The Jailhouse

[Ignutz]

Posted by: jimdecosta 2/17/2006 12:50 PM
This is Chapter 72, from my second book. It explains the ex-clearing process, and how it is integral to FTD fraud. I don't get a lot of time to follow things online, so my ability to respond to questions will be severely limited. Apologies in advance.

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OF DUST STORMS, TORNADOES, AND EX-CLEARING



One of the best ways to summarize how abusive DTCC participants and abusive DTCC management members pull off and facilitate naked short selling frauds is to relate it to the nature of law-making. When the securities laws (or any laws, for that matter) are written, there is always the “spirit” of the law which addresses a need perceived by the authors of the law - and there is the much weaker “text” of the law, which is the product of the human attempt to transfer the spirit of the law onto paper. Often the disparities between the two leave a “mini-dust storm” of confusion presenting loopholes which opportunistic fraudsters take advantage of.

I can think of no better example of this than the one cited in Chapter 42 involving the DTCC’s public statement implying that their DTCC participants need not follow the “spirit” of the new Reg SHO Federal law (“Mandating” the “Forced” buy-in of all 13-day old failed deliveries of threshold list securities). Why? Because the phraseology of the new Federal Law states that if you cannot do these “Forced” and “Mandated” buy-ins (which seems a bit paradoxical unless the definition of “Mandated” and “Forced” were recently changed) then you at least have to behave yourself in the future. I do credit the SEC for later clarifying that a b/d cannot use financial reasons as a valid excuse to circumvent “Mandated” buy-ins. Where does that leave us on this particular issue? It leaves us with the abusive DTCC participants playing the ace up their sleeve mentioned in Chapter 16. You remember - it’s that one-line rule in the 800-page rulebook of the DTCC stating that DTCC participants need not perform “Mandated” buy-ins (as per the old NASD Rule 11830) if they may be “Disruptive” to the market. Well isn’t that special! How many hundreds of billions of investor dollars has that little ditty cost U.S. investors?

What securities scholars refer to as “DTCC-sponsored” naked short selling is basically the result of clever attorneys and other opportunists, in and around our clearance and settlement system, that have managed to link the “dust storms” around the various securities laws, into a tornado that has swept through the U.S. corporate landscape - leaving the carcasses of probably thousands of otherwise promising development-stage U.S. corporations in its wake.

Nothing exemplifies this in practice more than the “Ex-clearing” processes used by the perpetrators of naked short selling frauds. A lot of people have trouble getting their arms around the concept of “Ex-clearing” naked short selling frauds. Ex-clearing frauds are a classic example of linking together these minor dust storms into a tornado of monstrous proportions.



Ex-Clearing Means Never Having To Say “I Deliver”

One of the most important concepts to understand in regards to ex-clearing frauds is the structure of share ownership on Wall Street. Recall from prior chapters how CEDE & Co., the nominee of the DTCC, “Owns” shares FBO its DTCC participant clearing firms, who in turn “Own” these shares FBO its “Correspondent” or “Introducing” broker/dealers, who then “Own” the shares FBO their clients, the investors - also known as the “Beneficiary owners”. The “Entitlement holders” we just discussed in regards to UCC Article 8 follow the same sequence.

Prior to Reg SHO, a person or firm was deemed to “Own” a security if the person had: “Purchased, or had entered into an “Unconditional contract”, binding on both parties thereto, to purchase it, but had not yet received it”. Thus, you technically “Owned” it even if you hadn’t received it yet. This definition of “Ownership” was codified by the old Rule 3b-3 of the ’34 Exchange Act. I can only imagine those of you rolling your eyes and saying, holy cow, there’s your death spiral financing loophole - and you’re partially right. In the past, if you financed a company via a death spiral convertible, you actually “Owned” the shares that you could later convert into.

The key to “Ownership” from the NSS fraudsters’ point of view is the ability of your b/d to sell that which you “Own,” without having to declare it as a “short sale” - and going out and executing an expensive and perhaps nearly impossible “Borrow”, or “Making an affirmative determination of the borrowability of shares prior to selling”. The execution of these “Unconditional contracts” not involving the receipt of shares, i.e. not involving “Good form delivery”, forms the foundation for ex-clearing frauds associated with naked short selling. The key for the fraudsters is to circumvent the necessity to make the “Borrow” especially in the case of thinly traded development stage corporations with very few shares held in margin accounts i.e. “nonmarginable” securities.

Abusive DTCC participants can legally (except for the obvious fraud implications) enter into “Unconditional contracts,” which basically state that, “I will eventually deliver an “electronic book entry” or “Entitlement” to you” (note this often has nothing to do with legitimate “shares” with an attendant “package of rights”). This then led to the creation of readily sellable book entry “Entitlements” to shares, which damage targeted corporations via dilution and the sometimes meteoric rise in the supply of these readily sellable “Book entries and/or Entitlements”. Recall that the arithmetic sum of all legitimate “Book entries” with paper-certificated shares in a DTCC vault plus all “Book entries” without paper-certificated shares in existence in a DTCC vault which UCC Article 8 allowed Wall Street to refer to as “Entitlements” to shares, becomes the “Supply” variable of the supply and demand interactions that determine share price. Why? Because they’re all “Readily sellable” and are “Implied” to investors as being shares held long somewhere within the system.

The DTCC facilitates this “Ex-clearing” process by their granting of “Securities orders” that lead to what they refer to as “Non-CNS delivery arrangements” –I love that term “Arrangements”, it even sounds devious.

What followed was abusive DTCC participant Market Makers and clearing firms pairing off with each other, and basically b/d “A” would promise to “eventually deliver” the $3 billion in failed deliveries of ACME owed to it by b/d “B”, in exchange for b/d “B” promising to “eventually deliver” the $3 billion in failed deliveries of XYZ Corporation. What this amounted to was a promise to never “buy-in” the failed deliveries of the other. When the debt amounts don’t match exactly, then collateralization cash must be transferred (a banking transaction).

Now, what is noticeably missing in this convenient “Arrangement”? It’s called “Good form delivery”, which is a necessity to accomplish what the law refers to as “settlement” of the trade. Now, you ask, wasn’t the DTCC mandated by Section 17A “to promptly and accurately clear and settle transactions involving the transference of ownership”? Where in 17A does it say that DTCC management can “delegate” out the settlement process and then put on a blindfold and claim to be “Powerless” to monitor the fulfillment of these “unconditional contracts”, i.e., “Powerless” to effect “settlement” of the trade that its participants enter into with each other via these “Non-CNS delivery ARRANGEMENTS”?”

Referring back to Table 12, this is example #14 of instances where DTCC policies create a gigantic temptation and capability for their abusive participants to defraud investors, followed by DTCC management’s “self-blindfolding” procedure and subsequent claiming to be “Powerless” to regulate the “business conduct” of the DTCC management’s bosses, the 11,000 b/ds and banks that comprise the DTCC. Recall from Chapter 43 the definition of an SRO like the DTCC as being: “An entity, such as the NASD, responsible for regulating its members through the adoption and enforcement of rules and regulations governing the business conduct of its members”.

Recall also from earlier chapters the DTCC’s claim to be “Powerless” in buying in the “Entitlements” owed directly to it as the voluntary “loan intermediary”, in each and every SBP failed delivery bailout. Now how clever is that - to volunteer to be the “Loan intermediary’ in the SBP “pseudo-borrows”, and then turn around and claim to be “Powerless” in buying-in the resultant IOUs/entitlements owed directly to it by its bosses?

The transference of ownership in ex-clearing frauds is “kinda/sorta” accomplished according to the old 3b-3 definition of “ownership”. How about “Prompt settlement”? In no way, shape, or form is that accomplished. These trades obviously don’t “settle” as there is no “Good form delivery” of that which was thought to be being purchased.

How can the SEC and DTCC allow abusive DTCC participants to commit these frauds? Well, technically they’re not occurring within the DTCC, according to the DTCC. Both the DTCC and SEC publicly maintain that these “Arrangements” are technically an “Unconditional contract” executed by the parties and that neither regulator is responsible for monitoring “contract law” only “securities law”. I’m not sure what happened to the responsibility of these regulators to regulate the “business conduct” of the participants of the DTCC.

And what about “Settlement”? That is the beauty for the fraudsters. When “Buyer Bob” finally takes his 90% loss on his purchase out of sheer frustration, then the “Settlement” of his purchase becomes a moot point. What ex-clearing technically does is it extends the timeframe between the “Clearance” of a trade and the “Settlement” of the trade. “Settlement” gets pushed off indefinitely, until it becomes a moot point i.e. when the purchaser sells his “entitlements” to “shares” that never existed in the first place. The extension of “settlement date” is clearly forbidden by Rule 15c6-1, as mentioned many times before. Artificially decoupling and extending the timeframe between “Clearance” and “Settlement” allows the commission of crimes related to this “Float” period, which are referred to as crimes involving “Kiting”. Remember the DTCC is a banking entity, a member of the Federal Reserve, and theoretically under the regulation of both the SEC and the New York State Banking Authorities. Kiting would legitimately be considered to be a no-no under these circumstances.



Summary

“Ex-clearing” provides larcenous participants with a perfect opportunity to collude with one another and create an unregulated, unobserved secondary market for the parking of “Entitlements” to nonexistent “shares”. The handy Chinese wall that the ex-clearing process introduces allows the fiction to be created and sustained that the system is performing as mandated, with prompt delivery assumed to be the case, on the honor system, behind the wall.

What is created in “ex-clearing” is the illusion that settlement is occurring. Things move so fast on Wall Street that in order to appreciate the fraud, one needs to put things into slow motion, as is the goal of the blow-by-blow nature of this chapter. The old Seventies anti-drug slogan “Speed kills” applies to development stage U.S. corporations in our equities markets nowadays, and that is tragic – the loopholes make it far too easy to serial kill these companies at their most vulnerable stage in their growth.

Fortunately for the naked short selling fraudsters there is no periodic reconciling of the books, or public viewing of the failed deliveries at the DTCC and those held/hidden in “ex-clearing” mode – it is all a secret. Why? Because all of this information is theoretically “Privileged and proprietary”, and the DTCC management does not want to reveal any “Proprietary trading methodologies” of its participants/bosses, and their co-conspiring unregulated hedge fund clients. The DTCC’s self-created rules and regulations conveniently don’t allow this. It is a handy black box, where anything can and does happen, away from prying eyes of regulators or investors.



A Final Note

I’ve been critical of certain aspects of Reg SHO in several chapters, but the SEC really did a decent job on redefining share “Ownership” to eliminate some of the aforementioned loopholes. There are now 8 qualifying parameters to share “Ownership”, which were well thought out and will make it especially tough for death spiral financiers to work their magic. Reg SHO’s requirement to aggregate long and short positions was also well executed. No longer can an abusive DTCC participant with 100 shares held “long” in one subdivision, and 100 million shares held “Short” in a different subdivision, refuse to mark its sell orders in the correct manner - without breaking Federal Law.

Those victimized issuers that have historically noticed all of the market making firms being long 100 of their shares on the DTCC’s “SPLs” (Securities Positions Listings) now know why this was so.

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