Opportunities in smallcaps header image 3

Short sellers and naked shorting

We will give a primer with a couple of useful links.

Basically, to short a share is to borrow it, sell it on the markets with the intention to buy it back at a lower price. Naked shorting is basically selling the share, but not really borrowing it (or at least, failing to deliver the shares when they are due).

General information

An extremely nice, concise bullit point oversight of manipulation and regulation is a very good place to start.

Here are a series of bullet points that highlight everything you need to know about the current crisis, in “elevator pitch” format:

  • Wall Street has a colorful history of institutionally-condoned stock manipulation and fraud.
  • Stock manipulation was not illegal until the introduction of the SEC in 1934.
  • Joe Kennedy, the first SEC Chairman (and father of JFK) made his fortune running stock manipulation “pools” on Wall Street.
  • The head of the NYSE, who argued successfully against any meaningful regulation and oversight of Wall Street participants (brokers) by the SEC (due to their integrity and high moral fiber), and introduced the notion of self-regulation on the “honor” system (still in place today), was subsequently sentenced to 10 years in Sing-Sing for embezzling client accounts – including a fund in his care set up for orphans.
  • The SEC originally was envisioned to have prosecution power.
  • The final bill giving birth to the SEC was so anaemic and watered-down that it was chastised as nonsense when it was passed, and it severely constrained the new Commission, and limited the SEC’s power to filing civil suits. Virtually all the rules with Congressional teeth were stripped out of the bill, at Wall Street’s behest. That state of affairs continues to this day.
  • The SEC was never intended to police Wall Street and ensure a level and fair playing field – Roosevelt created it to, “Restore investor confidence in the market” after the 1929 and 1932 crashes – not to ensure there was any good reason to have confidence.
  • The SEC’s track record of action against Wall Street players is worse than abysmal.
  • Broker/dealers have transitioned from owing their clients a fiduciary obligation of safekeeping, to a “customer” relationship, that is essentially adversarial – caveat emptor being the rule for customers.
  • As commissions have dwindled to nothing (due to the advent of discount brokers, following deregulation) Wall Street is now beholden to the large money movers for their income, and stock lending is one of their biggest profit centers.
  • Stock lending is exclusively an activity used by short sellers, who must borrow stock before selling it.
  • Short selling is a bet on stock price declines. The short seller borrows stock, and then sells that borrowed stock, hoping to buy it back at a lower price later, when he returns it to the lender.
  • Illegal “naked short selling” involves placing a sales transaction, but not borrowing the stock, and simply failing to deliver it on delivery day. It is also called “failing to deliver” or FTD – or delivery failure.
  • Delivery failure is a significant problem nowadays, as it can be used to run stock prices down in a manipulative manner. Delivery failure in any other industry is called fraud. Hedge funds are the biggest culprits in this illegal trading strategy, with broker/dealers right behind them in the culpability queue.
  • Hedge funds are now the largest players in the US equities markets, representing the majority of trading, with almost $2 trillion under management.
  • Hedge funds are large, virtually unregulated pools of anonymous money, used to invest in any way the operator sees fit.
  • Prime brokers allow their hedge fund customers leverage on their assets, meaning that for every dollar of asset, they could easily hold $10 of short positions.
  • This over-leverage presents a systemic risk should positions in several larger funds go the wrong way, as there isn’t enough collateral to cover the domino effect of multiple positions being forced to cover.
  • This over-leverage creates an environment where the brokers are now pregnant with their hedge fund customers’ liabilities, and have a vested interest in seeing depressed stock prices remain depressed – if the stocks go up, the hedge funds could easily fail, and the brokers are on the hook to buy-in and deliver the stock owed by the funds – resulting in brokerage failures.
  • The DTCC is ultimately at risk for this domino effect, as brokerages fail.
  • The DTCC is owned by the brokers, thus is the brokers.
  • The DTCC processes over $1.2 quadrillion (million trillion) every year, and owns most of the stock American investors hold in their accounts – but most of the country has never heard of the company. The total GNP of the planet is about $20 trillion per year.
  • 1% of all trades in dollar volume fail to settle (be delivered) every day, per the SEC.
  • $130 billion to $150 billion of equities trade every day.
  • $2 trillion of total trades are processed by the DTCC every day, including bonds.
  • The SEC does not qualify whether they refer to total trades, or total equities, when referring to 1% failing to settle.
  • The SEC keeps the total dollar value of trades that have failed to be delivered secret.
  • The Securities Industry Association publishes a spreadsheet that tallies the financial position of all NYSE member firms, and that spreadsheet shows $63 billion plus delivery and receipt failures as of the final day of Q2, 2006, just for those firms. Lines 69 and 103.
  • The DTCC claims delivery and receipt failures are a rolling $6 billion per day.
  • The disconnect in the numbers is CNS netting, wherein all fails are netted against all shares held long by the brokers, effectively concealing 90+% of the problem once netting is through.
  • The $63 billion number doesn’t include any of the massive international clearing firms. And that number is after pre-CNS netting, where the day’s buys are used to offset the day’s sells (even naked sells) at the broker and clearing house level, before reporting to the SIA, and before going into the CNS netting system.
  • Of the $130 to $160 billion per day that trades in stock, per the DTCC, 96% is handled by CNS netting. This is consistent with the disconnect in the $6 billion and the $63+ billion numbers. 96% is handled by netting, which means 4% isn’t. 4% of $130 billion is $5.2 billion not handled by CNS netting. Of that $5.2 billion, $2.1 billion fails. $1.1 billion of the fails are accommodated by the stock borrow program. $1 billion isn’t, and goes onto the $6 billion post netting failure pile.
  • $5.2 billion per day aren’t handled by CNS netting. $2.1 billion fail. That is 40% of the trades, fail. $130 billion to $160 billion stock trades daily. $63 billion fails just in NYSE firms. That is around 40%.
  • The SEC insists that the failure issue isn’t a big problem. So does the DTCC. So does Wall Street. None of these entities have commented on the SIA spreadsheet, nor has the NY financial press. Not one comment. None.
  • $63 billion is a big problem. That is a mark-to-market number, where yesterday’s $20 stock is today $1, thus yesterday’s $20 billion problem is now valued as a $1 billion problem. That means the actual true value of the problem is likely 10-20 times larger.
  • $630 billion to $1.2 trillion is a very big problem. Even by NY standards.
  • The SEC “grandfathered” all failed to deliver trades prior to January, 2005, effectively pardoning all those trades (for which money was paid but no stock ever delivered), from ever being required to deliver. This amounts to allowing those that violated delivery rules to keep the money from their illegal conduct.
  • The SEC keeps the number of shares grandfathered, as well as the dollar amount, secret, for fear of creating market disrupting “volatility”.
  • The above numbers do not take into account the large number of undelivered trades that are handled “Ex-Clearing” – a way of handling delivery outside the system. Nor do they take into account pre-CNS netting, nor international clearing house fails.
  • Many securities scholars believe the “Ex-Clearing” failure problem is 10 times larger than the in-system problem the above numbers represent.
  • Many investors that think they have “shares” in their brokerage accounts, don’t. They have “markers” that have no underlying share to validate them. Some call these “counterfeit shares”, with good reason. The technical term is “Securities Entitlement.”
  • UCC8 mandates that all Securities Entitlements have a genuine share on deposit at the DTC, or in the broker’s possession, for each Securities Entitlement. That rule is ignored by the SEC and Wall Street.
  • The DTCC, via Cede & Co., is the registered owner of all shares held in “Street Name,” which are all shares in margin accounts.
  • Margin accounts represent the bulk of independent investor account types.
  • Registered owners are free to use their “property” as collateral for loans or debt.
  • It is unknown what, if any, loans or debts are collateralized by the stock “owned” by the DTCC.
  • The DTCC’s “Stock Borrow Program” lends shares to be delivered to buyers, if sellers fail to deliver.
  • The Stock Borrow Program is operated on the honor system, and is anonymous.
  • It allows one genuine share to be lent multiple times, leaving a string of markers/IOUs in the share’s wake.
  • This creates a systemic risk for the stock market, as more markers are in investor accounts, falsely represented as shares, than shares actually authorized by the companies.
  • These markers are freely traded and treated by the system as real, resulting in a large secondary market of counterfeit shares – resulting in depressed stock prices.
  • With paper certificates being eliminated – by the DTCC – there is no way to confirm that a share is genuine, versus a bogus marker.
  • There is nothing to stop your broker from taking your money, and merely representing to you that you bought shares, without ever actually buying them. You have no way of knowing the difference, barring demanding paper certificates for your property.
  • Only a handful of people on the planet understand all this.
  • In the end, it is simple – Wall Street is printing shares electronically, investors are paying real money for those bogus shares, and the whole thing is predicated on the idea that few will ever understand what is being done, or bother to check.
  • This represents a hidden tax on investors and the economy.
  • It is, for the most part, illegal.
  • It is being kept secret by the DTCC and the SEC, who are terrified of systemic collapse, and a complete loss of investor confidence, should all the facts become known.
  • All the facts are becoming known.

A more detailed, but very good description can be found here
And here is another description from one of naked shorters most famous victims here

Organized short attacks

Here is a story that describes the total game plan, you can find it here

The Anatomy of a Short Attack — Abusive shorting are not random acts of a renegade hedge funds, but rather a coordinated business plan that is carried out by a collusive consortium of hedge funds and prime brokers, with help from their friends at the DTC and major clearinghouses. Potential target companies are identified, analyzed and prioritized. The attack is planned to its most minute detail.

The plan consists of taking a large short position, then crushing the stock price, and, if possible, putting the company into bankruptcy. Bankrupting the company is a short homerun because they never have to buy real shares to cover and they don’t pay taxes on the ill-gotten gain.

When it is time to drive the stock price down, a blitzkrieg is unleashed against the company by a cabal of short hedge funds and prime brokers. The playbook is very similar from attack to attack, and the participating prime brokers and lead shorts are fairly consistent as well.

Typical tactics include the following:

1. Flooding the offer side of the board — Ultimately the price of a stock is found at the balance point where supply (offer) and demand (bid) for the shares find equilibrium. This equation happens every day for every stock traded. On days when more people want to buy than want to sell, the price goes up, and, conversely, when shares offered for sale exceed the demand, the price goes down.

The shorts manipulate the laws of supply and demand by flooding the offer side with counterfeit shares. They will do what has been called a short down ladder. It works as follows: Short A will sell a counterfeit share at $10. Short B will purchase that counterfeit share covering a previously open position. Short B will then offer a short (counterfeit) share at $9. Short A will hit that offer, or short B will come down and hit Short A’s $9 bid. Short A buys the share for $9, covering his open $10 short and booking a $1 profit.

By repeating this process the shorts can put the stock price in a downward spiral. If there happens to be significant long buying, then the shorts draw from their reserve of “strategic fails-to-deliver” and flood the market with an avalanche of counterfeit shares that overwhelm the buy side demand. Attack days routinely see eighty percent or more of the shares offered for sale as counterfeit. Company news days are frequently attack days since the news will “mask” the extraordinary high volume. It doesn’t matter whether it is good news or bad news.

Flooding the market with shares requires foot soldiers to swamp the market with counterfeit shares. An off-shore hedge fund devised a remarkably effective incentive program to motivate the traders at certain broker dealers

2. Media assault — The shorts, in order to realize their profit, must ultimately purchase real shares at a price much cheaper than what they shorted at. These real shares come from the investing public who panics and sells into the manipulation. Panic is induced with assistance from the financial media.

The shorts have “friendly” reporters with the Dow Jones News Agency, the Wall Street Journal, Barrons, the New York Times, Gannett Publications (USA Today and the Arizona Republic), CNBC and others. The common thread: A number of the “friendly” reporters worked for The, an Internet advisory service that hedge-fund managers David Rocker and Jim Cramer owned. This alumni association supported the short attack by producing slanted, libelous, innuendo laden stories that disparaged the company, as it was being crashed.
One of the more outrageous stories was a front-page story in USA Today during a short crash of TASER’s stock price in June 2005. The story was almost a full page and the reporter concluded that TASER’s electrical jolt was the same as an electric chair — proof positive that TASERs did indeed kill innocent people.

To reach that conclusion the reporter over estimated the TASER’s amperage by a factor of one million times. This “mistake” was made despite a detailed technical briefing by TASER to seven USA Today editors two weeks prior to the story. The explanation “Due to a mathematical error” appeared three days later — after the damage was done to the stock price.

Jim Cramer, in a video-taped interview with The, best described the media function:

When (shorting) … The hedge fund mode is to not do anything remotely truthful, because the truth is so against your view, (so the hedge funds) create a new ‘truth’ that is development of the fictionâ€| you hit the brokerage houses with a series of orders (a short down ladder that pushes the price down), then we go to the press. You have a vicious cycle down — it’s a pretty good game.

This interview, which is more like a confession, was never supposed to get on the air, however, it somehow ended up on YouTube. Cramer and The have made repeated efforts, with some success, to get it taken off of YouTube.
3. Analyst Reports — Some alleged independent analysts were actually paid by the shorts to write slanted negative ratings reports. The reports, which were represented as being independent, were ghost written by the shorts and disseminated to coincide with a short attack. There is congressional testimony in the matter of Gradiant Analytic and Rocker Partners that expands upon this. These libelous reports would then become a story in the aforementioned “friendly” media. All were designed to panic small investors into selling their stock into the manipulation.

They even do it to whole countries!

Finally, Washington is starting to notice

Shorts and IOC

This is not something new. Dancy had to say this a couple of years ago already (here):
The company is on the SEC’s regulation SHO list, and has been on of the list for 180 days. The SHO list is a listing of companies whose shares have been sold short but shares have not been delivered as required by regulation. Of the 340 companies listed, IOC has been on the list longer than all but 10 of the companies. (Dancy)

This points to the following:

1) The shorts were shorting IOC massively before Elk1 was discovered. This is not terribly surprising: mix an exotic country, a loss-making small refinery, an unknown company with large concessions but no resource find.

2) But then, Elk1 was discovered, and the shorts were caught offguard. An awkward dilemma loomed as the stockprice zoomed higher on that news. Covering would be very expensive, but not covering was also risky. They chose the latter.

3) There is something to be said for that, it gave them time, and to properly assess a resource find like Elk with a single rig to drill would take another couple of wells at least, and a couple of years. Time enough to come up with some game plan.

4) This is when the dirty stuff started, things like

  • Stocklemon started to write about IOC, crying ‘stranded gas’ because a pipeline to Australia (that never made any sense anyway) was cancelled and predicting instant gloom and doom two years ago
  • an small engineering company (Ross Energy) was hired to write a negative report on Elk (they had to make a rather embarrassing backtrack considering the flowrates for Elk1)
  • a negative page-long article was written by a free-lance journalist in the New York Times
  • paid bashers showed up on message boards
  • and off course, the shorts started to take control of the price for most of the time

We will give a few examples of those tactics in another write-up


3 responses so far ↓

  • 1 Drastic times argue for drastic measures.. // Jul 15, 2008 at 9:17 pm

    […] Short sellers and naked shorting […]

  • 2 InterOil anti-basher’s kit — // Jan 11, 2010 at 1:10 am

    […] It really is incredible how many times he invokes that article. It must be hundreds of times, and it’s not that the article is very significant (very few facts and quite a bit of innuendo), it just shows they do not have a whole lot more. It’s a prime exhibit of an article purposely written to create doubt, which, as we have stated above, is not very hard to do. If you think serious media can’t be abused for these kind of purpose, think again. And read the last part of this link. […]

  • 3 Berry Laws // Sep 5, 2011 at 2:25 pm

    I have contacted the SEC a month ago, but got the usual run around. 2 stocks that I mentioned would drop on great news for longs. This has happened repeatedly. Nothing accomplished by the SEC.

You must log in to post a comment.