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Are those new anti-naked short rules effective?

September 22nd, 2008 · No Comments

The short answer is, it all depends. Not everybody things the new crackdown will be effective. Some opinions..

Not everybody is happy with the new short selling rules:

  • So here’s the deal. I lost my job at a financial firm, lost all or most of the value in my ESPP, and the 401k match. So I figure, I lost so much money due to the financial industry, I might as well short it. If you can’t beat ’em, join ’em. Now I am losing again. I love government intervention.

From deepcapture

  • On Wednesday of this week, the SEC rushed out new rules that purported “zero tolerance” for naked short selling. According to the SEC, there would now be a “hard” close out rule, requiring hedge funds to deliver real stock within three days of selling it.
  • Even if the SEC were to enforce a three day settlement, it wouldn’t do much, because the manipulators work like this: A hedge fund tells his broker to sell a million shares of XYZ. The broker doesn’t have any shares, but he sells them anyway. That is phantom stock and for three days it dilutes supply, and eats away at the financial system. When settlement day comes, the broker asks a second broker to sell him a million shares of XYX. The second broker doesn’t have any shares, but he sells a million shares of XYZ (the price now much lower) to the first broker, who uses the phantom stock to settle his initial sale of phantom stock.
  • When the second broker has to settle, he calls the first broker…and the phantom stock shuffle continues until the falling price makes it impossible for the company to raise capital.

We already pointed out here that the most significant addition of the rules is the end of exemption of options market makers. Otherwise, the above quote from the deepcapture article suggest that nothing fundamental has changed.

Compare the above quote from a passage from Mothly Fool from 2005:

  • the way it works is that one brokerage house sells short, has 13 days under your rule under which to acquire the shares, and in that 13-day period hands the whole transaction off to another brokerage house. They just keep moving it around and nobody ever has to settle.
  • Under the new rules, if shares haven’t been delivered for 13 days after the transaction, the broker must buy them back — with money it presumably would collect from the client who shorted the stock in the first place. So a bad actor can break the law a little bit, but if he breaks it a lot, he has to cover the short — which he was going to have to do anyway and, since he’s been manipulating the price by illegal activity, can probably be done at a bargain price.
  • Now that’s showing the bad guys! Moreover, as Sen. Bennett noted, brokers working together could get around even this restriction by passing the transaction among each other, starting the 13-day clock over again.

A sequence also holds some interesting points:

  • But can unsigned or lost certificates really explain why some companies have lingered on the list for weeks, meaning that more than 10,000 shares per day or over 0.5% of the company’s entire float is subject to failed settlement on a daily basis? If that’s the root cause, it would certainly seem to point to some pretty shoddy settlement practices among broker-dealers.
  • The potential problem is that unscrupulous folks could potentially register as market makers to take advantage of the exemptions. (Do you want to be a market maker? Go here for an application! It’s not a rubber-stamp process, but it’s not as hard as you might think.)
  • And here is a final source of potential trouble I’ll suggest. Say the broker placing the order to short a stock is in an offshore location where naked short selling is legal. This would seem to open up the same opportunities purportedly exploited to naked short the stock of companies that have issued floorless convertible debt.

Instead of 13 days, brokers and market makers have to comply with the T+3 rule, that is, they have to deliver within three days. But selling to one another is still possible.

Here are more sceptics:

  • critics said that the SEC has not gone far enough to prevent stock manipulation, and some short-sellers said the rules will do little to stem the market’s decline.
  • A new “close-out” requirement will force short sellers and their broker-dealers to deliver borrowed securities within three days of the transaction date. In addition, options market makers are no longer immune from the naked short rules. A third rule makes short sellers liable for fraud to lie about their intention or ability to deliver securities in time for settlement.
  • Critics assert that the SEC already has been putting a tighter leash on short sellers, making a greater effort to enforce rules that already existed. Some portfolio managers that oversee funds with short positions say that the changes won’t have a major effect on the share prices of firms getting hit hardest.
  • It’s very hard to manipulate in the current environment because, first, we know we’re being observed,” says Vivienne Hsu, senior portfolio manager of the Schwab Hedged Equity Fund. “And, second, the market would squeeze out those types of buyers.”
  • Mark Coffelt, president and chief investment officer of Empiric Funds, which has both long and short positions, was also unfazed by the changes.
  • “Essentially what they’re saying is, ‘We’re going to enforce the rules,'” says Coffelt. “The SEC is really flapping its gums here — it’s really not doing anything different,” says Robert Ellis, senior vice president of wealth management at Celent. “They missed another opportunity to bring back the uptick rule. I guess lobbyists and hedge funds don’t want them to bring it back.
  • “Still, just the promise of a more watchful regulatory eye and the threat of enforcement action may lead some traders to close out questionable short positions, says Ellis.
  • Bharath says the new SEC rules are “probably useless” in the long term, but might prove effective as a short-term tactic to calm irrational selling.
  • “It is very important to send the psychological message that manipulation will not be tolerated to calm down the markets,” says Bharath. “Whether it has a real effect is not clear.”

And then, of coarse, the prime crusader against naked shorting Dr. Byrne:

  • Dr. Byrne commented, “At the core of the SEC announcement is a decision that if a hedge fund naked shorts a stock, its broker isn’t supposed to let them naked short again. But guess what: they were not supposed to naked short in the first place. Instead of giving the buyer who receives the fail the right to put it back to the naked short selling participant, the SEC once again opts for nerf penalties for financial rapists.
  • “If the SEC were anything but a hedge fund bootlick,” continued Byrne, “it would not have taken the half-measure of a pre-borrow requirement applied only as a penalty for those failing to deliver within T+3, but would have instituted a market-wide pre-borrow requirement (as it did in its July 15, 2008 Emergency Order protecting Upper Caste financial firms), and mandatory buy-ins at T+3.
  • Some questions for the SEC:
  • 1. How will the SEC determine whether an institution is in compliance with this rule? The only way to determine compliance is through an SEC audit, something that could only occur months after the fact. In the case of a bear raid, that will be too late.
  • 2. Where is the ‘buy-in’ requirement? Under the new SEC rules a crooked hedge fund can still naked short sell without settlement and keep that short open indefinitely. It appears that only future naked short sales will require a pre-borrow and that there is still no closeout requirement for failed trades.
  • 3. What of manipulative day trading? Chairman Cox has admitted that the financial stocks did not have a significant level of naked shorts, but rather collapsed under day trading activities. The new rule fails to address this, the very activity that generated the need for the July 15, 2008 emergency order. The manipulative day trading short seller never has a position open for three days. However, under the new rules, he can still use a single locate multiple times to create the best leverage possible to drive natural investors out of the market.
  • 4. Where are the penalties? Without meaningful penalties, these rules have no bite. The SEC needs to make sure that the rules are strictly and aggressively enforced — both for failures to deliver that occur within the CNS system and outside the CNS system in ex-clearing trades, where, I suspect, there is naked shorting that makes the object of current SEC concerns look like small potatoes.
  • “Rule 10b-21, the short selling anti-fraud rule, is a carefully contrived joke. It moves from a low-penalty too-vague-to-enforce rule, to a high-penalty too-vague-to-enforce rule. Without strict and aggressive SEC enforcement (for which the SEC has zero demonstrated record) it will be just more lines of meaningless pabulum in the Federal Register.
  • On the bright side, the SEC has eliminated a major loophole in Regulation SHO, the options market maker exception. There was never a good reason why options market makers should have been allowed to naked short and fail to deliver in perpetuity. For taking this long overdue action, I applaud the SEC.
  • “What is needed is a Congressional investigation into the abortion that is our nation’s stock settlement system, focusing especially on the DTCC. A healthy next step would be to unplug the SEC and move its functions into the DOJ.”

We are largely in agreement with Dr. Byrne, as we stated before that the most meaningful addition was the end of exceptions to option market makers. We are still hopeful though, that excessively long listing on reg. SHO list, for instance (listing non-delivered shares) will catch some attention and perhaps the new open disclosure rule (not agreed yet) will lead the SEC to place a few phone calls, followed with an audit..

Tags: IOC · The Markets