September 28, 2009
Subject: Comment on File No. 4-590 for the Securities Lending and Short Sale Roundtable
Chairman Shapiro and Members of the Short Sale Roundtable:
Thank you for sponsoring the roundtable review of short sale practices. We support the scheduling of a review and appreciate the opportunity for comments from the public to be considered in the discussion.
As comments/contribution, we wish to bring to your attention some details on how retail brokers are routinely abusing the application of short-sale buy-in rules to retail accounts. We have observed, and experienced, instances where retail brokers have abusively executed buy-ins, as well instances where retail brokers have purposely misapplied short-sale rules. Finally, we present several possible remedies for your consideration.
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We routinely establish short positions in order to maintain a hedged portfolio. It is an accepted reality of shorting fact that the retail brokers will periodically suffer a decrease in shares available to borrow for shorting. When this occurs, the broker needs to comply with short-sale rules by having their customers cover the necessary portion of their short positions. In some instances the broker will send an email notification of an impending need to buy back a short position. With this warning, we are able to place orders to cover the short position at a reasonable loss to our portfolio.
In many instances, however, the retail brokers are applying forced buy-ins without any warning. In doing so they are selecting prices from the pre-market, often as much as 30 to 45 minutes before the market opens. Given that buy-ins often occur with thinly traded securities, the bid-offer spreads before the market-open are wildly disproportionate to the open-market bid-offer and, as such, are often predatory. The result has been buy-in prices as much as a dollar above the regular session, often at the Year-to-Date high for the security. These spikes-to-unreasonable-prices are easily visible during the open of a given stock.
In addition to the highly unfavorable pricing, the retail brokers are also routing these orders to their own market makers. This tactic allows a brokerage to earn extra fees for routing order flow to the detriment of their own customers. That is, the brokers are specifically choosing to place customer orders for buy-ins with their own market maker rather than submitting the order directly to the listed exchange (where any customer would submit the order, given a choice, and where there is greater liquidity and transparency in the pricing).
The end result is that the brokerages appear to be purposely selecting unreasonably high prices for customer buy-ins. Since the order-flow is always routed to their own market-maker, this allows the brokerage to trade ahead of their own customer. The market-maker sells shares to the customer for the forced buy-in at an exaggerated price and subsequently covers at a reasonable (often simply between the listed exchange's bid and offer) and profitable price. This covering almost always occurs moments after the initial opening and is directly visible in publicly available timesales public data. Further profit is achieved by the broker in the form of fee arrangements with the market-maker in exchange for order-flow.
This has become an extremely abusive practice that harms investors and stifles the market. The current situation stacks the deck against the small investor in a similar way to flash orders allowing certain large brokers to trade ahead of customers. All players in the market should be on a level playing-field.
Lastly, we have observed every major retail brokerage firm using the SEC as a fig-leaf for their buy-ins. These are often later admitted to be inadequate stock-borrow inventory accounting on their behalf or just failure-to-delivers. One major brokerage firm has even coded "FORCED BUYIN SEC EMERGMAF ORDER" into their automated transaction statements. They routinely apply this to last-minute buy-ins. When pressed as to how this relates to the SEC's emergency orders, the compliance departments quickly back-track and explain that through their original brokerage contracts they can buy-in whenever they want under any circumstance.
Some possible remedies that come to mind are:
1) If the current system must be retained then at least put a restriction on the brokerage which forces them to bypass their own market-maker and submit the buy-in directly to the listing exchange. This would at least deny the current double incentive for the broker to abuse a customer's account.
2) Forbid the brokerage from unilaterally doing a forced buy-in without informing the investor. Require email notification to the customer prior to the open. Should the customer not execute the buy-in within some reasonable time (say, within ten minutes of the stock opening) only then would the brokerage be allowed to a forced buy-in. In other words, give the customer a minimum time to attempt a buy-in at a price that is neither a windfall profit to the market maker nor above any logical trading price.
3) If the brokerage is submitting a forced buy-in to execute at the open, require that they use a limit order with a price that is no worse than some percentage above the previous trading day's closing price.
4) Lastly, in all cases, make it a punishable offense for the brokerage community to use SEC orders as subterfuge for their own accounting or back-office short-falls. Currently, they are using your promulgations as a smoke-screen for their own stock-borrow mis-allocation. Not once have we ever had a brokerage firm actually demonstrate how their particular buy-in request had any connection to any SEC Emergency Orders on short-selling. They are abusing the public and the SEC by purposely misinterpreting the SEC's rules and then trying to confuse the small investor with references to complex but non-applicable SEC written guidelines.
Ideally, we would not want to suffer a forced buy-in on a short position: we would prefer to have the opportunity to do the buy-in ourselves. However, if that is not possible, then at the very least, please remove the ability for a brokerage to route these orders to their own market makers where they have a double profit incentive. Force the brokerage to pick a fair price and submit the order directly to the listing exchange.
Short-selling has long been the falsely accused whipping-boy for many investors -- large and small -- when indexes fall. The public understandably fears security manipulation, and selling something one does not own is counter-intuitive and suggests predatory dumping to undercut prices. Predatory buying, as in the case of forced brokerage buy-ins, is less feared since most investors are long their securities. In reality, short sales are a necessary component of efficient exchanges: Short sales bring downward consequence to negative information, permit a hedged structure for buying under-priced securities and, crucially, increase liquidity. They are an essential element of a dynamic market.