From: Jon [jkniss@hotmail.com]
Sent: Monday, January 05, 2004 4:50 PM
To: rule-comments@sec.gov
Subject: S7-23-03:

Comments on Proposed Regulation SHO
Proposed Rule 203: Naked Short Selling

 

I am writing in response to the Commission's request for comments on "what 
benefits accrue from naked short selling?"  My comments will be confined to 
the OCTBB and Pink Sheets markets where I believe naked short selling plays 
an important role in maintaining market integrity and why the case against 
naked short selling as presented in the Proposed Rule is overstated. 

 

1.  The negative effects of naked short selling are overstated. 

In the Proposed Rule, the Commission points to toxic convertible or "death 
spiral" financing as an example of market manipulation via naked shorting.  
However, it fails to acknowledge that this is completely preventable and 
entirely within the control of the issuing companies.  No company is forced 
into such financing; if it is unable to attract risk capital, perhaps it 
should be liquidated or forced to seek other strategic alternatives.  The 
very nature of these deals ensures that toxic investors will sell-short or 
otherwise-to lock in gains.  Because they are hedged, they can sell 
aggressively without regard for price and in fact benefit from the effect 
their selling has on the stock price.

 

In contrast, an unhedged short seller (one who sells short a stock perceived 
to be overvalued on the expectation that it will decline) runs the real risk 
of loss if the price of the stock goes up.  While in theory it might seem 
possible for such an unhedged short seller to continue to short so as to 
prevent a stock from rising, this would be extremely risky; the short seller 
would be multiplying his risk and leverage.  In the Proposed Rule, it is 
claimed that naked shorts are analogous to an undated futures contract because 
they have reduced margin requirements and no future requirement to deliver.  
This is not the case for the unhedged naked short seller.  He is subject to 
the same margin requirements as with an affirmative borrow.  Further, while 
failures to deliver do exist and can persist for significant periods of time, 
buy-ins do occur, often at prices unattractive to the naked short seller.  
For a naked short in Canada, the buy-in may occur at up to a 20% premium to 
the daily high.  For a thinly traded issue with a large bid-ask spread, the 
short seller may find it impossible to replace his short position at a high 
enough price.  When given the choice between selling short using borrowed 
shares or selling naked, no short seller would choose the latter because of 
the increased buy-in risk.  Therefore, contrary to statements made in the 
Proposed Rule, naked shorting is an inferior substitute to conventional short 
selling and a strategy only to be employed when a borrow can not be obtained.

 

In short, the Proposed Rule is flawed in that it fails to distinguish between 
the naked shorting activities of toxic convertible investors and bona fide 
risk-taking short sellers.  No proof is offered of any manipulative activity 
with respect to the latter group, and there is no acknowledgement of the fact 
that naked shorting by the former group is facilitated and tacitly approved 
by the company being shorted.  Further, an argument can be made that the 
proposed elimination of naked short selling will not change the ultimate 
outcome.  Without naked short sales to lock in gains, private placement 
investors will simply seek larger discounts and other terms to achieve the same 
objective:  a return untied to investment risk of the borrowing company.  I 
suspect equity lines, where stock is issued in a series of drawn downs, will 
become even more prevalent as they give private placement investors the 
opportunity to sell shares before making additional loans.  

 

2.  Without naked shorting, the OTC BB and Pink Sheets will become one-sided 
markets.

The overwhelming consensus on short selling is that it is an overall positive 
influence on markets, a view that is reinforced by the Commission in the 
Proposed Rule.  The Commission seems to be taking the position that what is 
good for one market-the NYSE, for example-should be good for all others.  
However, a confluence of inter-related factors has combined to make the OTC 
BB and Pink Sheet markets a virtual breeding ground for stock promotion and 
fraud while at the same time severely restricting the ability of short sellers 
to sell short through the borrowing of stock.  Some of these factors include:  

 

-          very low (or in the case of the Pink Sheets, non-existent) listing 
requirements and virtually no scrutiny from regulating bodies;

-          reverse mergers, which allow companies to flout the intent of SEC 
procedures for entering  public markets;

-          very low public floats;

-          paid stock promotion;

-          fraud, in the form of false or misleading press releases and 
undisclosed insider trading;

-          excessive control of market pricing by market makers (they are 
not required to display customers limit orders and are not obligated to 
fill orders even if they match the bid or ask the market maker is displaying); 
and

-          the manipulation of stock borrowing by the rotation of stock 
from account to account.

 

Judging from the number of enforcement actions, the Commission should be well aware 
of these issues by now.   However, the Commissions efforts in this area are not 
nearly enough to balance out the negative market forces at work in these markets.  
The Commission simply does not have the resources to investigate every possible 
case, and not all stock promotions cross over the line to become outright fraud.  
This is where short sellers come in.  Here are some of the ways short sellers act 
to curb excesses, particularly in the OTC BB and Pink Sheet markets:

 

-          They supply both the Commission and investigative journalists 
with information about illegal or suspect activities.

-          They help to inform the public via websites such as 
Stocklemon.com and Ourstreet.com. 

-          They warn individual investors on internet bulletin 
boards and chat rooms.  

-          They provide liquidity to what are often very illiquid, 
one-sided markets (i.e., they are often the only sellers when a stock 
is being run up and vice versa),

 

In summation, naked short selling may not be an ideal solution to the problem of 
stock fraud and promotion on the OTC BB and Pink Sheets but that does not mean that 
these markets would be better off without it.  The Commission's case for eliminating 
this activity would be greatly strengthened if it were combined with a comprehensive 
effort to reform these markets.  Failing this, the Proposed Rule will only further 
strengthen the hand of ill-intentioned companies and stock promoters in their schemes 
to fleece the gullible investment public.  The Commission should always bear in mind 
the target of these stock promotions is not institutional investors or even 
sophisticated individuals; it is the small investor with limited investment expertise.  
All it takes is a couple clicks and $500 in an Ameritrade account.  

 

Access to the investing public is a privilege.  Companies that desire to trade in 
this system should be held to a much higher standard. 

 
J Kniss