Why Is Naked Short Selling/Failing To Deliver Such A Big a Deal, and Why Should I Care?
A) It is against the law. It actually violates a number of rules and sections of the 1934 Securities Exchange Act, as well as subsequent provisions. Those sections include 10(a)2, Rule 203 of SHO, Rule 15(c)6-1, 17(a) and a host of others.
B) It is against the law for a reason. It is used as a fraudulent act - essentially counterfeiting. The reason that it is counterfeiting is simple - the share that the buyer gets is represented to him as a legitimate share, when in fact it is not. That is fraud, wherein a fraudulently created and unregistered security is passed off to the buyer and represented as the real thing. Nobody in this case is told they are buying an IOU from the NSCC to the DTCC which likely isn't covered by a real share in the first place. Hence fraud, and the creation of an unregistered security for the purpose of creating a deception.
C) The recent NASD approach in the Compudyne case is consistent with this interpretation that naked short selling is the creation of an unregistered security, violations of Section 5 of the Securities Act of 1933 and thereby of NASD Conduct Rule 2110. Further, failing to make an affirmative determination (hand in hand with naked short selling) is a violation of NASD Conduct Rules 3370 and 2110. And the whole thing is a violation of 10(b)5 at a higher level - an artifice to defraud. There is also quite likely a violation in th NFI case of section 9(a)1 banning related party trading, the employment of a manipulative device by brokers/dealers - 10(b)3, and misappropriation (front running articles) - 10(b)5-2.
D) There's more. But that's the basics. Naked short selling is the Failing To Deliver a share that was promised - they took the buyer's money but didn't deliver the goods. The DTCC and NSCC's stock borrow program covers up that failure by "lending" a share from a virtual pool at the DTCC to the NSCC, who then delivers that share to the buyer on behalf of the seller. The problem is that the transfer of rights that the buyer is receiving is the literal definition of a sale, not a loan. The buyer didn't buy a loan, they bought a share. And the seller Failed To Deliver the share. So the DTCC violates its fiduciary obligation and "lends" a share to the NSCC so that it can make good on the seller's failure - but there's no mechanism to get the share back from the seller who "owes" the DTCC the share, thus in reality it is a sale, not a loan. The DTCC is calling a sale of a share to the NSCC a loan in order to circumvent the necessary event that would have to take place if it were called a sale. It does that to create a fraud, and perpetrate it, for profit, IMO. What it actually does is make a journal entry in a sub account, and then makes the false representation that it has delivered a legitimate share to the buyer, when in fact it has done no such thing.
Naked short selling/Failing To Deliver used to be pretty easy to curtail, as the paper certificate would be bought in if it wasn't delivered pretty quickly. The only way you could "Fail" would be to counterfeit a share of stock and deliver that instead. There was no computerized bookkeeping system to obfuscate whether the share was ever delivered. Now there's an elaborate and Byzantine system designed to create an electronic no-man's land, where nothing of substance ever has to change hands, and by converting a sale (buy-in) to a "loan" by creating this artifice the system has figured out a way to create an endless supply of unregistered, unauthorized shares - something that is illegal.
Imagine a pool of shares held by an entity entrusted with safeguarding them. That entity is the DTCC. Imagine an entity chartered with clearing trades in a timely manner – that entity is the NSCC.
How does the NSCC’s stock borrow program work, and how does it allow a fraud to be perpetrated wherein unregistered, unauthorized securities are produced and delivered as thought they are genuine?
The DTCC has a lending pool, say, of 100K shares of NFI. The NSCC has a fail on day T+3 of 50K shares from an entity we can call RP. The NSCC goes to the DTCC, and says “we need 50K shares to cover a fail” and the DTCC goes into its pool and gives them to the NSCC, who then gives them to the Buyer – whose broker is SB. Fine. SB gives the NSCC the money, who then gives it to the DTCC, who credits it against the lender’s pool.
Because of the way the DTCC handles the accounting, the DTCC sums the B account they fed the money from the “loan” into against the A account that represents the lending pool, and at the end of the day it shows 100K shares still there – because the cash from the loan offsets the share loan, the way they do the accounting. And now the DTCC also shows that broker SB has 50K shares in their lending pool account – the 50K they just had delivered from the NSCC. So now the DTCC shows 150K total shares available to lend, even though there are only 100K shares in the first place.
The next day another 50K fail occurs from RP, and the scenario is repeated. Now at the end of the day the DTCC shows 200K shares available to borrow – the original 100K, the 50K of “virtual” shares from day one, and a new 50K “virtual pool” from day 2.
Day 3 is a big day. Total fails from RP and 3 other related accounts are 200K shares. Not to worry, the DTCC shows 200K shares available to “loan”, in the 100K original pool, and now the 100K from day one and day two in SB’s account. So out the go, and now NFI has 400K “shares” trading where only 100K existed a few days before.
That’s why the lawyers are going after the DTCC – the hedge funds are guilty of violations of a slew of laws and regs, but the DTCC and NSCC makes those violations possible. And the regulators, who are completely aware of how this works, have elected to do nothing except help the DTCC and NSCC and the brokers who are complicit cover it up for as long as possible, in the hopes that they will somehow unwind the whole mess before the investing public catches on and the game stops. It’s musical chairs, where there are only 100K chairs, but perhaps a million or more folks that need chairs when the music stops. That’s why the DTCC “freezes” delivering paper certificates when they are demanded to on heavily shorted stocks – they would rather fight a five year legal battle than have to go into the market and buy enough legitimate shares to deliver the certificates.
The reason they would rather fight legal battles instead of complying with the law is the same reason that insurance companies would rather fight legitimate claims rather than settle them and pay like they were supposed to. Somewhere, someone has run a cost/benefit analysis and calculated that it is cheaper to keep stalling and fighting than it is to do the payout.
And in the meantime, they can always hope that the company gets driven out of business or down to pennies, which would allow them to solve their fail problem easily – either never closing out the position as the demoralized shareholders no longer trade the stock and it becomes de-listed, or closing it out for pennies over time.
It’s a pure financial play, and the felonies that abound at every level are simply the necessary “risk” associated with a lucrative venture. Given that our regulators have decided that their job doesn’t include enforcing the laws on the books, or demanding to see the DTCC’s books to assure themselves that counterfeit unregistered shares are not in fact being created electronically in the method described, and have further indicated that they are not responsible to ensure timely settlement of trades (in spite of the fact that it is part of their Congressional mandate), the odds favor the bad guys.
But now the cat is out of the bag. And inevitably what is going to happen is that this pattern of duplicity will be revealed, and the entities higher up the food chain are going to be at considerable risk – the clearing brokers, the banks, and the hedge funds that have all made fortunes abusing the system to perpetrate a fraud at the expense of the investing public and the companies that have been victimized.
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