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Expert Financial Analysis and Reporting

Part 6 Illegal Naked Shorting: The SEC’s Regulation SHO is Intended to Prevent Illegal Naked Shorting, But is Ineffective


In previous blogs I traced the history of stock trading from the 1960s when stock certificates and cash were physically exchanged to settle trades to the paper free, totally electronic system that exists today. Instead of owning stock certificates, we now own digital entries located somewhere in the vaults of the inscrutable Depository Trust and Clearing Corporation (DTCC). This electronic system is absolutely critical to the functioning of our capital markets and our strong economic system. However, the DTCC and the prime brokers who own it have made the clearing and settlement system virtually non-transparent. This enables the routine manipulation of primarily but not exclusively, small stocks through illegal naked shorting.

The Securities and Exchange Corporation (SEC) is an independent federal government agency responsible for protecting investors, maintaining fair and orderly functioning of securities markets and facilitating capital formation. It enforces legislation that was first passed in 1938 to address short selling. There was no further legislation until 2005 when Regulation SHO was implemented specifically to address naked shorting issues that were a result of the move to the electronic clearing and settlement system. In my opinion, Reg SHO is riddled with loopholes that render it ineffective in protecting investors from stock manipulation schemes enabled by illegal naked shorting. Also, the SEC seems strangely unconcerned about controlling illegal naked shorting and stock manipulation that results.

This blog goes into some of the key rules of Reg SHO which are routinely circumvented by Prime Brokers, the DTCC (owned by Prime Brokers) and aggressive, short selling hedge funds who routinely execute stock manipulation schemes enabled by illegal naked shorting. Before reading this blog, you might want to review my five prior blogs on illegal naked shorting that provide important background information.

Regulation SHO was Legislation Intended to Stop Illegal Naked Shorting

In 2005, the SEC formally adopted Regulation SHO that is intended to prevent illegal naked shorting and stock manipulation which it facilitates. It defines locate and close out requirements relating to stock borrowed to execute short sales. It also places limits on trading in threshold securities that have experienced substantial Failures to Deliver in which a stock in a short sale is not delivered at settlement. For an ordinary short sale, the stock must be located before the short sale can be executed. However, “bona fide” market makers are exempted from this rule and can short shares without locating the stock. This is naked shorting which if executed in accordance with the rules of Reg SHO is legal. When these rules are not followed, it becomes an illegal naked short.

If the stock involved in the naked short can be located and borrowed in the two day period before settlement, it is just an ordinary short sale. However, if the stock cannot be located and borrowed prior to settlement, it creates a Fail to Deliver (FTD) situation. If the case of an FTD, a broker dealer is supposed to take cash from the short account and purchase shares in the open market to close out the position. “Bona fide” market makers who are perceived as providing liquidity to stock trading can maintain naked shorts for a longer six day period.

In practice, these provisions are routinely circumvented so that FTDs are not closed out. This results in the creation of counterfeit shares which the DTCC treats in the same manner as legal, registered shares. A nearly unlimited supply of such counterfeit shares can be created to overwhelm buy interest in a stock and drive down the price. This is a routine practice on Wall Street that is at the heart of innumerable manipulation schemes. This blog focuses primarily on rules of Reg SHO that attempt unsuccessfully to prevent illegal naked shorting. Later blogs will focus on techniques used to circumvent Reg SHO.

Locate Requirement

Ordinary investors are required to locate and borrow shares from another investor who is long the stock before executing a short sale. However, under Reg SHO, broker-dealers are treated differently and are allowed to execute a short sale without having borrowed the stock. Rule 203 (a) states that if broker dealers have reasonable grounds to believe that the security can be borrowed and delivered on or before the date that delivery is due, they can naked short. This often relies on easy to borrow lists of securities that are generated and policed by prime brokers. Hard to borrow lists are also maintained which are intended to prevent naked shorting in stocks that appear on this list.

Under Reg SHO then, a broker dealer can short stocks appearing on the easy to borrow list without first locating the shares to be delivered at settlement. If the shares are not located in time or not at all as in the case of illegal naked shorting, this is called a Fail to Deliver (FTD). The SEC says that repeated FTDs is a reason to remove the stock from the easy to borrow list. Stocks on the hard to borrow list should not be shorted before a locate. Also, absence from the hard to borrow list does not satisfy the reasonable belief requirement.

There is considerable ambiguity in the SEC’s reasonable belief definition and the easy and hard to borrow lists are created and maintained by broker dealers, not the SEC. These lists are subjective with no standard guidelines. This vague rule enables illegal naked shorting. Brokers can also use the DTCC’s stock borrow program to circumvent this requirement. The stock borrow program is little understood and is at the heart of much illegal naked shorting. I plan to go into this in much more detail in the next blog.

 Bona Fide Market Makers are Granted Exceptions to the Locate Provision

The SEC has consistently stated that it believes that both legitimate shorting and naked shorting are important to maintain market liquidity. The agency’s actions seem to consistently place more importance on liquidity than preventing illegal naked shorting. Very importantly, Reg SHO exempts bona fide market makers from locate requirements that apply to ordinary investors because it believes this is necessary to facilitate customer orders and maintain liquidity in fast moving markets.  Hence, market makers are not required to adhere to the locate rule. They can naked short stock without a locate.

There is a lot of gray area in what constitutes a “bona fide” market maker. Reg SHO states that the exemption to the locate provision does not apply to speculative trading. It also states that market makers cannot use this to facilitate trading strategies for clients (short selling hedge funds). These guidelines are routinely ignored in day to day business on Wall Street.

In many cases, it is difficult to distinguish between market makers and hedge funds. All of the prime brokers are market makers and also operate hedge funds which they euphemistically refer to as proprietary trading. Also, the change from a fractional to a decimal system for trading stocks devastated the profitability of OTC market makers. In response, many shifted their strategy to become hedge funds while remaining market makers. Also, some of the larger hedge funds expanded their business model to include market making. These widely accepted business models often result in avoiding the locate provision. These prominent market participants can implement speculative short selling by masquerading as a “bona fide” market makers. The SEC seldom can differentiate between market making and speculative trading.

Close-out Requirement.

Rule 204 of Reg SHO covers the situation in which the short seller Fails to Deliver (FTD) the stock at the determined settlement time. If this occurs, Rule 204 requires action on the part of the brokers and dealers from whom the stock was borrowed to close out the trade by demanding that the short seller buy the stock in the open market. Settlements are made two days after a stock trade and this rule requires that the short seller must close out a FTD no later than the beginning of regular trading on the first day after the settlement date. This is three days after the trade and is referred to as T+2.

There are exemptions (of course) to this rule. If a broker- dealer has a FTD, but can demonstrate that that this resulted from “bona fide” market making activities, the close out of the FTD can be extended to the third day after the scheduled settlement day (T+5).  If the position is not closed out, a participant in the short sell can not undertake more short sells unless it has entered into a pre-borrowing agreement as ordinary investors are required to do. This restriction stays in place until the FTD is closed out. Shortly, I will describe how this rule is easily avoided.

Threshold Securities

Rule 203(B) is a component of Reg SHO which mandates the creation and operation of threshold securities lists. These are securities that have large and persistent Fail to Delivers that are a hallmark of illegal naked shorting. The SEC defines these as equity securities that have an aggregate Fail to Deliver position totaling 10,000 shares or more for five consecutive settlement days and is equal to at least 0.5% of the issuer's total shares outstanding. The various major exchanges create and publish these lists on a daily basis.

Designation of a stock as a threshold security triggers provisions of Reg SHO that are intended to eliminate the FTDs. If the security remains on the threshold list for thirteen days (T+13), whoever was responsible for delivering shares thirteen days earlier (likely a broker-dealer or market maker) must close out the failed position by purchasing equivalent shares in the open market. Until the time that the market participant responsible for the FTDs closes out the position, they cannot enter into new short sales of the threshold security without having first borrowed or entered into a bona fide agreement to borrow the shares. Unlike the locate requirements of Rule 203(A), market makers are not exempt from these close out requirements.

.In practice, this has not worked out so well. Many companies remain on the threshold list for months at a time. This can be explained by a practice in which the FTDs are rolled over from one brokerage house to another. After thirteen days, a market maker that naked shorted the shares is required by Reg SHO to buy shares in the open market and deliver them. However, before the close out requirements are triggered on day thirteen, the market maker can transfer the position to another willing market maker or broker and the thirteen-day countdown to a mandatory buy-in starts all over. This frequently used Wall Street trading technique allows FTDs to remain for months or years.

Techniques Used to Circumvent Reg SHO

 The SEC has limited enforcement ability and seems to be content to allow Wall Street and the DTCC to police themselves. This was made evident in one lawsuit that I read in which a household name Prime Broker was alleged to have committed numerous illegal actions. These are representative of techniques that are used routinely across Wall Street by almost all prime brokers. Examples are:

  • permitting important hedge fund clients to bypass the locate requirement when entering short sales,
  • creating and distributing easy to borrow lists that improperly included threshold and hard-to-borrow securities to the firm’s proprietary traders and clients
  • concealing FTDs through washed and matched trades, i.e. rolling over an FTD to another broker dealer
  • transacting illegal stock sales in dark pools off the primary markets to avoid NYSE oversight and to maintain anonymity
  • failing to reasonably supervise that locates were obtained and/or documented for short sales
  • falsely marking short sales as long on order tickets to conceal naked short positions,
  • falsely representing that they either possessed the borrowed securities or had located them for borrowing and delivery.
  • failing to make legitimate or reasonable efforts to locate shares prior to short selling,
  • entering into fictitious option contract to conceal naked short sales;
  • using the DTCC stock borrowing program as a means to conceal naked short sales,
  • submitting fake short interest and other reports to regulators;
  • concealing their activity through falsely reporting shares created through illegal naked shorting as shares in brokerage statements of investors as if these assets were representative of real shares
  • concealing their activity by issuing voting material to shareholders with nonexistent assets who have no corporate rights including the right to vote shares,
  • failing to comply with responsibilities and duties to investigate and report suspicious transactions to regulatory authorities

Elimination of the Uptick Rule

Another noteworthy change in rules governing short selling was the elimination of the uptick rule that required an increase in the stock price before allowing a short sale. Bernie Madoff successfully led the effort to eliminate the uptick rule in 2007. Madoff’s firm was both a market maker and a hedge fund and an enthusiastic participant in illegal naked shorting. This was secondary, of course, to his money management pyramid scheme. Until the latter was discovered, Madoff was a highly respected source of input for the exchanges and the SEC and is widely given credit for getting rid of the uptick rule.

The SEC endorsed and defended the decision stating that the uptick rule reduced liquidity. This is another example of the SEC placing much greater importance on liquidity to the benefit of Wall Street than on protecting investors from predatory Wall Street trading practices. Not all agreed with Bernie and the SEC.  On August 27, 2007, the New York Times published an article by Muriel Siebert, the well- known and respected former state banking superintendent of New York in which she expressed severe concerns about the effect on the market. She said "The SEC took away the short-sale rule and when the markets were falling, institutional investors just pounded stocks because they didn't need an uptick.”



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