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[Thirsty Tiger]

So far the best explanation of SHO's "grandfather" clause I have seen.
From the OMOG board

By: tchauncy
07 Jan 2005, 09:28 AM EST
Msg. 194523 of 194551
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I have had several people ask me this specific question having to do with Reg. SHO, so I will attempt to answer it here. The question is "What does the SEC mean when it says that all existing `Fails' (Naked Shorts) are `Grand fathered', and does this mean that all past fails will escape the new rules."

It is a confusing subject but let me make a stab at it as I think I understand it.

I assume that in order to attempt to cause the least amount of havoc as possible, the SEC decided to put the "grandfather" clause in since not doing it would probably mean that all naked shorts would have had to be covered within 13 days after Jan. 10th. But, don't misunderstand. This does NOT let all the old Naked Shorts off the hook. It just spreads the forced covering out over a longer period.

First of all, understand, all legal shorts, those that actually did borrow shares are not affected by the rule other than perhaps the natural supposition that if a company has a large legal short, there is a good chance it could also have a large naked short. Which would mean that "buy ins" that the naked shorts would have to make could drive the stock price up and create grief for the legitimate shorts.

Now lets go back and define a "naked short". As I have posted here many times, a naked short is illegal and is a stock that was sold without first having been bought. It is a "sale not long". In other words it would be like me calling my broker and telling him to sell 1000 shares of IBM that he does not have "long" in my account with him. (On line brokers do not allow this, but most full service brokers do) Now the discussion would probably go like this. My broker would probably say; "Tchauncy, you don't have any IBM with me". I would respond, "I know, I have it in my safe deposit box. I will bring it to you." With that said, he will sell the shares "long". (not mark the sell ticket "sell short" and borrow the shares as he would if he knew it was a short sale). Now while I have a good relationship with my full service broker, up until now, he would probably give me as long as month to deliver those share certificates. But, If I were a hedge fund that generated a lot of business, who worked through the "institutional desk", and gave such an order, most firms would let me skate for maybe a year or maybe forever unless they get a buyin notice. This is where DTC would come in and "lend" your certs to my broker to cover any buyins. If you know anything about all the lawsuits against DTC on the subject, the real problem is that DTC has in many cases electronically lent the same certificates over and over if enough shares are not in CEDE (their vault). The problem is that this is suppose to be illegal. But lending electronic shares has been so profitable for DTC over the years, it was never attacked .

Now what is wrong with what I just described and therefore illegal? And why might I not have just borrowed the shares and had my broker mark the ticket "sell short"? Well, here is why. Brokerage firms are only suppose to allow shares that are authorized for margin and are held in margin accounts to be legally lent. Only listed stocks are legally allowed to be marginable. So right off the bat, except for a minuscule set of circumstances, no pink sheet or BB stock is marginable, so it is not possible for your broker to borrow those shares so it is not possible to legitimately sell theses stocks short unless you are a MM. So up until Reg SHO, the only way Pinkies or BB's
could be shorted is naked. Reg SHO is suppose to eliminate this once and for all. (we hope)

Up until the last couple of years, the SEC either was in denial or just didn't care of the rampant abuse that was going on as describe above. Thanks to people like David Patch at investigatethesec.com and the campaign they have been weighing for the past three years, it appears that the SEC has finally awoken to what was happening and is trying to stop it. They have identified that over 20% of all stocks have abusive naked shorting going on. (The "threshold" of .05% of total shares outstanding or 10,000 shares). Many of these are listed
stock which might make one ask, why would a stock that is legally allowed to be shorted have a naked short? Well in many cases, the short is so big that all the legal shares that could be borrowed were. But in the past that has never stopped these hedge funds. They would then short more "naked" as I describe above. So the "threshold" describe above only has to do with the "naked shorts", not the legitimate ones.

So, with this background, back to my original subject, the
"Grandfather" clause and what penetrates its umbrella. Simply stated, it is volume that penetrates it. The bigger the short, the more volume, the more problems the naked shorts have. It doesn't make any difference if that volume is upside, or downside. IMO, it goes something like this, a couple of examples:

If a company has a 5% naked short fail position that is unresolved past settlement on January 3 and no shares traded this whole past week, then that naked short is not forced to do anything YET. But, lets say that I bought 10,000 shares of that stock from you on Wednesday and that was the only shares that traded that day, then, even though it was not the short seller who did anything, 500 shares under the "grandfather" umbrella would be penetrated. This happens because when I bought those shares from you DTC electronically transferred 10,000 shares on settlement date to my account, BUT due to the naked short, they really didn't have 10,000 "certificate backed" shares to legally transfer to me. They only had 9,500. So you can see
that 500 shares just went into a "fail". Now don't worry, you bought and paid for your shares, they are not going to go after you. BUT they will have to electronically trace back the genesis of the shares and eventually find who naked shorted those shares and he WILL receive a "buy in" notice on those shares. Which means he will then have 13 days from your settlement day to either buy in those 500 shares himself, or
if he doesn't, it will be bought in for him on the 14th day. (In the old days, it was still very possible on listed stocks that he could eventually receive a buy in notice, but he was given more time to try to go out an borrow the shares if he didn't want to cover. That rule to my understanding has changed. If he is caught now, he can no longer just go borrow shares, he WILL be "bought in", either willingly or unwillingly. Now this example is very simplistic but should get the intended concept across. Obviously if more shares are traded, say 100,000 then 5,000 shares are affected, etc.

Now with the above concept, you can extrapolate the situation for whatever percent naked shorts or fails are in the particular stock. If a company has 25% naked short, then 2,500 shares per 10,000 volume penetrates the Grandfather. 50% naked, 5000 shares, 100% naked, all the shares. So, the cute part about this situation is that it is so self perpetuating. If the short is large enough, even the short himself will further create his own problem with his future buy ins

Now with the above said, It might just explain why we have seen the stock move up so easily this week on very light volume. Big spreads by MM's are usually done when they want to dry up volume. Just as the day before when we spent four hours bid .016, offer .017, we spent four hours yesterday bid .017, offer .018.

BTW, as I have been posting for the past ten days, There is no question in my mind that we have a very large short here but I still don't know whether we are going to be on a "PUBLISHED" list or not since we are not reporting and there still doesn't seem to be a venue website to handle pinks, but the trading tells me, as it has for the past week, that something is different in the way this is trading here. But only time will tell if Reg. SHO is going to have a lasting affect on OMOG but the most important thing to remember is that the SEC has clearly stated that all future naked short selling will not be
tolerated.