Comments of Feldman Weinstein LLP to Proposed Regulation SHO, File No. S7-23-03
It is unfortunate that the Commission proposes to respond to a handful of sketchily alleged and apparently unproven "abuses" by short sellers of stock by placing a series of new tools at the hands of the promoters of penny-stock "pump and dump" schemes to work their frauds. This cannot be the Commission's express intent, but it will be the principal result, leaving investors with fewer, not more, protections from fraud in the securities markets.
The Commission's apparent principal goal with this proposed regulation is to kill off future-priced, so-called "toxic" convertible securities. This particular type of security has become virtually extinct in the marketplace through a combination of free-market forces and civil litigation between the issuers of such securities and the purchasers of the same. The Commission could more effectively complete that job by revoking or modifying current Manual of Telephone Interpretations March 1999 Supplement #3.S to deem the sale of a floating-priced convertible security to be a "not closed" transaction, and therefore unregistrable for resale by the investor. The balance of proposed Regulation SHO essentially attacks the flea of toxic convertibles with a cluster bomb which will impact the market for all privately-placed securities, with immediate and negative impacts on the cost of capital for all public companies with market capitalizations below $500,000,000.
Our specific comments to specific provisions of proposed Regulation SHO are keyed to the outline numbering of Release No. 34-48709.
So-called "naked shorting" is a problem only for intrinsically valueless issuers perpetrating penny stock frauds on investors. Where an investor sells stock short without borrowing the necessary shares for timely delivery, the investor assumes unlimited financial risk to cover that position when delivery is finally demanded. The investor, which believes the shares being sold are worth either nothing at all or at best something considerably less than their current trading price, is putting his money where his mouth is with respect to a particular stock. If the Commission is concerned about the possibility of "bear raids", it could solve that problem much more easily by imposing the newly proposed bid-price test to Nasdaq SmallCap, OTCBB and Pink Sheet companies as well as the currently proposed National Market and exchange-listed securities. This would eliminate the possibility of a bear raid while allowing an investor to make a negative bet on a particular issuer's stock.
Borrowing shares priced below $5.00 for the purpose of selling short is generally difficult and often prohibitively expensive due to minimum margin share value requirements. If the Commission's concern with naked shorting is the clearance and settlement system service providers, we are unaware of any complaints lodged by Depository Trust Company or others to the Commission with respect to this. If the Commission has any such materials, we believe they should be disclosed to the public for further comment. Existing NASD Rule 11830 appears to be fully adequate to protect the integrity of the clearance system, and no other changes are required.
The Commission's concern seems to be with the holders of "toxic" convertible instruments. Notwithstanding the almost total disappearance of such securities from the marketplace (see, e.g., The PIPEs Report, December 1, 2003), the Commission knows that the holder of such an instrument can always deliver covering shares by means of a conversion of its instrument, barring a default by the issuer in honoring a conversion notice. Further, the holder of a toxic convertible is already, and will continue to be exempt from the proposed bid-price rule (and the current uptick rules) because their trades fit within the definition of "special arbitrage accounts".
Thus, the Commission's stated concern of chaos in the settlement system is a non-issue, so the Commission unfortunately ends up deterring investors from expressing their negative opinions about the actual business prospects of issuers; while doing nothing to counter the endless flood of shaded half-truths devoted to inflating stock prices which have emanated from issuer managements for decades. The passage of The Sarbanes-Oxley Act of 2002 has done nothing to change this. Fair market pricing of shares is the ultimate investor protection for all investors. The Nasdaq Stock Market has rigorously enforced its corporate governance listing rules for at least the last five years. They have de-listed hundreds of companies for management errors, despite the havoc such de-listing wreaks on innocent shareholders, on the grounds that no new investor should purchase shares in deficient companies. The Commission should follow the same objective. Protecting the existing investors in penny stock scams from the truth only serves to facilitate stealing from new investors.
The proposed five-day standard for physical delivery of shares sold short should exclude the situation where the short sales are executed in a special arbitrage account. It is frequently the case that the holder of a convertible security or a warrant will sell short prior to conversion of a convertible security or exercise of a warrant in order to lock in a profit. This practice is currently recognized and condoned by the Commission in existing Rule 10a-1 and will be continued in Rule 201 with respect to the bid price test. Because the holder of the convertible security frequently holds a restricted security with the underlying shares registered for resale by the holder, the holder must tender its security for conversion, and will typically receive back a "legended" stock certificate, which must then be re-tendered to the issuer's transfer agent to be re-issued in the name of the ultimate buyer, without restrictive legend. This process, which is solely in the hands of issuers and their designated transfer agents, invariably takes longer than five days, and often longer than 10 days.
The holder of the securities should not be subject to the draconian penalties of a 90-day freeze on its account in that security for a situation solely in the hands of the issuer. In fact, the proposed rule, in this context, will encourage issuers to delay processing of conversions or transfers for the sole purpose of taking a legitimate seller out of the market, artificially propping up the issuer's stock price. There should be no set time limit on deliveries by such short sales by special arbitrage accounts if the short sale is accompanied by prospectus delivery (where otherwise required) and the broker handling the trade is provided with documentary evidence (such as copies of conversion notices, tenders to the issuer's transfer agent for de-legending of stock certificates, etc.) that the seller has in fact attempted to convert its convertible security. In this case, the delay in delivery is then attributable to the issuer, not the seller. If the Commission finds that suggestion unacceptable, then the current 10-day buy-in period provided by NASD Rule 11830 should be retained.
The Commission also requested comment on whether there were circumstances other than bona-fide market making where a party might need to maintain a "fail to deliver" beyond five days and where the locate and borrow requirements would not apply. The special arbitrage account situation described above is certainly one such situation. To require a holder of a convertible instrument to convert first and sell second to avoid the imposition of these requirements elevates form over substance. If the Commission is concerned about so-called "toxic" convertibles being used to abuse this exception (even though, as indicated above, toxic convertibles are not typically found in the marketplace any longer), then the exception could be limited to arbitrage securities with fixed conversion or exercise prices.
The prohibition on a broker using borrowed shares to make delivery on a long sale should contain an exception for a customer's fail to deliver where the customer owns a security purchased in a private placement which, while effectively registered for resale by such customer, requires legal-transfer processing at the issuer and/or the issuer's transfer agent. In this circumstance the selling broker should be allowed to use borrowed stock to make settlement, without other restrictions.
The proposed bid-price test will permit short sales with borrowed stock only in rising markets, as opposed to the current uptick rules. Here, the Commission unintentionally assists promoters of irrationally priced stocks by disallowing investors with contrary ideas about a company's value from expressing their views in an auction market, yielding an endless supply of inflated stock prices. Further, the one-cent differential will interfere with existing pricing anomalies in the Nasdaq market, where stocks are often bid out to hundredths of a cent where market makers are competing for a trade. It will also make short sales nearly impossible in the penny-stock market, where one cent may exceed the value of a share. Since the penny stock market is where criminal promotion of share prices is much more common to begin with, the Commission should be encouraging, not discouraging, investors to short these stocks to help preclude any return to the bubble market of the late 1990s.
The proposed exemption for WVAP-matched trades should not be limited to "actively traded securities" as proposed. VWAP trading is a widely-practiced method for investors to limit their exposure to massive intra-day price swings in volatile stocks, and is not limited to stocks trading over $1,000,000 per day in the marketplace. The threshold, if there is one at all, should be much lower, perhaps a requirement that at least 100,000 shares per day be traded on average, regardless of price.
The proposed retention of the exception proposed in Rule 201(d)(1) is essential to the functioning of the private placement market, where late deliveries due to the slowness of issuers and their transfer agents to transfer privately placed shares are common, and do not represent any potential for abuse of the markets except by the issuers themselves.
The exception for special arbitrage accounts should be retained for the reasons set forth above under our comments to Sections II.C.1 and VI.A.1. There should be no requirement that special arbitrage accounts be set up as separate accounts. The Commission has more than enough tools, from annual and special audits of the broker-dealers handling the accounts to its civil investigative powers, to ascertain that an investor's holdings and trading in a particular security are the result of special arbitrage trading. Any requirement to have a separate account for each of these holdings only creates a paperwork burden on the investor, its broker and the clearing agencies, and serves no useful regulatory purpose.
The Commission's invitation for further comment for a further proposed revision to proposed Rule 200(b)(2) regarding "present delivery" represents the Commission engaged in a useless search for non-existent "abuses", of which the Commission cannot identify any real-world examples. The notion of "present delivery" is a solution in search of a problem. Many private placement contracts specify both price and quantity, but defer closing and funding until a subsequent event, often a shareholder approval requirement by the issuer's listing exchange or Nasdaq. The investor should not be precluded from selling long if the sole impediment to making delivery is a contractual obligation in the control of the issuer, not the investor. This has been an accepted practice by the Division of Corporation Finance for a number of years (see e.g. Manual of Telephone Interpretations, March 1999 Supplement 3.S.)
We also think it is inappropriate for the Commission to impose a strict requirement that the price and quantity of securities be absolutely fixed in order to consider a sale "long". So long as there is an ascertainable minimum number of securities that will be purchased, at least that number of shares should be deemed long. It would not be unreasonable for the Commission to consider shares that might become issuable upon the occurrence of later events to be non-existent and therefore sellable only as "short" sales. The Commission's focus on "incentive to depress the market price" fails to include the issuer's equal incentive to increase the market price, through orchestrated purchases, misleading optimistic press releases, improper earnings management, outright accounting fraud and other market manipulation devices routinely used by issuers for decades to inflate their stock prices. Sarbanes-Oxley was passed to address many years of proven abuses and crimes by issuers, not by short-sellers. If Regulation SHO ignites another speculative bubble of fraudulent stock hype by issuers, as is quite likely, the Commission will be held accountable by the public, the securities markets and Congress.
Hedging transactions should be exempted from Rule 201 in the same way as special arbitrage accounts. To avoid any perceived opportunity for abuse, the exemption should be limited to sales equal to the investor's net-long position in the security with a fixed price.
Rule 105 should not be changed at all as the Commission has not produced any evidence of any abuses under this rule. We believe the Commission's opening paragraph of the release is a surprising capitulation to the same forces that led to the enactment of Sarbanes-Oxley and the lesser reforms of research analyst regulation and the NASDR's current proposed changes to the IPO sales process - laddering, tying arrangements, spinning, fraudulent research by investment banks, outright accounting frauds by issuers - the entire panoply of scandals of the last five years.
The most effective antidote to what can only be characterized as the professional lying industry is short selling. It is to be encouraged, not discouraged, for the protection of investors. Investors are NOT PROTECTED by a system that is rigged from the ground up to raise stock prices without reference to economic merit and criminalizes the handful of investors who risk their own money to gamble that the many lies underlying many publicly-traded companies, from Enron, Worldcom and Vivendi down to the tawdriest penny stock frauds will come to light and come undone. Investors are protected when the government agency to which they look for protection, the SEC, allows a free market to determine stock prices. Limiting short selling does the opposite. It decreases supply without increasing demand, an insidious inflationary spiral seen time and time again. The Commission needs to completely re-think Regulation SHO, which will deter "abuses" that do not exist and encourage the return of the enormously risky bubble market conditions of 1999.
The Commission's only stated reason for repealing the exception to Rule 105 for Rule 415 offerings is that, "We believe that the use of shelf offerings is common today". The undersigned fails to understand how the common use of a regulation expressly adopted by the Commission within very recent memory becomes an "abuse" through use. The current system of exempting shelf offerings from Rule 105 only applies to larger issuers to begin with, as the smallest issuers (below $75 million market float) are ineligible for the shelf process. Allowing offerees of shelf offerings to declare their conviction that the proposed offering is overpriced by shorting the stock CREATES a true market price, it does not "distort" it. The Commission's proposal, as with the rest of proposed Regulation SHO, will distort market prices by pushing them relentlessly upward without regard to any fundamental economic basis of the underlying securities.
One part of the proposal that makes some sense is the fourth question posed under subsection XVI.B., regarding prohibiting short sales prior to conversion of a future-priced security where the price is determined at least in part during the period in which the short sales are made. The Division of Corporation Finance has somewhat grudgingly tolerated and condoned future-priced securities for years, but they are completely legal. Prohibiting short selling during an applicable pricing period would reduce the perceived abuse of the so-called death spiral convertible. As noted previously in these comments, the death spiral has been virtually eliminated from the marketplace over the last two years anyway, so the impact of such a rule change would be limited.
The Commission has given nothing but lip service to the impact on the economy from adopting Regulation SHO. The Commission has admitted that the "abuses" it has purportedly found perpetrated against small issuers relate to issuers with, in the Commission's own words, "no alternative financing" available. Enacting Regulation SHO as proposed, would NOT provide any alternatives to these issuers. It will severely increase the cost of capital to them, or, as always for the weakest of the class, make them completely unfinanceable and put these companies, out of business entirely, since virtually none of these issuers are actually profitable businesses.
Investors currently financing issuers through downside-protected instruments will have to receive all of their downside protection at the time of closing, i.e., the price paid for shares will not be 90% of current market, it will be 30% or 50% of current market, and the existing shareholders, whom the Commission claims to be protecting here, will suffer far greater dilution than they do under current market practices. The same will be true from the repeal of the exception to Rule 105 for shelf offerings. If risk cannot be hedged by an investor, that risk will not be assumed, it will be eliminated in the pricing ab initio, or the deal will never close.
We understand it may be difficult for the Commission to admit that it has been misled by penny stock promoters into proposing as ill-conceived a regulation as SHO, but the time to make that admission is right now, before the Commission succeeds in furthering the oligopolization of the American economy by eliminating the public capital markets as a realistic resource for smaller, entrepreneurial companies. Investors are protected by fair market prices, not by prices manipulated by issuers, analysts, investment banks and promoters. Short selling is NOT the problem facing the capital markets. Regulation SHO is a solution in search of a problem. It will not fix the alleged problem, and it will hurt investors and companies who seek to use the public capital markets. It should not be adopted.
cc: Hon. Paul Sarbanes
Chief Counsel's Office, Division of Corporation Finance