More on naked shorting
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STOCKGATE TODAY- April 12th, 2005
An online newspaper reporting the issues of Securities Fraud
Wall Street Collusion and your Investments – April 12, 2005
David Patch
Naked Shorting, the process by which an investor will sell a security they do not possess nor execute a legal borrow to make good on delivery to the buying investor. While the financial impacts of naked shorting are not fully understood the subtleties of this process should raise the hairs on the back of your neck. Has Wall Street and Wall Street Regulators colluded to willfully defraud the investing public?
Collusion: A secret agreement or cooperation especially for an illegal or deceitful purpose.
On the surface collusion is a tough act to prove. How are you ever going to get evidence of that secret handshake or that wink? Fortunately, I am not one who has to prove it. I will just provide the circumstantial evidence that hints to it.
Trade Settlement. The conclusion of a securities transaction; a broker/dealer buying securities pays for them; a selling broker delivers the securities to the buyer's broker. (Taken from NASD Glossary)
Under Rule 15c6-1 [Settlement Cycle] of the Securities Act of 1934:
Except as provided in paragraphs (b), (c), and (d) of this section, a broker or dealer shall not effect or enter into a contract for the purchase or sale of a security (other than an exempted security, government security, municipal security, commercial paper, bankers' acceptances, or commercial bills) that provides for payment of funds and delivery of securities later than the third business day after the date of the contract unless otherwise expressly agreed to by the parties at the time of the transaction.
In essence, no two brokers can willfully enter into a contract for trade knowing that they will either fail to deliver the shares required for settlement (seller) or knowing that they will not pay for or seek out delivery of those shares (buyer) within three business days after the date of the contract. Exceptions to these guidelines are limited in scope and require agreement by both parties at the time the contract is being entered in to as defined by the SEC Rule.
Industry Collusion comes into play when these contracts are repeatedly entered into whereby neither party has the “intent” on meeting the terms or the enforcement of such contract.
Let’s take the principles of naked shorting, the evidence provided by the Securities and Exchange Commission and comments by the Depository Trust Clearing Corporation (DTCC) and apply what we know to Rule 15c6-1 and argue our case.
October 2003, the SEC released proposed Regulation SHO to address among other things short sale abuses. In the contents of the proposal the SEC identifies naked shorting as a reality in the market place and highlights that for some issuers the number of settlement failures in their security may reach and exceed the number of shares trading within the public float. Each one of those failures, beyond legal exemptions, represents a contractual violation of Rule 15c6-1. These trades all failed to settle within 3-days.
For the record, there are no legal exemptions that qualify for a magnitude of trade fails that would exceed the entire public float of a company. Bona-Fide Market Making is a limited naked short exemption provided to the members to handle temporary volume volatility and has no legal standing to amass to failure levels exceeding the public float without settlement.
June 2004, the SEC releases Regulation SHO and identifies that the new proposal will have two significant articles of incorporation. First, In January 2005 when SHO is implemented, all prior settlement failures need not comply with the mandatory closeout provisions incorporated into SHO. Second, each major market center will publish a listing of securities whose stock currently contains settlement failures that exceed 10,000 shares and 0.5% of the shares outstanding for a period of no less than 5 consecutive trading days.
As the SEC grandfathered the prior settlement failures from mandatory closeout provisions they in essence pardoned all past violations of Rule 15c6-1 regardless of the standing of those trades today. This is not like pardoning Mark McGuire for possible steroid violations in 2000 when he is clean today. This is pardoning everybody that robbed the bank and still has the money in his or her savings accounts. Only in this case, the SEC has an easier task of finding the robbers that the local cops. The trade data on this theft is still recorded on the books of Wall Street institutions and at the DTCC.
The threshold security list publication, now a requirement of Regulation SHO, is over 3 months old and maintains many of the original listed companies that were first presented on January 7, 2005. Many of these companies have settlement failures beyond imaginable numbers but all abusive failures pardoned by the SEC.
Over the past month the Depository Trust Clearing Corporation (DTCC), the representative Federal Reserve of Wall Street, has taken to the public their views on naked shorting. While the DTCC vehemently denies any responsibilities to the fraudulent acts of naked shorting they have provided us with evidence to support claims of abuse.
DTCC Deputy Chief General Counsel Larry Thompson, in a published DTCC newsletter, provided figures stating that 24,000 trades daily will fail settlement. Twenty four thousand trades daily will fail to meet the contractual obligations of Rule 15c6-1. Logistically, that would imply that every broker/dealer representing Wall Street is involved in failing both the selling obligations and buying obligations of Rule 15c6-1 trade contracts. It does not matter what percentage of overall trades this represents, 24,000 trades daily is a large number to ignore in the electronic age we live in.
When asked about these failures DTCC spokesman Steve Letzler indicated that while the DTCC will “settle” the transaction through the NSCC Stock Borrow Program, the fail will remain on the books until that time in which the seller delivers on their obligation. Steve called this a “liability” to the broker/dealer. “That broker/dealer could incur a premium liability should a buy-in take place forcing an open market purchase of a security” at any cost.
Liability. Defined as a pecuniary obligation: Debt. One that acts as a disadvantage.
I queried Steve on the shortcomings of this “liability” based on the reality of the back office operations and the evidence of tremendous settlement failure obligations [Larry Thomson identified the cost at $6 Billion presently recorded on the books at DTCC]. Ultimately, how is a liability incurred if there was no standard industry practices to buy-in a settlement failure? Steve admitted that while buy-ins were “rare” it was a liability nonetheless.
Using an analogy, Steve and I agreed that this liability was similar to the liability of getting a speeding ticket for going 60 in a 55 mph speed zone on our Nations highways. History proves that it simply doesn’t happen with any frequency so the liability is really slim to none. The risk of breaking the speeding law was so miniscule over the reward of getting there sooner that the law is broken repeatedly and daily. That speeding law in our Securities Industry is Rule 15c6-1 and being broken are the contracts for trade settlements. The rewards for such infractions, greater revenue stream in trade commissions and greater sell side leverage to the selling party/client.
Rule 15c6-1 is a Securities Law like all others. Violations to Rule 15c6-1 have never been enforced by the SEC to the best of my knowledge. In fact, under two NASD enforcement complaints [NASD vs. Fiero Brothers & NASD vs. Hilary Shane] for naked shorting abuses, and an SEC Enforcement [SEC vs. Rhino Advisors] there were never any charges brought against member firms for the execution of those illegal trades. The Fiero Brothers activities ultimately resulted in the insolvency of clearing firm Adler Coleman due to the magnitude of unsettled trades being carried on their books. Failures had amassed to that level without Wall Street calling in the failed trades from the buy side broker/dealers under the guidelines and provisions of Rule 15c6-1.
In the most recent case, NASD vs. Hilary Shane (December 2003), Ms. Shane executed 975 consecutive trades of CompuDyne stock [475,000 shares] without a single buying broker/dealer executing a mandatory buy-in of her failure to deliver her shares. The NASD complaint contests that Ms. Shane was selling shares not yet registered by the company and only planned to make good on delivery of shares after the shares were registered and available. Ms. Shane was selling naked short ahead of company news to lock in profits and the buying firms aided her by allowing the fails to take place without forced buy-ins and delivery.
While this may be the most recent case, it is not the best suited to support collusion.
In February 2003 the SEC brought up charges against Rhino Advisors for the manipulation of Sedona Corporation stock. This enforcement action by the SEC resulted in further criminal indictments being brought by the DOJ against Thomas and Andreas Badian, Executives of Rhino Advisors, for stock manipulation. As part of the arrest warrants were transcripts of audiotapes the SEC provided to the DOJ to support their case. On the audiotapes was Andreas Badian telling a US broker/dealer to sell Sedona stock with “unbridled levels of aggression”. The Broker/Dealer did and the stock collapsed as intended. The scheme to defraud happened because the industry elected to ignore their fiduciary responsibility to force delivery of the trades executed by the scheme to defraud. A manipulative scheme to defraud that took place in 2000/2001 only yielded a $1 million fine by the SEC against Rhino Advisors in 2003.
Our Securities Laws, as presented to the public and to Congress are crystal clear. Under Rule 15c6-1 no two brokers can enter into a contract for trade that will exceed 3-day settlement unless expressly agreed upon by both parties. With buy-in provisions written into our securities laws, it is as much an obligation of a buying broker/dealer to enforce this contract on behalf of their client as it is for the selling firm to deliver. Failing to do so in a consistent manner implicates the buying broker/dealer in collusion with the selling broker/dealer acting in the conspiracy to commit fraud. The buying broker put the interests of another broker ahead of the interests of their client.
The incentive is obvious. Forgive me this time and I will forgive you the next. A win-win for both. Clearly there is no other incentive for the buying broker/dealer who just had a contract violated and violated repeatedly.
Collusion: A secret agreement or cooperation especially for an illegal or deceitful purpose.
Certainly entering into contractual obligations whereby neither party has intent on enforcing the contractual obligations, and one party is trading from an illegal standing of stock ownership, raises concerns about implied cooperation to an illegal act by all parties involved. Including regulators!
Is there circumstantial evidence to support collusion by the industry to defraud the investing public? Without a doubt the answer is yes.
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Copyright 2005
