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The 'phantom shares' menace: naked short selling distorts shareholder control.

In 1985, the National Association of Securities Dealers (NASD) commissioned Irving M. Pollack, a securities law expert and former Securities and Exchange commissioner, to conduct a comprehensive review of short selling in NASDAQ securities. The NASD sought to determine what, if any, additional short selling regulation was needed for the NASDAQ market. The result was the now-famous "Pollack Study," which described the short selling landscape of the day and made important recommendations regarding the disclosure, reporting, and settlement of short sales.

Pollack concluded that short selling was a vital source of liquidity and a valuable mechanism for efficient price discovery. He added, however, that without proper institutions to guarantee prompt clearance and settlement of short sales, short selling was open to abuse. Of the settlement regime, he cautioned that it "effectively insulates the clearing corporation and brokers from fails to deliver and receive by contra-parties; but it permits fails to deliver and receive to develop without an automatic check." He issued a sober warning:
 The fail-to-deliver/fail-to-receive problem has the potential for
 causing serious difficulties in a lengthy bear market. While the
 evidence does not suggest that delivery problems exist in many
 securities, the fact that there is no automatic mechanism
 preventing the substantial buildup of short positions at the
 clearing corporation and of fails to receive in brokerage firms
 carries the potential for serious problems, particularly in the
 event of crisis market conditions.

The phrase "short positions at the clearing corporation" refers to "failures to deliver" (FTDS), which effectively increase the net supply of an issue in circulation and, by definition, depress price. This price depression is, of course, more significant for small and medium cap companies than for large cap companies with greater liquidity.

There is currently much controversy surrounding so-called "naked short selling," about which Pollack also warned over two decades ago. Some companies, investors, and academics see naked short selling and the delivery failures that can result as harmful (and illegal) wealth destruction mechanisms. Skeptics claim that naked short selling, as an issue, is buoyed only by poor-performing companies and investors seeking a scapegoat for stock price declines.

Unfortunately, the drama associated with this clash has drawn attention away from the uncomfortable fact that illegal, unsettled trades are a large and growing problem in U.S. equity markets. Those unsettled trades threaten the corporate voting system, the viability of small companies, and market integrity as a whole. Large unsettled trades persist because of loopholes in stock market institutions and apathy on the part of those charged with enforcing existing regulations.



Physical stock certificates are an anachronism in modern stock markets. Today, stock ownership changes are reflected in electronic book-entry movements among broker-dealers' accounts at the Depository Trust Company (DTC), a central stock depository and member of the Federal Reserve System. The DTC acts as a custodian for the majority of securities issues. The DTC emerged in response to the "paper crisis" of the 1960s, when stock transfer volume in the United States grew so large that issuers, transfer agents, exchanges, and brokerages were unable to process efficiently the paperwork associated with stock trades. The marketplace was overwhelmed by paper and timely transfer became impossible. The securities industry created the DTC in order to make stock transfer efficient and orderly.

The DTC modernized markets through "dematerialization": the transition from physical stock certificates to electronic bookkeeping. With dematerialization came major revisions to the Uniform Commercial Code in 1977, and later in 1994. Those revisions introduced "security entitlements" to our markets, which took the place of direct share ownership. Strictly defined, a security entitlement "guarantees an entitlement holder a priority in the financial assets held in [an] account over the securities intermediary or the security intermediary's creditors."

Today, investors trade in securities entitlements while physical certificates are held in "fungible bulk" at the DTC. As Erik Sirri, director of the SEC's Division of Trading and Markets, explained at a 2007 symposium on proxy processing:
 Broker participants in DTC own a pro rata interest in
 the aggregate number of shares of an issue held by
 DTC. And their beneficial owners, the end customer,
 owns an interest in the shares in which the brokers,
 themselves, have an interest. Consequently, there are
 no specific shares directly owned by either broker participants,
 DTC, or the underlying beneficial owner. As
 a result, the beneficial owner's ownership cannot be
 tracked to a specific share, but rather, his ownership
 interest is represented as a securities entitlement at his
 or her own broker dealer. Each of these beneficial
 owners don't own the actual shares that have been
 credited to their account, but rather, they own a bundle
 of rights defined by Federal and State law and by
 their contract with the broker.

That bundle of rights is represented by security entitlements in investor brokerage statements. Most investors, however, believe that a security entitlement is an electronic claim of ownership on a given number of shares of an issue. That belief is incorrect.

The DTC is a subsidiary of the Depository Trust and Clearing Corporation (DTCC), which acts as a central counterparty for U.S. exchanges and markets for equities, bonds, U.S. Government treasuries, and other securities. The DTCC manages the clearance and settlement system for U.S. equities through its subsidiary, the National Securities Clearing Corporation (NSCC). While physical payment and stock transfer occur within the DTC, it is the NSCC that provides final settlement instructions to customers and participant firms.


Short selling is a bet that a stock price will decline. A short seller borrows stock and then sells it, hoping to buy back the same amount of stock later, at a lower price, for return to the lender. Though sometimes controversial, short selling is a legal and vital source of liquidity and efficient price discovery. Executing short sales without borrowing or delivering shares, however, can lead to delivery failures.

Naked short selling involves selling without first borrowing stock (or even locating stock to borrow). If a naked short seller does not borrow the stock he sells, he will be unable to deliver that stock to the buyer to settle the trade. Intentional naked short selling is illegal, though market makers are currently allowed to naked short temporarily when engaged in bona fide market making. (Even market maker FTDs, however, are illegal when delivery failure exceeds 13 days.)

In U.S. equity markets, settlement occurs within three days of a trade. In the case of both long and short sales, if shares are unavailable for delivery then the settlement process can be complicated by FTDS and "failures to receive" (FTRS). To the extent that FTDs and FTRs are only occasional and temporary, trade in security entitlements rather than physical shares helps to keep markets liquid and efficient.

Delivery failures are problematic, however, when they are large and persistent. In those situations, FTDs act as "phantom" or counterfeit shares that circulate in the system as real shares. Just as counterfeit currency dilutes and destroys value, phantom or counterfeit shares deflate share prices by flooding the market with false supply.

Retail brokerage customers generally never learn that they paid money for something that failed to be delivered to their accounts. That is because retail customers' brokerage account statements do not reveal whether delivery takes place; even when no shares are delivered at settlement, share entitlements are still credited to the buyer's account. Those credited share entitlements then trade in the market as if they were real shares issued by the company.

Though part of the Federal Reserve System, the DTCC is collectively owned and operated by the large U.S. brokerages. As a result, DTCC operations are technically overseen by the SEC. In fact, the DTCC operates with minimal SEC oversight. Until recently, the size of past (but not current) FTDs in given equity issues could only be obtained through petition to the SEC's Freedom of Information Act office, which must request the information, in turn, from the DTCC. This process took months and resulted in the release of stale market data. The SEC recently made available for Internet download limited FTD data for all securities listed on U.S. equity markets. As this article goes to print, however, only FTD data from the previous fiscal quarter are available (starting with August 2007). The DTCC claims to support limited disclosure of FTD data, but no additional data have been disclosed beyond that offered by the SEC.

The data released through Freedom of Information Act requests reveal that FTDs represent a significant percentage of average volume in the major exchanges and select issuers, as shown in Tables 1 and 2. The DTCC claims that FTDs and FTRS sum to $6 billion daily, or 1.5 percent of the dollar volume. But that $6 billion is only the present ("marked to market") value of failed trades and perhaps represents just a fraction of the total problem. Because many failed trades go undelivered for months or years, they effectively depress prices by creating false supply.

Delivery failures are not confined to the equity markets. According to the Securities Industry and Financial Markets Association (SIFMA), at the end of the second quarter of 2007, NYSE member firms had over $42 billion in FTDs and $150 billion in FTRs. It is unclear what portion of those fails represents equities and what portion represents fixed income, derivatives, or other securities. The SIFMA Fails Working Group wants to develop a Standard Fail Report so that broker-dealers can effectively report fails to trade counterparties.

CNS In equity markets, the origin of FTDs is obscured by the Continuous Net Settlement (CNS) system, operated by the NSCC. The CNS constantly nets stock trades among broker-dealer accounts at the DTC. In a dematerialized world, the CNS allows trades to settle promptly and efficiently, and helps to provide liquidity when there are occasional and temporary FTDs. According to Sirri, through CNS the NSCC effectively "steps in between two parties to a trade and nets each party's obligation to trade over multiple trades, so that each obligation to receive or deliver, and an obligation to deliver or receive, can be combined together into one." He adds,
 If the broker fails to deliver to NSCC, NSCC allocates that
 fail using a random distribution algorithm to the broker
 that is due to receive securities of that issue. This
 innovation in netting process precludes identifying or
 tracking which specific customer or broker fails to
 receive shares. The broker that did not, in fact, receive
 securities because of this allocation will nonetheless
 credit the securities positions to his customer accounts
 even though no shares appeared in their DTC account.
 This creates an imbalance between the number of shares
 credited to the broker's DTC account and the number of
 shares credited to the broker's customer accounts.

By cloaking delivery failures in anonymity, CNS opens up the settlement system to abuse and fraud. Pollack remarked in 1986, "While the CNS system ... has substantially increased the efficiency of the clearing process, the unlimited mark-to-the-market procedures also permit brokers to postpone delivery indefinitely, unless the purchasing broker initiates buy-in procedures." Forcing delivery and payment from trade counterparties through such buy-ins is, however, exceptionally rare in the stock market because of the resulting reputation effects. In a 2005 analysis of 69,000 stock transactions, economists Richard Evans, Christopher Geczy, David Musto, and Adam Reed found that buy-ins occurred only 0.12 percent of the time.

The DTCC asserts that CNS has "eliminated the need to settle 96 percent of total obligations." If the DTCC processes $400 billion in trades daily as claimed, then $384 billion are netted out and only $16 billion require delivery. In a 2005 letter to the DTCC, Robert Shapiro, former undersecretary of commerce for economics, observed that the $6 billion in FTDs that exist on any given day is 37.5 percent of the $16 billion in trades that require delivery--"25 times the 1.5 percent reported by the DTCC."

Notably, the FTD data do not include "ex-clearing" transactions-that is, trades cleared directly by brokers that bypass the DTCC. Those trades are also referred to as "non-CNS" in that they occur external to the NSCC and are reported differently. Neither the SEC nor the exchanges will disclose the names of the institutions failing to deliver on the grounds that "fails statistics of individual firms ... is proprietary information and may reflect firms' trading strategies." That statement seems odd; what is proprietary about data on illegal trading activity? Moreover, how are FTD data more proprietary than short interest data, which are reported twice monthly?


The little that is known publicly about FTDS is available as a result of Regulation SHO, implemented by the SEC in January 2005 to curb abusive naked short selling and reduce FTDS. Regulation SHO requires exchanges to publish daily lists of firms with FTDs that exceed a pre-determined threshold. That list is known as the Regulation SHO Threshold List. According to SEC chairman Christopher Cox,
 The need for Regulation SHO grew out of long-standing
 and growing problems with failures to deliver
 stock by the end of the standard three-day settlement
 period for trades.... Selling short without having stock
 available for delivery, and intentionally failing to deliver
 stock within the standard three-day settlement period,
 is market manipulation that is clearly violative of
 the federal securities laws.

According to the SEC, 11,345 securities have "graduated" from Threshold Lists since January 10, 2005, "representing 8.2 billion shares in fails." Public data aggregated from the exchanges reveal that 6,555 unique securities have appeared on Threshold Lists since Regulation SHO was adopted (there are roughly 15,000 total publicly traded equity issues in the United States). Thus, as shown in Table 3, many companies have been on the Threshold List more than once; some have been on for hundreds of trading days, belying the SEC's 13-day settlement rule.

In response to questions submitted by the House Financial Services Committee in June of 2007, the SEC claimed that Regulation SHO had reduced fails. The SEC compared a pre-Regulation SHO period (April 1, 2004 to December 31, 2004) to a post-Regulation SHO period (January 1, 2005 to May 31, 2007) for all stocks with aggregate FTDs of 10,000 shares or more as reported by the NSCC. In that period, the SEC found:

* The average daily aggregate FTDs declined by 27.0 percent.

* The average daily number of FTD positions declined by 14.0 percent.

* The average daily number of threshold securities declined by 38.0 percent.

* The average daily fails of threshold securities declined by 50.8 percent.

However, the SEC's choice of time periods was selective, and appears to mask what subsequent data show is a serious and growing problem. First, the SEC's assertion that aggregate FTDs are decreasing is false. As depicted in Figure 1, NSCC data on aggregate fail-to-deliver positions across the New York Stock Exchange, NASDAQ, bulletin boards, and pink sheets show that fail levels are highly volatile and, on the whole, increasing.

By comparing the average of this time period with the average of the pre-Regulation SHO time period, the SEC appears to make a statistical error. To see this, consider the incentives faced by broker-dealers and other market participants with large FTD positions pre-Regulation SHO. The final rule was announced on July 28, 2004, with a compliance date of January 3, 2005. Without knowledge of how Regulation SHO would be enforced, it is likely that those firms tried to reduce fails in the SEC's pre-Regulation SHO comparison period (April 1, 2004 to December 31, 2004). Once it was clear that enforcement would be minimal and compliance unnecessary, fails increased again in 2005. That scenario yields FTD averages consistent with both the SEC's claims and the recent increase in fails.

Second, not only have the aggregate FTDs in the system increased in the face of Regulation SHO, but FTD positions in certain public companies have grown large and persistent. That finding is consistent with a 2005 paper by University of New Mexico finance professor Leslie Boni, who researched the FTD issue for the SEC and found that fails were concentrated in hard-to-borrow stocks. Pollack wrote that the same was true 20 years ago: "When extensive short selling occurs, stock is not readily available and sometimes cannot be borrowed at all. In these cases, the incentive to deliver securities is substantially less, and there may be an incentive to avoid or postpone delivery."



Serious loopholes in Regulation SHO have perpetuated settlement failures. In a 2006 public hearing, Cox spoke candidly of "abusive naked short sales...which can be used as a tool to drive down a company's stock price to the detriment of all of its investors. The Commission is particularly concerned about persistent failures to deliver in the market for some securities that may be due to loopholes in the Commission's Regulation SHO."

GRANDFATHERING One such loophole is Regulation SHO's "grandfathering" of FTDs that occurred prior to January 2005. The regulation also allows FTDS that do not remain open long enough for the issuer to appear on the Threshold List.

The SEC voted to eliminate the grandfather clause in August 2007. That rule change became effective December 5, 2007.

OPTIONS MARKET MAKER EXCEPTION The second loophole is the options market maker exception. In theory, stock markets are made more efficient by intermediaries who "make markets" in order to smooth price and volume fluctuations. A market maker poses as a buyer or a seller, acting as a temporary counterpart-/when needed to create market liquidity. Ideally, market maker positions last minutes or hours; generally, positions are closed out at the end of each day. In the process of making markets, market makers may temporarily need to sell stock they do not have. For this reason, Regulation SHO has allowed options market makers an "exception from the uniform 'locate' requirement ... for short sales executed by market makers ... including specialists and options market makers, but only in connection with bona-fide market making activities."

Not surprisingly, market participants have abused this exception. There is clear evidence that, when shares in a stock are hard to borrow, sophisticated short sellers illegally "rent" the exception in order to obtain phantom shares that they can sell into the market as real shares. For example, in July 2007 the American Stock Exchange disciplined two options market makers for precisely this violation of Regulation SHO; aggregate fines and penalties totaled $8 million.

In response to overwhelming evidence of abuse, the SEC proposed amending Regulation SHO to narrow or eliminate the options market maker exception in August 2007. The SEC writes:
 We are concerned that persistent fails to deliver will
 continue in certain equity securities unless the
 options market maker exception is eliminated entirely.... The
 ability of options market makers to sell short
 and never have to close out a resulting fail to deliver
 position, provided the short sale was effected to hedge
 options positions created before the security became a
 threshold security, runs counter to the goal of similar
 treatment for fails to deliver resulting from sales of
 securities and may have a negative impact on the market
 for those securities.

In the proposed amendment, the SEC suggests that the options market maker exception has been misread and abused:
 [T]he current options market maker exception only excepts from
 Regulation SHO's mandatory 13 consecutive settlement day close-out
 requirement those fail to deliver positions that result from short
 sales effected by registered options market makers to establish or
 maintain a hedge on options positions established before the
 underlying security became a threshold security. Thus, it does not
 apply to fails to deliver resulting from short sales effected to
 establish or maintain a hedge on options positions established
 after the underlying security became a threshold security.

Moreover, the SEC admits that the exception is being used improperly to roll failed positions:
 [It] has become apparent to us during the comment
 process that the language of the current exception is
 being interpreted more broadly than the Commission
 intended, such that the exception seems to be operating
 significantly differently from our original expectations.... For
 example, options market makers' practice
 of "rolling" positions from one expiration month to
 the next potentially allows these options market makers
 to not close out fail to deliver positions as required
 by the close-out requirements of Regulation SHO.

Though the comment period for the proposed elimination officially ended in September of 2007, comments are still being accepted by the SEC and no action has been taken.

LOCATE REQUIREMENT Another crucial loophole in Regulation SHO lies in the nebulous wording of the "locate" requirement, which allows a broker-dealer to execute a short sale with only "reasonable grounds to believe that the security can be borrowed so that it can be delivered." The locate requirement originated with SEC proposed rule 10b-21 (1973), which said one "had to borrow or have reasonable grounds to believe the stock could be borrowed" prior to effecting a short sale. That rule was withdrawn, but the concept later evolved into NASD Rule 3370, which requires that "prior to accepting a short sale order ... a member must make an affirmative determination that the member will receive delivery of the security from the ... broker-dealer or that the member can borrow the security on behalf of the ... broker-dealer for delivery by the settlement date." This vague standard makes meaningful enforcement nearly impossible; the "reasonable grounds" condition is easy to meet and difficult for a prosecutor to refute.

Regulation SHO includes important exceptions to the locate requirement. Besides the options market maker exception discussed above, there is an exception for stocks on so-called "easy-to-borrow" lists. Regulation SHO states:
 "Easy to Borrow" lists may provide "reasonable
 grounds" for a broker-dealer to believe that the security
 sold short is available for borrowing without directly
 contacting the source of the borrowed securities. In
 order for it to be reasonable that a broker-dealer rely
 on such lists, the information used to generate the
 "Easy to Borrow" list must be less than 24 hours old,
 and securities on the list must be readily available such
 that it would be unlikely that a failure to deliver would
 occur.... [R]epeated failures to deliver in securities
 included on an "Easy to Borrow" list would indicate
 that the broker-dealer's reliance on such a list did not
 satisfy the "reasonable grounds" standard of Rule 203.

Broker-dealers also create "hard-to-borrow" lists, but "the fact that a security is not on a hard-to-borrow list cannot satisfy the 'reasonable grounds' test" of Regulation SHO.


FTDs threaten market integrity in at least three ways:

* They undermine corporate voting mechanisms.

* They damage and destroy firms.

* They increase the possibility of systemic collapse.

On the first point, large and persistent FTDs lead to more claims of ownership than there are shares to own and vote, resulting in chronic over-voting and undermining our corporate voting system. According to Sirri, "Hopefully, in time the broker who fails to deliver will deliver shares to DTC and correct the imbalance. If the broker does nothing to rectify this imbalance, the firm may ultimately end up casting more votes than actually he is entitled to vote based on the number of shares it has at DTC." Bob Drummond of Bloomberg Markets Magazine reported in April 2006, "In close contests with little room for error, the results of high-stakes company decisions may hinge on the invisible influence of millions of votes that shouldn't be counted." According to Thomas Montrone, CEO of Registrar and Transfer Co., "It is an abomination.... A lot of the time we have no idea who's entitled to vote and who isn't. It's nothing short of criminal." Another securities consultant notes, "There are votes cast twice on almost every matter of substance.... It definitely can and does, in my experience, affect the outcome of corporate elections and proposals."

Bloomberg Markets also reported on a review of proxy vote counts conducted by a large stock transfer agent in 2005. That review, originally made public by the Securities Transfer Association, a trade group for stock transfer agents, tabulated the results of all proxy votes submitted by banks and brokers in 2005. For 341 equity issues, attempted over-voting--the submission of too many ballots--occurred in all 341 cases. Arbitrageurs are exploiting this crack, suggests Drummond; one source notes, "It appears to be the case where there are opportunities to game the system." Drummond concluded that until these problems are fixed, "double and triple voting on one share will continue to make a mockery of shareholder democracy."

On the second point that companies and shareholder value are destroyed, former SEC chairman Harvey Pitt claims:
 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.

Boni shows that many FTDs are strategic--that is, concentrated in a subset of issues. The distribution of those failures is inconsistent with the hypothesis that they occur through random human error. As Boni put it diplomatically, persistent fails "are more likely the result of strategic fails rather than inadvertent delivery delays." That is, they are intentional. Because regulations are loose and (as we will see) enforcement is lax (and difficult), some market participants are apparently unafraid of intentionally failing to deliver.

Shapiro, who now is a consultant for lawyers representing some of the alleged victims of naked short selling mentioned above, said in a 2007 Bloomberg Television special report on unsettled trades that as many as 1,000 public companies were damaged by naked shorting prior to enactment of Regulation SHO:
 A lot of those companies are gone. A lot of them died.
 This was a fatal attack. Now, some of them were weak
 when they were attacked. Some of them would have
 failed anyway. Others wouldn't have. Again, it's not up
 to the naked short sellers to decide. It's up to the
 investors that play by the rules.

Skeptics argue that many (if not most) companies harmed by naked short selling suffer from performance problems or poor business models. The SEC's own "Key Points about Regulation SHO" contains this warning:
 There also may be instances where a company insider
 or paid promoter provides false and misleading excuses
 for why a company's stock price has recently
 decreased.... [T]hese individuals may claim that the
 price decrease is a temporary condition resulting from
 the activities of naked short sellers.... Often, the price
 decrease is a result of the company's poor financial
 situation rather than the reasons provided by the
 insiders or promoters.

Following the SEC's lead, the DTCC has responded to lawsuits from companies challenging its role in settlement failures by attacking those companies' financials. DTCC general counsel Larry Thompson writes, "According to their own 10K and 10Q reports financial auditor's disclosure statements, many of these firms have admitted that 'factors raise substantial doubt about the company's ability to continue as a going concern.' They have had little or no revenue...and substantial losses." Nevertheless, fraud and illegal manipulation are never justified, even in situations where an issuer has genuine performance problems.

Moreover, fails in thinly traded equity issues are far more toxic than fails in thickly traded treasuries or other securities. At a high enough concentration, such FTDs could threaten market integrity. Some S00 million shares remain unsettled at the DTCC on any given day. Bradley Abelow, a former DTCC director questioned under oath for confirmation as New Jersey treasurer, described failures within the settlement system as "occur[ing] as a matter of course with great regularity," adding "fails to deliver of securities is endemic." Boni describes the FTDs as "pervasive." In fact, according to the SEC, "The grandfathering provisions of Regulation SHO were adopted because the Commission was concerned about creating volatility where there were large pre-existing open positions." That concern may have been justified. If FTDs result in more claims of ownership than physical shares of an issue, what happens when fail data are made public? What happens if the fail data reveal that the imbalance exceeds the liquidity in the system?


On the topic of "massive naked short sales," Shapiro writes:
 [T]his type of stock manipulation has occurred in
 many hundreds and perhaps thousands of cases over
 the last decade.... Illicit short sales on such a scale or
 anything approaching it point to grave inadequacies
 in the current regulatory regime.

The answer to why these "grave inadequacies" exist lies in the structure of the SEC, in the design of the rule-making process, and in the incentives faced by SEC staff.

The SEC Division of Trading and Markets (formerly the Division of Market Regulation) provides daily oversight of major securities market participants, including exchanges and self-regulatory organizations, broker-dealers, clearing agencies, stock transfer agents, proxy processing services, and credit rating agencies. The Division of Trading and Markets also proposes and adopts new SEC rules. Rule proposals go through three stages:

* Concept release, where the SEC describes a general area of interest and asks for guidance from the public.

* Rule proposal, where the SEC puts forward a specific proposal and solicits formal comment from the public.

* Rule adoption, where the SEC considers the public comments and formulates the final rule.

If all five SEC commissioners vote to adopt the rule then it becomes regulation and is incorporated into the Federal Register.

The 2003 SEC short sale rule proposal was broad and instructive. The proposal provided historical context for short sale rules (including the now-eliminated "tick test"), short sales in connection with a public offering (Rule 105), short/long order marking requirements, market making and rule exceptions, and preconditions for effecting short sales. The proposal asked for public comment on short sale abuses and delivery failures connected with naked short sales.

The Regulation SHO comment period lasted over six months, until July 2004. Public comments were divided and voluminous. The broker-dealer community, both individually and through its trade group, the Securities Industry Association (now SIFMA), favored a permissive regulatory regime that refrained from punishing those who failed to deliver on the grounds that such leniency would maximize liquidity. In addition to submitting letters, SIFMA organized conference calls and meetings with SEC staff. Retail investors and members of the general public, on the other hand, submitted passionate but generally less polished opposing views. For reasons unknown, few issuers commented.

The contrast between SIFMA and retail investors-and their relative influence over the SEC rulemaking process-reflects the classic dispersed costs and concentrated benefits model of political action. It is economical for broker-dealers to unite and lobby the SEC for favorable regulations. SIFMA meets with SEC staff regularly, both to discuss specific proposed rules and to offer guidance on future SEC actions. Retail investors, on the other hand, are not unified and it is expensive for individuals to gather information, organize, and lobby the SEC as the SIFMA does.

Not surprisingly, the grandfather clause and the options market maker exception were suggested by SIFMA members and the options exchanges, respectively. No members of the public had opportunity to comment on those "loopholes" before they were made law. Furthermore, the original Regulation SHO proposal suggested penalties for failing to deliver. After strident objections by SIFMA-member firms, that proposal was dropped.

Though there are loopholes, Regulation SHO is not as nugatory as some critics maintain. The regulation clearly states that fails must be closed out after 13 days and even options market makers may not fail in issues with enough FTDS to be on the Threshold List. Regulation SHO also has clear reporting and order marking requirements. Enforcement of even those watered-down rules has been weak, however. The SEC itself acknowledges that rule violations are extant, but in response to the 2007 review by the House Financial Services Committee the Commission admitted that, "To date, there have been no Commission enforcement actions announced involving Regulation SHO."

The exchanges have taken some action. In July 2007, the American Stock Exchange fined two options market makers for Regulation SHO violations. The year before, the New York Stock Exchange brought four Regulation SHO enforcement actions, censuring and fining Daiwa Securities America, Goldman Sachs Execution and Clearing, Citigroup Global Markets, and Credit Suisse Securities (USA) for operational deficiencies and supervisory violations concerning Regulation SHO. The cases resulted in total fines of just $1.25 million.

Notably, those cases focused on the actions of the broker-dealers and not their clients. For example, Goldman Sachs Execution and Clearing was sanctioned for repeatedly accepting clients' faulty locates and allowing those clients to mis-mark short trades as long (in order to avoid compliance with Regulation SHO). But the stock exchanges' jurisdiction extends only to member firms. Institutions and investors fall outside of that jurisdiction, but within the purview of the SEC, whose inaction therefore shields institutions and investors.

Why has the SEC Enforcement Division taken no action when the SEC admits that there remain "large and persistent fail to deliver positions?" One explanation may be that certain provisions of Regulation SHO are too imprecise for meaningful enforcement. (For example, what is meant by a "reasonable grounds to believe" that a security can be borrowed prior to selling short?) Another hurdle is that Regulation SHO contains no mention of penalties for those who violate the rules. Those explanations, however, are belied by the NYSE and AMEX enforcement decisions noted above. Those decisions followed the text of Regulation SHO and found violations so flagrant that even brokers acting on behalf of clients were sanctioned.

It is also possible that, in the wake of prominent fraud and accounting scandals, the Enforcement Division has become focused on issuers and largely ignores broker-dealer misconduct. That would be ironic given that the 1933 Pecora Hearings (which predated the 1933 Securities Act and the 1934 Securities and Exchange Act) expressly investigated the actions of brokers and speculative investment "pools," which were notorious fonts of long- and short-side market manipulation, including both penny stock scams and "bear raids."

Institutional inertia may also be a factor. A recent Government Accountability Office report revealed serious operational flaws in the SEC's Enforcement Division and the Office of Compliance, Inspection, and Examination. As Sen. Chuck Grassley (R-Iowa) summarized in a September 2007 memorandum:
 The GAO report ... found that two-thirds of the SEC's
 cases had been open for more than two years, one-third
 had been open for more than five years, and 13
 percent had been open for more than 10 years. Many
 of these cases "had not resulted in an enforcement
 action and were no longer being actively pursued,"
 according to the GAO. The GAO also found that the
 SEC's system for tracking cases was "severely limited
 and virtually unusable."

A more sinister explanation is that SEC investigators face political pressure and other incentives not to pursue Regulation SHO cases. The GAO report was requested by the Senate Judiciary Committee, which was investigating serious allegations of misconduct and corruption in the firing of former SEC attorney Gary Aguirre. Prior to his dismissal, Aguirre led an insider trading investigation that implicated Pequot Capital and led to John Mack, CEO of Morgan Stanley. When Aguirre tried to subpoena Mack, the investigation was terminated. Aguirre's superior, branch chief Robert Hanson, said in an e-mail that the investigation would be problematic because Mack's legal counsel had "juice." Shortly thereafter, Aguirre was fired.

In May of 2006, Aguirre wrote ranking members of the Senate Finance Committee, describing serious oversight problems at the SEC and the return of 1920s-style speculation to the American capital markets. Aguirre also described how naked short selling emerged as an important component of his investigation into Pequot and Morgan Stanley:
 The [market manipulation] prong of the investigation
 involved two classes of suspected violations: wash sales
 and naked shorts. Some of my colleagues believed this
 prong held a greater potential to severely injure the capital
 markets. Evidence indicated that hedge funds used
 wash sales to spike stock prices just as unregulated pools
 used wash sales to spike stock prices in the 1920s. The
 investigation of both wash sales and naked shorts led to
 the hedge fund's prime broker, a large investment bank.

After an extensive investigation and several public hearings, the Senate Finance and Judiciary Committees issued a joint 711-page report that confirmed all of Aguirre's claims. The report criticizes the SEC for its failure to act in the face of clear evidence that Pequot and Morgan Stanley had engaged in manipulative conduct. More importantly, the report excoriates the SEC's Office of the Inspector General (OIG), which is tasked with evaluating the SEC's "compliance with policies, procedures, laws, or regulations":

The OIG investigation into Aguirre's allegations was flawed from the beginning and hindered by missteps during the entire process.... One of the major problems with the OIG seems to be the perception within the SEC regarding the independence of the office and whether or not employees who approach the OIG are treated fairly. The SEC needs to take immediate action to restore the independence, competence, and confidence in the OIG. One area in need of attention is the OIG's independence from SEC management.... [F]acts and circumstances do not suggest a sufficient degree of independence.... Congress passed the IG Act in 1974, with the goal of ensuring that the public would have faith in government by providing an impartial arbiter tasked with independently overseeing the operations at an agency, protecting the integrity and promoting the efficiency of government.... [T]he OIG at the SEC seems to have failed in its mission.

Walter Stachnik, the first and only SEC inspector general at that time, resigned the day after the report's release.

On March 4, 2008, the SEC proposed a new anti-fraud rule directed at "misrepresentations in connection with a seller's ability or intent to deliver securities by settlement date." In theory, the rule would offer the SEC Enforcement Division additional tools to curtail manipulative naked short selling and the delivery failures that can result. The rule proposal is now in a public comment period. It remains to be seen what the final text of the rule will be and how it will be enforced.


Unless action is taken to reform regulations governing the settlement system, unsettled trades will multiply. As they do, voting will be further corrupted, companies will be destroyed, and the pre-conditions for a systemic event will be fed.

Unfortunately, the impetus for reform will not come from the securities industry itself. Hedge funds and the prime brokers that serve those funds benefit from unconstrained naked short sales. Hedge funds benefit because they can short without paying to borrow stock first. Prime brokers benefit by loaning out the same securities multiple times to different clients. As of the third quarter of 2007, hedge fund assets were $2.68 trillion and growing, as was the demand for shares to borrow. Securities lending generates $16 billion annually, and prime brokerage is among the most lucrative businesses for broker-dealers.

Harvey Pitt recommends the following to solve the FTD problem:

* The SECs needs actively to pursue ongoing chronic and serial short selling infractions.

* Meaningful penalties have to be imposed for violations of existing Regulation SHO requirements.

* The SEC should define and punish abusive naked short selling practices as securities fraud.

* The SEC should eliminate the option market maker exception. It is not demonstrably of any value, and it risks facilitating illegal activity.

* Regulation SHO should impose firm locate requirements as a condition precedent to all short sales.

* Chronic and unjustified violations of settlement rules should be punished.

* 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.

Numerous economists, the U.S. Chamber of Commerce, members of Congress, public companies, and hundreds of retail investors have urged the SEC to amend and enforce provisions of Regulation SHO. Whether the SEC will close the loopholes giving vague license to a highly profitable crime is yet to be determined. To borrow a phrase from Sen. Daniel Patrick Moynihan, the SEC has an unfortunate record of "defining deviancy down"--that is, making rules to accommodate existing market practices, regardless of how offensive those practices may be to law or common sense.

The SEC and the DTCC defend occasional naked short selling and delivery failures on the grounds that they foster "liquidity." Such arguments reveal that these regulators and professionals have forgotten that a price is a mixture of scarcity, risk, and value; unlimited liquidity obliterates scarcity and undermines the price system. As William Donaldson, Pitt's successor as chairman of the SEC, once remarked, "How much fraud are you willing to tolerate for liquidity? I think the answer is zero."


* A Review of Investor Protection and Market Oversight with the Five Commissioners of the Securities and Exchange Commission," prepared by the Committee on Financial Services, U.S. House of Representatives. June 26, 2007.

* Address to the Coalition Against Phantom Trading, by Harvey Pitt. November 16, 2007.

* "Corporate Voting Charade," by Bob Drummond. Bloomberg Markets Magazine, April 2006.

* "Failure Is an Option: Impediments to Short Selling and Options Prices," by Richard B. Evans, et al. May 5, 2003.

* "Married Puts and Reverse Conversions on the Chicago Stock Exchange," by John W. Welborn. October 9, 2007.

* "Naked Short Selling and the Stock Borrow Program," by Larry Thompson. DTCC First Deputy General Counsel, 2005.

* "Phantom Shares," a Bloomberg Television Special Report. Air date: March 14, 2007.

* "Phantom Shares," by Jonathan E. Johnson III. Washington Times, November 21, 2007.

* "SHO Underperforms in Reducing Fails," by David Patch. June 27, 2007.

* "Short-sale Regulation of NASDAQ Securities," by Irving M. Pollack. July 1986.

* "Short Selling, Death Spiral Convertibles, and the Profitability of Stock Market Manipulation," by John D. Finnerty. March 2005.

* "Strategic Delivery Failures in U.S. Markets," by Leslie Boni. June 25, 2005.

* "The Firing of an SEC Attorney and the Investigation of Pequot Capital Management," prepared by the Minority Staff of the Committee on Finance and the Committee on the Judiciary, United States Senate. August 2007.


The Haverford Group

John W. Welborn is an economist with the Haverford Group, an investment firm.
Table 1
Failures to Deliver on Major Exchanges (2006)

Exchange Peak FTDs Peak Date Average Volume

NYSE 172,707,364 31-Jan-06 1,701,643,478
and pink sheets 1,337,784,073 13-Mar-06 15,455,938,738

Exchange FTDs as % of
 Average Volume

NYSE 10%
and pink sheets 9%

SOURCES: SEC, Exchanges

Table 2
FTDs of Select Securities (2004-2006)

Issuer Peak FTDs Peak date Average

Cal-Maine (CALM) 2,498,529 10-Jan-05 430,102
Global Crossing (GLBC) 2,387,641 21-Jan-05 660,604
iMergent (11G) 289,054 2-May-05 30,385
Inhibitex (INHX) 3,129,627 7-Apr-06 20,738
Krispy Kreme (KKD) 4,652,372 28-Mar-05 4,359,081
Netflix (NFLX) 4,959,482 3-Jan-05 2,578,794
Novastar Financial, 3,223,846 10-Nov-04 409,272
 Inc. (NFI) (OSTK) 3,800,172 20-Mar-06 932,835
Vonage (VG) 5,662,925 30-May-06 1,681,333

Issuer FTDs as % Shares FTDs as
 of average outstanding shares
 volume on peak day outstanding

Cal-Maine (CALM) 581% 23,682,000 10.55%
Global Crossing (GLBC) 361% 22,054,000 10.83%
iMergent (11G) 295% 12,124,200 2.38%
Inhibitex (INHX) 15,091% 30,243,300 10.35%
Krispy Kreme (KKD) 107% 61,756,000 7.53%
Netflix (NFLX) 192% 52,732,000 9.41%
Novastar Financial, 788% 6,357,000 50.71%
 Inc. (NFI) (OSTK) 407% 20,536,000 18.50%
Vonage (VG) 337% 154,727,000 3.66%

Table 3
Threshold List
Total number of days on the list, January 2005-January 2008

Days # of Securities

 13+ 4164
 25+ 2698
 50+ 1478
100+ 625
200+ 172
400+ 22
600 4

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Author:Welborn, John W.
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Date:Mar 22, 2008
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