From: Alden James [aldenjames9@hotmail.com] Sent: Friday, February 13, 2004 9:10 PM To: rule-comments@sec.gov Subject: Short Sales [Release No. 34-48709; File No. S7-23-03] On February 4, 2004, J.P. Morgan submitted electronic rule-comments on Short Sales. [Release No. 34-48709; File No. S7-23-03] (See J.P. Morgan comments at http://www.sec.gov/rules/proposed/s72303/ajames121103.htm ) Since J.P. Morgan’s comments were accepted after the comment period, I would like to supplement my rule-comments posted at http://www.sec.gov/rules/proposed/s72303/ajames121103.htm as to J.P.Morgan’s comments related to naked short selling.In its comments (http://www.sec.gov/rules/proposed/s72303/jpmorgan013004.htm), J.P. Morgan states in pertinent part:“The recent study on short selling issued by the Financial Services Authority of the United Kingdom (the "FSA") evaluated the usefulness of substantive short sale regulation. It concluded that no preventive measures are necessary with respect to short sales and recommended disclosure in place of a short-sale rule.1 The Firms believe the FSA's conclusions are correct and that the Commission should move in a similar direction.” Footnote 1 is given below: ____________________________ 1 See Financial Services Authority, Discussion Paper 17, "Short Selling", October 2002, available at http://www.fsa.gov.uk/pubs/discussion/17/. After the consultation, Gay Huey Evans, Director of Markets and Exchanges at the FSA announced that the FSA had concluded that no substantive regulation of short selling itself other than a requirement of greater transparency should be introduced: The consultation confirmed our view that there was no need to impose additional controls on short selling but that greater transparency would be valuable. We therefore welcome CRESTCo's initiative to publish securities lending data. This proposal meets all the criteria we set out in our consultation. The FSA's conclusions are published at: http://www.fsa.gov.uk/pubs/press/2003/057.html (30 April 2003) J.P. Morgan refers to FSA’ s conclusions of April 2003 before FSA was embarrassed by a naked shorting scandal in December 2003 cited in my comment letter, to wit: (http://www.investrend.com/articles/article.asp?analystId=0&id=6037&topicId=160&level=160 “Extreme Short Selling’ Rocks London Markets /December 2, 2003. (FinancialWire) Naked short selling, which apparently robs American investors thousands, perhaps millions of dollars every day, is causing an uproar in Britain. In the U.S., the controversy, the subject of Regulation SHO, which is available at the U.S. Securities and Exchange Commission web site through January 5, has embroiled at least 119 public companies, including some 13 brokers, including Ameritrade Holding Corp. (NASDAQ: AMTD), Deutsche Bank AG (NYSE: DB), and E*Trade Group, Inc. (NYSE: ET). The London controversy centers on Room Service (LSE: RSV). Britains Financial Services Authority is considering a “crack down” on short-selling after being alerted to a massive short position in an AIM-listed company which has left a group of private investors claiming unfair treatment, according to the British press. Press reports said the city watchdog said it had taken a "keen interest" in the case and was "working closely" with the London Stock Exchange to see whether regulations had been breached. Room Service, a cash shell, had been founded to operate an online food delivery service, and a huge short position by Evolution Beeson Gregory, a market-maker in the company, is believed to have developed. It is estimated that the broker has sold stock more than the entire value of Room Service, equaling as much as 162% of the company. Because of that, Evolution has been unable to deliver shares, the investors group has alleged. Of course in the U.S., that is an every day occurrence in an untold number of stocks. The FSA had investigated short selling earlier in the year, and stated that the practice has a “positive impact” on the market, sounding a bit like the “anonymous” detractors recently quoted by Business Week. Now it says it is launching an inquiry into “extreme short-selling.” In March, the FSA imposed disclosure rules on short-selling after a review of the practice. Some thirteen on the list of 119 U.S. companies, such as FleetBoston (NYSE: FBF), Goldman, Sachs &Co. (NYSE: GS), Knight Securities, LP (NASDAQ: NITE), Ladenburg Thalmann &Co., Inc. (AMEX: LHS), M. H. Myerson &Co., Inc. (NASDAQ: MHMY), Olde / H&R Block (NYSE: HRB), Charles Schwab (NYSE: SCH), Toronto-Dominion’s (NYSE: TD), TD Waterhouse Group and vFinance, Inc. (OTCBB: VFIN). A.G. Edwards, Inc. (NYSE: AGE), Ameritrade Holding Corp. (NASDAQ: AMTD), Deutsche Bank AG (NYSE: DB), and E*Trade Group, Inc. (NYSE: ET), have been accused by one or more public companies as allegedly participating in short selling.” FSA was surprised to discover that one broker held a 162% naked short position in one stock because FSA arrived at is conclusions after acknowledging that information on short selling was not collected. Moreover, FSA makes the claim that the risk is much greater for those who take short positions in less liquid stocks. This is only true when the market makers are in a position to get caught before they have time to bankrupt the company or cover after dissipating all buying interest over time regardless of company progress. Then FSA opines that shorts sales have limited profitability. But this is not the case if the market maker does not actually deliver shares or take an actual market risk. (See excerpts from FSA Discussion Paper 17, page 12 at http://www.fsa.gov.uk/pubs/discussion/17)“ 1.5 Information on short selling is not collected, so it is difficult to know exactly how much is going on. However, based on a mixture of market intelligence and proxy data, we think that there has been no general upsurge in short selling over the past few months. Indeed it appears that the trend in short selling by hedge funds may be down, although hedging strategies used by other market players frequently involve a short sale and may have an impact on market prices.Page 5,6 3.6 Short selling involves considerable risk. Given that short sellers must at some point buy back an equivalent number of the same securities that were sold – either to meet their obligations to the purchaser, or to return the securities to the lender – they are exposed to the risk of the price of shorted securities rising rather than falling. In practice, that risk may be considerable if short sellers are caught in a ‘bear squeeze’3 or are otherwise unable to find securities to buy, making it difficult for them to close out their positions. Clearly, this risk is that much greater for those who take short positions in less liquid securities. A short seller also faces the risk that the borrowed securities may be recalled by the lender and it then may be difficult to locate more of the same stock. It must also be remembered that where long positions can offer potentially unlimited upside benefit, short positions have limited payoff potential in that share prices can go only to zero.” The FSA's conclusions are published at http://www.fsa.gov.uk/pubs/press/2003/057.html I attach relevant excerpts with emphasis supplied by me. Option 5 – Disclosure of short sales in specific situations 3.41 This option envisaged that those taking ‘naked’ (uncovered) short positions ina security would have to disclose these positions.Q11: Do you think that ‘naked’ short sales should be disclosed to the market? How would you use that information?Would any market participants be disadvantaged by sucha disclosure?3.42 A third of respondents on this option were in favour of requiring disclosure of‘naked’ short positions. These respondents said that ‘naked’ short sellingrepresented a risk to the settlement system and to orderly markets. They feltthat requiring short sellers to disclose their ‘naked’ short positions wouldimprove transparency and prevent abuses. Several respondents also suggestedtightening the existing settlement framework to encourage participants to cover‘naked’ short positions. Some said that disclosure would help to discourage thepractice altogether, although this was also used as an argument againstdisclosure. One respondent said that ‘naked’ short selling should be prohibited.3.43 Many of those against this option objected to it for reasons generally related todisclosure of short positions. These reasons included: that disclosure would expose short sellers to the risk of short squeezes; that implementation and maintenance costs were unjustified; and that it would be difficult to define what constituted a ‘naked’ short. In particular, deciding for how long a positionwould have to remain uncovered to warrant disclosure was problematic andgave rise to doubts over how accurate the information would be by the time itwas disclosed. Several respondents felt that the existing settlement discipline andenforcement regime were sufficient to deal with any concerns. 3.44 Respondents also argued that there was no benefit in singling out ‘naked’shorts for disclosure: a market participant’s overall short position was of moreinterest than information about whether a particular sale was ‘naked’ orcovered. Others denied that the information would be of any use inpreventing settlement disruption, given that only aggregate information wouldbe published. One respondent said that parties wishing to conceal ‘naked’short positions would simply cover their positions by buying a derivative suchas a deep out-of-the-money call to circumvent disclosure requirements.3.45 The obligation of market makers to make a price each way meant that theywere sometimes required to sell short. Several respondents therefore arguedthat any disclosure requirement would need to exempt market makers,otherwise they would be unable to fulfil their regulatory obligations and wouldbe unfairly prejudiced.Our response: We agree that ‘naked’ short selling may in certain circumstances present a risk to orderly markets. Given that ‘naked’ short positions are by definition uncovered, they present a higher risk of settlement disruption and failure. ‘Naked’ short selling might in some circumstances contribute to a false or disorderly market in a security by giving the perception of liquidity. However, there are often circumstances in which it is legitimate or necessary for a participant to open a ‘naked’ short position. We believe it would be disproportionate to introduce measures that would impact on the entire market when only relatively few participants are responsible for the problems associated with failing to cover ‘naked’ short sales. So, we do not propose to require disclosure of ‘naked’ short positions. Having said this, we want to address the problems which ‘naked’ short selling can cause. We are therefore proposing a package of several initiatives aimed at addressing settlement problems created by ‘naked’ short selling, particularly in illiquid securities. These initiatives will help us to prevent, monitor and resolve potential problems. We believe they are a more appropriate response to the concerns of those who are worried about the disruption caused by aggressive or abusive ‘naked’ short selling. The initiatives are outlined below in our response to feedback we received on settlement options.Page 20, 21 Our (FSA’s) response: We recognise concerns that ‘naked’ short selling in illiquid securities may lead to settlement disruption for buyers who have contracted to purchase shares on the Intended Settlement Date. We also acknowledge concerns that ‘naked’ short selling may in some circumstances be used to manipulate share prices. However, requiring all short sales to be transacted with guaranteed delivery does not look to be a sensible method of dealing with potential settlement problems. Any blanket requirement would not be justified given the infrequency with which problems arise. And we share doubts about the effectiveness ofguaranteed delivery in the circumstances it would be intended to address.We have had further discussions with CRESTCo, the London Stock xchange and virt-x in light of the responses to DP17 and further examination of overseas practices. We consider the following package of measures will help improve settlement and delivery in illiquid securities .• First, CRESTCo is prepared to publish data on settlement failures for those securities with the highest proportion of failures, identified as the percentage of failed transactions to the total volume of securities in the CREST system. This would be published alongside data on stock borrowing in individual securities. There are numerous reasons, unrelated to short selling, why settlement failures occur. Data on settlement failures would not identify which failures resulted from ‘naked’ short selling. But we believe that it would provide helpful information to the market and would act as an indication of pressure building in a particular security. This initiative would not appear to involve any additional costs. • Second, the London Stock Exchange and virt-x have agreed to publish market status messages notifying their members about securities experiencing a significant proportion of settlement failures.There are certain circumstances in which settlement disruption in particular securities may affect the orderly operation of the market in those securities. We believe that notifying the market of building problems will reduce the risk of a disorderly market developing. Settlement disruption may also have adverse consequences for customers who have bought or who wish to buy the securities in question. This is because they may not be entered on the register of members of the relevant company and may not therefore be able to participate in corporate votes. As such, knowledge that a particular security is experiencing a significant level of settlement failures may affect a customer's investment decisions. We are concerned that customers who seek to buy a security in which there is asignificant build-up of settlement failures should be advised that settlement delays in the relevant security are likely. We believe that the most efficient and effective way of getting this information to investors is for brokers to deliver warnings to their customers when those customers ask about buying the securities in question. Our preference is for a market-based solution in this area and we are discussing appropriate alternatives for possible methods with the Exchanges and trade associations. However, if a satisfactory market-based solution cannot be found, we will consider whether it might be necessary to introduce a conduct of business rule requiring FSA authorised persons to communicate settlement failure warnings to their customers in certain circumstances. • Third, we are also discussing with the London Stock Exchange the possibility of shortening the buy-in timeframe for illiquid securities experiencing a significant build up of settlement failures. We believe that this would be more proportionate than tightening the buy-in timeframe generally for illiquid securities. • Finally, the Exchanges will keep penalties for buy-in under review.The London Stock Exchange and virt-x must consult with their members before any changes can be made to their existing settlement rules. But feedback we received during the short selling consultation process suggests that the market would support properly targeted measures.We believe that the proposals we have suggested provide a proportionate response to settlement disruption problems caused by ‘naked’ short selling in illiquid securities. We will continue our discussions with relevant parties with a view to pursuing the implementation of these proposals as soon as possible.Page 23-25 End of excerpts from FSA Conclusions http://www.fsa.gov.uk/pubs/press/2003/057.html In its newsletter comments on short selling, FSA summarizes its conclusions as follows: “• Option 5 – disclosure of ‘naked’ short sales – was opposed by the majority of respondents. Reasons given for this included disadvantages to the seller’s position; the costs of such a requirement; and operational issues. We consider that the option would bedisproportionate and that there are better ways to deal with the potential settlement risks posed by ‘naked’ short selling.” http://www.fsa.gov.uk/pubs/discussion/fs17/ newsletter.pdf In my proposed rules (repeated below), I address each of these concerns. Summary reports by DTCC involve little cost and such reports will be secret for 30 days except to the regulatory agencies. Moreover, if caps on naked short positions of 30% or covered short positions of 100% won’t keep a stock from rising, the stock should be allowed to rise, even if it is a penny stock. Can our markets and economy really afford to address the shorting selling problem by continuing to not know how much shorting is going on? From: Alden James [aldenjames9@hotmail.com] Sent: December 11, 2003 To: rule-comments@sec.gov Subject: File No. S7-23-03 Short Sales [Release No. 34-48709; File No. S7-23-03] Please post this corrected copy for mine of 12/9/03. Based on the discussion and answers to follow, I suggest consideration of the following rules governing short selling in all public exchanges: 1. If a DTCC market maker or broker dealer (“members”) may short a stock, then short selling of that stock shall be open to all investors, including retail investors, subject to reasonable margin requirements. All margin shall be actually held in the accounts of the member, i.e., no letters of credit, etc. A member may not short any stock for its own account unless immediately thereafter its assets will exceed its liabilities by an amount greater than or equal to the margin charged to non-members for their short positions. [Supplemental comments. If everyone can short, then real investors can help moderate the price while taking real market risks.] 2. Total covered short interest in a stock is capped at 100% of outstanding shares. Naked short selling of a stock is capped at 30% of outstanding shares. Once the naked short cap is reached, members must surrender their short positions to satisfy short sell purchases of customers. A member’s and its customers’ naked short positions shall be closed prior to a regular short interest position being created. A member may substitute a customer’s naked short position for a regular short position. [Supplemental comments. A cap might also be established based on the “public float,” i.e., shares held at the DTCC less shares in retirement accounts, etc. The objective is for the SEC to fine tune the caps to serve the long and short sides of the market.] 3. Short positions in all stocks shall be reconciled at the end of each trading day by the DTCC. In the event an aforementioned cap is exceeded, the DTCC shall order a pro rata reduction by all market makers and broker dealers on the next trading day until the cap is reestablished. In any calendar quarter wherein the volume of trading of a stock is in excess of 25% of its outstanding shares, further naked shorting of that stock for the balance of that quarter shall be prohibited. [Supplemental comments. Stock is like currency. If the DTCC cannot reconcile short positions between its members every Night, then banking authorities should. If stock volume reaches 25% of outstanding shares in a quarter, it is not illiquid and there is no justification for naked shorting.] 4. By 9:00 p.m. (ET) on each trading day, a member of the DTCC shall report, whether or not its position is “flat,” for each stock owned by it and/or its customers, the following: Stock (XYZ); Total Shares Outstanding; Member’s Customers’ Shares Owned; Member’s Shares Owned; Member’s Customers’ Total Short Positions - Covered; Member’s Customers’ Total Short Positions - Naked; Member’s Total Short Positions - Covered; Member’s Total Short Positions - Naked. A responsible managing officer (RMO) of the member shall certify under penalty of perjury based upon information and belief and reasonable inquiry that such reports to the DTCC are true and correct. From time to time, members’ books and records shall be audited by federal banking examiners.[Supplemental comments. Customer accounts of member banks are reconciled every night. The DTCC should be able to achieve a similar result using summary reports from its members. Summary reports, issue by issue, would stop naked shorting beyond that necessary to an orderly and fair market. The description of the DTCC fungible bulk system is repeated below. ] 5. Naked short sales in violation of the aforementioned rules shall be deemed fraud on a customer. Members (particularly wholesale market makers) cooperating to close short positions in a stock shall be deemed market manipulation. Members’ daily short position history for each stock shall be publicly available at the close of each trading day, 30 days in arrears. [Supplemental comments. This proposal protects the market makers ability to trade while making them accountable.] As I have described in my prior rule comments and excerpt below, DTCC members are taking advantage of the disconnect between customer records at the member level versus fungible bulk “street name” certificates at the DTCC level. The BBX might have ameliorated the CUSTOMER RECORDS VERSUS DTCC RECORDS dilemma. It is time for the SEC and DTCC to propose the “other means” to fix the naked short problem. CUSTOMER RECORDS VERSUS DTCC RECORDS DILEMMA. “The Depository Trust Company(DTC) was created in 1973 as a privately operated ‘Federal Reserve for stocks’ designed to provide efficient, secure and accurate central custody and post trade processing services for transactions in the United States securities markets. The DTC is owned by several hundred brokerage firms, financial institutions (collectively, the DTC “participants”), and the New York and American Stock Exchanges. Its vaults in New York contain over $23 trillion of securities, including stocks, corporate bonds, mutual funds, warrants, and municipal bonds and government obligations. The DTC carries out two major functions. The first is the immobilization of the securities of DTC participants, which reduces the need for participants to maintain their own certificate safekeeping facilities. Second, the DTC maintains a computerized book-entry system in which changes of ownership among participants are recorded. This replaces costly, problem-prone physical delivery of securities for settlement. The DTC holds all securities in “fungible status” (also known as “fungible bulk”), with the DTC’s computers recording ownership of aggregate amounts of each security in the name of a participant firm. The DTC does not maintain records describing the ownership of securities by individual customers, other than for the holdings of major institutions that are themselves DTC participants. Instead, the DTC regards the participant firms as the nominal holders, in “street name”, of all their customers’ securities. Customer level record keeping is the responsibility of the participant firms. The DTC’s book entry system allows participants to deposit securities for safekeeping, transfer them conveniently to other participants, collect payment for the securities transferred and withdraw certificates, if desired by a customer. It is the widespread use of these services by DTC participants that creates economies of scale, permitting low-cost processing and speed without the sacrifice of security and accuracy. In 1999, for example, the DTC processed more than 189 million computer book entry deliveries between brokers and clearing corporations, with a value of over $94 trillion. Today over 72% of all common shares issued by NASDAQ-listed companies are immobilized at the DTC, and not held by the investors themselves. Not all changes in security ownership result in DTC transfers. The National Securities Clearing Corporation (NSCC) operates clearing, netting and settlement services that assist member firms in processing transactions. The NSCC compares buy and sell transactions and nets them down to reduce the number of transactions requiring a transfer of securities positions on the books of DTC. For example, if, during the same day, customers of Merrill Lynch sell customers of Goldman Sachs 50,000 shares of XYZ stock, and customers of Goldman Sachs sell customers of Merrill Lynch 50,000 shares of XYZ stock in numerous separate transactions, the NSCC will automatically net down the transactions, and no transfers will result on DTC books. In 1999, DTC and NSCC combined together under a new umbrella organization called Depository Trust and Clearing Corporation (DTCC).Under the standard arrangements between customers and their brokerage and banking firms, the securities held in brokerage accounts are commingled in a single fungible mass. For example, if Merrill Lynch had five customers who held CLC stock on a single day, Merrill Lynch would hold all of the shares of these five customers in a single commingled fungible bulk account at DTC in Merrill Lynch’s name. Of course, Merrill would have a record of the identity of the investors whose stock is represented in the mass. Consequently, where securities are held in street name, the task of keeping records as to which individual customer owns how much of which security is the responsibility of the brokerage firm. In the absence of paper shares, the only written evidence that an individual customer has of his or her holdings are brokerage statements or trade confirmation slips. The typical brokerage customer margin account agreements allow the brokerage to hypothecate or lend the customers’ securities without notice or benefit to the customer. It is the brokerage that earns interest on the loan, and not the shareholder, and this fact is acknowledged in the account agreement. When brokerage firms lend their customers’ stock, they do so out of the general pool of marginable fungible securities held by the firm. Having deposited all of their customers’ securities into a fungible mass, they cannot and do not keep records documenting the ownership of the securities that have been lent. Brokers cannot tell their customers when their stock has been lent (or returned) because it is the fungible pool of stock that serves as the source of the loans. In fact, this pool of stock has no identifying characteristics linking it to particular customers, because it is simply an electronic entry at the DTC and the brokerage. The move to holding shares in street name significantly complicates identifying which investor holds an actual share and which investor holds an artificial share.” Reference 5. (http://schwert.ssb.rochester.edu/short.htm) As the Duke of Wellington said, “I trust no man whose interest is involved.” We don’t let banks print their own money to provide “liquidity” to the marketplace because banks cannot be trusted with such power. Market makers certainly cannot be trust with an unregulated power to print stock certificates in the OTC market. Sincerely, Alden James _________________________________________________________________ Get some great ideas here for your sweetheart on Valentine's Day - and beyond. http://special.msn.com/network/celebrateromance.armx