July 28, 2007
Since the SEC appears to be dragging it's feet I offer the following recap.
Regulation SHO - Punch-drunk Reform with a Handout
What is Regulation SHO and why did the SEC introduce it?
"Proposed Regulation SHO would, among other things, require short sellers in all equity securities to locate securities to borrow before selling, and would also impose strict delivery requirements on securities where many sellers have failed to deliver the securities. In part, this action is designed to address the problem of "naked" short selling. Proposed Regulation SHO would also institute a new uniform bid test allowing short sales to be effected at a price one cent above the consolidated best bid."
That was the statement from the SEC when they proposed Regulation SHO. To the SECs credit at the time the proposed Regulation SHO addressed many shareholder and company concerns, put some teeth in short sale regulation and went after naked short selling abuses. Unfortunately, the Final Rule-Regulation SHO and the Proposed Rule-Regulation SHO were two entirely different documents. Wall Street complained, lobbied, whined, chastised and ultimately had all of the teeth removed from the rule. By the time the Securities Industry was done beating on the SEC what was left standing is a disappointing piece of punch-drunk reform that came with an egregiuos handout to the Securities Industry. Regulation SHO became a half measure and should be held up as the poster child of what the Securities Industry's money and influence produces when they apply pressure.
When a rule is proposed by the SEC there is a comment period that follows. During the comment period anyone is allowed to submit their thoughts on the proposed rule. Since the Securities Industry usually has a vested interest in any rules proposed by the SEC the comments are usually written by Industry participants. The proposed short sale rule was different. It generated a mass of comments from all walks of the investing spectrum. Small investors, large investors, options dealers, Wall St firms, lawyers, hedge funds, you name it they commented. The mere mention of short sale reform got everyone all worked up in a frenzy. I have taken the time to read most of the comments and can say with certainty the large majority of individual investors were in favor of the reforms proposed in the rule while the Securities Industry had issues with virtually every aspect of the proposed reform. The comment letters are a classic read of opposing interests asking the government to see it their way.
I believe the SEC started the short sale regulation process with the best of intentions. The proposed rule genuinely reflects a desire to curb naked short selling and failing to deliver. The SEC wanted to solve this problem once and for all with some tough rule changes and requirements with penalties. Unfortunately as you will come to realize the SEC got taken to the woodshed, beat till submission and came out with watered down regulation essentially written by the Securities Industry. The regulation is Final Rule-Short Sale, called Regulation SHO, and it is the best rule the Securities Industry could buy with their lobbying dollars. Any restriction, penalty or equalizer intended curb naked short selling or failing to deliver contained in the Proposed Rule was met with the ire of the Securities Industry and ultimately dropped or modified to satisfy the Industrys desires. Here are some the proposed restrictive, penalizing or equalizing measures and what ultimately happened to them when the Final Rule was published.
1. The first restrictive issue proposed by the SEC involved the Domestic Arbitrage exemption. This exemption permits short sales on minus ticks for bona fide arbitrage transactions involving convertible, exchangeable, and other rights to acquire the securities sold short. The new rule change would have obligated the arbitrageur to subsequently acquire or purchase the security upon which the arbitrage is based. The current exemption does not require the subsequent acquisition or purchase of the security. The SIA agreed with the SEC that bona fide arbitrage is based on a genuine effort to profit from a price differential however they opposed this change. They felt the arbitrageurs needed alternative means to close out their arbitrage. The Securities Industry won out on this change and the requirement to acquire the security was NOT included in the Final rule.
2. The next proposed change pertained to aggregation. SEC rules requires a seller of an equity security to aggregate all of its positions in that security in order to determine whether the seller has a "net long position" in the security. That way the security is in the brokers possession when they sell it. The SEC wanted firms to upgrade their computer systems to aggregate within the firm on a continuous, real-time basis, its net position for every security that it trades. The SEC wanted some accountability in the firms aggregation and stated the continuous real time aggregation holds firms accountable for knowing the activities and positions of each aggregation unit.
The Securities Industry opposed the proposed technological change on the basis it would be a costly, burdensome and potentially counterproductive undertaking":
"The Proposing Release asks whether, in light of the advances in technology since imposition of an at-least daily netting obligation in 1990, it is possible for firms to determine their aggregate position in all proprietary accounts contemporaneously throughout the day. SIA believes that this will create substantial technical difficulties for many broker-dealers, particularly those who have not implemented aggregation units in which net positions are already continuously determined. As acknowledged in the Proposing Release, broker-dealers have long represented that netting on a daily basis is a costly, burdensome and potentially counterproductive undertaking for large, multi-service firms. Nevertheless, firms have implemented electronic recordkeeping systems designed to meet this daily netting obligation. SIA believes, however, that requiring firms to modify their respective systems to net positions in real-time would be significantly expensive with little or no attendant benefit to the investing public."
The SEC caved again. Apparently an industry that had the capability of handing out seventeen (17) Billion in bonuses in 2005 did not have the capacity to upgrade their computer systems to provide some accountability in real time. The continuous, real-time aggregation requirement was NOT in the final rule. The Securities Industry won a softened ambiguous requirement that stated determines at the time of each sale its net position for every security that it trades.
3a. The SEC wanted to standardize the locate and deliver requirements before a broker could sell an investor a share of stock short. The SEC wanted to make sure brokers had the stock to sell so that naked short sales and fail to delivers would not occur. The first of three proposed changes on this front, and least restrictive to the industry, would prohibit a broker-dealer from executing a short sale order for its own account or the account of another person unless the broker-dealer or the person for whose account the short sale is executed until they borrowed the security or entered into a bona fide arrangement to borrow the security The SIA in turn recommended the 1. allowance of relying on so-called "easy to borrow" lists. 2. that broker-dealers may rely on a representation from a customer that the customer has located stock to borrow. The SEC and Securities Industry agreed on this issue for the most part and it was included in the Final Rule.
3b. The second part of standardizing the locate and deliver requirements to limit naked short selling and fail to delivers came in the form of a Two Day/90 Day freeze. The rule said brokers must deliver shares sold within two days of settlement or be barred from selling for 90 days. This represented some of the teeth in the proposed rule and stated:
As an additional safeguard against some of the problems associated with naked short selling, we are proposing a delivery requirement targeted at securities where there is evidence of significant settlement failures. ....We believe a two-day grace period is appropriate to allow for transfer delays or delays due to a variety of circumstances that prevent timely delivery. If for any reason such security was not delivered within two days after the settlement date, the rule would restrict the broker-dealer, including market makers, from executing future short sales in such security for the person for whose account the failure to deliver occurred unless the broker-dealer or the person for whose account the short sale is executed borrowed the security, or entered into a bona fide arrangement to borrow the security, prior to executing the short sale and delivered on settlement date. This restriction would be in effect for a period of 90 calendar days.
The Securities Industry Association wanted neither of these stiff requirements to curb naked short selling or failing to deliver as proposed. In place of the two day grace period, the Industry wanted ten days. In place of the 90-day freeze the Industry wanted a buy in requirement to force the broker-dealer that carries the fail to deliver account to buy in the position. The Industry cited the following logistical problems at the NSCC for their opposition to the 90 day freeze:
Because NSCC's continuous net settlement system nets all buys and sells within a particular firm, the broker-dealer cannot determine which customer's transaction gave rise to the fail. While it is possible to allocate the costs of a buy-in among multiple short sellers, a trading freeze, however, cannot be allocated. SIA believes that a mandatory buy-in rule would be a better means to create additional discipline on naked short selling and should, in conjunction with existing regulatory requirements, provide firms with an incentive to eliminate fails.
The SEC failed to insist on requiring some changes in the NSCC system to facilitate their proposal, the Securities Industry won on both counts. The two day grace period became ten days and the 90 day freeze became a buy in requirement. The SECs two day requirement would have been a much stricter rule and the 90 day penalty would have certainly put dent in naked short sales. The SEC caved under the Industrys pressure. No compromise.
3c. The next proposed change represented the real teeth in the proposed rule and it spread real fear in the Industry. Why? because it hit the perpetrators right in the wallet with financial penalties or equalizers. If this proposed requirement would have made it to the final rule it would have eliminated any potential financial benefit to naked short selling or failing to deliver. The SEC wanted to impose stiff penalties or equalizers for naked short selling:
"the rule would require the rules of the registered clearing agency that processed the transaction to include the following provisions: (A) A broker or dealer failing to deliver such securities shall be referred to the NASD and the designated examining authority for such broker-dealer for appropriate action and (B) The registered clearing agency shall withhold a benefit of any mark-to-market amounts or payments that otherwise would be made to the party failing to deliver, and take other appropriate action, including assessing appropriate charges against the party failing to deliver. Both of these requirements should assist the Commission in preventing abuses and promote the prompt and accurate clearance and settlement of securities transactions."
The Securities Industry wanted nothing to do with this rule change. Anything threatening their wallets had them freaking out and the comment letters reflect that panic. From their Securities Industry comment letter:
"SIA believes that the imposition of financial penalties, e.g., clearing agencies withholding the benefit of any mark-to-market amounts would be unnecessary and unduly harsh. Both existing rules as well as some of the proposed rules effectively address extended fails and create the incentives for market participants to increase their efforts to reduce extended fails."
UNNECESSARY and UNDULY HARSH Did the Industry stop and think how unnecessary or harsh it is to naked short sell or FTD? Did the Industry think about the effects of naked short selling or failing to deliver on companies and shareholders? Absolutely not and if anyone was questioning how important a cash cow naked short selling or failing to deliver is to Wall Street they need to look no further than this defense of the existing rules contained in the comment letters.
The Securities Industry considers making good on an obligation between a buyer and seller unnecessary and harsh. Why do they think its unnecessary and harsh? Because they are making tons of money off the practice. Thats right, billions of dollars. There wasnt a single argument presented by the Industry in their comment letters indicating that failing to deliver or naked short selling loses the Industry money or that positions generally move against the naked short seller. No, no, no and the absence of such an argument speaks volumes as to who is benefiting from naked short selling or failing to deliver. If the Industry lost money on this aberrant practice it would have been argument number one in favor of the proposed rule. You know it, I know it, the SEC knows it and the Securities Industry knows it. Wall Street doesnt do anything unless it puts a buck in their pocket and that includes naked short selling. The fuzziness of the existing rules have enabled a multi-billion dollar cash cow and the Securities Industry does not want to let go of it.
In addition to the absurd statements that penalties would be unnecessary and unduly harsh the Industry controlled NSCC chimed in that their system would need to be upgraded. In the end the SEC was left with deciding between a proposed rule change that would protect investors by nullifying any benefit from naked short selling and a whining Securities Industry protecting its cash cow. Who won? You got it. The Securities Industry of course. Was there any middle ground, any compromise or any agreement to update the NSCC system over time to enforce a penalty structure. The answer is NO. The Final Rule contained no financial penalties. Why did the SEC choose Wall Streets wallet over individual investors wallets? Why didnt the SEC require an industry making billions to update the NSCC system over time?
Regarding the NSCC system change, instead of forcing a system upgrade, investors were given two open ended promises from the SEC, without any benchmarks, in the Final Rule – Short Sale AKA Regulation SHO:
1. "We note that while this may be the current situation in the industry, if the Commission believes that the rules as adopted are not having the intended effects of reducing potentially manipulative behavior, we may consider additional rulemaking that could require broker-dealers to identify individual accounts that are causing fails to deliver."
2. "We are not adopting at this time the proposal that would require NSCC to withhold mark-to-market amounts paid to individuals. However, the Commission intends to pay close attention to the operation and efficacy of the provisions we are adopting, and will consider whether any further action is warranted".
The SEC had their chance and folded under Industry pressure. The SEC is supposed to understand how the markets and market systems work. Why the hell did the SEC propose rules and regulations that the Industry so easily discarded as infeasible, redundant, ineffectual, too costly, burdensome and illogical. Is the SEC a hapless body that guesses when they propose a rule or do they know what the heck they are doing? Does the SEC even have access to the systems they are trying to change? Does anyone at the SEC know how Wall Street systems function? This whole rule-making process really was pathetic. It was either a lobbying smack down of mammoth proportions or SEC ineptitude on display and it got worse. The cherry on top of this punch-drunk reform, after removing all the teeth, was a massive corporate handout.
The SEC, in the ultimate insult to millions of individual investors that were sold undelivered shares (naked sales), granted the Securities Industry one of the most egregious handouts in regulatory history. Instead of forcing Wall St to deliver the undelivered shares under the new rules the SEC handed Wall St a "GRANDFATHER" clause. The SEC decided to give the perpetrators of this nonsense a free pass. What is so striking, so absolutely disturbing is the multi-billion dollar grandfather clause wasnt even mentioned in the proposed rule. It appeared in the final rule out of some secret backroom deal without a single public comment on the topic. The SEC explained the grandfather rule on their website like this:
Grandfathering Under Regulation SHO
The requirement to close-out fail to deliver positions in threshold securities that remain for 13 consecutive settlement days does not apply to positions that were established prior to the security becoming a threshold security. This is known as "grandfathering." For example, open fail positions in securities that existed prior to the effective date of Regulation SHO on January 3, 2005 are not required to be closed out under Regulation SHO.
The grandfathering provisions of Regulation SHO were adopted because the Commission was concerned about creating volatility where there were large pre-existing open positions. The Commission will continue to monitor whether grandfathered open fail positions are being cleaned up under existing delivery and settlement guidelines or whether further action is warranted. It is important to note that the "grandfathering" clause of the Regulation does not affect the Commission's ability to prosecute violations of law that may involve such securities or violations that may have occurred before the adoption of Regulation SHO or that occurred before the security became a threshold security.
Not only was the provision an insult but it may also be one of the biggest smoke and mirror acts perpetrated on the American investor. You will note above that the SEC gave the promise that they would monitor the grandfathered fail to delivers or naked short sales to insure that they get cleaned up under existing delivery and settlement guidelines or whether further action is warranted. I filed numerous Freedom of Information Act requests to make sure they were doing just that and the "grandfathered" fails were getting cleaned up. I requested the following information:
U.S. Securities Exchange Commission
FOIA Office, Stop O-5
6432 General Green Way
Alexandria, VA 22312-2413
Under the Freedom of Information Act (FOIA), please send me any aggregate "fail to deliver" data, benchmarks or methodology enabling the SEC "to monitor whether grandfathered open fail positions are being cleaned up under existing delivery and settlement guidelines or whether further action is warranted." (see notation # 1). I want whatever the SEC is "monitoring" on an aggregate level and how the SEC differentiates grandfathered fails from new fails to "monitor" them.
What I received was a shocking admission. The SEC had no idea how may shares of stock they had grandfathered. In fact they were not tracking grandfathered fails at all. The SECs response stated:
"The FOIA requires us to disclose records existing at the time we received your request. It does not require us to create records in order to respond to it. Note, the staff indicated that to generate such information would necessitate the expenditure of significant staff resources to conduct research, to compile information from multiple sources, to extract and manipulate that third party data, and to create new records"
Pure Smoke and Mirrors perpetrated by the SEC to protect Wall Street. The SEC was not "monitoring" grandfathered fails at all. In fact they did not even have any data to monitor the "grandfathered" fails.
In closing, when half-measured, punch-drunk reform is passed off as real reform we all suffer. If rewarding bad behavior in non-public negotiations is now acceptable iat the Regulatory level then we should just pack it in. The danger that looms is large and it is similar to previously corrupt time in market history:
It is the danger that investors will lose confidence in the markets because the markets are rigged. "People will not entrust their resources to a marketplace they don't believe is fair," an American Bar Association task force said 20 years ago in a study of insider trading, "any more than a card player will put his chips on the table in a poker game that may be fixed." The same holds true today. If investors' faith in the integrity of the markets is shaken, some will pull their money out, meaning less money will be available for American corporations to invest in ways essential to the nation's prosperity. Investors will also be unwilling to pay as much for stocks or bonds in initial or subsequent public offerings, making it more difficult for companies to raise money for expansion or the creation of new technologies and products. The effect on the markets, and on the American economy, would be devastating.
THE SEC MUST FIX THE PROBLEM and GIVE INVESTORS TRANSPARENCY.