SEC corruption

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Their complaints, and consequently the subcommittees investigative efforts, have focused on questions of improving the short-selling mechanism and curtailing related abuses, so that short selling can most effectively serve its legitimate function in the market.
III. Abuse and Manipulation By Short Sellers
A. Credibility of Abuse Allegations
The subcommittees investigation of short selling has included extensive review of the allegations of short-seller abuse offered by affected issuers and investors or reported in the press. In addition to the widespread press reports, allegations of abuse were reported by witnesses in the subcommittees hearings, by issuers who responded to the subcommittees questionnaire, and by other issuers and investors in numerous unsolicited off-the-record contacts with the subcommittee. The subcommittee did not, however, attempt independent verification of their accuracy through field investigation.
Because of the lack of independent investigation and verification, the committee has not made any findings that certain of these allegations were conclusively demonstrated to be true. The committee cannot, therefore, report documentation of specific incidents of abuse by short sellers.
The committee has found, however, that many of the reports of rumor-spreading abuse are entirely credible and are strongly suggestive of abuse. Moreover, the widespread nature of these reports and the high degree of similarity among them constitute a highly consistent pattern. The committee finds, therefore, that a pattern of abusive and destructive rumormongering, targeted specifically at companies in the equity securities of which some short-selling investors have established major short positions, appears to be occurring.
Other reports have alleged direct price manipulation or other trading abuses by short sellers in the trading of target companies shares. Many of these reports have alleged that certain parties were engaging in naked short selling, presumably with the cooperation of a major broker or dealer.
None of the reports of naked short selling were supported with direct evidence, and in its evaluation of these reports the subcommittee found the circumstantial evidence offered to be inconclusive. The charges of naked short selling do raise important questions of the proper functioning of the markets, however, and the subcommittee has therefore initiated a study of clearing and settlement delays and their relationship to short selling, as reported previously.
This study has not been completed, but the evidence examined so far suggests that naked short selling or its functional equivalent does occur in large volume in some equity issues. The committee does tentatively conclude, therefore, that the reports of naked short selling offered by issuers and other investors, while lacking direct supporting evidence, may nevertheless be true in some instances.
Other allegations of direct price manipulation by short sellers have appeared to the subcommittee to lack substance. For this reason the committee has concluded that, aside from the reports of spreading false rumors and engaging in naked short selling, many of the complaints about short-seller abuse are not soundly based and may reflect a misunderstanding of the short-selling process.
b. the psychological environment
The committees principal concern in its evaluation of short-selling issues has been broader than just whether specific abuses and violations have occurred and are being regulated. The committee is particularly concerned with whether:
a. The equity market functions fairly for investors who invest in the shares of companies that are actively sold short by other investors; and
b. Whether the equity market prices such stocks efficiently and appropriately so that these companies will continue to have access to the market for new capital on a sound and fair competitive basis.
The committee has found, in this connection, that the fairness and efficiency of the equity market for stocks that are actively targeted by short sellers suffer from serious disturbances that cannot be attributed solely to specific instances of short-seller abuse.
The pricing and trading of individual equity issues are highly dependent on subjective elements of psychology and perception among investors generally, and the committee finds that many investors and issuers have a perception that short sellers have great manipulative power over stocks. Moreover, the committee finds a widespread perception, expressed in many ways to the subcommittee, that the SEC is indifferent to the manipulative activities of the short sellers and assists them indirectly by their attitude of indifference.
The psychological environment is further affected by the fact that major short-selling investors function entirely anonymously. Under present reporting rules it cannot be known, except through a special investigation by the SEC, the exchanges, or the NASD, who is holding the major short positions in a particular stock.
The committee finds a strong undercurrent of disillusionment with the public equity markets and with the SEC in the viewpoints expressed by many investors and issuers whose shares are targeted by short sellers. Among these investors and issuers there appears to be a sense of being victimized by powerful but unknown abusers who do their will without restraint from any regulators. If these were isolated views, they might not be significant, but the committee finds them sufficiently prevalent to constitute a troubling pattern.
In some instances, as reported previously, the targets of short selling appear to have drawn conclusions about the manipulative power of short sellers without a solid factual basis, but this tendency of many investors to draw such unfounded conclusions is the fundamental reason for concern about the psychological climate.
The fact is that some short-selling partnerships possess very substantial financial resources and a capacity, financially speaking, to influence heavily or even dominate the trading activity in a small capitalization issue of stock over an extended period of time. When this general fact is combined in the minds of company executives and shareholders with the information that some unknown but presumably powerful party or parties is or are actively short selling a particular stock and when these executives and shareholders also share a conviction that the SEC ignores abusive practices by the short sellers and does not ensure a fair market it is readily understandable that these executives and shareholders of the affected issuer may reach exaggerated and ill-founded conclusions about the short-selling "threat." When such exaggerated reactions to active short selling become frequent and persistent, as the committee believes they have in many stock issues, then pricing efficiency and market fairness suffer.
Moreover, the impairment of pricing efficiency affects not just the immediate targets of short sellers but the entire class of firms, many of them small but some large as well, that are viewed in the investing community as potentially vulnerable to short-seller abuse. Given the perceived power of anonymous short sellers to manipulate the market, it is only ordinary prudence to many investors to avoid such issues altogether, which in turn unjustifiably depresses the pricing of such issues relative to others perceived as less vulnerable.
This analysis of pricing inefficiency would not be valid if short sellers do in fact possess the great capacity to manipulate prices and hurt companies that is widely attributed to them. That is, if these investor evaluations of the short-selling threat are soundly based and relatively accurate on average (i.e., statistically unbiased), then the resulting effects on pricing could be compatible with efficient market functioning. The foundation of this analysis of probable pricing inefficiency is that, on the contrary, the psychological environment surrounding short selling has led investors to systematically overestimate the manipulative power of short sellers. Although there appear to have been some cases of serious abuse with a potential for significant price distortions on individual issues, the committee does not believe, as a general matter, that short sellers possess the extraordinary manipulative power that is widely attributed to them.
This is precisely the environment in which improved public information is clearly needed. While not necessarily providing a complete solution, better public information is the natural first remedy for such difficulties. By injecting factual clarity, it reduces the scope for fear based on imaginative speculations and unfounded assumptions. The issue of improved public information is discussed in Sections IV and V below.
C. The American Stock Exchange Surveillance Report
In 1987 the American Stock Exchange received complaints from three companies that holders of short positions were engaged in downside manipulation of the companys stock. Each company reported that it was the target of malicious negative rumors which, it felt, were being spread by the short sellers as part of a scheme to depress the price of its stock. In addition, many negative press stories had appeared about these companies, notably in Barrons.
The American Exchanges Surveillance Department conducted investigations into the short selling of each companys stock. It compiled detailed trading data on these companies stocks for certain study periods that ranged from 3 to 12 weeks and attempted to determine whether any of the short sellers had engaged in price manipulation in their trading during the study periods.
The trading data compiled in the investigation and the Exchanges findings were reported to the SEC. In each case, the Exchange concluded that none of the information it gathered revealed evidence of manipulation by short sellers. However, it stated that it could not determine whether certain principal short sellers had acted in concert. Moreover, since most of the principal short sellers were not members of the Exchange and therefore not subject to the Exchanges jurisdiction, it stated that the Exchange could not do a thorough investigation of the short-sellers activities. It submitted the report to the SEC with a recommendation that the SEC should further investigate the activities of the short sellers to determine whether the short sellers had acted in concert to depress the stock prices.
The Exchange also made a limited attempt to evaluate the companies claims of false rumors, but this work did not represent a thorough investigation. In its report the Exchange concluded that the charges of false rumors were a subject for the SEC to deal with. In particular, it recommended that the SEC should determine whether there had been any improper contact between the short sellers and the press.
The SEC did some additional investigation after it received the surveillance report. This included contacting the companies and the stock analysts that followed the companies, as well as searching various databases for negative articles or other information about the companies. Although it found negative articles from its database searches, the SEC said it did not find any articles which contained materially false information about the companies. In describing its response to the American Exchanges recommendation for further investigation, the SEC stated to the subcommittee that it found no indication of illegal activity by the short sellers in these cases and, moreover, that the SEC had brought action against one of the companies involved for improper accounting methods.
The subcommittee found, on close study of the Exchanges surveillance report, that the report contained both statistical discrepancies and unexplained information gaps. When questioned, the Exchange attributed the statistical discrepancies to human error but was unable to explain why certain information requested from one broker was never received. More importantly, the study periods selected by the Exchange for the three stocks did not correspond to the months when the reported short interest for these stocks was highest, or to the build-up of the short interest figures to their highest levels. Moreover, in the case of two stocks, high volume trading days occurred in the week immediately prior or subsequent to the study periods but were excluded from the study periods.
Finally, the Exchanges evaluation of the extensive trading data that was assembled lacked focus. It was never clearly stated what pattern they were looking for or what pattern would have raised concerns about manipulation. For this reason and because of the inadequacies cited above, the committee, while acknowledging the extensive effort of the Exchange, questions the effectiveness of its surveillance examination.
Moreover, the inadequacies found by the subcommittee should have been evident to the SEC but apparently were never detected. The committee finds, therefore, that the SECs response and followup to the American Exchange surveillance report were superficial and did not represent a serious effort to investigate the company charges of manipulation by short sellers.
D. The Role of the SEC
The Securities and Exchange Commission is responsible for enforcing the antifraud and antimanipulation provisions of the securities laws, and agency witnesses testified in the subcommittees hearings that the agency performs this responsibility vigorously when evidence of illegal behavior by short sellers is brought to their attention. In support of this the agency testimony cited certain enforcement cases brought by the Commission where the behavior of short sellers was challenged.
Other witnesses questioned the adequacy of the SECs efforts to control short-seller abuses, however. Moreover, several company officials have told privately of bringing complaints of short-seller abuse to the SEC without any apparent SEC action resulting. Some company officials even reported to the subcommittee that, after they brought their complaints to the SEC, the SEC turned around and investigated their own companies groundlessly for suspected accounting fraud, public disclosure violations, or other matters, without ever bringing formal charges.
The SEC has never, as far as the committee is aware, brought an enforcement case or even sought seriously to investigate a case in which the central allegation of abuse was the malicious dissemination of false or unverifiable negative reports about a public company, its officers, its products, or other matters that, if true or believed by investors, would be likely to influence negatively the trading price of the companys stock.
For this reason, the committee finds substantial basis for concern that the SECs policing of the fairness of the markets in this respect may not be adequate.
The committees concern regarding this aspect of the SECs enforcement program is further heightened by the prepared testimony of Mr. Sturc for the SECs Division of Enforcement. In explaining why the SEC has not found it practical to bring enforcement cases against short sellers in most instances, he stated:
Finally, many of the complaints we receive about alleged illegal short selling come from companies and corporate officers who are themselves under investigation by the Commission or others for possible violations of the securities and other laws. When there is an obvious economic justification for short sales, it is extremely difficult to prove: . . . (ii) the material false statement/omission and fraudulent intent requirements of Rule 10b-5. This is particularly true in those situations where, for example, our investigation tends to show that at the time when short sellers were allegedly disseminating false rumors, in fact, the issuer was disseminating materially false financial statements.

This statement by Mr. Sturc has the appearance of a de facto "no-action" assurance to short sellers concerning any actions they may take to disseminate false rumors about companies that are the object of SEC fraud investigations. Moreover, since the SEC does not bring formal charges against the company in many of the cases where it initiates an investigation, this statement represents a policy of ignoring possible cases of abuse by short sellers on the basis of unproven and potentially untrue suppositions about company behavior. The committee finds this policy very disturbing.
Finally, the committee finds that there has been an uncomfortably close direct working relationship between certain unknown short sellers and the SEC enforcement staff. Mr. Sturc acknowledged in the subcommittee hearing that the SEC staff "listen" when short sellers make allegations that a company is doing something wrong, because the short-sellers information is often accurate. Short sellers, in other words, frequently provide useful enforcement tips to the SEC staff.
That the SEC staff does frequently act on the tips provided by short sellers may also be inferred from a statistical survey the subcommittee staff conducted, with SEC cooperation, of SEC investigations of NASDAQ companies for accounting fraud or other fraudulent public disclosures during the period March 1989 through March 1990. During this period 24 percent of the formal investigations opened involving NASDAQ companies, and 17 percent of the informal investigations opened involving NASDAQ companies, were investigations targeted at companies in which the reported short interest in the company stock immediately prior to the opening of the investigation was at least 5 percent of the public float in that company’s stock. That is, substantial percentages of all SEC investigations of NASDAQ companies during this period were investigations of short-seller targets.
The subcommittee does not find anything inherently improper in this pattern of enforcement investigations by the SEC. This pattern does, nevertheless, raise a troubling question. The question is whether the SECs selection of investigation targets is biased in a manner that provides unwarranted assistance to the short sellers.
The knowledge in the market that a company is the object of an SEC investigation for possible fraud is generally expected to disappoint or alarm investors and to directly cause a decline in the companys stock price. The opening of such SEC investigations after short sellers have established substantial short positions in the target companies securities is therefore very beneficial to the short sellers. For this reason the SEC needs to exercise extreme caution in opening investigations of short-seller target companies, especially on the basis of tips from the short sellers, in order to guard against any appearance of bias favoring the short sellers.
Regardless of the appropriateness, from an enforcement perspective, of the investigations opened regarding possible fraud by short-seller target companies, the de facto working relationship between short sellers and the SEC enforcement staff has the effect of providing bounties to the short sellers for their enforcement tips when the enforcement investigations become known in the market. In this context, the committee finds it highly improper that the SEC staff should also exempt from any enforcement scrutiny the behavior of the short sellers whose tips they determine to act on, as Mr. Sturc testified.
IV. The Integrity of Information about Company Affairs
Accurate and timely information for investors is essential for a fair and efficient securities market. The unchallenged and unpunished circulation of false or misleading reports about company affairs is very destructive of fair markets. It discourages long-term investors from committing their funds to companies that have been made the targets of information distortions, and in this way it impairs and may even destroy these companies access to the equity market for new capital.
The SEC does not take an evenhanded and balanced approach toward information integrity in the equity market. The SEC vigorously investigates suspected cases of misleading or false information released by company officials about their own companies, which is entirely proper regulatory scrutiny, but the SEC does not employ equal vigor on the other side. The SEC has not committed itself to a policy of suppressing false or manipulative rumor circulation by parties seeking to discredit a company or its officers or products, and it has not displayed any such commitment in practice through its enforcement program.
Small companies are especially vulnerable to campaigns of intentional distortion about their company affairs, for two reasons. First, they lack the resources usually available to a larger company to conduct an expensive information campaign to combat false rumors directly. Second, knowledge of their affairs among the financial press and among securities professionals, who may be able to evaluate false charges critically and render a constructive independent judgment, is generally much less widespread than in the case of large companies.
The SEC should adopt a formal policy and administrative program for improving the integrity of information flows about public companies, especially smaller companies. This program should include a commitment of resources to vigorous investigation of suspected cases of dissemination of false information or of unverifiable information under false pretenses (such as impersonation of company officers or regulatory authorities). The SEC should also evaluate the adequacy of the enforcement authority at its disposal for controlling information distortions about public companies, and should advise Congress of its recommendations for additional authority, if needed.
This commitment by the SEC is needed in part to provide greater confidence to investors that they can commit their funds to investments in small company stocks without excessive vulnerability to abusive information distortion by short sellers. A commitment of this nature by the SEC is needed to dissipate the unhealthy psychological atmosphere, referred to above, that adversely affects the markets for many stock issues in which there is substantial short-selling activity.
V. Market Efficiency and Market Information
a. information about short-sale trading and share expansion
In any asset market, expansion in the supply of a particular asset that investors must hold will normally drive down the price, at least temporarily. Only when there is a perfectly elastic demand for that asset, which is extremely rare in the stock market, will price be unaffected when the supply expands. An abrupt supply change, in particular, can be disruptive if it takes place without prior announcement and without advance preparation of the market.
The distribution of new shares of stock into the equity market through a company offering of new shares represents the kind of supply expansion that can be disruptive if done abruptly without prior warning. For this reason, among others, elaborate disclosure rules have been put in place so that investors are able to be fully informed about what is going on when a company sells new shares in this manner. Investors are thereby able to have a fuller understanding of the factors underlying any price decline or increased trading volume they may see in a stock in which a distribution of new shares is taking place or is planned.
Short selling causes a similar share expansion, as explained above. New investors must be induced to purchase the shares being offered by short sellers, or existing shareholders must be induced to increase their holdings, so that the increased quantity of shares can be absorbed. An unannounced share expansion that arises from short selling can therefore be just as disruptive to market pricing as an unannounced distribution of new company shares would be.
The recent price behavior and trading volume in a stock convey information to other investors in the market. The information that is conveyed is different, however, if new shares are being distributed by short sellers than if existing stockholders are selling their positions.
Shareholders who sell generally do not seek to profit from a further decline in the stock price, and they may not expect any decline. They may merely need cash or may prefer other investments. In fact, if they sell only part of their holdings, then they clearly want the rest of their shares to appreciate further. For these reasons their sales do not necessarily suggest a negative evaluation of the stock.
Short sellers, on the other hand, clearly expect and seek to profit from a decline in the stock price. Their motivations and expectations are different. When short sellers are active, other investors must expect that these short sellers hold a highly negative evaluation of the stock and may drive the price down through further short selling. Short selling, furthermore, has the added significance of expanding the markets total holdings of the stock, which may require a price decline merely to induce new investors to absorb the new shares.
For this reason, investors should have accurate and timely information about all significant distributions of new shares that arise because of heavy short-selling volume. In the absence of this information, investors are presently unable to distinguish between heavy sales by current stockholders and the introduction of new book entry shares into the market through short selling. As a result, they may inappropriately infer that existing stockholders who are reducing their holdings are responsible for an observation of heavy trading volume and a price decline when in fact these are due to a supply expansion caused by short selling.
The present reporting of short interest statistics by the exchanges and the NASD does not supply the necessary information to the market and is entirely inadequate for this purpose. Aggregated short interest data are reported monthly to the exchanges and the NASD by brokers and dealers and are disseminated through the public media several days later, so the net short sales from one monthly reporting date to the next, net of purchases to cover previous short sales, are eventually known. No other data on short selling in individual stocks is available to the market, however. Market participants cannot know, therefore, except on a delayed basis several weeks later, about changes in the supply of an issuers shares through short selling.
These organizations should develop a method for collecting daily short-selling activity and weekly short interest data from brokers and dealers. They should then make this information available electronically to the market in aggregate form.
C. Disclosure of Material Individual Short Positions
Investors who acquire 5 percent or more of the shares of a company must report this fact to the SEC within 10 days, and the SEC filing is made public. However, short sellers who acquire a short position of this magnitude in a companys stock are not subject to any similar reporting requirement. Regardless of how large an investors short position in the stock of an individual company, he or she may remain entirely anonymous.
The subcommittee has received very strong expressions of support from company executives and interested stockholders for the concept of a public reporting requirement for large individual short positions, analogous to the present reporting requirement for investors who acquire 5 percent of a companys shares. Moreover, no substantial opposition to this concept has been expressed to the subcommittee. In the subcommittees hearings, the witnesses for the American Stock Exchange and the SEC expressed reservations about whether disclosure of major individual short positions might have unintended effects on the market and might represent an unwarranted disclosure of proprietary trading strategies, but these concerns were not expressed in a manner to reflect a position of opposition to the concept.
Moreover, as described above in Section III, the committee believes that the psychological atmosphere among investors and issuers regarding stocks targeted by short sellers exhibits a disturbing and unhealthy pattern that may seriously interfere with fair markets and efficient pricing, and the committee believes that the complete anonymity with which major short sellers are now permitted to operate contributes importantly to this unhealthy market psychology.
The committee therefore finds that such a public reporting requirement for large individual short positions is needed, for two closely related reasons. First, the committee believes that stockholders and issuers whose portfolio investments and business activities are under direct attack through the large-scale activities of sophisticated multi-million dollar short-selling partnerships have a right to know who the individual short sellers are in cases where their respective short investments are large enough to be material in relation to the total outstanding shares of the company; and second, the committee believes that the equity market will function more fairly and more efficiently if this information is available publicly.
The committee therefore recommends legislative enactment of such a reporting requirement. Although this reporting requirement might also be accomplished through SEC rulemaking, the SEC has recently stated in its concept release seeking public comment on the suggestion of such a reporting requirement that the agency’s authority to implement such a rule for purposes of market information is not clear. The committee therefore believes that legislation is the appropriate method for implementing this disclosure requirement
SECTIONS OF THE REPORT DEALING WITH THE EFFECT OF SHORT SALES ON PROXY VOTING HAVE BEEN OMITTED.