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  Thomas J. Mazzarisi
Executive Vice President
& General Counsel

January 5, 2004

Via E-Mail/rule-comments@sec.gov

Securities and Exchange Commission
450 Fifth Street, NW
Washington, DC 20549-0609
Attention: Jonathan G. Katz, Secretary

Re: File No. S7-23-03/Regulation SHO

Ladies and Gentlemen:

We would first like to thank the Commission for the opportunity to comment on proposed Regulation SHO, which is intended, in part, to reform short selling rules to curb serious abuses resulting from illegal naked short selling. As our company is a small business issuer on the OTCBB, we will focus most of our comments on those portions of the proposed rule that relate to naked short selling and its effect on issuers on the OTCBB and their shareholders.

Historical Context

The OTCBB began operation in 1990 as a result of important OTC market reforms mandated by the Penny Stock Reform Act of 1990 (the "Penny Stock Act"). The Penny Stock Act sought to increase transparency in the OTC markets to combat pervasive penny stock fraud by, amongst others, requiring various disclosure requirements for broker-dealers of penny stocks and the development of an automated quotation system for penny stocks (which became the OTCBB). These reforms represented a quantum leap forward in the regulatory structure of the OTC market at the time.

With a basic quotation system in place and broker-dealers being required to make some disclosure to clients regarding the risks of investing in penny stocks, the next major reform regarding penny stocks came nearly a decade later, when in 1999 the Commission approved the OTCBB Eligibility Rule. On a phased-in basis, OTCBB companies were required to report their current financial information to the SEC in a timely manner, the same as listed exchange companies had long been required to do. These two reforms, which focused predominantly on issuers, formed the basic underpinnings of the regulatory structure with respect to the OTCBB as it exists today. While these reforms have greatly improved the integrity of the OTCBB and gone a long way in making it more difficult for parties to perpetrate the types of penny stock fraud that were prevalent in the 80's and early 90's, these reforms simply could not effectively address naked short selling, which is the new fraud of choice in the penny stock markets.

The single most important flaw in this regulatory structure is that it focuses only on protecting investors from unscrupulous penny stock issuers. While no legitimate OTCBB issuer would question the need for such protections, no penny stock reform can truly be effective unless it acknowledges that the OTCBB, while still far from perfect, has matured since 1990 giving rise to new risks for investors that result from the actions and inactions of parties other than issuers. Unless the Commission is willing to fully reflect this concept, not only in the proposed Regulation SHO, but also in its day-to-day policy decisions regarding OTC market regulation and enforcement, any reforms that are implemented will be strictly cosmetic and not provide penny stock investors with the protections they need and deserve.

The Problem

With the regulatory structure of the OTC markets keenly focused on issuers, it became apparent to many parties that there was a loophole in the system which presented them with the opportunity to reap windfall after windfall by financing OTCBB issuers through what has come to be commonly referred to as "toxic" or "death spiral" financing. These windfalls were made possible by the following factors coming together to create the ultimate golden goose:

  1. A regulatory structure focused almost exclusively on protecting investors from unscrupulous issuers;

  2. Parties having the ability to engage in toxic financing with cash strapped OTCBB companies where there is no downside limit on the price of the stock they were to receive for their financing;

  3. Toxic financiers having the ability to naked short the stock of their OTCBB target without an affirmative determination ever being made that the stock they are shorting can be borrowed;

  4. Broker-Dealers not requiring short sellers to buy-in their naked short positions and settle their trades for substantial periods of time, if ever;

  5. Market makers having no real check on their ability to engage in naked short selling of OTCBB issues for purposes other than bona fide market making activity.

  6. Reporting of short interest in OTCBB issues not being mandated (as it is for issues on listed exchanges), thereby allowing all of the above to take place under a veil of complete secrecy.

The Result

With the above factors festering for years, whatever integrity was brought to the OTC markets by the Penny Stock Act and the OTCBB Eligibility Rule has largely been eradicated and we now have a market where investors cannot be certain of something as fundamental as whether they truly own the shares of the company on which they have spent their hard earned money. Some of the results of unchecked naked short selling include the following:

  1. Issuers and investors are unable to determine the true number of shares outstanding in their stock on any given day. In determining an issuer's outstanding shares, the transfer agent takes into account the number of registered shares on the transfer agent's books and adds to that the position it maintains on its records for CEDE & Co., the nominee for "the street." While shares can move between the transfer agent's registered stockholder list and the CEDE & Co. position, in no instance can the number of outstanding shares lawfully increase unless new shares are issued by the company. However, on any given day when naked short positions are created, short sellers, broker-dealers and market makers create the appearance and effect of newly issued shares but are never required to account for the additional dilution which they create.

  2. Since naked short positions (or normal short positions for that matter) are not reported by the OTCBB, disclosure is inherently deficient for OTCBB investors, since they are deprived of the opportunity of making informed decisions regarding the effect that naked short selling may have on the company in which they have invested.

  3. The counterfeit shares created by naked short selling have a trickle down effect on investors and issuers. For example, investors who believe they are shareholders in a company, but who bought from naked short sellers, are routinely deprived of the right to vote on important corporate matters that affect their investment. If a company has 20 million shares outstanding and on any given day a naked short position of 10 million shares, there are now 10 million additional shares which cannot be lawfully voted since votes on any corporate matter cannot exceed the number of outstanding shares as reflected on the books of the transfer agent. What results from such situations is that broker-dealers must arbitrarily determine which shares are voted.

  4. Just as investors can be stripped of their voting rights, as described above, investors can also be denied dividend distributions due to naked short positions. Using the example in 2. above, a company would only be able to issue a dividend to the holders of its 20 million lawfully outstanding shares. Therefore, once again broker-dealers must step in and arbitrarily determine which of their clients receives the dividend and which holders of the 10 million counterfeit shares will be excluded from participating in the dividend.

  5. Each day that the naked short position of 10 million shares, in our example above, is not bought-in the issuer experiences a real dilutive effect, which it would not have experienced but for the naked short position. Most OTCBB issuers go to great lengths to control dilution to protect shareholder value and make day-to-day decisions that take into account the potential dilutive effect of certain actions. For example, the OTCBB company with 20 million shares outstanding may decide to reduce expenditures or delay potential growth initiatives in order to not incur significant dilution at that point in time. And all along, while the issuer is struggling to control dilution, naked short sellers, broker-dealers and market makers are creating, with total impunity, the dilution which the issuer has struggled to avoid. In addition to such dilution being involuntarily created, both the issuer and its shareholders experience this very real dilutive effect while receiving absolutely nothing for that dilution. This is hardly the telltale sign of an efficient and transparent market.

  6. Naked short selling makes it more costly and difficult for OTCBB issuers to raise money, which is the life blood of small developing OTCBB companies.

  7. A large number of companies are left with no alternative but to devote company resources to protecting their shareholders against naked short selling practices, which, were it not for such practices, could be devoted to more constructive ends.

  8. The proliferation of lawsuits which have been initiated relating to naked short selling and toxic financing have a chilling affect on legitimate financiers who would otherwise be interested in financing OTCBB companies, but elect to forego such opportunities for fear of being embroiled in litigation.

The Solution

When examined closely, the history and effects of naked short selling on the OTCBB paint an unfortunate picture of a market where transparency and disclosure have been rendered an illusion and investors are unable to determine whether the company they are intending to invest in has 20 million shares outstanding or the functional equivalent of a number of shares far in excess of that amount. We believe that this situation has created a crisis in the micro cap markets that requires not only prompt implementation of the reforms set forth in Regulation SHO but also implementation of other reforms to begin to restore some level of integrity to the micro caps markets.

To do this, it is not sufficient for the Commission to implement Regulation SHO, or some variation of it, since this will only address matters going forward and leave completely unaddressed the fundamental problems and inequities that years of unchecked naked short selling abuses have brought to the micro cap markets. Accordingly, we strongly believe that the following actions, related and unrelated to Regulation SHO, must be implemented immediately to effectively deal with this problem:

  1. All broker-dealers with positions in OTCBB issues should be required to immediately report their short positions and fails in those issues. This information should then be made publicly available and updated daily on an ongoing basis.

  2. All broker dealers and market makers with naked short positions that are open for more than 2 days past settlement date should be required to buy-in those short positions immediately and settle such outstanding trades (even if they are for the accounts of customers). We do not see any legitimate reason why a short seller cannot deliver securities by at least T+5. Further, mandatory buy-ins are the only effective remedy for dealing with naked short selling abuses, not to mention the fairest and most efficient way to correct the problem. Through forced buy-ins the market imbalances created by naked short sellers are corrected once and for all and the clean-up costs are imposed equitably on the parties who created the mess. If they are guilty of creating a large naked short position, the cost of correction will be high, and rightfully so. If the naked short position they created is less substantial, the market insures that the cost will be commensurately less. When the various market scandals arose in 2003, the Commission and legislature acted swiftly and decisively in imposing the regulatory burden to correct such wrong doing on the parties who were in the best position to prevent such events from occurring again, the issuers themselves. The naked short selling crisis is no different in that respect and therefore the regulatory burden should lie squarely at the feet of the short sellers, broker-dealers and market makers who are responsible for the problem. Further, if short sellers fail to buy-in their naked short positions as required, broker-dealers should be obligated to effect the buy-in on behalf of their customer and then seek recovery from the customer. This serious remedy would cause broker-dealers to initiate meaningful internal safeguards that would significantly curtail naked short selling abuses from arising in the first place As long as issuers and investors are required to pay the price for the actions of naked short sellers and the inaction of their broker-dealers, the problem will never be solved effectively.

  3. In light of the current state of the OTCBB market, it is nearly impossible to envision that "easy to borrow" or "hard to borrow" lists can be compiled with any accuracy for OTCBB issues. Accordingly, we believe that the test of "reasonable grounds to believe that the security could be borrowed" of the proposed "locate" requirement should apply to each short transaction and not be susceptible to satisfaction from any blanket assurance lists.

  4. We agree that market makers involved in bona fide market making activities should be exempt from the "locate" requirement. If, as the Commission assumes, most market makers seek a net "flat" position at the end of each trading day, and in fact do so, then the exemption should not be problematic. However, if a market maker elects to make a consistent market on the "sell" side without any meaningful activity on the "buy" side, as is frequently the case in OTCBB issues, they should in all instances be required to deliver securities sold short in T+5. The role of a market maker is to maintain liquidity and an orderly market, which is strictly a function of daily market conditions. Accordingly, there is no reason for bona fide market making activities to result in naked short positions for any extended period of time.

  5. While a step in the right direction, the proposed consequences set forth in Regulation SHO for failing to deliver securities fall short of what is necessary to insure that naked short positions do not languish for extended periods of time. Take for example a short seller who creates a naked short position of 1,000,000 shares in an OTCBB issue over a two week period. The only regulatory consequences that the short seller and broker-dealer face in this situation are that the broker-dealer is now barred from taking short sale orders from that short seller for that security for a period of 90 days and may, in addition, face a fine or some other administrative action from NASD. Since the short sellers have made their money and the broker-dealers have made their commissions, this consequence amounts to little more than a transaction tax to parties who are making millions of dollars from such naked short selling. In addition, although short sellers will be barred from shorting that security through the broker-dealer they just used for their naked short sale, it appears that nothing prevents them from shorting that same OTCBB issue through another broker-dealer, thus allowing them to circumvent the intent of the rule. Short sellers who don't deliver securities within T+5 should be barred from shorting any securities through any broker-dealer until those securities are delivered.

  6. Some commenters have indicated that naked short selling should be permissible since it serves as a counterbalance to overzealous OTCBB stock promoters and assists the regulatory bodies in keeping such promoters in check. Some even go on to suggest that naked short sellers serve an even higher purpose by weeding out companies who, due to faulty business plans, don't deserve investor dollars. The absurdity of this position is mind boggling. First, naked short sellers, broker-dealers and market makers should not function as a deputized lynch mob for any regulatory body. The notion of any regulatory body tacitly appointing these parties, who are the cause of the naked short selling problem, to insure any type of market stability would be the equivalent of the commission appointing Enron to oversee corporate governance reforms when that scandal came to light. The success or failure of any public company should be determined by its shareholders in a free market with a level playing field.

  7. Although it cannot be directly addressed by Regulation SHO, the Commission should also give consideration to the effect that Canadian broker-dealers have on the naked short issue in the United States. It is our understanding that naked short positions can be lawfully maintained by Canadian broker-dealers and that as a result a flood of naked sales have been initiated in US markets through Canada. A close examination of potential regulatory reforms in this area should be undertaken by the Commission, including an examination of the role of The Canadian Depository for Securities in this matter.

The naked short selling issue is a very complex and thorny issue for the Commission to address. However, despite its complexity, the problem screams out for a simple solution. With respect to the problem that has been created to date, the applicable parties who created the problem should be required to buy-in their naked short positions and restore some integrity and balance to the micro cap market. As to the regulatory burden going forward, that should also be imposed squarely on the responsible parties, who in this instance are also the parties that are in the best position to carry out the regulatory reforms and bear the cost of such regulatory burden.

Very truly yours,


By: _______________________
Thomas J. Mazzarisi
Executive Vice President
& General Counsel