August 15, 2006
August 15, 2006
I am relieved to hear that the SEC is examining changes to Reg. SHO. Many market participants have been perplexed by the lack of urgency displayed by those governing bodies charged with protecting the investing public. It is obvious to many what has been taking place with these persistent fails and is damaging to ones faith in US capital markets.
To make Reg. SHO effective, it needs to be simplified. If a loophole remains, it will be exploited. The following changes are recommended:
1. Eliminate the Grandfather Clause. Grandfathering violations of a decades-old rule is abhorrent. It protects the violators and punishes parties seeking delivery of their securities. The fails in the securities grandfathered have not been reduced and several of the grandfathered stocks have been on the Threshold list more often than not since the lists inception.
The SEC says it wants to protect short-sellers from squeezes but does nothing to protect longs from bear raids. Allowing delivery failures creates an opportunity for an unlimited number of shares to be sold, depressing share prices and hence total US market capitalization.
2. Limit the market-maker exemption. There is no need for a market maker to short 20% of a companys float to keep an orderly market on a stock or a stocks derivatives. This loophole may lead to much of the abuse we witness.
3. Allow short selling only when a borrow is arranged. A locate is insufficient as it allows the same shares to be pledged to multiple sellers.
4. There must be a material financial penalty built in to discourage delivery failures. This can easily be done.
5. There must be an effective buy-in system to rectify fails. The TSX (Toronto Stock Exchange) has a very effective buy-in tender system. If stock is not delivered upon settlement (T + 3), the buyer notifies the exchange. The seller is given two business days to produce the shares, since there are at times legitimate reasons for late delivery. If the shares are still not delivered on T + 5, the TSX invites shareholders with cash stock (i.e. available for same-day settlement) to tender their stock at a material, pre-determined premium to the current market price. The mechanism works very well and the TSX does not exhibit the same persistent fails as US markets.
If the SEC cannot enforce something as simple as stock settlement, it risks permanent damage to the reputation and efficacy of its capital markets. The problem is getting worse and the time to act is now.