The SEC's proposal in Regulation SHO to ban naked short selling is based primarily on the perception that naked short selling is widely used to manipulate stocks downward and therefore should be eliminated from the marketplace. In reality, the opposite is true:
(1) There is no evidence to support the perception that naked short selling is widely used to manipulate stocks. In fact, data will be presented to show that those companies and groups that have publicly complained to have been harmed by naked short selling tend to be grossly overvalued, and in some cases are associated with individuals who have been charged with stock fraud in the past. Regulation SHO itself presents only one instance of manipulation by naked short selling, and it's a special situation involving "death spiral" convertible financing. It is recommended that new regulations address specifically death spiral convertible financing, and not naked short selling in general.
(2) Upward manipulation of stocks is much more widespread than downward manipulation, particularly among thinly-capitalized securities in the Bulletin Board and Pink Sheet markets. This contention is supported by an academic study that examined market manipulation cases pursued by the SEC itself: 85% of the market manipulation cases studied were for upward manipulation, while less than 1% were for downward manipulation.
(3) Naked short selling is an important market force in combating upward manipulation of thinly-capitalized securities. Because it is extremely difficult to get a borrow on thinly-capitalized stocks, banning naked short selling will eliminate the majority of short selling in this marketplace. By eliminating naked short selling, the SEC is making the environment more fertile for the type of manipulation that is most prevalent.
Each of the above three points are discussed in detail below.
(1) The Myth of Widespread Manipulation via Naked Short Selling The very first sentence in the section on naked short selling in Regulation SHO states "Many issuers and investors have complained about alleged "naked short selling", especially in thinly-capitalized securities trading over-the-counter." Indeed, there is a group of companies and promoters that have "declared war" on naked short selling and for the past year have put out a constant stream of press releases that in essence claim that naked short selling is being used to manipulated downward the price of scores of Bulletin Board and Pink Sheet stocks. It appears that the SEC is proposing to ban naked short selling in order to appease this very vocal group of issuers, promoters, and misguided investors. However, these groups have produced no evidence to back up their claims that their stocks have been manipulated by naked short sellers. Indeed, upon close examination the group waging the war on naked short selling consists of companies that for the most part appear to be grossly overvalued with no evidence of depressed stock prices due to naked short selling. Also, there are some rather shady characters associated with these groups. The credibility of these groups and their claims are examined below:
ICI / NAANS / Genemax:
Investor Communications International (ICI) is a stock promotion firm that has been the most vocal critic of naked short selling. ICI has formed the National Association Against Naked Short Selling (NAANSS) which has been lobbying in Washington DC against naked short selling. On their website (http://www.nakedshortselling.com ), they ask people to join their organization in order to "make your voice heard in Washington, D.C.". ICI and its associated companies have issued numerous press releases complaining about manipulation by naked short sellers, but have never presented any evidence to back up these claims.
In a recent SEC filing, the president of ICI is listed as Brent Pierce (filing DEF 14C for Petrogen Corp issued on 12/31/02 http://www.sec.gov/Archives/edgar/data/1057226/000105050202001084/hadro- def14c.txt ). Pierce was found to have committed securities fraud by the British Columbia Securities Commission and was "prohibited from becoming or acting as a director or officer of any reporting issuer for a period of 15 years" (http://www.bcsc.bc.ca/Enforcement/eol/pierce_gordon.htm).
ICI is well known for its close ties to the biotech company Genemax (BB:GMXX). ICI brought Genemax public, performs investor relations for it, and is a large shareholder. ICI and Genemax also share the same address in Blaine, WA, and share various officers and consultants. Genemax and ICI launched a widely publicized campaign against naked short sellers last year when Genemax tried to exit the Depository Trust Corporation (DTC) and have its shares trade only as paper certificates in an effort to prevent naked short selling of their stock. Excitement over this tactic caused shares of Genemax to soar from about $1.00 per share to over $20.00 (and then back to $1.00), and ICI persuaded dozens of other companies to attempt to leave the DTC. These companies claimed that naked short selling was depressing the price of their stock, but did not present any evidence that this was indeed true. The SEC ultimately did not allow these companies to go to trading of paper certificates.
James D. Davidson, until recently CFO, director, and a shareholder of Genemax, is an editor and founder of Agora publishing, which was recently charged by the SEC with stock fraud (http://www.sec.gov/litigation/complaints/comp18090.htm ).
With these types of associations, ICI is not a credible source for complaints about stock manipulation.
The 106 Companies Allegedly Damaged by Naked Short Selling: Investrend, a financial services company that caters to small market capitalization companies, has issued numerous press releases that list 106 companies that allegedly have been damaged by naked short selling. These press releases have been so widely distributed that other media sources have referred to this list as well. The vast majority of companies on the list trade on the Bulletin Board or Pink Sheets. Seven of the Nasdaq/NYSE companies on the list that were contacted, and they said that they were unaware of such a list and did not wish to be affiliated with it. Since the remaining 99 companies on the list have claimed to have depressed stock prices due to naked short selling, I attempted to compile basic financial data on these companies and looked for evidence of depressed stock prices. I was able to find basic financial data on 70 of these companies; for many of the Pink Sheet companies basic financial data was not publicly available. A table containing financial data on the 70 companies can be found in Attachments 2 and 3. A summary of this data:
These companies and their shareholders apparently believe that they should be trading near their 52-week highs and that naked short sellers have illegally manipulated their stock prices lower. However, looking at the financial data there is no evidence that this is true. With a current average market cap of $20M, little revenue, big losses, and little cash, these companies are by no means suffering from depressed stock prices. The data is actually worst then suggested by the averages since most of the revenue is from just a few companies. If you remove the 5 companies with the most revenue, the current average market cap drops to $16M, however average annual revenue drops to only $0.9M, and the Price/Sales ratio balloons to 17. These companies are overvalued, not undervalued.
Another troubling aspect of these companies is that 26 of the 70 have either been associated with an SEC investigation, or have been investigated by www.our-street.com , www.stocklemon.com , or www.stockpatrol.com (as indicated in Attachment 1). I find Our-Street, Stocklemon, and Stockpatrol to be credible sources that publish very detailed fundamental research on companies which they believe are being "pumped and dumped". In fact, many of the companies they profile are later investigated by the SEC.
(2) The Reality: Widespread Upward Manipulation It has certainly been my experience in observing the stock market that upward manipulation is much more widespread than downward manipulation. This is particularly true among thinly-capitalized stocks which are the easiest to manipulate. A recent study entitled "Stock Market Manipulation û Theory and Evidence" by Rajesh Aggarwal of the Tuck School of Business, Dartmouth College and Guojun Wu of the University of Michigan Business School (http://groups.haas.berkeley.edu/afa/UPDF/P306_Asset_Pricing.pdf ) collected "data on stock market manipulation cases pursued by the U.S. Securities and Exchange Commission from January 1990 to October 2001." One of their results: "84.51% of manipulation cases involve the inflation of stock prices while less than 1% of cases involve the deflation of stock prices. Stabilization accounts for 2%. For about 13% of cases we do not have enough information to classify the type of manipulation."
This academic study by reputable researchers refutes the claims made by companies and promoters that downward manipulation is widespread. Indeed, it indicates that upward manipulation is more than 84 times more prevalent.
(3) Naked Short Selling is an Important Market Force in Combating Upward Manipulation Naked short selling is being targeted by companies and promoters because it is the primary type of short selling that occurs among thinly-capitalized securities. It is extremely difficult to borrow shares of these stocks to sell short, and so if naked short selling is banned there will be very little short selling in this market segment. For many of these stocks, especially during the "pump" phase, the float is controlled by insiders, and so borrowing shares to sell short is virtually impossible. Another problem is that the system used to obtain a "borrow" is highly inefficient. With the shares of a stock spread across borrow desks at innumerable brokers and clearing houses across the country (not to mention offshore), it makes it difficult for a short seller to borrow a reasonable number of shares of a thinly-capitalized stock.
Short selling is a critical part of every market. There have been numerous studies that show when short selling is suppressed, stocks become overpriced, investors lose money, and resources are wasted. An intriguing defense of short selling in general was presented by Owen A. Lamont of the Graduate School of Business, University of Chicago to the U.S. House of Representatives Committee of Financial Services on 5/22/03, and can be found here: http://220.127.116.11/search?q=cache:6Y223CS4M9AJ:financialservices.house.gov/media/pdf/052203ol.pdf .
Short sellers are a vital part of the market for thinly-capitalized stocks, not only because of the selling pressure they put on overvalued stocks, but also because of the policing function they perform. Stock promoters spend a lot of resources trying to bring buyers to their stocks via a combination of mass emails, FAXs, mailers, websites, and pumping on message boards. Naked short sellers are usually the only public voice offering an opposing point of view. They scour the market for active pump-and- dump schemes and then post their detailed research on message boards. Websites such as www.our-street.com, www.stocklemon.com, and www.stockpatrol.com also search out stocks that are being pumped and publish detailed research. If the SEC does indeed ban naked short selling, stock promoters will be able to dominate message boards and other public discussion of these stocks with little opposition. Analysts and the media rarely cover thinly-capitalized stocks, and the SEC is so short on resources that it uncovers only a fraction of the pump-and-dump schemes that occur in this market. There will be a significant increase in overvaluation and manipulation among Bulletin Board, Pink Sheet, and low-price Nasdaq and Amex stocks if naked short selling is eliminated. Retail investors will lose money and legitimate companies in these markets will become tainted.
It appears that by banning naked short selling the SEC is attacking the 1% of manipulation cases and making the ground more fertile for the other 85%.
In Regulation SHO, with regard to the proposed regulations intended to curtail naked short selling, you state "In our view, these delivery requirements would protect and enhance the operation, integrity and stability of marketsàIn particular, we believe that they will protect buyers of securities by substantially curtailing naked short selling." In this letter I've tried to demonstrate that in fact the complete opposite is true: that this regulation, if enacted, will reduce the integrity and stability of markets, and will leave buyers of securities with much less protection than they have today.
A group of companies and promoters have conducted a very effective public relations campaign in which they've convinced the public and, unfortunately, some regulators, that naked short selling is widely used to manipulate stocks downward. An examination on these companies shows them to be overvalued and to have associations with questionable individuals. Many are related in some manner to SEC investigations into stock fraud. These companies and promoters are not credible sources for ideas on how to add integrity and stability to the markets.
The SEC should produce credible evidence of widespread abuse by naked short sellers and make that evidence public before it takes any action. In Regulation SHO the SEC has pointed to a situation involving "death spiral" convertible financings where manipulative naked short selling occurred. "Death spiral" financing by its very nature is extremely prone to manipulation, and a more appropriate response would be to introduce new regulations that apply specifically to this type of financing.
Naked short selling is an important market force in combating "pump and dump" and other types of upward manipulation that are prevalent in these markets. If it is eliminated, stock fraud will dramatically increase, not decrease, among thinly-capitalized stocks.
Attachment 1: Research / SEC Investigations of Companies Claiming Damage by Naked Short Sellers
ADZR AdZone Research, Inc.
BIFT BIFS Technologies Corp
COHIA Composite Holdings
EDGH Edgetech Services
EVSC Endovasc Ltd.
EPXR EPIXTAR Corp.
FLST(FSFY) Flight Safety Technologies
FSRCE FreeStar Technologies
GENI Genesis Intermedia
GMXX GeneMax Corp.
HQNT H-Quotient, Inc.
IBCL International Biochem
IBCS International Broadcasting Corp
ISTO InternetStudios, Inc.
LAIR Lair Holdings
NPCT Nanopierce Technologies, Inc.
NPHC Nutra Pharmaceutical
OECI Orbit E-Commerce, Inc.
PACC Pacel Corp.
RMEC Rocky Mountain Energy Corp.
RTNHE(SAFS) RTIN Holdings
STEH Suncomm Technologies
USXP Universal Express, Inc.
VGNI Viragen International
Note: Attachments 2 & 3 are contained in a word document attached to this email.
Attachment 2: Financial Data at 52 Week High
Attachment 3: Financial Data on 1/2/04
Notes on Attachments 2 and 3:
OS: Number of Outstanding Shares
(2) The primary source for all of the financial data is SEC filings, or in the absence of filings, Knobias or the company's website.
(3) The OS numbers are considered to be reasonable estimates. Since many of these companies are continuously issuing new shares, it is hard to get a precise number for the OS.
(4) Due to the large amount of data, these tables may contain some minor errors. However, it is extremely doubtful that any errors would significantly affect the average values or change the conclusions drawn from this data.