March 28, 2007
I strongly support the following commentary by Bob O'Brien from his TheSanitycheck web site, and want it entered into the SEC public record for interested historians to access.
A Summary Of My Email Comment To The SEC On Reg SHO
Location: Bob O'Brien's Sanity Check Blog
Posted by: bobo 3/27/2007 8:12 PM
I submitted a freehand comment email to the SEC that appeared earlier today at the SEC website. I have been asked by a few folks to synthesize my points and observations so as to make them as linear as possible - the email was written quickly, in anger, as I went through the litany of abuses investors have been subjected to by this crew of bureaucratic thugs. It is stream of consciousness rather than a proper list of grievances and comments, so I've attempted to group the comments and observations so they are more easily digested.
1) The SEC currently allows an exemption for options market makers to naked short sell in order to hedge options activity. There is no reason for this other than to allow options market makers - for-profit speculators that "make a market" in the options trade (traffic in and create options contracts) - to enjoy cost-free ability to hedge their trades. This directly harms equity securities investors in the stock market, and forces them to bear the cost of this "liquidity" for market makers in a completely different market - the derivatives market.
The exemption is in conflict with the SEC's mandate in Section 36 of the 1934 Act, which allows the SEC to create exceptions to the 1934 Act, "...to the extent that such exemption is necessary or appropriate in the public interest, and is consistent with the protection of investors..." (emphasis added). By investors, the 1934 Act means you and I - equity investors in the stock market. Not billion dollar banks creating whole separate markets in derivatives.
The SEC is precluded from creating exemptions that are not consistent with the protection of investors, and allowing options market makers to naked short sell is counter to the public interest and harms equity investors, thus plainly conflicts with the 1934 Act. The 1934 Act is not an elective or a suggestion. It is the language and law that created the SEC. The SEC is bound to abide by it, and has clearly decided to disregard its mandate to protect investors in favor of granting sweetheart exemptions and loopholes to special interests, in this case in a whole different market - it allows these options market participants to profit at the expense of stock market investors, something it doesn't have the authority to do.
2) Ditto for the market maker exemption wherein market makers are allowed to naked short sell in order to engage in "bona-fide market making." This notion, that these market makers require the ability to create fictional stock, in order to somehow "stabilize" or "make" the market, is in direct conflict with the types of persistent failures to deliver in the equities markets that last weeks, or months, or years. And yet that is precisely what we have - many billions of dollars of failures to deliver, ostensibly created at least in part by bona-fide market makers, who howl with rage in their comment letters to the SEC at the thought their windfall should end any time soon.
I maintain that any sane test of this "bona-fide" status would show a complete breakdown in the concept, when there are groups who are naked short many millions of shares in victim stocks, and whose failures persist in perpetuity. That isn't bona-fide anything. It is larceny and stock manipulation. The exemption for market makers, and its failure to require a mandatory buy-in after a reasonable latency (say, 3 days), harms investors who have made good-faith purchases of stocks in the belief that participants can't just fire up printing presses and create as much unauthorized stock as they like.
Many foreign markets function quite nicely without exemptions allowing market makers to fail delivery, effectively refuting any claims that these exemptions are a requirement for liquidity or efficiency. They aren't. That's a lie, and an excuse, advanced by those directly benefiting from the inequity the exemptions create. Expect to read many more thinly veiled threats of breakdowns of the free-world's markets (or at least the NY market) if their meal ticket is reined in - authored by those so fattened at the trough of unfair exemptions they are incapable of acknowledging global reality.
3) The 1933 Act defines clearly terms like "security", "issuer", and "registered" securities.
For a "security", Section 2 of the 1933 Act, item a, under "Definitions" - number 1:
"1. The term "security" means any note, stock, treasury stock, security future, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a "security", or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing."
Now, does a security entitlement, essentially a claim on a share of stock awaiting prompt delivery (but for which prompt delivery has come and gone), sound like one of these things? It sure does to me. Some will argue that it really is more of a derivative instrument - a promise of future delivery at some unspecified point in time. I could see that perspective if there was a separate market for SEs, where it was understood that they weren't equity security claims with a one-for-one equity security ostensibly backing them - but there is no such beast. No, security entitlements are represented to investors as "the same" as the underlying stock - you can sell them at any time, exactly as with stock, and presumably have all the rights of stock - even if somewhere in the 40-page brokerage agreement you never read it says something about claims against shares rather than shares. What is left out is that UCC8 requires prompt delivery, and thereafter the maintenance of a one-for-one ratio of like financial instruments (the stock) for each security entitlement. A security entitlement absent that critical caveat, the delivery and maintenance of the underlying asset, is something other than a security entitlement. What it is is debatable, but what it isn't is a security entitlement as defined by UCC8. Absent delivery, it becomes not that, but something different - a claim on an absent, and undelivered, share.
That claim on a share is a "security" as the 33 Act defines one, when it represents a claim whose delivery time has come and gone. But it isn't the "security" advertised for sale, and for which you paid your money. It is a new security, created by the broker, representing a best-efforts claim to get you your property at some undefined future point. Definitely a "security," but a different one. "Issued" by the broker, not the company. Which makes the broker the "issuer" per the same 1933 Act's Section 2. And it is a violation of federal law to issue and trade in unregistered securities, as the only one authorized to issue the registered securities in a company is the company. Which is what you paid for (genuine registered securities), but which you didn't get - instead you got this unregistered facsimile "issued" by the broker. Sure sounds like issuing unregistered securities to me.
Now, the SEC will likely take the position that the 1933 Act can be open to loose interpretation, and that with the wave of its unelected bureaucratic pen, it can exempt whatever it likes - including the definitions of securities, issuers, and registration requirements. That is for a court to decide. I think it is pretty clear that the 33 Act, which predates the SEC, has specific items in mind it wants to define and regulate. Securities and issuers are some of those things. The SEC can argue all it likes, but again, that is up to a court. I'm reading the language of the Act, and it seems straightforward to me.
4) The SEC is supposed to put out any rule or proposed modification to a rule for comment before enacting or modifying the rule. The infamous grandfather provision/addition to Reg SHO never got that scrutiny. Thus, it is in violation of the SEC's own accepted practices and procedures, as well as required conduct. Which raises serious questions as to whether it is even lawful. I maintain it isn't - the SEC cannot exempt acts that harm investors, grandfathering delivery failure harms investors (who paid money for stock that was never delivered to them and is thus sanctioned to never have to be delivered, effectively legalizing the refusal of property rights to those who paid for them), thus grandfathering is in conflict with Section 36 and the SEC's exemption abilities.
That nobody has brought this up is scary. When a regulator can ignore its own rules and create de facto law via proclamation and edict, versus any semblance of process, we have a big problem.
So in short (or only sort of long) the SEC isn't allowed to exempt activity that harms investors (which it has), isn't allowed to rewrite the 1933 Act to suit its masters on Wall Street's desired ends (which it has), and isn't allowed to give them all get out of jail free cards for deeds that have harmed investors (which it did).
And this comment period is nothing more than a sham to stall any action, and to get comments that represent Wall Street's agenda into the official record long after the window for doing so closed. It is disgraceful, offers no new illumination on the issues it claims to be concerned about, and is a shabby attempt to yet further delay any semblance of fairness returning to the market.