June 10, 2009
SEC Forgives Past Larceny With No Penalty - Why?
Why would the SEC grandfather all prior fails, as well as current fails below the threshold, and knowingly violate their Congressional mandate? It is akin to allowing bank robbers keep the proceeds of all prior bank robberies. There are two logical explanations available to us:
1) The SEC knows about the systemic risk FTD's cause, it is terrified of the implications, and it wanted to, at the stroke of a pen, eliminate that risk from the system, even if it violated the law and was at the expense of shareholders who had been financially decimated by the practice.
A choice was made to allow the brokers and hedge funds to keep the proceeds of their ill-gotten gains, and not require them to ever buy in the shares they had printed whole cloth.
The SEC admits it, in their own bureaucrat-ese. From the February, 2005 Euromoney article on the controversy:
The SEC's Brigagliano says the commission made a choice. "We were concerned about generating volatility where there were large pre-existing open positions, and we wanted to start afresh with new regulation, not re-write history."
Substitute the words "not enforce existing, decade-old laws" for "not re-write history" and you have the plain English version. The SEC violated 17A, knowingly, because they were worried about causing "volatility" - SEC-speak for short squeezes, where stocks with millions of FTD's go through the roof as they are bought in - essentially a return of capital to those damaged by the FTD's, as their cash is returned to them, in return for selling their genuine shares. That would be the fair way equitable markets would work - those who had made untold billions using FTD's would have to pay most or all of it back in short squeezes, as legitimate supply and demand are returned to an unbalanced market (because of the current artificial supply of FTD's).
The SEC was apparently so concerned about that "volatility", that their solution was to give the violators a free pass, and allow the damaged shareholders and companies to remain damaged in perpetuity, never settling nor having record ownership transferred. This decision underscores the likelihood that the SEC understands the systemic risk years of FTD creation have created, and will go to great lengths to avoid triggering an event that would cause the violators to have to settle the trades.
A more cynical interpretation is that the SEC didn't want to cause undue financial hardship for the more politically and financially important violators (the violators would likely be both, as they had years of selling non-existent shares with which to build and solidify their financial importance - and to spread the wealth by supporting their elected officials with contributions), choosing instead to lock in the industry's illegally generated profits, rather than have the violators pay it back - the SEC favored the hedge funds and brokers that had violated the law, over the shareholders and companies that had been brutalized by the practice.
2) The far more ominous logical explanation is that the SEC grandfathered not out of concern for the system, but rather to limit its own liability under the law - that after years of permitting felony short selling/securities fraud manipulation, the SEC ultimately came to realize that it had committed collateral crimes, and could be held accountable - as accessories to the felonies. This explanation posits that in passing Regulation SHO, the SEC wasn?t just grandfathering the previous illegal short selling to protect the short sellers, but rather it was, much more importantly, protecting the SEC itself. And it focused the ire of the victims on the rule violators who financially benefitted, rather than upon the regulator that had permitted the felonious activity for years.
The legal argument would go like this (simplified): The felony committed and suborned in this situation is USC 18, Title 514, the commission of counterfeiting of a commercial security, a Class B Federal Felony. By permitting this felony to be an endemic part of the modern market system, and by knowingly failing to enforce rules designed to prevent counterfeiting of a commercial security, the SEC aided and abetted those who have done so, subjecting it to risk of civil and criminal redress. The permission of a large float of FTD's to be part of the markets is a de facto permission of counterfeiting (wherein the bogus IOU/Markers are represented as and have the effect of legitimate stock shares, on the auction price of the security as well as on the long term size of the float), and thus creates an accessory risk for the Commission. Arguments have been advanced that, as in the Elgindy case, naked short selling was used for money laundering for Middle Eastern arms dealers, thus constituting treason during a time of war (according to the Patriot Act), a Class A Felony - that the Commission was ignorant of the outcome of its permitting the counterfeiting does not absolve it of the legal jeopardy arising from that outcome, any more than the driver of a getaway car in a bank robbery is absolved of the murder of a teller during the robbery - even though he was ignorant of the ultimate crime committed. That is not how the law works.
Note that I take no position as to the likelihood of this second explanation being correct. It is a credible explanation advanced by several experts familiar with the legal ramifications of allowing FTD's to remain in the system in perpetuity, and failing to enforce rules designed to stop larcenous action, nothing more.
FWIW, it is far more likely that the SEC folks understand that upon retirement they will receive $700 per hour jobs with top lawfirms representing Wall Street, and that knowing this they are much more likely to favor Wall Street's interests. Most agencies of the Government have the conceit that comes from unbridled power, and it is hard to imagine Federal employees actually afraid of liability for anything. Thus, the second explanation is a hard one to swallow.
But whatever the motivation, charitable or cynical, you arrive at the same effective point: Years of lawless predation were pardoned (in violation of 17A's Congressional mandate), the profits kept by the criminals, with no penalty or sanctions imposed - leaving investors and the victimized companies out of luck, and money.
So what about now?
Since the new FTD rule was passed (Regulation SHO, for SHOrt) and went into effect January, 2005, more companies have gone onto the Threshold list (a list of companies whose FTD's exceed a "threshold" of 10,000 shares AND 1/2% of their total issued shares), and more FTD's have been created. The industry can't help itself (and truthfully why would they?) - it is just too lucrative to ignore the un-enforced rules, and continue to manufacture IOU's. The systemic risk continues to build, and the regulators that hoped the industry would heal itself are left unwilling or unable to act - the imperative to create fair markets is clearly subordinate to pandering to the financial well being of the violators.
The DTCC and the SEC take the position that information about this crisis is proprietary and secret, and that our elected officials and companies and we shareholders have no need or right to know the true parameters of the problem. The workings of the machine are opaque, and transparency is derided as an unnecessary invasion of the industry's privacy.
Again, the charitable explanation for this stance is because they want to avoid a potentially damaging meltdown (albeit of their own creation). The cynical explanation is that investors would riot in the streets or abandon the market if they understood what was being done to them, and would hold the SEC accountable for their role in it. Regardless of the explanation that one feels best explains the SEC and the DTCC's actions, what is unarguable is that the size, scope, and ongoing treatment of the crisis is top secret.
This is very much like the way the regulators handled the SL crisis, allowing a large systemic problem to develop into a catastrophic systemic problem that wound up costing hundreds of billions of dollars, and every man, woman and child in the US about $2K in taxes. We are still paying for it today.
In that episode, the SL's accounted for about a third of all the business Wall Street did in the 80's, and every big house stuffed the most larcenous of the SL's with untold billions of junk bonds and options and precarious loans, knowing and understanding that the American taxpayer would ultimately have to pay the freight via secured deposits. Wall Street was assisted in this wholesale looting of the financial system by every major accounting firm in existence, and the most prominent attorneys in the country. Fraud of a mind boggling scale was perpetrated and perpetuated by that industry, and one of the primary beneficiaries was Wall Street, who that time also got to keep the money, laying off the blame on the SL's. This time around we have hedge funds comprising over 50% of Wall Street's action, and we as a nation seem to have learned nothing from our prior fleecing. One can't understand that catastrophe and not draw striking parallels to this situation.
In fact, the entire FTD crisis is very similar to the SL crisis, in the sense that staggering amounts of money are in play, private interests are operating in an unregulated environment (hedge funds and ex-clearing), leverage is being employed to compound the risk, Wall Street wunderkind are making preposterous profits, phenomenally wealthy players are receiving preferential treatment even as they knowingly violate the law, Greenspan is saying that no restrictive regulation is required, the industry is protesting that there is no problem, and the entire affair is taking place shrouded in secrecy.
That didn't end well.
The above is simplified, and is conceptual, as in reality there is no single share followed through the system - there are debits and credits to participant accounts at the NSCC, which are netted against total long positions, further obfuscating the mechanisms. But the fundamentals are accurate, if lacking in a certain specificity that could fill volumes. Hopefully it is enough for the reader to grasp the issue and the scope thereof.
From "Symphony of Greed - Financial Terrorism and Super-Crime on Wall Street", by Bob O'Brien, in progress. Interested literary agents or publishers are encouraged to contact Bob at NCANS.email@example.com