Dr. Patrick Byrne's Summary Of The Naked Shorting Problem
3/13/05 CEO, Overstock.com
The issue of “naked shorting” seems to be becoming a news item, and is even (perhaps) a scandal in the making: I have been called by several publications in the last week to discuss the issue, and there is word of a major exposé on a network news program to run soon. This is especially topical, given the issue of Social Security private accounts.
As is known by those who have been regular readers of this board, my involvement with the issue is that of a concerned citizen. However, I figured I would write something here so those who are interested can follow along. Some of this draws together points I have tried to make in earlier threads about “Wall Street Criminals,” but most of this is new. I have tried to explain here the Failure-to-Deliver and Naked Short issue in plain English. You auction sellers in particular will find many parallels between this issue and the issue of auction fraud, albeit it on a grander scale. In any case, I hope that those who are interested may find this a concise and useful précis on the issue.
1. Shorting Stock: This is a legal and honorable method of investing. Suppose a share of IBM stock is trading at $90, but I expect IBM to go down. I “short” it. This means that, through my broker, I borrow a share of IBM, sell it in the open market, and collect $90. Assume that IBM then drops from $90 to $50. That is as low as I think it is going to go, so I “cover” my short: I take $50 of the $90 that I collected, I buy a share out in the market, and return it (through my broker) to the person who loaned me a share in the first place. I am left with $40 profit.
2. Failure-to-Deliver (“FTD”): The American stock market runs on a “T+3” system. This means that when you sell a share of stock, you have 3 days to deliver that share. If you do not deliver within 3 days, you have, “failed to deliver,” or “FTD’ed”. Think of this like someone who posts auctions but does not deliver the goods.
3. DTCC: Depository Trust & Clearing Corporation. This is the back-office of Wall Street. Rather than have people run around with paper stock certificates, the DTCC keeps electronic records of who owns which stock at which brokerages, and settles the trading of stocks. If you “FTD” (“Fail to Deliver”), the DTCC are the folks whose books don’t match.
4. Strategic Failures to Deliver: Not all FTD’s are necessarily illegal. Someone may forget to get shares of stock out of her sock draw and deliver them to her broker within three days of a sale, yet this does not make her a criminal. Also, in the center of Wall Street there exists a job known as a “market maker,” someone who is charged with maintaining an orderly market in a stock by continuously buying and selling to create liquidity. Market makers are allowed (on a good faith basis) to buy and sell stock that does not exist, temporarily, just to keep liquidity in a stock. Again, this is expected and allowed. What is not allowed, however, is for investors to sell and fail-to-deliver purposefully: doing so (through a variety of mechanisms that I will explain below) in an attempt to manipulate the price of a stock, is a “strategic” failure-to-deliver. Some folks believe that Strategic FTD’s played a role in the 1929 meltdown. In any case, there have been regulations against it since 1933 (regulations which provide for criminal and civil penalties). The slang term for “Strategic Failure to Deliver” is, “naked shorting.”
5. The Economics of Naked Shorting: The gist of naked shorting is simply, when a hedge fund pretends to short a stock (I say, “pretends” because it is stock that it does not really own, and which it does not really borrow). It sells those made-up shares into the marketplace, and collects the money just as though it sold real shares (note that this is “counterfeiting,” more or less, though with electrons rather than paper). If it is stock in a small company, and does not trade with much liquidity, then the hedge fund can keep “selling” its made-up shares and drive the stock price down to wherever it wants it to go.
In a healthy market, the check-and-balance on shorting would simply be the number of shares that are available for short sellers to borrow and sell. Since there would only be a finite number of shares to borrow and sell, there would be only a finite amount of pressure the shorts could bring upon a stock (and it would be offset by buying pressure holding that stock up). But if naked shorting is allowed, then there is no limit on how many bogus shares hedge funds can create. Thus means they can drive a stock’s price down close to $0. At the very least, this practice destroys peoples’ savings (remember, the shorts make money by driving the stock down, whereas any stockholders lose that same amount of money as the stock price drops). Some folks believe companies have been driven out of business by this, because they cannot raise new capital once those stocks have cratered badly enough.
The key is this: if given the right to create an unlimited number of new shares, essentially out of thin air, not limited by the number of shares “in the borrow” as legal shorting requires, these hedge funds can always drive the price down and always cover for a profit. That is why it’s, “illegal.”
6. How can Naked Shorting Occur in Our Regulated Markets?
_____a. The lazy explanation: How can a hedge fund get away with selling shares it neither owns nor borrows? One theory is that the DTCC (and some brokers) look the other way for “favored” clients. “Sell 100,000 shares of XYZ for me.” “Do you have the shares?” “Oh, you know I’m good for it!” Large clients enjoy such favored relationships and, because they have deep pockets, the DTCC and the brokers assume they can trust those clients to operate like this and true things up later. This lackadaisical attitude, however, gives dishonest hedge funds opportunity to “sell” stock that does not exist, and thus create downward pricing pressure that becomes self-fulfilling: as the stock gets driven down it reaches the point that other owners lose confidence and dump their stock, and as it gains downward momentum, the naked shorts can cover their shorts and move on.
_____b. The sleazy explanation: Believe it or not, there is a more insidious explanation of how this game works. Imagine that a sleazy hedge fund chooses a small, illiquid company to attack. Often that company is in a poorly understood sector, or is a company with some accounting complexities so it will be possible to create “where there’s smoke there’s fire” skepticism about its books. Here is what happens:
__________i. The hedge fund gets that US firm listed on foreign exchanges.
__________ii. That hedge fund then “sells” shares it neither has nor borrows.
__________iii. When the DTCC calls after three days and says, “Where are those shares?” The hedge fund replies, “I borrowed them on the German exchange, they will take a few weeks to show up,” or “I am a market maker for the German Exchanges in that stock, and thus excluded from the no naked shorting rules.”
__________iv. With a nudge and a wink the DTCC says, “OK, we’ll loan you from our own reserves of that stock.” The DTCC collects a high fee from the hedge fund to do this.
__________v. The hedge fund has relationships with a few compliant reporters, who are called and told, “Do a hatchet job on Company XYZ.” They do so, perhaps in return for off-shore compensation.
__________vi. The combination of bad publicity coupled with the selling of an unlimited number of shares drives the stock down to the point either that the hedge fund covers and moves on, making a quick $20 - $50 million, or the company goes bankrupt, or simply remains a penny stock (in which case the hedge fund never has to cover its short, and hence, never pays taxes!)
7. The Regulatory Environment: After years of pressure, in 2004 the SEC promulgated Reg SHO (for “SHORT”), which directs the exchanges (NYSE, NASDAQ, etc.), to start publishing early in 2005 lists of companies whose FTD’s exceed a reasonable amount (“reasonable” = “greater than .5% of the shares in the company”). This list is called, “The Reg SHO Threshold List.” It does not list the amounts of FTD’s, just the names of companies that are experiencing them.
The way Reg SHO is supposed to work is as follows. If a company crosses beyond the threshold of a reasonable amount of FTD’s, and then stays there for 5 days without crossing back under the threshold, its name goes on the Reg SHO list. Then, after 13 more days, if it is still on the list, brokers are supposed to tell those hedge funds that are failing to deliver that they must stop failing to deliver, and those brokers are not supposed to take any more short sale orders from those accounts for those stocks.
8. Reg SHO is flimsy: So flimsy, in fact, it set folks scratching their heads - does the SEC not get it? Here is why it is flimsy:
_____a. Telling the hedge funds after 13 days, “You are not supposed to do any more naked shorting in this stock,” is meaningless - they weren’t supposed to be naked shorting it in the first place.
_____b. There are no sanctions for violators.
_____c. Why grandfather violations that have been illegal for 71 years?
9. Two theories regarding how big a problem this is:
_____a. Tame theory: This is a problem for a small percent of companies, just those that find themselves on the Reg SHO list. Thus this is not a hard problem to fix. But fixing it is going to cause a lot of hedge funds to lose money. They are well-connected with the SEC, and the SEC is co-opted to the point that they are tightening down on this half-heartedly.
_____b. Extreme Theory: This problem is so endemic that if the SEC tried to fix it the system would crack. There are so many losses waiting to be realized by the hedge funds, it would be like the failure of Long Term Capital Management, but on a massive scale (see Roger Lowenstein’s, When Genius Failed, for an excellent explanation of the risk that the failure of even one large hedge fund put on our financial system). In this scenario, the reason the SEC is not being suitably aggressive is because they know the problem has gotten beyond what can be solved without a systemic failure.
10. Which theory is correct? I don’t know. No one knows outside the DTCC, SEC, and maybe the NASDAQ and NYSE. And they are not telling. I have asked the DTCC, SEC, and NASDAQ for the size of Overstock’s FTD, but they all refused to disclose it. This amazes me: if I sold 100 shares out the back door of Overstock without registering them I would go to jail, but (per our inclusion on the SHO Threshold list) some hedge funds have sold hundreds of thousands (or millions) of phantom shares, and the SEC and DTCC protect them. When I ask, “By appeal to what law or regulation are you refusing to disclose this to me?” they clam up. This is one of the warnings telling me that this may be a problem of catastrophic proportions.
I hesitate to describe the others, as it sounds like I might be lining my hat with tinfoil. But in the interest of completeness, I shall. In 2004 it became public that one well-known short seller, David Rocker (of Rocker Partners), was shorting our company. In October, 2004 I invited him on a conference call to debate me, and it got pretty nasty (see this transcript for details:
Click here for the transcript
Immediately thereafter some knowledgeable-sounding people got in touch and warned me of four things to come, in this order:
_____a) Reporters A, B, C, and D would call and do hatchet jobs on me, as they were lackeys to Rocker;
_____b) I would find Overstock.com listed on innumerable foreign exchange;
_____c) We would find ourselves on the Reg SHO Threshold list when it came out in January.
_____d) The SEC would announce they were starting some inquiry on us.
I already knew Reporters A, B, and C, who had gone far out of their way to write uncharitable articles about me, and while I always wondered at their eagerness to do so, I gave the prediction of more such articles little credit. Yet I had never heard of Predicted Reporter D (Elizabeth MacDonald of Forbes): within two days, she (along with A, B, and C) had called with clear intent to write something unpleasant. Elizabeth hunted for a week, then gave up: we are so squeaky clean, the most such reporters can do is write anodyne trivia: e.g., Herb Greenberg actually once devoted a whole column to how quickly or slowly I returned his calls, and how this could be interpreted as a sign of sinister intent (as opposed to, say, whether or not I was getting on and off planes as I synched my emails).
Then over the autumn of 2004 we found ourselves listed on five exchanges in Germany and one in Australia: someone went to all the trouble to get us listed on these exchanges, though hardly any shares have traded since (this confirms the theory that these foreign exchanges are used simply as smoke screens by hedge funds needing an excuse for the DTCC).
On January 27 we appeared on the Reg SHO Threshold list (only about .4% of companies are on this list).
Thus, these “crazies” had made four pretty far out predictions. The first three of them have come true. The test of any theory is its ability to make accurate predictions, and the “crazies” have passed that test. So I started paying a lot more attention to what they had to say.
Incidentally, their fourth prediction (the SEC trying to make trouble for me) has not come true. However, an increasing number of smart people are telling me that, now that I am taking a lead role in this issue, and am the first non-fringe player to do so, the SEC is going to crucify me, for they (according to these sources) are thin-skinned, vindictive, unused to criticism from those whom they regulate, and partly captured by the very hedge funds that benefit from these practices.
11. The “Pay-No-Attention-To-The-Man-Behind-The-Curtain” Responses: A party line has developed within Wall Street that runs like this:
_____a. “There is no naked shorting”: This used to be the party line, but since 300 companies appeared on Reg SHO since January 2005 it has worn thin.
_____b. “Reg SHO will address this problem”: As only a handful of those 300 firms have dropped from the Threshold List, this is dubious, too.
_____c. “CEO’s who make an issue of this are just mad that their stock is down.” I have nothing about which to be mad: our stock is 2-3X where it was in early 2004. I am trying to bring attention to this because there is a risk to the public.
_____d. “The folks who make a big deal about this are crazies who line their hat with tinfoil.” Could be. I know they sound whacko. I know I sound whacko, too. But the test of a theory is its ability to predict, and these “crazies” make accurate predictions. I have been called by precisely those journalists they predicted would call me. OSTK has appeared on 6 foreign exchanges, none at our own request. On January 27 we appeared on the Reg SHO list (and as we have not come off it since then, I feel the “crazies” are right about the flimsiness of the Reg SHO mechanism, too). The only thing these “crazies” have missed so far is that the SEC has not started any vendetta against me (yet) for bringing attention to this issue.
I hope this gives you, dear reader, a broad enough overview of this problem that it may suggest further inquiry. I repeat, I do not know how deep a problem this is. It could be next to nothing, or it could be an Enron waiting to happen (with far greater ramifications, as the failure could be systemic). I don’t know, but I do know that it would be easy for the SEC to clear up the mystery: all they have to do is publish the size of the FTD’s for the companies on the Reg SHO Threshold List.
This is, I think, a fair question for me to ask: after all, if without registering them I sold 100 shares of Overstock out the back door of the firm I would go to jail. Yet per our inclusion on the Reg SHO Threshold list we know that some hedge funds have done that with hundreds of thousands (or millions) of shares: why won't the SEC reveal who, and how many counterfeit shares they "issued"? The fact that the SEC, the DTCC, and the exchanges refuse to disclose this (though they must have the information every night, else how could the calculate whether or not a company belonged on Reg SHO list?) makes me worried that it might be a bigger problem than they want anyone to know.
On the other hand, if there is really nothing to this issue, then the problem can be cleared up overnight, and myself (and all the other “crazies”) would go away. All we need are the answers to five simple questions, which I write out below in the hopes that some concerned citizens, or an enterprising journalist, can use them to dig a little deeper on her own.
12. Five Questions for the SEC
_____a. Does SEC receive daily data from the DTCC/NSCC on Fail to Delivers?
__________i. If not, why not?
__________ii. How can the SEC regulate without this?
_____b. How large is the fail to deliver problem? Does the SEC even know?
__________i. Why won’t the DTCC tell anyone how large the problem is?
__________ii. Why won’t the DTCC tell the SHO companies how large their FTD problem is?
_____c. How can firms remain on the threshold list if Reg SHO is enforced?
_____d. Why grandfather - pardon - all violations prior to January 7, 2005?
__________i. Wasn’t it against the rules (10(a)2, 15(c)6-1, 17(a)) since 1934?
__________ii. Why won’t the SEC enforce rules on the books for 71 years?
__________iii. What logic supports pardoning flagrant, regular violation of rules?
_____e. Who are the biggest violators of the Failure to Deliver rules?
__________i. Who benefits the most from the past fails being pardoned?
__________ii. Why reward these hedge funds for systematically violating the rules?
_____f. How can private SS accounts be considered while this is going on?
I thank any reader who has stuck with me through this long explanation. I made it as clear and concise as I could, and hope that through these modest efforts some enterprising reader or journalist will have gained the ammunition needed to breech the defenses of Wall Street and get some answers.
And if for my efforts you see me doing the perp walk on TV, remember to send me a cake with a file in it!
Respectfully submitted,
Patrick M. Byrne (Ph.D., Stanford)
CEO, Overstock.com
PS My disclaimers:
- While David Rocker has been public about being short us (and a surprising percentage of other companies on the Reg SHO Threshold List!), I do not mean to claim that he is naked short Overstock. Someone is, but it is not necessarily him. He could simply be short us, and it be some other party who is naked short our stock.
- The Tools of Satan are going to try to claim that this is all some scheme of mine to get people to buy our stock. It is not true. None, and I mean none, of this is intended to get anyone to think about buying Overstock stock. I am doing this because I am convinced enough of the issue to want the public to get some answers. Someone has to do this, and John Wayne is dead. But do not confuse my involvement with this issue with any valuation or other issue regarding Overstock.com. Hey, I get involved in other political issues to (e.g., education reform), and they are not all driven by some secret aspirations to get customers or shareholders.
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