Subject: File No. S7-27-09
From: Tom Garcia, Ph.D.
Affiliation: Professor (retired), University of Chicago, Booth Business School

December 11, 2009


The stock you think you are buying in the stock market may not be that stock, but an inferior imitation. The inferior imitation is phantom stock, and it occurs in short selling. We propose procedures to close a perilous loophole for this fraud that the SEC rules permit.

Phantom Stock and Fraud in the Stock Market
C. B. Garcia,
Professor (retired), University of Chicago, Booth Business School and W. I. Zangwill, Professor, University of Chicago, Booth Business School

For certain trades in the stock market, the public should know the product and seller and/or buyer in a trade. The problem is fraud because the stock you think you are buying may not be that stock, but an inferior imitation. Particularly for short selling, the enhanced transparency we propose should close a perilous loophole for this fraud that the SEC rules permit.
The underlying problem of fraudulent inferior imitation exists in all markets. You would not buy corn flakes if you did not know the manufacturer, because the product inside might harm you. Nor in an auction market for a valuable painting would you bid if the seller is not identified out of fear it is a fake. Similarly, if the bidder hides behind a curtain, you might be concerned she is the owner and bidding the price up.
Short Selling.
In the stock market, the inferior imitation is phantom stock, and it occurs in short selling. In short selling, a trader borrows shares, typically of a struggling stock weakened by poor financial conditions, and then later sells those shares. The borrower expects to reap profits by repurchasing, or covering, the stock later after its price has dropped.
The same shares can be borrowed multiple times, creating a huge quantity of phantom stock. A lends his common shares to B, who sells them to C, who lends them to D, etc., with each sale creating new phantom shares that are being sold to investors unaware these are not genuine common stock but imitations. On the one hand, pro-shorts may argue that the phantom shares created increase liquidity. On the other hand, anti-shorts may assert that short sellers ought to be banished to the derivatives market because phantom shares can inundate the market, artificially diluting, for a few hours or days, an already weak stock. When the short seller covers his position, the phantom shares vanish. Common shareholders suffer unrealized losses, and phantom shareholders also lose money to him. (If the SEC were to release data, researchers can resolve this issue by investigating whether or not there is a negative correlation between the number of phantom shares and the stock price.)
The SEC Act of 1933 was created to protect investors by providing full disclosure of information necessary for informed investment decisions. Then, as we propose, why are buyers not informed whether they are buying common or phantom shares of stock? Contrast this simple, value-free rule to the complicated and controversial uptick/price test/circuit breaker rules by the SEC.
Naked Short Selling.
The SEC imposes margin and borrowing rules to slow down a short seller. But a short seller can create unlimited phantom shares much faster through naked short selling, which is the act of selling without owning or borrowing shares. Illegal naked short selling is widespread, costly to detect and poorly enforced. It is often employed for market manipulation. In the recent congressional hearings on the failures of Lehman Brothers and AIG, claim is made that naked short selling had cost investors $100 billion and drove 1,000 companies, including Bear Stearns, Lehman and AIG, into the ground.
Naked short sellers have three trading days to borrow the shares backing the shorts. Otherwise, Regulation SHO of 2005 mandates close-out of the fail-to-deliver positions. Under the (Bernard) Madoff exemption, Regulation SHO exempts bona fide market making. This allows the trader to buy phantom shares, with their replacement guaranteed in a few days, and simultaneously, put options from a collaborating market maker. The illiquid puts are there only to make the buying of the phantom shares legal. Selling without shorting the highly liquid phantom shares is where the trader makes money.
A flagrant example occurred on Tuesday, March 11, 2008, when someone bought roughly 10 million of very cheap put options on Bear Stearns for $1.7 million. This crazy bet would make money only if the banks shares were to lose more than half their value within 9 days.
It required only three trading days for the stock to plummet from $60 to $2, one-fifth of the $10 buyout price announced by J P Morgan that following Monday. That someone made 159 times his money, $270 million without even tripping Regulation SHO. The question of alleged fraud and manipulation has been raised.
In reaction to the recent financial collapse, the SEC promulgated Rule 240 in July, 2009 which, among other things, eliminates the Madoff exemption, forces the close-out of naked short sales within three trading days of the trade and requires publication of information on short sales on a daily basis.
However, enforcing this new rule is complex, cumbersome, and will require considerable resources from the SEC. Besides, three trading days is an eternity today when milliseconds matter, and a single (furtive) rollover of a short position is all it may require to crush a stock. Rule 240 keeps open this sizable loophole for fraud.
A Value-Free Rule.
We propose a simpler and more effective rule to open the trades to the scrutiny of everyone, virtually stopping the fraud: flag a trade when it is a sell short, a naked short sale or a cover and identify if the short seller is a market maker, specialist, insider, institution, accredited investor, etc.
This rule we propose will allow the public to determine, in real time, the number of phantom shares outstanding. This would signal excess demand for shares or an excess supply of phantom shares in the stock. Traders can instantaneously track major players as they short or cover a stock. The information levels the playing field and helps traders in their buy/sell decisions.
New information will become available in a variety of ways. For example, if a stream of short sales by strong players crosses the tape, traders may decide to avoid the stock, and the ensuing lower price may encourage short sellers to think twice. If the tape is indicating no short selling, or better yet, a stream of covering, traders may discern a buy signal for the stock. Similarly, if market makers are short prior to market close, that information would be bullish because most market makers want to be neutral by market close. If there are significant naked short sales, traders may reconsider their decisions for the next three trading days.
Short sellers may object to our proposal on grounds of privacy and tipping their hand. These objections cannot be justified. The prevention of market manipulation trumps their privacy concerns, because, after all, they are selling phantom shares - inferior imitations - intending to push the stock price down. Besides, they will retain privacy based on the classification that we propose. Many of them want their privileged data to remain exclusive, thwarting the SECs mandate to inform the public. Their self-serving arguments enable a pathway to questionable activities and fraud.
Fraud in all its forms has to be stopped, since public trust in the market is paramount. The SECs enforcement task is too complex to stop the fraud possible with short selling. But with the eyes of the entire public watching, as our proposal suggests, honesty will be upheld, and the market will retain its openness, integrity and trust.