FYI: Regulation SHO: This Could Get Interesting
Source: The OTC Journal, today's edition
The OTC Journal archives reveal I have written three editions on the subject of illegal naked short selling over the past two years. It is a fascinating subject, and one that is back in the news as a new SEC regulation goes into effect this week.
If you have an interest in this subject and want to review the past editions, here they are: 4/19/03,5/18/03, and 2/4/04.
Illegal naked short selling has been problematic for microcap stocks for many years, but the pendulum began to swing the other way in early 2004. Normal short selling requires the seller to borrow the shares ahead of executing a sell trade in shares not owned. The seller hopes to buy them back later at a lower price and lock in a profit.
For many years short sellers have been able to simply sell unlimited supplies of small stocks through overseas brokerage firms, even though no shares have been borrowed. Thanks to loopholes in the clearing system, these sellers are never forced to deliver the shares. In essence, short sellers have been able to "counterfeit" supplies of stock by avoiding the regulations from offshore.
Small and microcap companies have been particularly vulnerable to this practice as there is often little institutional support for the stocks. When a stock starts trading poorly, small investors tend to panic and sell, forcing prices even lower. Once an enormous short position is established, a smear campaign often follows, characterized by negative articles from questionable sources and malicious posting on message boards with no disclosure. The stock ends up trading so poorly the company cannot raise equity capital, and many die a premature death.
A high profile example of this kind of practice occurred in the middle of December. Sirius Satellite Radio (NASDAQ: SIRI) had been on a tear over the past several months. Clearly the stock was richly valued and extended, and it was rumored short sellers were getting killed. Miraculously a complete hatchet job article appeared in Barron's, which sent the stock temporarily plummeting. While indeed, there was a strong argument the stock was overvalued, the article was completely one sided and gave no credence to the growth argument. A similar article in the Wall Street Journal was much more balanced. If you think the Barron's article was an accident, and short sellers didn't know about it in advance, you are living in LaLa land.
Small companies have been hounding regulators for years to take steps to eliminate these oppressive practices. In February of last year the NASD one upped the SEC by implementing the Affirmative Determination Rule, which required US brokerage firms to affirmatively determine if an overseas brokerage firm selling shares through them can actually deliver the shares. This made for some exciting moves in heavily shorted stocks.
The SEC has finally implemented the long awaited Regulation SHO. Regulation SHO went into effect on January 3rd. Beginning January 10th, each day a list of securities with excessive open naked short positions will be publicly published.
This required list is referred to as the Threshold Securities List. Under Regulation SHO, threshold securities are defined by two criteria: 1) there are at least 10,000 shares in aggregate failed deliveries for the security for five consecutive settlement days and, 2) these fails to deliver constitute 0.5% or more of outstanding shares.
If the failed deliveries for the stocks on the Threshold List are not rectified within 13 trading days, the market maker to whom the shares was sold will effect a "buy in" in the open market.
Each exchange is required to maintain a daily Threshold List. I am guessing the list will be found at the web site of the exchange; i.e. www.nasdaq.com and www.otcbb.com.
It will be interesting to start monitoring the Threshold Lists for unusual movements to the upside.
I am not opposed to the practice of short selling. I believe all investors should be able to bet on any stock in either direction. I am opposed to sophisticated fund managers with offshore accounts using loopholes to initiate trades you that you and I cannot execute through our regular brokerage accounts. If they can do, we should all be able to do it.
The Threshold List could become a favorite resource for locating trading ideas on the long side. It might become the sport of hedge fund managers. These new regulations are emerging out of down side excesses from the the 2000 to 2003 time frame. The pendulum is finally swinging back to a level playing field. These actions by the regulators will help the OTC Bulletin Board become the incubator it is intended to be.
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