Wall Street's Lobbies for more Profit Protection - January 4, 2007
David Patch
In today's Traders Magazine columnist Peter Chapman discussed the most recent Wall Street debate over Regulation SHO and the now infamous grandfather clause imbedded in the law. In reading between the lines of the article, Wall Street appears to be looking for more party favors from the SEC to keep the 2006 jamboree rolling into 2007.
Recall, in 2004 the SEC released the final version of Regulation SHO to the public and with this release they presented, for the first time, this otherwise unheard of hall pass called the "grandfather clause". After succumbing to the lobbying of the Securities Industry Association (SIA) the SEC incorporated this controversial clause into law without the benefit of public comment or even public awareness. The clause, intended to protect the industry members from their responsibility (liability) in settling what were considered to be excessive and sometimes illegal short positions, was quietly added to the fine print of the released at the 12th hour against the wishes and recommendations of Congressional oversight.
Today, after reconsidering such rule making, the SEC has proposed eliminating this controversial clause identifying it as a loophole that needs to be closed. One SEC Commissioner has called the revision under consideration a mere fine-tuning of the newly created law.
"In fine-tuning Reg SHO," SEC Commissioner Roel Campos remarked in a speech this summer, "our efforts are targeted at protecting a small universe of thinly-capitalized securities from abusive trading wherein the level of fails to deliver can harm the market for the security."
Consider that the difference between today and June 2004 is merely 18-months of opportunity for Wall Street to slowly cover potentially abusive trade liabilities profitably.
As for that "small universe of thinly-capitalized securities" referenced by Campos, to date more than 25% of all NYSE and 30% of all NASDAQ listed securities have held a position on the SEC's threshold security list for excessive failures with neither market rarely considered as being loaded with thinly capitalized companies. In total over, 4000 of the near 13,000 publicly traded companies have seen time on the list.
No small universe by my standards.
The 18-month delay by the regulators in enforcing the laws still may not satisfy Wall Street as the Securities Industry and Financial Markets Association (SIFMA), formerly SIA, apparently continues to lobby the SEC on behalf of the members of Wall Street.
SIFMA contends that the elimination of the grandfather clause would lead to a rash of short squeezes as presented in an industry sponsored comment memo to the SEC by the lobbyist organization. Preventing short squeezes was why the SEC created the grandfather exemption in the first place, SIFMA contends.
A short squeeze occurs when shorts are forced to buy in their positions. In this case, Industry concern is over being responsible to cover shorts sold to investors but never delivered beyond a 13-day trading period.
But short squeezes are not illegal and certainly not illegal if they are the result of simply making the seller deliver what he/she sold. Manipulating the market by flooding the market with stock that does not exist to deliver, and gaining the leverage by upsetting the true balance of supply and demand, is.
By law, any short that is executed on behalf of an investor must settle within 3 business days. Rules 15c3-3 and 15c6-1 of the Exchange Act of 1934 spell that out very clearly. Any failure thereafter becomes the liability of he industry members who executed such orders without fully performing the duties of execution.
Wall Street broker dealers will charge the short seller the fee to borrow the security making the liability of the fail for not borrowing the shares the firms. It is this liability that SIFMA seeks to eliminate from the financial service operations and pass on to the investing public.
The only exempted short from the 3-day settlement period are those shorts created by market makers and specialists who are exempted from the 3-day settlement while making a bona-fide market in a security; creating liquidity. However, bona-fide market making laws also maintain that such transactions must be done to address temporary volatility in the market and can not be claimed exempt if it is for a house account under a trading strategy.
Trading into indefinite deliveries is a trading strategy and not a temporary adjustment for market volume volatility.
But Knight Securities, UBS, and other market making firms like Bernard L. Madoff Investment Securities look at this differently. "This [eliminating grandfather clause] is going to have a serious impact on our ability to make markets," Mark Madoff, co-director of trading at the family-owned Bernard L. Madoff Investment Securities, said of the SEC's planned elimination of the grandfather clause.
There is only one problem with Madoff's assertions.
Making markets is about matching legitimate buyers and sellers and about only creating temporary liquidity when they two can't be matched. Using a naked shorting exemption to sell off securities to unsuspecting buyers, and then failing to make good on delivery of these securities for long indefinite periods in time, is not considered temporary market making. Such a trading strategy is no longer making a bona-fide market but executing a trading strategy. When involved in this type of trading strategy market makers then fall under the same trading guidelines as every other market investor and carry the equivalent risk an investor would carry.
In law, there should never be any legal exemption for market makers in any security to execute a trading strategy that insures risk is only passed on to the investor. Such a legal exemption would be the first step to creating a rigged marketplace and would be the cornerstone to possible market manipulation. To make such concessions into law would disrupt investor confidence in the system and the regulators and have an overall negative impact on our markets.
But to a Wall Street Industry where $57 Million bonuses are being handed out to top executives that produce record earnings, this is exactly what is being expected of industry laws and exactly what the industries top lobbyist is preaching in the very halls of the SEC.
Total Wall Street bonuses, using trading profits as a catalyst, peaked at over $27 Billion for 2006 and still that is not enough. SIFMA, representing the industry, wants more and wants it at investor risk.
Protect us from any possible losses is what the SIFMA is requesting and until now how the SEC has responded favorably. Ultimately what SIFMA really wants is for Wall Street to continue to grow and thus continue to invest heavily in SIFMA's high-powered lobbying efforts.
SIFMA, who claims to represent the interests of nearly 93 Million investors, is actually representing none. SIFMA speaks for the industry interests at the expense of 93 Million investors financial safety.
How the SEC will finally conclude this saga is anyone's guess. They have shown little backbone in standing up to industry lobbyists in the past and may very well cower under industry pressures again. One thing is for sure however, Congress is watching this time and Congress, unlike Commissioner Campos, are seeing the results of the data and have concluded one in three companies is not a small universe of companies after all.
If applied equally, one in three investors would equal more than 30 million people who may have been impacted by this reportedly small problem.
For more on this issue please visit the Host site at www.investigatethesec. com .
