Message: Former SEC Chairman Harvey Pitt regarding Naked Shorting! Nov.16/07
FORMER SEC CHAIRMAN, REGARDING NAKED SHORTING
MR. HARVEY PITT
NOV. 16, 2007
(excerpts)
The problem isn’t short selling itself, but rather the ability of short
sellers to sell stocks they haven’t actually borrowed in advance of
their short sale, which frequently causes fails to deliver. Naked
shorts expose sellers and those linked to their short sales to the risk
that when settlement day arrives, the short seller won’t have the
necessary shares available. Naked shorting harms the market and
market participants, particularly when fails persist for substantial
periods, as they clearly have.
Naked short sellers effectively gain more leverage than if they
were required to borrow securities and deliver within a reasonable
period of time. And this additional leverage may be used to drive
down a stock’s price. In addition, naked shorting effectively
dilutes the pool of real securities.
Phantom shares created by naked shorting are analogous to
counterfeit money. In a stock market corollary to Gresham’s law,
the more phantom shares of an issuer’s stock that circulate the
more they drive out or devalue an issuer’s real shares to the
detriment of investors and issuers alike. Fails associated with
naked shorting harm investors in other ways, for example, by
depressing stock prices to the point that shares may not be
marginable, denying shareholders the ability to borrow against
them.
The SEC has now acknowledged this problem and is taking steps
to address it. Thus far, however, its efforts haven’t gone far
enough or proven entirely successful. Reg SHO requires short
sellers and their brokers reasonably to believe security sold short
can be, quote, borrowed and delivered at settlement, close quote.
But reasonable belief is very much like beauty, it’s dependent on
who you ask.
Many prime brokers, for example, assert reasonable grounds by
assuming that if large long positions reside somewhere in-house,
they’ll be able to borrow those shares without actually checking to
see if the shares are available for borrowing, and without ascertaining
if the same shares have already provided reasonable grounds for
another short sale of the same securities. This, of course, leads to
over shorting of securities, a phenomenon in which
the number of shares shorted actually exceeds the number of shares
physically available for trading.
When the number of shares shorted exceeds the number of shares
available for trading, a stock’s price can take a pounding that’s
wholly unrelated to the actual value of the stock. To combat naked
shorting of heavily shorted threshold securities, Reg SHO requires
brokers planning a short sale in a threshold security prior to
shorting, to have a definitive arrangement to borrow those shares.
While this helps, it doesn’t solve the entire problem. It doesn’t
even address situations where stocks not on the threshold list are
subject to naked shorting. In addition, in another step in the right
direction, last year the self-regulatory organizations adopted SEC
guidance that shares brought in by brokers to satisfy undelivered
shortage shares must be applied to the earliest undelivered shorts.
This essentially requires brokers to buy in all shares they failed to
deliver once any shares are bought in. But still, this isn’t enough.
In January 2005, when Reg SHO became effective, there were
520 threshold securities. As of two days ago, even with all of the
SEC’s efforts, there are still 451, many of which have been on the
list for months, and some of which have been on the list for years.
The SEC is concerned, as it should be, the number is still way too
high. So what’s to be done?
One answer is that the SEC and exchanges should actually enforce
existing rules. This is to some extent occurring. But in the two
years since Reg SHO’s adoption, the New York Stock Exchange
has brought seven enforcement actions, but imposed total fines of
$1.9 million. While these enforcement actions are positive, fines
of that aggregate magnitude won’t provide much deterrence.
In contrast, by the way, this summer the AMEX brought
disciplinary actions for Reg SHO violations against two firms
resulting in aggregate penalties and fines of $8 million, including
$2.6 of disgorgement. And last month, the SEC settled an
enforcement action against a hedge fund advisor, its CEO, and two
employees for improper short sales resulting in total fines of over
$8 million, including $6.7 million in disgorgement. Now penalties
of this latter magnitude are more likely to inhibit impermissible
short selling, particularly if the more cases are brought.
The SEC should eliminate the option market maker
exception. It isn’t demonstrably of any value, and it risks
facilitating illegal activity. Next. Reg SHO should impose firm
locate requirements as a condition precedent to all short sales.
Next. Reg SHO should cover securities that are also traded in the
pink sheets. Naked shorts occur in the shares of small, thinly
traded issuers, and those are likely to trade in the pink sheets
Chronic and unjustified violations of T+3 settlement rules
should be punished. Next. Before brokers are allowed to borrow
margin shares, they should make clear disclosure and give
investors the opportunity to opt out. Next. Securities lending
should occur openly and transparently at arms-length prices,
enhancing returns, increasing efficiency, promotion valid short
selling, and curbing abuses.
Next. The NSCC should allow members to settle borrowing and
lending activity through these facilities that I’ve just mentioned so
accurate accounting and data is available to market participants
and regulators. Next. Shady activities thrive in shadowy market
corners. Exchanges in other markets should be required to report
the securities on daily threshold lists and aggregate daily volume of
fails for each such security. And, finally, Form 13F, institutional
investor’s reports, should disclose both short and long positions.
That would provide issuers and investors with a better
understanding of trading activity.
Now in closing, I’m reminded of Daniel Drew, an 19th Century
speculator and robber barron, who was fond of cornering markets
and enjoyed forcing short sellers to cover their shorts when there
weren’t enough securities available. He allegedly authored the
following refrain, “He that sells what isn’t his’n, must buy it back
or go to prison.”
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