January 20, 2000
Hill, Thompson, Magid & Co., Inc.
15 Exchange Place
Jersey City, NJ 07302-3912
Jonathan G. Katz
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549-0609
RE: File No. S7-24-99
Dear Mr. Katz:
Hill, Thompson, Magid & Co., Inc. ("Hill Thompson")1 appreciates the opportunity to comment on the Concept Release proposed by the Securities and Exchange Commission ("Commission")2 regarding the regulation of short sales of securities. As market makers in over-the-counter (OTC) securities, Hill Thompson wishes to stress the important role that "short sellers" have traditionally played in the market by contributing to both market liquidity and pricing efficiency. These efforts mirror the Commission's overall goal of maintaining a national market system of securities that is both transparent and fair to investors.
Non-Exchange Listed Securities
The Concept Release seeks comment on whether the existing framework for regulating short sales (including NASD Rule 3350) is sufficiently expansive. The Commission asks whether short selling regulation also may be appropriate for securities traded in the over-the-counter markets, such as the Nasdaq SmallCap or even the Bulletin Board (OTCBB) markets. Hill Thompson is concerned that the Commission may be seeking a correlation between this issue and the notion of exempting actively traded securities from the short sale rules.
Volume should not be a determinate of the application of the short sale rules. Hill Thompson believes that expanding the framework for regulating short sales to the SmallCap or the OTCBB markets is unnecessary. The same market factors that have lead the Commission to consider abolishing or significantly decreasing the application of the short sale rules for exchange listed and Nasdaq National Market securities equally apply to the SmallCap and OTCBB markets.
Because Section 10(a) of the Securities Exchange Act of 1934 ("Exchange Act") does not provide the Commission with specific authority to regulate this market sector, any such regulation would have to be based on other statutory authority. Hill Thompson believes that the framers of the Exchange Act deliberately limited the Commission's authority to regulate this market sector in order to foster capital formation for the nation's small businesses. The Commission should not seek to expand statutory authority to apply regulations which are already rife with criticism.
Hill Thompson questions the relationship between the objectives of Rule 10(a)-1 of the Exchange Act and its operation. As noted in studies comparing the exchange listed market with the Nasdaq market pre-Rule 3350, the existence of the "tick test" rule on the exchanges does not significantly influence the association between stock prices and short selling.3 Short sellers provide market liquidity by shorting into up markets and reducing short positions in down markets. In fact, most short selling is done by market professionals such as Hill Thompson who provide liquidity to the market.4
Short selling is a legitimate market maker function. Hill Thompson maintains that short sellers provide valuable liquidity to the markets both in their selling activities and in subsequent covering purchases. Short sellers temper the price volatility of securities and preserve market integrity by identifying over-valued companies, whereas a short sale rule leads to pricing inefficiencies in the market. Since short selling abuses can be controlled with the anti-manipulation regulations already in place, Hill Thompson believes that additional short sale regulation is unnecessary. The "tick test" type of short sale regulation impedes trading decisions. If short selling suffers misinformation and a poor public image, the appropriate response should be the education of issuers and the public, not a new regulatory scheme.
The public perception of short sellers, as evidenced by the many comments the Commission has already received from public investors, is one of manipulators of the markets who work through false statements and unsubstantiated rumors about the issuers of securities or through other fraudulent practices. However, the perception that short sellers manipulate markets to make a profit on declining prices is without theoretical and empirical support.5 There has been only one Commission case of short sale manipulation within the last ten years as compared to the over one hundred upside manipulations.6 Those few bad apples who have created such a poor perception of short selling are most appropriately regulated through the existing anti-fraud and anti-manipulation provisions of the federal securities laws. The short sale rule has been shown to be a wholly ineffective means of controlling such manipulative behavior because it was not intended to be an anti-fraud mechanism. Rather, it was intended to be a tool for market stabilization.7 Yet even this role is now circumspect.8
Exemption For Nasdaq Market Makers
Despite comments to the contrary, if the Commission determines that it is necessary to apply the short sale rules to the SmallCap and OTCBB markets, Hill Thompson strongly urges the Commission to provide an exemption for market makers so that dealer activities that provide liquidity and continuity to these markets will continue uninterrupted. The current NASD short sale rule contains an exemption for qualified market makers. The application of a short sale rule to market makers would dramatically reduce their ability to quickly adjust inventory positions, thereby lessening liquidity throughout the marketplace. This situation would harm the individual retail investors. The SmallCap and OTCBB markets are based on the public retail investors' business. Institutional investors play a small part in these markets. Any reduction of market maker liquidity will have a disproportionate impact on retail individual investors. "To the extent that short sales are effected in the market by securities professionals, such short sale activities, in effect, add to the trading supply of stock available to purchasers and reduce the risk that the price paid by investors is artificially high because of a temporary contraction of supply."9
Any short sale rule must be formulated in a manner to avoid artificial restrictions on trading. Such a rule must operate in a manner designed to preserve market maker depth and liquidity in the competitive environment of the SmallCap and OTCBB markets. These markets provide an efficient and liquid trading environment through quote competition. The very nature of the competitive market maker system requires dealers to take substantial inventory positions.
Examples of Short Selling to Maintain an Orderly Market
The practice of short selling is critical to SmallCap and OTCBB market making because it facilitates transactions by permitting market makers to assume larger positions than would otherwise be possible. Hill Thompson routinely fills orders that are significantly above the minimum allowable tier size in these markets.10 This allows for enhanced liquidity, which is a benefit to individual investors, throughout the SmallCap and OTCBB markets. As a market maker, Hill Thompson must make strategic trading decisions in which selling short becomes an integral part of the strategy. Hill Thompson would like to relate several actual recent trading scenarios as examples of the legitimate use of short selling through which Hill Thompson's obligations of maintaining a fair and orderly market were accomplished:
1. The recent trading of Iridium World Communications Inc. (IRIDQ) is an example. On August 13, 1999, the company filed for Chapter 11 bankruptcy protection. On November 22, 1999 the stock was delisted from the Nasdaq National Market to the OTCBB and the price hit a low of 90 cents. Despite the bankruptcy, the investing public continued to place buy orders for the stock. Hill Thompson sold short to fill the orders. The stock price rose to a peak of about 6 ¼ by December 10, 1999. During this period Hill Thompson's short position reached a total of 79,000 shares. Again, the buying interest faded quickly as public investors switched to selling the stock. The price dropped to a range of about 2 ½ for the rest of December. Hill Thompson traders bought stock from these sellers and eventually covered the firm's short position.
2. The trading in the stock of Boston Chicken Inc. (BOSTQ) on the OTCBB during 1999 was very similar to Iridium. Boston Chicken is another bankrupt company, which was delisted from the Nasdaq National Market on December 10, 1998. Throughout 1999 almost all stock analysts valued the company as nearly worthless, yet the stock was being touted by public investors through the use of Internet chat rooms. Therefore, buyers continued to enter the market. BOSTQ began 1999 at a price of 30 cents per share and rose to 90 cents by late January 1999. The stock continued in the 60-70 cents range through July and then slowly dropped to a low of 10 cents by the end of December 1999. Hill Thompson continued to fill the steady flow of buyers during the first part of the year by selling short. At one point Hill Thompson was at risk for an extremely large short position. However, Hill Thompson did not try to cover its position by buying into the market for this would have added to what Hill Thompson believed was an already overvalued price. As the public investors began to sell, Hill Thompson slowly covered its short position. Hill Thompson believes that it maintained an orderly market in the face of unfair attempts by some public investors to raise the price of BOSTQ and saved some public customers from potentially greater losses than they may have already suffered.
In this way Hill Thompson performed its market maker function of maintaining a fair and orderly market during a volatile trading period. Each one of the above actual trading scenarios is an example of how a fair and orderly market was accomplished through the self regulatory mechanism of market competition and the prudent and effective means of short selling, all without the need for a short sale rule. Of course, these are not the only examples. Hill Thompson and the other market makers in the SmallCap and OTCBB markets experience this type of trading in some form everyday. It is an expected part of being a responsible market maker.
As a market maker, Hill Thompson reacts to the market sentiment as measured by the balance of buy and sell orders it receives. To maintain an orderly market, Hill Thompson stands ready to risk its capital to take the opposite side of an investor's trade despite what may be a huge imbalance. Hill Thompson, like most market makers, normally does not carry large long positions in inventory, and therefore must sell short to meet the sudden buying demands of market investors. In some instances this requires short selling vast amounts of stock.11 If, as a market maker, Hill Thompson were subject to a short sale rule, it could not continue to sell short on down bids to those customers who wanted to buy stock as quickly and efficiently as possible.
Market makers like Hill Thompson provide part of the self-regulatory benefits of market competition by acting as the counterweight to public exuberance, helping to temper volatile price rises and subsequent drops. It is difficult to sufficiently quantify the role a market maker plays in protecting investors from wild price swings. In providing much needed liquidity to the SmallCap and OTCBB markets, market makers are also actively participating in the price-determination process. Without the ability to freely short sell, Hill Thompson could not afford to be at risk by holding such large positions and would be forced to only fill customer orders at the minimum size requirements, thereby decreasing liquidity, raising the costs of trading, and ultimately harming individual investors.
Since short selling abuses can be controlled with the anti-manipulation regulations already in place, Hill Thompson believes that the additional short sale regulation of the SmallCap and OTCBB markets is unnecessary. Market makers must have the unimpeded ability to effect short sales to balance their positions or to anticipate customer buying interest at any time during the trading day.12 Therefore any proposed rule should include an exemption that does not frustrate a market maker's ability to efficiently buy and sell stock. Hill Thompson must be permitted the flexibility to sell short when necessary so that it will be able to adjust quickly to market movements and control the risks associated with market making while continuing to provide the maximum possible liquidity. The ability to manage risk with short positions is fundamental to market maker performance. The Commission should be committed to implementing a short sale rule that does not adversely affect a market maker's ability to manage risk. If a short sale rule were to impact adversely its ability to manage risk, Hill Thompson may be forced to reduce its support for the stocks in which it currently makes markets.
We applaud the Commission's efforts to address the inadequacies of the short sale rule, and offer our assistance to you in this endeavor. Please contact me or Fredric A. Leslie at (201) 434-6900 if you would like to discuss these issues in greater detail.
Anthony Broy Jr.
CEO, Hill, Thompson, Magid & Co., Inc.
1 Founded in 1932, Hill Thompson's primary business is whole sale market making in approximately 8,000 stocks on the over-the-counter NASDAQ SmallCap, Bulletin Board, and Pink Sheet markets. Hill Thompson, which employs about 50 traders, has been consistently listed in Equities Magazine's "Top 10 Market-Makers" rankings. The CEO of Hill Thompson, Mr. Anthony Broy Jr., serves on the NASD's OTCBB Advisory Committee. On November 2, 1999, Hill Thompson was acquired by Freedom Securities Corporation. Freedom,(NYSE:FSI), based in Boston, is a holding company for leading full service, regionally focused retail brokerage, national equity capital markets, and asset management firms with approximately 2,600 employees. Its subsidiaries include Boston-based Tucker Anthony, Philadelphia and Lancaster-based Hopper Soliday, New Jersey-based Gibraltar Securities; California-based Sutro & Co.; Tucker Anthony Cleary Gull, a capital markets and banking firm; and Freedom Capital Management, an advisory firm also based in Boston.
2 Exchange Act Release No. 42037, 64 FR 57,996 (October 20, 1999).
3 See J. Randall Woolridge and Amy Dickinson, Short Selling and Common Stock Prices, Financial Analysts Journal, January-February 1994.
5 Jonathan R. Macey, Mark Mitchell, and Jeffry Netter, Restrictions on Short Sales: an Analysis of the Uptick Rule and its Role in View of the October 1987 Stock Market Crash, 74 Cornell L. Rev. 799, 820 (1989).
6 See, e.g., S.E.C. v. Gardiner, 48 S.E.C. Docket 811, No. 91 Civ. 2091 (S.D.N.Y. March 27, 1991) (alleged manipulation by sales representative by directing or inducing customers to sell stock short in order to depress its price).
7 Concept Release at 57,997.
8 See; Jonathan R. Macey, Mark Mitchell, and Jeffry Netter, Restrictions on Short Sales: an Analysis of the Uptick Rule and its Role in View of the October 1987 Stock Market Crash, 74 Cornell L. Rev. 799, 820 (1989).
9 Concept Release at 57,997.
10 NASD Rule 6750 minimum quotation size requirements for OTCBB tiers are the following:
$.01 - .50
$.51 - 1.00
$1.01 - 10
$10.01 - 100
$100.01 - 200
11 Hill Thompson would like the Commission to note that the illiquid lower tier stocks present market makers with the added risk that the shorted securities are difficult and costly to borrow and may be expensive due to a possible buy-in.
12 See Securities Exchange Act Release No. 34277 (July 6, 1994), 59 FR 34885.