May 1, 2009
This is a copy of a letter from Roel C. Campos, former Commissioner of the Securities and Exchange Commission (2002-2007) to Ms. Elizabeth M. Murphy, Secretary of the Securities and Exchange Commission.
Letter dated March 25, 2009
Re: File No. S7-30-08, Release No. 34-58773, Amendments to Regulation SHO
File No. S7-31-08, Release No. 34-58785.. Disclosure of Short Sales and Short Positions by Institutional Investment Managers
File No. S7-08-08, Release No. 34-58774, "Naked" Short Selling Antifraud Rule
The PDF file was too large to attach. See PDF file at http://www.sec.gov/comments/s7-30-08/s73008-108.pdf
Dear Ms. Murphy:
This letter presents the views of a group of issuers (public companies) regarding naked short selling. As a fundamental matter, this group does not seek to limit or to prohibit legitimate short selling. Short sales are acknowledged as important to the markets in providing price discovery, liquidity, and balance. In contrast, naked short selling is a tool to violate the securities laws and continues to cause damage to issuers and their shareholders (including pension funds, 401 (k) holders, and retail shareholders). In evaluating the need for further changes to Regulation SHO, it is important that the Securities and Exchange Commission (the "Commission") take into account the viewpoint of issuers and their shareholders and not simply those of professional traders and organizations that service the market. In the current climate of financial crisis, naked short selling is the "proverbial fuel on the fire" that can vastly accelerate the downward pressure on share prices. Naked short selling will also impede and thwart the national goals of TARP and the rescue of the U.S. bank system.
The Commission has recently announced its intention to reconsider the appropriateness of restoring the so called "tick test" in which short sales can only be executed when the share price is rising. We have no objection to restoring the tick test. However, the tick test will not by itself solve the problem of naked short selling. As discussed herein, much will remain for the Agency to accomplish to remove the great harm to the markets that is caused by naked short selling.
I. Naked short selling continues to cause great harm to issuers and investors.
In spite of the much needed recent improvements to Regulation SHO, naked short selling continues to occur in significant volumes and has not been eliminated. 1 It is true that the number of Regulation SHO Threshold List (the "Threshold List") companies (-30) is a small percentage of all U.S. public companies. However, this fact should provide little comfort to regulators. Failures-to-deliver, a proxy for naked short selling, continue to occur in companies that do not appear on the Regulation SHO Threshold List -either because the company has a large amount of issued and outstanding shares or because the failures-to-deliver occur ex-clearing (e.g., outside of the Continuous Net Settlement system). When a company has a large amount of issued and outstanding shares, the actual number of failed-to-deliver shares can be significant without the company appearing on the Regulation SHO Threshold List. We believe that the majority of these failures-to-deliver are not the result of honest mistakes or bad processing. Rather, these companies are instead targets of illegal and manipulative trading, with intentional failures-to-deliver used by traders to extract profits as the share price plummets.
Clearly, the Threshold List should not be seen as an accurate reflection of the total danger posed by naked short selling. The Threshold List is only the tip of the iceberg. The Threshold List tracks sustained, elevated failures-to-deliver, which are not representative of the market's reaction to naked short selling. Witness last year's tumultuous demise of Bear Stearns and Lehman Brothers. In the appendix to this letter, the latest data (up to the fourth quarter of 2008), show that failures-to-deliver increased tremendously in close proximity with plunging share prices. While naked short selling is not responsible for the majority of sell orders, its existence (as evidenced by failures-to-deliver) adds high octane fuel to a flame that can wipe out billions of dollars in shareholder equity in just days or hours. In times of crisis and gloomy psychology, naked short selling works disproportionately to force a stampede of shareholders to the exits.
It is not appropriate for regulators to accept as a matter of policy the current situation -that a significant number of public companies should be the target of outright theft from naked short selling and manipulation. Failure to fix Regulation SHO will continue to have serious long term adverse consequences for the U.S. markets. In its most benign form, naked short selling is a hidden tax on equity markets, our largest wealth creation mechanism. At its worst, it is a violent force of wealth destruction that affects all market participants. Unless the Commission enacts better and more enforceable regulation, manipulative traders will continue to use this pernicious market mechanism for extracting illegal profits at the expense of shareholders, issuers, and, now with TARP, U.S. taxpayers.
II. Naked short selling will threaten TARP, taxpayers, and national goals to rescue the banking system.
Bank and insurance companies that are essential to the economy, including those receiving funds from Troubled Asset Relief Program (TARP), are at risk from naked short selling tactics, similar to those used against Bear Stearns and Lehman Brothers. Past data suggests that TARP entities were also subjected to naked short selling and manipulative conduct, resulting in shareholder wealth destruction. In fact, the Commission moved to protect these entities by prohibiting short sales of these companies through an Emergency Order. As noted earlier, naked short selling has the potential to have a vast disproportionate impact to help drive down the share price of even the largest banks, destroying government efforts to invest taxpayer money into those companies. The damage to the TARP and the economic recovery are certainly additional urgent reasons why the Commission needs to amend Regulation SHO in the manner described below.
III. Restoring the Tick Test Is Not Enough
The Commission recently indicated that it would reconsider in April 2009 whether to restore some form of the so-called tick test, which existed in SEC regulation for 68 years before it was eliminated in January, 2005. Before eliminating the rule, the Commission studied the tick test and concluded that the test was ineffective and anachronistic given the current market environment and that its elimination did not contribute to market volatility. Those conclusions have been heavily challenged in recent days.
We offer no opposition to restoring a tick test. However, the Commission must first decide fundamentally whether its objective is to end abusive naked short selling or whether its objective is merely to create a "speed bump" to those whose objective is to manipulate a stock down. If the Agency's goal is a true end of abusive naked short selling, it must decide how to do that. If the Agency's goal is merely to create a "speed bump," a rule with a simple uptick (any fraction of a penny) requirement will be easily circumvented and invite both buying and selling to produce the result. In a modern electronic market a tick test similar to the prior rule will do little to mitigate the threat of manipulative bear raids. Sophisticated algorithmic trading can easily subvert a tick test for short sales. Further, price tests are inefficient and ineffective prophylaxis.
If a variation of the tick test is ultimately adopted, it will not by itself rid the markets of the tremendous harm and abuses of naked short selling. Given the structure of our trading and settlement institutions, as discussed below, the only way to end abusive and illegal naked short selling is to require both a pre-borrow and hard delivery for short sales, as well as other amendments.
IV. Recent Amendments to Regulation SHO were positive improvements, but new amendments are needed.
The Commission should be commended for its recent efforts to eliminate naked short selling. The temporary hard-delivery requirement (204T, which sunsets on July 31, 2009), the naked short selling antifraud rule (Rule 10b-21), and the temporary disclosure requirement (10a-3T, which sunsets on August 1, 2009) each reflect a significant improvement to the regulatory regime. The Commission should adopt these temporary rules as final rules and not allow them to sunset.
However, several additional, permanent amendments to Regulation SHO would allow the Commission to achieve its goal of eliminating naked short selling in the U.S. capital markets. The Commission needs to
(1) institute a pre-borrow requirement (2) extend Regulation SHO coverage to all trading activity, including that which occurs outside of the CNS (3) publicly disclose a new and valuable piece of information under the existing Order Audit Trail System that will identify as long or short all trades and (4) Disclose the failures-to-deliver (FTDs) information on a per-stock basis more frequently than once a quarter.
A. A pre-borrow requirement in Regulation SHO is necessary to stop naked short selling.
In spite of the Commission's efforts to improve Regulation SHO by adopting 204T, 10a-3T, and 10b-21, naked short selling continues to occur at an unacceptable rate. Until Regulation SHO includes a pre-borrow requirement (one that the Commission included in its interim July 2008 Emergency Order protecting 17 investment banks, Fannie Mae, and Freddie Mac), naked short selling will continue. Only by Ms. Elizabeth M. Murphy Page 4 March 25, 2009 requiring traders to pre-borrow the shares that they wish to sell short will there be assurance that the shares will be available for delivery at the end of the settlement period.
B. A pre-borrow rule will help balance the scales between long and short trading.
Current rules give traders who short stock a huge advantage over long investors. For three days, as provided by the T+3 settlement period (which is in practice T+4),9 a trader is able to short, without additional margin requirements, as large an amount of shares as he can plausibly claim to have located or have a reasonable belief that he will be able to locate for subsequent delivery to the buyer. This essentially allows traders to make a relatively free bet that the shorted shares will go down in price for the period to deliver -T+3+1. Buying long, on the other hand, requires having capital on deposit for margin requirements. Consequently, the short sale rules in effect act as a government subsidy for short trading by providing relatively costless leverage.
The cost associated with removing this favorable government subsidy is not unfair, when one considers that prior versions of Regulation SHO contemplated a pre-borrow requirement that would force traders to absorb the necessary costs to reserve shares for delivery. In addition to there being no justification for a subsidy for short sales, the Commission should not give weight to the argument regarding the costs imposed by 204T and a pre-borrow requirement so long as the distortions arise in part from arbitrary prime brokerage policies. Furthermore, new rule regimes often lead to new technologies and new entrants in the marketplace. While some traders may find a pre-borrow requirement inconvenient in the short-run, it is very likely that prime brokerage will evolve to accommodate a new rule regime of this type.
To be sure, the Commission's temporary 204T rule does require the executing broker to ensure that shares are available for borrowing prior to executing the short sales. By itself, however, the "hard delivery" requirement is insufficient for either (1) preventing fails from occurring (witness the continuing existence of the approximate 30 public companies on the Threshold List) or (2) mitigating the large leverage available for the T + 3 +1 days to delivery. So long as traders operate without a pre-borrow requirement, the Commission will leave open the possibility of large failures-to-deliver, causing huge downward leverage on share price, sometimes before a targeted company ever appears on the Regulation SHO Threshold List.
The SEC staff also appears concerned that a pre-borrow requirement and a tighter Regulation SHO will allegedly reduce market liquidity. This concern lacks foundation. Changes in liquidity around the time of recent events, such as the SEC's Emergency Order, are just as likely caused by other factors such as regulatory uncertainty and the possibility of lenders halting their stock loans. Above all, when discussing liquidity, the more fundamental question is that posed by former SEC Chairman William Donaldson, "Concern about protecting liquidity... must be balanced against a simple question, 'How much fraud are you willing to tolerate for liquidity?' I think the answer is zero.
C. "Reasonable belief" is not an effective standard for enforcement.
Regulation SHO currently allows a short seller to execute a short sale if he has a "reasonable belief' that he will be able to locate the stock in the future. This "reasonable belief' standard allows gamesmanship and, in an enforcement action, it is very difficult to show the trader's required scienter (mental state) necessary for proving a violation of Regulation SHO. A recent SEC Inspector General Report demonstrates clearly that the Enforcement Division's attitude toward naked short selling has been to completely ignore complaints of such activity. 12 The report's findings are not surprising considering the difficulty under the current rules to show the requisite scienter. Requiring traders to pre-borrow shares, or to have a legally enforceable right to deliver the shares to be shorted prior to executing the short sale, will (1) Stop naked short selling, and (2) make enforcement easier, and thus more effective, as there will be a clear and track able rule.
D. Contrary to industry claims, prime brokerages can adopt a pre-borrow requirement with minimal costs given a shift in their internal policies and systems.
SIMFA and MFA claim that 204T unnecessarily produces additional failures-to-deliver due to the contractual agreements that prime brokerages currently have in place. However, there is currently no mandate that the industry maintain the antiquated time allowances stipulated in the Recall requirements (T+3) and Stock Lending Agreements (T+2). Further, current information technology expertise can adapt to serve the purposes of a pre-borrow requirement. While some traders may find this shift inconvenient in the short-run, the industry may not legitimately claim that such policies are rigid and fixed. There can be no serious doubts that prime brokerage can evolve to accommodate this new rule regime and already has in place such systems to accommodate careful traders.
Some individuals claim that a pre-borrow requirement introduces costly impediments to automated trading. Despite these assertions, there are currently systems available in the market that allow enforceable pre-borrowing arrangements to operate concurrently with automated trading without interruption and without resorting to manual trading. Further, other jurisdictions, such as Hong Kong and Australia and many in Europe, have successfully maintained pre-borrow requirements for years.
E. The Commission should examine the existence of naked short sales that are occurring outside the Continuous Net Settlement (CNS) System.
Both Regulation SHO and our capital markets participants rely on the presence of an effective disclosure regime. The Commission has already taken steps to improve disclosure through weekly Form SH filings by large institutional investors. However, new disclosure requirements should be applied to failures-to-deliver that occur throughout the U.S. capital markets. There is evidence that clearing of short trades is occurring outside the CNS through transactions designated as "ex-clearing." This unaccounted activity may be occurring in large volumes, which, if true, defeats the objectives of Regulation SHO. The Commission should investigate this practice, and all short sales, including those outside CNS, should be included in the Regulation SHO rule regime. The language of the amended rule should be broad enough to encompass ex-clear activity.
F. The Commission should require the marking of all executed trades as long or short, such as that required under FINRA's the Order Audit Trail System.
To improve market transparency and promote fairness, the Commission should also strive to make disclosure timely by also reporting the designation of the order as a short sale, as done for NASDAQ stocks under OATS. Reporting can be modified to include short / long ticket marking information. Moreover, this reporting change would require little systemic modification and could be accommodated within the existing OATS parameters. This would benefit both retail investors and regulators. With the disclosure of long/short information, the amount of short trades in particular, stocks could be correlated to other data, such as failures-to-deliver. This information would be useful, promote transparency, and ameliorate the current retail investor concern with market manipulation. Further, this information would not reveal the source of the trades or positions. This disclosure improvement would ultimately encourage more participation in the markets by strengthening investor knowledge and confidence.
G. The Commission should enable transparency by requiring more timely disclosure of the volume of all failures-to-deliver.
Currently, the volume of failures-to-deliver on a per-stock basis is disclosed quarterly. While there are legitimate concerns about protecting proprietary trading strategies, the Commission can certainly disclose this failures-to-deliver data to the public on a more timely basis (e.g., monthly), with no proprietary harm from the reporting. There is no reason why short interest should be reported bimonthly while failures-to deliver are reported quarterly.
In closing, it seems apropos to once again recall Chairman Donaldson's earlier cited quote above, "... 'How much fraud are you willing to tolerate for liquidity?' I think the answer is zero." Rephrasing this quotation and placing it in today's context of naked short selling, Chairman Donaldson might ask, "How much fraud will the SEC tolerate through a loose Regulation SHO that facilitates significant theft of shareholder and taxpayer value and impedes national TARP objectives?" Given the recent forceful statements by new SEC Chairman Shapiro, we believe that the SEC will conclude, as did Chairman Donaldson, that the answer is emphatically "zero" As discussed herein, the SEC should adopt the simple amendments to Regulation SHO presented in this letter and permanently eliminate naked short selling.
Thank you for your consideration.