August 25, 2007
Ms. Nancy M. Morris, Secretary
Securities and Exchange Commission
100 F. Street, NE
Washington, DC 20549-1090
Re: Comments on Proposed Amendments to Regulation SHO
File No S7-19-07
Dear Secretary Morris:
I write to provide comments on the Commission's proposed amendments to Regulation SHO. In previous remarks, I have stated my opinion that the SEC must move to a regulatory position as promptly as possible that allows no transaction whatsoever in registered securities without actual delivery of shares by the seller within ten days (T+10). Failing this timely delivery, the broker of the seller should be required to buy-in the shares on behalf of the seller and deliver them to the buyer. Any regulatory position that falls short of actual delivery of shares purchased by the buyer effectively countenances fraud upon the market, since no retail buyer of shares presently is informed of failures of shares to be delivered in exchange for buyers' funds delivered as the purchase price. At the same time, management of the issuer is defrauded in such a transaction, because the seller is acquiring funds for sale of corporate shares when that seller owns no such shares and has no standing to sell them (other than the implicit standing presently given by the ill-advised provisions of Reg. SHO), and the issuer's shares are being diluted illicitly.
In this context, I strongly support the proposed amendment of Reg SHO to eliminate the clause that permits options market makers to sell shares that are neither owned nor delivered to the buyer. This provision has been unjustifiable from the outset, as it enables options market makers and their clients to create artificial dilution of the underlying shares, thus driving share price downward and achieving the investment objective of options investors buying puts, which profit when share price declines. What is much worse, this regulatory privilege to options market makers is being severely abused daily, as informed observers can detect in the trading of shares targeted by short sellers. Short sellers buy "put" contracts, knowing the options market maker will promptly use this Reg SHO exemption to sell shares short without delivery. The put contract buyer negotiates a share price to buy these dilutive, non-existent shares from the options market maker. The put contract buyer is then putatively "long" the undelivered shares bought from the options market maker and sells them into the market to drive down the share price, thus driving the put contract into profitability. This is blatantly illegal manipulation of the share prices through dilution of share float and ought to be detected by the SEC's enforcement staff and severely punished. Yet, no enforcement actions have been taken by the agency. The options market maker exemption under Reg SHO ought to be eliminated as proposed at the earliest possible date.
In encouraging prompt and resolute action by the agency to eliminate every vestige of failure-to-deliver that is corrupting U. S. financial markets, I remind you of the SEC staff memorandum attached as an exhibit to the recently released minority report of the Senate Finance Committee and the Senate Judiciary Committee. In 2005, an SEC staff agent cataloged so-called "sell-to-buy" transactions between separate accounts of a major hedge fund. The hedge fund's trading desk repeatedly created fake, counterfeit, highly dilutive shares of a particular issuer by selling short from one account to another account, so that the second account would thus be "long" the same shares. Then the second account sold the shares into the market, driving down the share price. This tactic was repeated until the confidence of investors relying on fundamental or technical analysis was broken. The hedge fund then covered its short position, reaping millions of dollars in profits. This occurred in 2004 and was documented by SEC staff in 2005, yet no enforcement action has been forthcoming. Almost certainly, although the fact is not documented in the staff memorandum, the shares sold short by the hedge fund to itself were neither borrowed nor delivered. So the failure-to-deliver manipulation described above relating to options market makers is also prevalent in U. S. markets even without the assistance of options market makers. The SEC should take more effective enforcement actions to eliminate such corrupt practices, especially when perpetrated by the largest financial institutions. Their use of such tactics against other market participants should not be tolerated to any degree.
Despite the Commission's recent action to strengthen Regulation SHO through the elimination of Regulation SHO's grandfather clause and Chairman Cox's public statements about the abuses of naked short selling and the need to end this manipulative practice, these abuses continue daily.
As I have argued above, elimination of the options market maker exception and the grandfather provision will significantly strengthen Regulation SHO, but these changes alone will not eliminate naked short selling and failures-to-deliver, as should be the case. The Commission should (1) impose in Regulation SHO a requirement of a firm borrowing of shares before a short sale can be executed, and (2) allow NO additional time for delivery of shares in a short sale or in a long sale, with mandatory buy-in no later than T+10 without exception. The Commission should issue and complete promptly a notice of proposed rulemaking to implement these critical components of effective reform.