To: Securities Exchange Commission Rules Committee
Subject: File No. S7-23-03: Comments on the "Proposed Rule: Short Sales," 17 CFR 240 and 242, Release No. 34-48709
From: Robert J. Shapiro
Date: December 24, 2003

I am Robert J. Shapiro, chairman of Sonecon, LLC, an economic advisory and investment firm in Washington, D.C. I am also a Senior Fellow of the Brookings Institution and Counselor to the U.S. Conference Board. From1998 to 2001, I was Under Secretary of Commerce for Economic Affairs. Previous to that, I was Vice President and co-founder of the Progressive Policy Institute and principal economic advisor to Governor Bill Clinton in his 1991-1992 presidential campaign. I hold a Ph.D. from Harvard University.

I commend the Securities Exchange Commission (SEC) for, at long last, addressing the issue of abuses in short sales. No one questions that the legitimate use of short sales often promotes the efficiency and stability of our capital markets. Short sales alert investors to other investors' judgments that certain firms are over-valued; short sales also enable market makers, as necessary, to provide liquidity and offset temporary imbalances in the supply and demand for particular stocks. These legitimate and positive uses of short sales depend on two particular features of the transaction - namely, that the short sale is covered as required by SEC regulation, and not undertaken to manipulate a stock's price. Without these features, the use of uncovered or "naked" shorts to manipulate the price of targeted shares can present a significant threat to investors. When carried out on a large and widespread scale, naked shorts threaten the basic integrity of equity markets. In my judgment, the Commission's proposals would not materially reduce these threats.

Concern about the illegitimate use of short sales is as old as the SEC itself. The Commission writes that "Congress, in 1934, directed the Commission to 'purge the market' of short selling abuses, and in response, the Commission adopted restrictions that have remained essentially unchanged for over 60 years."1 It has been evident for some time that the regulations adopted in 1938, principally Rule 10a-1 restricting short selling in a stock while its price is falling, have not stemmed illegitimate short-selling. This failure suggests systemic problems with the short sale system that have eroded the basic integrity of the equity markets, including: 1) broker-dealers and investment firms apparently participating in the creation of significant numbers of sham short sales to artificially drive down the price of targeted firms, 2) apparently lax and faulty arrangements at the industry-owned Depository Trust and Clearing Corporation (DTCC) and its National Securities Clearing Corporation (NSCC) subsidiary that have allowed millions of uncovered shorts to persist in the system; and 3) the apparent incapacity or unwillingness of the SEC to enforce existing short sale regulation by investment companies, the DTCC and the NSCC.

The SEC has definitively acknowledged the inadequacy of current regulation by proposing to replace Rules 10a-1, 10a-2 and 3b-3 with new Regulation SHO. Moreover, the Commission also now acknowledges that one reason for the proposed change is the failure of existing arrangements to prevent naked short selling on a large scale, signified by extended failures to deliver shares on a sufficient scale to affect the price of individual equities:

"(A)t times, the amount of fails to deliver may be greater than the total public float. In effect, the naked short seller unilaterally converts a securities contract (which should settle in three days after the trade date) into an undated futures-type contract, which the buyer might not have agreed to or that would have been priced differently."2

When the number of uncovered short sales in a stock exceeds its public float-or even the total number of shares issued or outstanding--the only plausible explanation is a concerted and illegal effort by short sellers to flood the marketplace with counterfeit or fictitious shares, in order to artificially drive down the stock's price and increase the value of the shorts. Massive naked short sales turn the equity market into a form of monopoly pricing for the firms that fall victim to such sales, in which the short seller sets the price at a level guaranteed to provide a quasi-monopoly return. These actions, in effect, destroy the integrity of the market system for firms targeted by naked short sellers and create a direct transfer of wealth from existing shareholders to the illegal short sellers. The firms targeted for such manipulation are generally smaller, younger public firms - the type of company which has generated many of the technological and organizational innovations that have contributed so much to the increases in business investment and productivity of recent years. As relatively small and young companies with much fewer shares in their public floats than their older and larger counterparts, their individual decline or destruction also generally attracts little public attention.

These illegal short sellers cannot achieve pricing power over a firm by themselves, since it involves creating hundreds of thousands or even millions of phantom or non-existent shares in direct breach of numerous regulations and laws. This undertaking requires the collaboration of broker-dealers who will carry out short sales without transferring actual shares, and the tacit countenance of the market organizations and regulatory bodies charged with clearing and settling those short sales. The fact that naked short sales occur on this scale, therefore, points to serious problems involving compliance with short sale regulation at the investment firms conducting these transactions for their customers. It also points to troubling problems involving the enforcement of these rules at the NSCC, where these transactions are supposed to be cleared and settled in accordance with the rules, at the NSCC's corporate parent, the DTCC, and at the SEC offices entrusted with overseeing the DTCC, the NSCC and investment firms.

The DTCC describes its responsibilities in this area in very unambiguous terms:

It is the job of [the DTCC and NSCC] to provide an efficient and safe way for the buyer and seller to exchange securities and money, thus 'clearing and settling' the transactions. NSCC steps into the middle of a trade, becomes a contra-party to both firms and guarantees completion of the transaction. This guarantee assures all members that NSCC will complete trades on the original terms."3

The DTCC and NSCC further guarantee that all trades, including short sales, are promptly cleared and settled-since 1995, within three business days:

NSCC guarantees and settles transactions between market professionals during this time period [three business days] to ensure sellers are paid and buyers receive their securities in a manner that reduces risk, cost and post-trade uncertainties. NSCC guarantees that a trade will be completed once it enters our system as compared, which means all trade details from the buyer and seller match up."4

Despite these intentions, there is considerable evidence that market manipulation through the use of naked short sales has been much more common than almost anyone has suspected, and certainly more widespread than most investors believe. I have studied one form of illegitimate short selling, based on the use of a convertible warrant guaranteeing the investor the right to convert his investment into shares at the lowest public share price over some look-back period, minus a substantial discount. The use of this financial instrument, commonly called "death spiral financing," was widespread in the 1990s and the recent turn of the century, and created strong incentives for large-scale naked short sales focused on small and medium-size public companies. This particular instrument creates conditions under which an investor can profit by short-selling the firm in which he is otherwise invested: If the investor can drive down the firm's share price through short sales, he profits from his shorts while his convertible warrant protects the value of his original investment, regardless of how much the stock declines. The investor also can use his warrants to produce the shares he needs to eventually close his short positions.

The appeal of the death-spiral instrument to a short seller intent on driving down a firm's share price is clear: It eliminates economic risk, since the warrant guarantees the delivery of shares equal to the investment plus a large premium, regardless of the stock's price. However, a short seller without such a warrant can also virtually eliminate his financial risk by undertaking short sales on a scale sufficient to drive down the stock's price. Normally, a legitimate short seller increases his exposure by expanding his short position. For a short seller operating on a sufficient scale to affect the stock price, however, the more extensively he shorts a stock, the greater his prospects of profiting and the greater his profits will likely be.

The more the share price falls, the greater the short-seller's return; and the greater the percentage of tradable shares that the shorts account for, the greater the price decline. The only difficulty facing a short seller intent on manipulating a stock's price is securing enough shares to cover such large-scale short sales. The typical solution is the large-scale naked short sales that the Commission has found--in some cases greater than the total number of tradable, outstanding or issued shares in the firm being shorted. As the Commission notes,

[N]aked short sellers enjoy greater leverage than if they were required to borrow securities and deliver within a reasonable period, and they may use this additional leverage to engage in trading activities that deliberately depress the price of a security."

My own research has found, thus far, that a sample of more than 200 companies that appear to have been victimized by this new form of "bear raid" posted a combined market loss of more than $105 billion. Others also have found substantial evidence of the ill effects of naked short sales. Two European economists, Professors Pierre Hillion and Theo Vermaelen, tracked 467 issues of floating-price "death spiral" convertible warrants by 261 U.S. firms from December 1994 to July 1998.5 They found that despite the strong bull market of that period, the shares of 85 percent of those firms fell by an average of 34 percent in the year following the issue of the convertible instrument. Nor were these declines consistent with comparable firms that had not undertaken this financing: The year before issuing these warrants, firms using this form of finance under-performed various market indices by 5 to 11 percent; a year after issuing the warrants, the same firms under-performed the same indices by 40 to 54 percent.

Considering massive naked short sales undertaken either with or without a floating-price convertible warrant, we believe that this type of stock manipulation has occurred in many hundreds and perhaps thousands of cases over the last decade.

Illicit short sales on such a scale or anything approaching it point to grave inadequacies in the current regulatory regime. In principal, it should be simple to identify short selling of the extent required to manipulate a stock's price. The stock exchanges track the short interest in every issue and can easily identify stocks with sufficient short-sale activity to raise questions of manipulation. It also should be simple to prevent the extended use of naked short sales, since an investor's broker-dealer will know of any failure to deliver the shares being shorted, the information systems within investment firms track such failures to deliver, and the NSCC is charged with monitoring the failures to deliver reported by investment firms.

The large-scale naked short-sales now acknowledged by the SEC and confirmed by research require broker dealers willing to look the other way as their customers carry out their short sale strategy, with some of these broker dealers perhaps relying on a customer's convertible warrant to guarantee that the shorts will be closed eventually. The success of these large-scale naked short sale strategies also depends on a persistent failure by the supervisors and employers of these broker dealers to question or investigate massive short sales transacted through their firms and followed, time after time, by the effective destruction of the targeted companies. The strategy's success further depends on NSCC staff willing to overlook thousands of instances in which large numbers of shares are not delivered for an extended period or on their supervisors' ignoring such reports.

Finally, these manipulations can occur only in a lax enforcement environment. The record shows that the SEC has not disciplined a single broker-dealer, a single investment firm, a single staff or official of the NSCC or DTCC in connection with the massive illegal activities which the Commission acknowledges have occurred.

The rules governing short sales must be tightened and, just as important, the new rules must be strictly enforced. I do not believe, however, that the SEC's proposals in their current form will have an appreciable effect deterring these abuses.

The proposed reforms of the "tick test" will do little to curb the serious abuses in short selling. The Commission writes that a strict "tick test" can prevent,

" short selling at successively lower prices, thus eliminating short selling as a tool for driving the market down" [and prevent] "short sellers from accelerating a declining market by exhausting all remaining bids at one price level, causing successively lower prices to be established by long sellers."6

This analysis gravely underestimates the ability of sophisticated manipulators to drive down a stock price while technically complying with the tick test. A technically-sophisticated short-selling operation, for example, can carry out a trading strategy that creates or includes brief up-ticks of one-penny, as required under the new test. Whether a manipulated stock's pattern of price decline is smooth or punctuated by plateaus and penny increases on the long way down does not alter the manipulation. In addition, the new bid test, like the current one, would apply only to exchange-listed and NASDAQ NMS securities, and not to NASDAQ small cap, Over the Counter Bulletin Board, and Pink Sheet securities-the equities that are most vulnerable to such manipulation.7 Finally, the proposal to reform the tick test addresses the timing of short sales relative to the price set by immediately-previous short or long sales, but not the core issue of naked short sales.

The Commission considers another approach in the proposed Rule 203. The new rule would authorize the NASD to bar a broker-dealer from executing short sales in a particular security for 90 days for either his own account or the account of a customer who had failed to deliver 10,000 or more shares of that security sold short, within two days of its settlement date. In addition, the clearing agency for the failed delivery could deny the customer who had failed to deliver the benefit of mark-to-market on his short sales, which would freeze his collateral.

The 90-day bar in Rule 203, as currently written, will not "protect buyers of securities by substantially curtailing naked short selling" as the Commission hopes, because it would inhibit only those illegal short sellers working with only one broker dealer and working alone. Under the new rule, an investor caught using naked shorts to drive down the price of stock could find another accommodating broker-dealer or an associate could carry on the scheme the original broker dealer. I urge the Commission to revise the proposed rule to ensure its effective application under such circumstances.

The Commission's proposal to authorize the clearing agency for a failed delivery to deny a customer the benefit of marking to market on his short sales has more potential for curbing short-sale abuses, since it could freeze the profits of naked short sellers. By itself, however, the rule is insufficient: Based on the SEC's findings as well as independent research, we cannot assume that broker dealers or clearing agents always will follow the rules when they can profit from bending or breaking them. As the Commission writes regarding market makers,

" [W]e believe that extended failures to deliver appear characteristic of an investment or trading strategy, rather than being related to market making. We believe it is questionable whether a market maker carrying a short position in a heavily shorted security for an extended period of time is in fact engaged in providing liquidity for customers, or rather is engaged in a speculative trading strategy."

I urge the Commission to improve the proposal by making the sanctions mandatory: In every case of an extended failure to deliver shares, the collateral will be frozen until the shares are delivered. If the shares are not delivered within five business days-almost twice the length of the normal clearance and settlement procedure-the investment firm should be compelled to use the collateral to buy-in the position and liquidate the short sale. Finally, the NSCC should publish the names of individuals who fail to cover substantial short positions in five days, and investment firms should be prohibited from conducting any transactions for 90 days for those individuals or the firms which employ them.

I also urge the Commission to heed the concerns about market makers noted above and develop rigorous criteria for distinguishing genuine markets makers from those claiming the role in order to escape regulation and, among genuine market makers, distinguish clearly those activities which fall under such market making and those which do not. In any case in which short sales are conducted under a cover of genuine market making for which they do not qualify, as in the example noted above by the Commission, the sanctions we propose for everyone else should apply to the so-called market maker.

Even such strict rules cannot guarantee compliance. Current regulations require that any uncovered short be covered within 10 days of settlement; but the NASD, DTCC, NSCC and SEC have failed to penalize their myriad violations. Nor would the new rules affect the abuses associated with death-spiral financing, since that instrument provides a short-selling manipulator with the shares to eventually cover his massive naked shorts. In all these matters, the NASD, DTCC, NSCC and SEC have not shown the commitment required to enforce rules which ultimately guarantee the integrity of the capital markets.

In this context, the Commission's proposal to suspend the tick test for two years for specified liquid securities could send a dangerous message to market participants.8 The tick test, as noted above, is not always effective in preventing short sale abuse; but its suspension in an environment of lax oversight of failures to deliver could substantially increase such abuses. I am particularly concerned with the Commission's comment that the purpose of this pilot program is to "assess whether short sale regulation should be removed, in part or in whole, for actively traded securities."9 I concur that strict regulation of short sales would "especially help smaller issues, whose securities may be more susceptible to the effects of naked short selling and would promote capital efficiency in smaller, thinly capitalized securities that are more susceptible to manipulation."10 That does not mean, however, that larger issues are always invulnerable. Manipulating their shares would require greater resources and more cooperation from broker dealers and clearinghouse agents, but such efforts could certainly flourish if short sale regulation were removed.

Finally, the Commission has asked for comments on whether the proposed amendments will promote efficiency, competition and capital formation, as required under section 3(f) of Exchange Act. To respond, we must be clear about how short sale abuses impair economic goods. As noted earlier, manipulative short selling, in effect, introduces a form of monopoly pricing that undermines the efficiency of capital markets. The public perception that equity markets are vulnerable to such abuses and that the appropriate agencies are unwilling or unable to crack down, could sharply reduce public confidence in those markets. In turn, declining public confidence can materially damage market efficiency by reducing liquidity in many issues, ultimately reducing capital formation and impairing competition by inhibiting business creation and expansion.

In my judgment, the proposed regulations would not significantly reduce short sale abuses. To have a genuine impact on the efficiency and competitiveness of the equity markets, the regulations should provide much stronger disincentives for naked short sales. The integrity of the capital markets demands much stricter regulation than those currently proposed, much greater industry compliance than has occurred of late, and much tighter enforcement than has been seen thus far.

Robert J. Shapiro
December 24, 2003


Endnotes