July 20, 2008
The SEC's Selective Short Protection - It Makes Me Want To Vomit
Small and microcap companies have been complaining for years about the abuses built into the system that favor "illegal naked short selling". For those of you unfamiliar with the practice, let's go over some basics about short selling.
When you sell a stock short, you do the sell transaction first, and the buy transaction second. You sell, and hope to buy back later at a lower price. Instead of "buy low and sell high", it's "sell high and buy low". When you buy the shares back, it is known as "covering your short".
In order to trade in this manner, us regular, every day investors have to get our brokerage to "locate" shares, borrow them, and then allow us to execute the short sale. Market makers are allowed by regulation to short stocks without borrowing them as part of their normal trading practices.
I think short selling is great, and anyone should be allowed to short a stock who has the capital.
Illegal naked short selling has been the subject of much complaining and consternation by many public companies and interested parties for many years. This occurs when a short sell is executed without a legitimate borrow first. Institutional investors are allowed to do this on a regular basis as a course of business. The fact that it is allowed is 100% the fault of the SEC's lax attitude towards this practice.
Prime brokers generate millions in fees on the trading side. The DTC system, the people who keep track of the street name stock at your brokerage firm, also collects millions in fees for "open fail to delivers"- shares of stocks that have been sold, but the trades never settled since the seller couldn't deliver.
The whole practice is the subject of a giant class action suit by the guys who got big tobacco and the asbestos industry. In essence, as many have pointed out in the past, illegal naked short selling allows sellers to actually create "counterfeit shares"- shares that don't exist, and sell them to create excess supply.
This past week, the Christopher Cox, the Chairman of the SEC, was interviewed on CNBC, and after watching the interview I was literally ready to vomit.
Early in the week the SEC announced it was invoking a "Ban on Illegal Naked Short Selling". Wow I thought to myself. If there was one good thing that would come out of this Bear Market, having the SEC get rid of illegal naked short selling by closing up the loopholes in the DTC System would be my #1 choice.
Alas, the level of stupidity, and the unbelievable hypocrisy of these guys just blew my mind. The SEC is going to monitor and stop illegal naked short selling, but only on 17 designated financial stocks that trade gazzilions of shares everyday, and have been beaten into oblivion by the bears.
Christopher Cox got up on CNBC, and in an interview actually stated that Illegal Naked Short Selling was, in fact, not illegal. Technically, it might simply be a violation of SEC regs- and it happens due to a series of loopholes in the system that allow it to happen.
He stated they were invoking the special power to ban the naked short selling in 17 bank stocks for 30 days, but that it would be far too difficult and inefficient to ban naked short selling across the board on every stock.
Dear Mr. Chairman- please answer this question for me? if you can ban illegal naked short selling on 17 of the most heavily traded financial stocks- stocks that trade literally hundreds of millions of shares everyday and are traded by hundreds of hedge funds and other institutions, why can't you ban illegal naked short selling on a $.50 stock that only trades 100,000 shares everyday. Wouldn't that be far easier to track?
About 15 minutes after the interview, CNBC trotted out Cramer. This guy can certainly have his moments, and this was one of them. I applaud his courage. He called out the shear stupidity of the SEC stance on this issue, and was actually waving a copy of the statute that requires the SEC to regulate the proper settlement of trades.
Ladies and gentlemen, unfortunately, this is your government regulators at their very worst. This whole thing is one big transparent gimmick to prevent Fanny and Freddie from completely melting down to nothing, and is selective enforcement at its worst.
Over the past couple of years the SEC has implemented some rule changes favoring small companies that I applaud. Rule 405, which limits the number of share small companies can include in a registration statement, was great for financing small companies. The change in Rule 144 and the relative ease of the registration process under the current SEC is a welcome change for smaller companies and enhances their ability to raise capital in a way that is not a detrimental to stock values.
However, this ban on illegal naked short selling for a few companies is a real slap in the face for investors on the long side. A personal thank you goes out the Jim Cramer for pointing out the shear hypocrisy.
It makes me want to vomit. If it's right for 17 financials, it's right for all stocks. Chairman Cox suggested the commission could look into some "rule changes", which of course they won't do.
SEC- do your job and make the playing field fair for all investors. If huge institutions can naked short stocks without legitimate borrows, let me do it too. Make it the rule. If not, enforce the existing rules.
All they need to do is enforce the existing rules. That's it.