STOCKGATE TODAY
An online newspaper reporting the issues of Securities Fraud
Wall Streets Rigged Market Status – November 22, 2004
By Dave Patch
Earlier last week the Securities Industry Association (SIA) held a symposium for Wall Street Members on the SEC’s recent short selling reform package; Regulation SHO. The symposium, with a panel consisting of SRO and SEC personnel, highlighted the context of the new regulation and presented the members with the necessary tools to insure compliance. In the end, the SEC put the members on notice that the settlement failure issues presently floating in the markets must be changed. For that I give the SEC some credit.
But what of the Settlement Failure issue itself and how has it impacted Wall Street?
During the symposium, the panel members addressed a working document that was created by Professor Leslie Boni of the University of New Mexico. Professor Boni was employed as a visiting financial economist for the SEC in 2004 and had been documenting the background to settlement failures as well as the impacts of Regulation SHO in the marketplace. The document is now a published report titled “Strategic Delivery Failures in the US Equity Markets”. Her published report is startling.
Professor Boni’s report relies on a consistent theme of the industry, which she calls “Strategic Failures”. To a layman like me it is better stated as “Rigged Market Conditions”.
According to Professor Boni, Strategic Failures occur “when the short sellers choose not to deliver shares that would be too expensive to borrow”. Her analysis of Regulation SHO was that, “pre-Regulation SHO, equity and options market makers strategically failed to deliver shares that were expensive to borrow or impossible to borrow”. With evidence that “strategic fails (i.e. naked short sales) likely accounted for a higher percentage of short interest pre-Regulation SHO than previously understood”. The professor claims ultimately that 42% of listed stocks (NYSE, NASDAQ, AMEX) and 47% of unlisted stocks (OTCBB, Pink Sheets) had persistent fails of 5 days or more with 4% being above the SEC’s threshold limits for failures. The standard for settlement is presently 3 days with a concept proposal by the SEC in comment to reduce 3 day settlement to 1day.
Professor Boni delved deeper into the bowels of the settlement process and investigated the buy-in proceedings of the market place and the compliance to this rule. Her reference to a study conducted by Evans, Geczy, Musto, and Reed in 2003 provided evidence that while the SRO’s have buy-in requirements buy-ins, in themselves, are rarely requested in settling these failures. One such market maker who was audited failed to deliver all or at least a portion of shares in 69,063 transactions through the years of 1998-1999 and was only bought in on 86 of these positions or .12% of the time. The remaining failures would fall into the category of strategic failures accepted by the Industry.
The published report only gets more accusatory of Industry motives for settlement failures. Each concept ultimately resorting to financial rationalizations to dilute our securities with unreported settlement failures. With such a report in hand, it is only left to our imaginations why the SEC has yet to take action against the member firms for their self serving activities.
Going back to the SIA Symposium, a particular question by a member is now made clearer. The Industry was requesting “Commercially Reasonable” time to close out failures in threshold securities because they “don’t want to impact present market conditions”. The member was concerned that if they have a significant position of failures than they would drive the price up during the buy-in and the cost to settle would not be financially beneficial. I was amused by this question as all pre-threshold fails are grandfathered so, by default, that large failure position being forced to close out was sell side pressure that would have already impacted market pricing. That large block of fails would have had to fail the requirements of Affirmative Determination and, it would have had to take place over a short duration of time. Overselling in a short period of time can only affect a stock in one way.
The SEC did highlight for the members in attendance that there was no “commercially reasonable” language built into the reform and that the close outs would be mandatory on threshold securities.
In my research into this matter of strategic failures I have reviewed the SEC’s charter document; Securities Acts of 1933 and 1934 and I have failed to find any language detailing strategic failures. In fact, I find just the opposite. Section 17A of the Securities Act of 1934 mandates prompt and accurate clearance and settlement of trades. The admission of Strategic Failures is also in direct violation of Rule 15c6-1.
Rule 15c6-1 defines the settlement cycle for trades executed and states that no Broker Dealer may enter into a contract for the sale of a security whereby the payment for that security and the delivery of that security is greater than 3 business days. For market making activities there is a slight exemption from the delivery in a Bona Fide Market Making activity but as the SEC and SRO’s have repeatedly stated, Bona Fide Market making is not simply supporting the best offer in a naked short sale without also representing the best bid or near best bid in a long trade. They must be actively making a market on both sides of trading to use the exemption.
Strategic Fails being defined in the Professor’s report as a known execution of short sales for which there is no intention of meeting 3-day settlement is the violation. It was pre-determined that it was not cost beneficial to seek out and borrow that security for delivery and thus the contract could be deemed illegal. A conscious decision was being made to violate rule 15c6-1 and the compliance departments never blinked.
Recently the industry has gone through allegations of price rigging in insurance contracts and market timing in the mutual fund industry. These frauds were orchestrated to achieve higher corporate financial success at the expense of the innocent and unsuspecting. Strategic failures and the collusion of this as an industry wide practice has affected every investor regardless of the security they have purchased over time. Strategic Fails affect the balance of supply and demand and do so as a sell side attack on the market pricing of that security. It would be my contention that the stock market burst of the late 1990’s and early 2000 were exacerbated by strategic failures orchestrated by the industry.
The SEC is committed to regulation SHO and we can only hope they tightly enforce these rules. Whether the SEC will take a step back and address the past sins of the Industries conspiracy to defraud will be something else we will watch closely. A rigged marketplace is a dangerous marketplace.
Editors Note:
Reporters who have spoken to member firms about the plight of my efforts and those like me have received responses like ones I have personally received by members of the Securities and Exchange Commission. We are being categorized as stock promoters looking to initiate a short squeeze after losing money in the market. To this I will answer all who question my motives.
My motives are simple. As an investor I want to fight for every right to trade in a fair marketplace void of any appearance of rigged conditions. For those stocks I own, I rarely if ever mention them by name in my writings, as it is not these stocks singularly for which I fight this battle. My fight is for the global settlement of trades. If I don’t mention a particular security I thought I could not be accused of pumping any particular stock. I guess I was wrong. It appears some are turning defensive at a time of guilt.
For those within the Industry who fear the possibility of a short squeeze, they are doing so because they know they had taken advantage of the situation and have now been caught. They are feeling the pressures of guilt and fear. A short squeeze can ONLY happen if there is an issue with a securities settlement status at these firms. No squeeze can happen without a problem on the books or valid business growth that drives market performance.
I believe, and have stated several times, that there are companies who are claiming abuse trying to initiate an action that does not exist. They do so because the Industry and the Regulators have allowed the situation to get out of control for so long. The Industry created the presence of strategic fails and Investors have finally caught wind of this practice. Shame on the members for doing it in the first place and shame on them for now lobbying to continue to get away with it. Investors should not have to read on a frequent basis the Industries practices of fraud to achieve higher bottom lines and higher compensation packages.
I challenge all in the industry that oppose me to simply come clean and open their books for an audit of settlement status. Do not fight discovery in our courts if you have nothing to hide. It only makes the Industry look that much guiltier with documents like Professor Boni’s validating my concerns.
For more on this issue please visit the Host site at www.investigatethesec.com .
Copyright 2004
