March 23, 2008
I favor legal short selling and personally use it to hedge risks. In addition to being a good risk management tool, legal short selling helps to constrain market volatility, which, in turn, has a positive influence on the aggregate valuation of our markets. However, naked short selling and the discontinuation of the "Uptick Rule have combined to increase volatility and, thereby, lower the aggregate valuation of our markets. In addition to this, they have also provided nefarious short sellers the tools to attack and literally destroy otherwise viable American businesses and keep others from accessing the capital they need to fund expansion and innovation. It is therefore in our best economic and strategic interests to fix these problems and take the steps necessary to level the playing field that currently favors institutions and hedge funds over small individual investors.
There is one simple reason for a company to "go public" doing so puts it in the "currency" business. Once public, a company can print currency in the form of stock certificates and exchange these certificates for the currency of a sovereign nation. Its this ability to exchange value on an incremental basis that facilitates liquidity and access to capital markets.
Before we go on, lets pause for a moment to see if Websters definition of currency supports this contention. Webster defines currency simply as something in circulation that is used as a medium of exchange. In my view, a stock certificate fits the scope of this definition.
Not convinced, think of it this way let's say you negotiate a deal to buy a new Chevy. At the end of the negotiations you tell the salesperson you will pay the agreed price in either Zimbabwean dollars (inflation in Zimbabwe last year was over 26,000%, which means the currency literally lost value by the second) or in shares of General Motors stock. Not knowing how to react to this offer, but wanting to keep the sale in tact, the salesperson summons the owner of the dealership to make the call. The owner, knowing he could obtain the up to the moment value of the stock over the Internet and easily take the shares of GM stock to his local broker and convert them to cash would, much more likely than not, choose to accept the GM stock in place of the relatively illiquid currency. The moral of the story is that stock certificates in private companies can be more liquid and universally acceptable for exchange than the currency of a sovereign country.
What determines the value of a given currency is a hotly debated topic today, but one thing is for sure, regardless of the details, there is no argument that the foundation of value for a currency or, for that matter, anything else, is based on the balance of supply and demand. This is why sovereign nations take counterfeiting very seriously and why the U.S. government goes to great lengths to make its currency hard to copy and prosecutes counterfeiters harshly after all the value of our currency is at the foundation of our democracy and counterfeiting steals a portion of this value.
Naked shorting is analogues to counterfeiting. Naked shorting simply creates shares from thin air just as though they were being duplicated on a printing press and, thereby, increases the float (supply) of a stock. And, as we all know, when all else is equal, higher supply results in a lower per unit value.
Small public companies are the easiest targets for short sellers. These companies employ literally tens of thousands Americans, are the seeds from which our competitive advantages as a country grow and are therefore vital to our economic and strategic interests. These and all public companies should be afforded protection from counterfeiting (naked short selling). If the U.S. government refuses to provide this protection, its publicly traded stock markets lose value for both the companies that are members and the investors who buy the shares that constitute the ownership of these companies.
Providing protection from the counterfeiting of stock certificates (company currency), in paper or in an electronic form, is fundamental and where the SEC and congress must start their efforts to restore value and confidence in our public equity markets, but it is far from where they should stop.
Part Two – Reinstate the Uptick Rule 10a-1:
When you combine naked shorting with an ability to short a stock on a down-tick, short sellers can literally ruin an otherwise sound business. Why the SEC decided to abolish a rule that has protected our markets and individual investors for over seven decades at a time when our country was obviously facing a liquidity problem of monstrous proportions is so far beyond all conceivable logic that even Machiavelli would shake his head in disgust.
The Uptick Rule (Rule 10a-1 in SEC lingo) was initiated in 1934 (the same year the SEC was created by an act of congress) to place reasonable controls on short selling as our country was fighting its way through the liquidity crisis of the great depression. The intent was to restore faith in our public equity markets by preventing short sellers from selling stocks following a downtick in the price.
When well-funded short sellers like hedge funds can short stocks on down-ticks they can drive the price down so fast and so significantly it can trip both margin calls and pain thresholds for individual investors and, as a result, lead to forced selling that feeds the downward spiral of the stock's price. This downward spiral destroys the companys ability to raise capital and in some cases, can cause the company to face margin calls on debt, which in extreme cases leads to insolvency. In addition to this, the more subtle damage is that the lack of uptick protection increases volatility and, therefore, decreases the aggregate value of the entire U.S. stock market.
The SEC Charter:
The first paragraph of the introduction to the SEC self-described charter states:
"The mission of the U.S. Securities and Exchange Commission is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation."
Later in the introduction, the SEC states in no uncertain terms:
"People who sell and trade securities – brokers, dealers, and exchanges – must treat investors fairly and honestly, putting investors' interests first."
I believe it is self-evident the SEC is not living up to its charter and that it is now time for congress to live up to its by taking decisive steps to protect individual investors from those who absent law, regulation and the rigid enforcement of the of both would destroy our capital markets and with it, the life savings of our citizens and our security as a country. The two most obvious things the SEC must do are:
1. Reinstated the Uptick Rule for all but the largest 100 companies traded on our public exchanges.
2. Request congress to write new laws making naked short selling a federal offense with stiff and mandatory penalties.
More than Money:
Since those who participate in naked shorting are used to weighing risks against potential rewards, we must enact laws that make the risk of illegal naked short selling substantial and difficult to quantify in terms of dollars. To accomplish this, we must elevate the risks beyond monetary and regulatory penalties. To protect the economic and strategic interests of America and its citizens, congress must pass legislation making naked shorting a federal offense punishable with mandatory incarceration.
Sincerely, Paul McWilliams
cc: Representative Dennis Moore
Senator Sam Brownback
Senator Pat Roberts