February 25, 2007
Nancy M. Morris, Secretary
Securities and Exchange Commission
100 F Street, NE
Washington, DC 20549-0609
Dear Secretary Morris,
I hereby submit the following article from FinancialWire/Investrend that I find germane to the issues we are attempting to resolve with respect to problems with the present effectiveness of Regulation SHO.
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The Securities Industries Association, exercising extraordinary private access to U.S. Securities and Exchange Commission staff during the development of the controversial Regulation SHO, appears to have quietly torpedoed a rule that would have made settlement of fails-to-deliver contractual and mandatory, FinancialWire has exclusively learned from various sources close to and involved in the process.
The SIA is a membership organization of some 800 securities firms, Its membership, at http://www.sia.com/member_directory/index.html, include such industry heavyweights as Bank of America Corp. (NYSE: BAC), Bear Stearns Cos. (NYSE: BSC), Citigroup Inc. (NYSE: C), Merrill Lynch (NYSE: MER), many of whom have been charged in civil suits and even regulatory actions for not only fails-to-deliver but also by entities such as The Electronic Trading Group, LLC, for charging unearned fees, commissions and interest on short sales when the broker-dealers failed to borrow or deliver the stock to back a short position.
Others defendants in that suit, which the plaintiffs hope to convert to a class action, include Credit Suisse Group ((NYSE: CSR), Deutsche Bank ((NYSE: DB), Goldman Sachs Group Inc. (NYSE: GS), Lehman Brothers Inc. (NYSE: LEH), Morgan Stanley (NYSE: MS), Bank of New York ((NYSE: BK), and UBS AG (NYSE: UBS).
"Defendants collusively condone and engage in these practices to their individual and collective enrichment, routinely alternating among themselves in the roles of prime broker who fails to deliver and third-party broker-dealer who permits the (failure to deliver) to persist," according to the filings.
The SIA is said to have privately, and out of the publics eye, vehemently and successfully opposed language that would have created a contractual obligation on the part of its brokerage members. The language was one of the preferred alternatives in the original SEC staff draft, and which, if adopted as proposed, would have drastically altered how Regulation SHO has operated for the past one-and one-half years.
Rule 203, as adopted:
We are adopting proposed Rule 203, with some modifications, after considering the comments received. As adopted, Rule 203(b) creates a uniform Commission rule requiring a broker-dealer, prior to effecting a short sale in any equity security, to "locate" securities available for borrowing. For covered securities, Rule 203 supplants current overlapping SRO rules. Specifically, the rule prohibits a broker-dealer from accepting a short sale order in any equity security from another person, or effecting a short sale order for the broker-dealer's own account unless the broker-dealer has (1) borrowed the security, or entered into an arrangement to borrow the security, or (2) has reasonable grounds to believe that the security can be borrowed so that it can be delivered on the date delivery is due. The locate must be made and documented prior to effecting a short sale, regardless of whether the seller's short position may be closed out by purchasing securities the same day.
The key here is that (1) requires an actual borrow, but 2 does not. Staff had wanted to eliminate (2) but the SIA, privately and out of the public eye, strenuously opposed that, knowing, perhaps, uniquely, that the word locate does not actually require a borrow and delivery, and its position prevailed inside the SECs process.
Some of the staff were said to have been surprised that no issuer had opposed the inclusion of provision (2), but no one should have been caught unawares, since only the SEC staff and the SIA understood the implications that the final result removed all the teeth from Regulation SHO, something that has continued to confuse and mystify many industry observers, and also only the two understood the meaning of the word locate.
One source told FinancialWire that the locate requirement is interpreted to mean that all you need to do is find the stock as opposed to finding it and contracting to borrow it. Finding is satisfied by seeing it on the easy to borrow list and under some circumstances having the customer tell you he found it. But you can also preborrow or reserve the stock which is done for various purposes. In discussions leading up to Reg SHO the possibility of a conractual requirement was discussed but the SIA vehemently opposed it on the grounds it would result in unnecessary borrowing costs.
Another close to the process pointed out that the word locate was first floated in a 1973 release and I believe it comes from rule 15c3-3 where arguably it had the meaning of found and borrowed. Reg SHO however only requires you to find it and if its not there 3 days later, you have still satisfied the requirement even though you never borrowed it but you located it.
In its public comment letter, dated January 30, 2004, the SIA had noted that in developing "Easy to Borrow" lists, broker-dealer stock loan desks use information from a number of sources, including institutional lenders that have sophisticated systems for estimating borrow supply. Broker-dealer stock loan desks also consider the availability of inventory at their own firms and potential availability from other broker-dealers that act as conduit lenders.
While a staffer admits that the contractual proposal championed did not prevail in the final adopting rule, he does not criticize the SIA. The SIA has enormous access but they also provide significant industry knowledge of the inner workings of the market, he states.
Even U.S. Senators have been mystified that Regulation SHO, which sheds light on the enormity of the fails-to-deliver for companies on the list, some of which have been there almost since the rule was adopted, and at least one SEC Commissioner, William Donaldson, testifying before the Senate, have been unable to explain why Regulation SHO isnt working to reduce or elmininate fails to deliver.
Theyve been asking the wrong people. The SIA understands it completely.
It is not known if the rule can be modified to eliminate provision (2), but that would apparently resolve the major issues associated with the ineffectiveness of Regulation SHO as it exists today.