IR for Investors

[LCLiving]

Posted by: plastipunk
In reply to: lowman who wrote msg# 1683
Date:7/30/2007 3:41:17 PM
Post #of 1711

Don't know if this has been posted before, but here goes:



If you agree with what Senator Bennett is doing, please email him and thank him. http://bennett.senate.gov/contact/email_opinion.cfm

Senator Bennett Discusses Naked Short Selling on the Senate Floor July 20, 2007

Mr. President, after all the fireworks and contention on some previous issues this week, I rise to speak about something that has very little interest to most Americans but tremendous interest, I believe, to a certain portion of our economy. I want to use this opportunity to call it to the attention of the Senate.

I am talking about a practice that occurs in the stock market that has the very interesting name of naked short selling. That conjures up all kinds of interesting images in many people's minds, but this is what it is: It is a practice where somebody sells short a particular stock and never ever has to cover the sale.

Now, even that may be too much stock-market-type jargon for people to understand what I am talking about. So let me quote from an article that appeared in the Wall Street Journal a few weeks ago.

Mr. President, I ask unanimous consent that the article be printed in the Record at the conclusion of my remarks.

Quoting from the article, it says:

“The naked [short selling] debate is a product of the revolution that has occurred in stock trading over the past 40 years. Up to the 1960s, trading involved hundreds of messengers crisscrossing lower Manhattan with bags of stock certificates and checks. As trading volume hit 15 million shares daily, the New York Stock Exchange had to close for part of each week to clear the paperwork backlog.”

As an insert in the quotation, I remember those days. I was trading in the stock market at the time, and having the market shut down to clear the back office paperwork was not an unusual experience. Going back to the article:

“That led to the creation of DTCC (The Depository Trust and Clearing Corporation), which is regulated by the SEC.”

If I might, as an aside, I do not think that last statement is true. I am not sure that the SEC has control over the DTCC. Almost all stock is now kept at the company's central depository and never leaves there. Instead, a stock buyer's brokerage account is electronically credited with a ``securities entitlement.'' This electronic credit can, in turn, be sold to someone else.

Replacing paper with electrons has allowed stock-trading volume to rise to billions of shares daily. The cost of buying or selling stock has fallen to less than 3.5 cents a share, a tenth of paper-era costs.

But to keep trading moving at this pace, the system can provide cover for naked shorting, critics argue. If the stock in a given transaction isn't delivered in the 3-day period, the buyer, who paid his money, is routinely given electronic credit for the stock. While the SEC calls for delivery in three days, the agency has no mechanism to enforce that guideline.

This is where the practice of naked short selling comes in. I did not really understand it until I had some investment bankers--not the kind you find on Wall Street but the more modest kind you find in Salt Lake City--sit me down in front of a screen and show me what happens with stock trading. To put it in the simplest terms, someone who wants to sell short--that is, sell stock he does not own--will place a sale order.

Now, when I first sold short as a participant in the market, my broker gave me this crude little poem to remember. He said: ``He who sells what isn't his'n, must buy it back or go to prison.'' He said: You have to understand, if you sell a stock short, the time is going to come when you are going to have to buy it back to cover that sale by delivering shares. In the days the Wall Street Journal talked about, that meant buying a crinkly piece of paper--a stock certificate--and delivering it so you have covered your short sale.

Today, that is not the case because all of the stock certificates are gone, and the crinkly pieces of paper have been replaced by electronic impulses in a computer. So this is what happens. A short seller enters the market and says: I want to short--I want to sell--1,000 shares of XYZ stock. That means at some point he has to produce 1,000 shares to cover his sale. How do you do that? You borrow the shares, and then you buy them back at some future time.

All right. From whom do you borrow them? The DTCC. They have all the shares on deposit, and so you go to the DTCC and you say: I want to borrow 1,000 shares of XYZ stock. They say: Fine, we have them on deposit. We will lend them to you so you can use them for your short sale.

All right, everything is fine--except in this electronic age, it is possible for you to keep shuffling around the electronic impulses that represent the stock and never ever have to buy it back.

Stop and think about that. That is a pretty good business plan. You can sell as much as you want and never ever have to pay for it. If a stock is trading at $5 a share, you could go in and sell 1,000 shares, and you get paid $5,000 for selling 1,000 shares, and you never have to buy them. Because you are constantly moving around the electronic impulses that represent those shares, you never have to cover.

Now, when you talk to the DTCC people, they say: No, we always make sure there is a delivery. And if there is not, it is not our fault. It is not our responsibility to police this. It is up to the brokerage houses to do this.

The SEC has spent enough time looking at this and enough time talking to me that they issued to me a three-page letter outlining the steps they have taken to stop the practice of naked short selling.

I think the SEC letter goes a long way--the SEC actions go a long way. Without getting too technical about it, they have taken a number of steps to prevent what are called ``fails to deliver'' and, therefore, to try to stop the naked short-selling situation.

But I have discovered something that appears to be a way around the SEC rules. Here is the transaction: Broker A shorts 1,000 shares. At the end of 13 days, which is the period he has to produce the shares, he has been unable to find any--probably hasn't even looked--but he has this requirement under the SEC rule to produce 1,000 shares. So he goes to broker B and says quietly: Sell me a thousand shares. Broker B says: I don't have any. Broker A says: It doesn't matter; sell me a thousand shares so I can cover. Broker B: All right. I will sell you a thousand shares so you can cover and there will be no passage of money; this is a deal between the two of us--a rollover. At the end of 13 days, broker B has to deliver a thousand shares, so broker A sells the same 1,000 phantom shares back to broker B, and they ping-pong these back and forth for as long as they want.

So you can have a situation where people are selling shares that don't exist, taking commissions on the sale, and the profits of the sale, and never, ever having to produce the shares.

I think it is serious enough that we ought to have a hearing about this in the Banking Committee. I have spoken to the chairman of the Banking Committee, Senator Dodd, and asked him if it wouldn't be possible for us to have such a hearing at some point in the future. He has expressed a willingness to do that. I understand we can't set a time for that right now; there are too many other things going on in the Banking Committee. But I am delighted to know he is willing to cooperate with us in examining this issue.

I would like to suggest several things I would like to discuss at that hearing. First, by the way, I want the officials of the DTCC to have the opportunity to come in and explain how it works. I have seen letters to the editor in the Wall Street Journal, where they say this article is inaccurate, and I don't want to be relying on this article if it is inaccurate. I think a congressional hearing is a good place for those who are running the DTCC to explain to us how it works. I would like the SEC to come in and give us their background and information as to how their rules are working to try to stop the naked short selling. But I have these two additional recommendations that I would hope we could get done by regulation and, if not, I am prepared to introduce legislation to deal with them.

First, I think there should be a rule which says there cannot be borrowing, that brokers cannot borrow for short sales more stock than is on deposit with the DTCC. I think that is obvious. If there are 3 million shares of XYZ Company on deposit at the DTCC, people should not be able to short sell 4 million shares. I have seen the situation where people with these small companies--and all this happens primarily in little companies--people with small companies, in an effort to defend their stock against the short sales that are rolling over, are buying stock, and it is electronically credited to them and end up on paper, or at least on computer, owning more shares than exist. How can that be? If somebody buys the stock for his company and ends up owning 110 percent of the issued stock, and people are still selling that stock, you know you are dealing with phantom shares.

So my first recommendation would be that the DTCC cannot make available as loans for short sellers more stock than they have on deposit. Once they have reached the point that 100 percent of the shares they have on deposit have been loaned out, they can't loan out any more. I think that is an obvious commonsense recommendation, but it doesn't apply now.

Secondly, I think there ought to be a rule which says a broker cannot be paid a commission on a short sale until the shares are delivered. Back to the business model. The broker sells $5,000 worth of stock. He can do it every day. He can get $5,000 every day, without ever having to cover the stock, and he gets a commission on making the sale. So if you say, no, there will be no commissions paid until the stock is delivered, you will have a significant impact on stopping this activity.

Now, people who hear the complaints about naked short selling say: It only represents a tiny percentage of the trillions of dollars' worth of trading activity that goes on in American markets every day. They are right. It is only a tiny percentage. But that is small comfort to those who have gotten a few dollars together, formed a business, gone to the market to try to raise some capital to support the business, put on the marketplace, say, 25 percent of their shares, holding the other 75 percent for themselves, and then getting some support in the market so that the shares edge up from 25 cents to 50 cents to $1, to $1.25 and then suddenly see the short sellers come in and say: OK, we will drive that stock back down from $1.25 to 2.5 cents, and we will do it by selling stock that doesn't exist and in the process we will ruin the company.

The one thing that convinced me this was real was when the investment bankers sat me down in front of a screen and showed me the stock trading of a company that has been out of business for 3 years, and the stock trades regularly, every 13 days. You know exactly what they are doing. The brokers are rolling the stock back and forth every 13 days, so they are meeting the SEC requirements--they are delivering--but the shares they are delivering to each other back and forth do not exist. The company was driven out of business by the short sellers who made it impossible for them to go to the capital markets.

As I said in my opening remarks, this is a tiny matter. It does not involve very many people, but to the people who are involved, it, frankly, can be a matter of life and death. There are enough of them starting businesses and creating entrepreneurial activity in the United States that we owe it to them to find out exactly what is going on with respect to this activity. That is why I have asked Chairman Dodd to consider a hearing on this matter to let us hear from the SEC, to let us hear from the DTCC, and to let us hear from those in the marketplace who have actual experience and see if the present SEC rules are sufficient or if we need to do additional things along the lines of the two items I have suggested.

I yield the floor.

http://bennett.senate.gov/