submitted last month, it said it favors the release of more data but adds that the decision of what, when and how much of the data should be made available must be left up to the SEC and the brokerages to sort out.

"A fundamental issue of concern within the industry has been that disclosing current fails data on a stock would reveal position information and could be used to manipulate the market," said Larry Thompson, DTCC's general counsel, in a Sept. 27 letter.

It's an attitude that irks state regulators. In the last year, Connecticut and Utah have attempted to get trade failure data out of the DTCC, with mixed results. Connecticut subpoenaed the DTCC for data on the stocks of four Connecticut companies, while Utah's request was far broader, involving trade failures by brokerages licensed to do business in the state. (DTCC would describe Utah's request as "numbing.")

In each instance, the DTCC told the states that the data was confidential and, in any event, that it didn't have to respond to the state requests because it was not regulated by them but by the SEC. If the states wanted the data, they would have to go through the SEC to get it.

Connecticut, working with the DTCC through the SEC, did just that and obtained its data. The state is investigating the trading activity of the four companies to see if manipulative short-selling is involved, says Division of Securities Director Ralph Lambiase, a former president of the securities administrators group.

But Utah is still working on it, as it notes in its own comment letter, the substance of which was repeated in the NASAA's letter this month.

Wayne Klein, director of Utah's Division of Securities, wrote in a letter to the SEC, "The division does not know whether the obstreperous attitude of DTCC is because DTCC has shortcomings that it fears releasing or whether DTCC's lack of cooperation is at the behest of its participant firms."

In a letter fired off by the DTCC's outside counsel, Proskauer Rose, to Klein a few days after that comment letter appeared, the DTCC said the accusations that it hampered his investigation were "false" and demanded that Utah "correct the record" with the SEC on its dealings with the DTCC. Klein said by telephone Thursday that he had not responded to that letter.

http://www.forbes.com/business/2006/10/13/state-regulators-naked-shorts-biz-cx_lm_1016shorts.html