Forget SEC "Regulations".... This is Good Old-Fashioned Fraud

It's been over a year since the SEC approved Regulation SHO, designed to supposedly alleviate the illegal prectice of naked short selling, in which billions of shares of counterfeit stock are sold short, or borrowed, but never delivered to their rightful owners.

As this fraud has grown exponentially, millions of stockholders who have bought stock in companies have discovered that the stock that they purchased has never been delivered to their accounts. Time after time, investors have requested their stock certificates, only to be told by their brokers that they can't deliver them.....because they never bought them in the first place. The excuses for failure to deliver what stockholders have bought and paid for are varied and numerous, but in the end, they are no more valid than "the dog ate my homework", or in this case, "the DTCC trade settlement system ate your stock certificates".

The band-aid that the SEC applied to the problem in the form of Reg SHO has done absolutely nothing to stem the flow of counterfeit shares being dumped onto the stock market, and in fact, has just served to point out just how rampant this scandal is, as numerous companies, both large and and small, have been on the "trade settlement failure" list since day one.....over 140 days and counting. That's 140 days (and who knows how long before the list was published) that stocks have been bought and sold to investors by brokers who NEVER DELIVERED THEM. (Remember that phrase: NEVER DELIVERED)

While the NASD has done nothing but make lame excuses and deny responsibility (even thought their own loopholes have helped to create this financial nightmare in our stock market system), thousands of hedge funds and their ultra-rich clientele have reaped the benefits of stock counterfeiting, by short selling billions of shares of counterfeit stock with absolutely no intention of ever delivering those shares, and the SEC has in effect pardoned all past transactions by "grandfathering" in all past trade settlement failures, and by constantly changing their interpretations of their own regulations to fit the crimes.

If this betrayal of the very investors who they are pledged to protect weren't enough, the SEC, in concert with the DTCC, has initiated a covert crusade to convince the states to eliminate paper stock certificates altogether, leaving investors with absolutely no way to of knowing if the stock that they've bought and paid for has been delivered to them, or if brokers are buying and selling them imaginary stock created out of thin air, stock THAT THEY NEVER DELIVER.

And Congress, who could step in at any time and put a halt to this massive fraud, this financial terrorism, this systematic dismantling of our economy and financial institutions, has, up to now, been all talk and absolutely no action. Oh sure, there have been some public displays of indignation, as far back as March of this year, and a few brave souls on Capitol Hill have spoken out, but so far, that's all that we've heard.....talk. In the meantime, billions and billions of dollars continues to pour out of America into offshore hedge funds and foreign entities, and there is compelling evidence that much of it is finding its way into organized crime syndicates and known terrorist groups. As I said earlier, this is financial terrorism, nothing less. (Note to our elected representatives: Actions speak louder than words.....especially your words.)

Investors and the companies involved have, in the meantime, been left with nothing......no shares, no money, and little recourse other than costly class action lawsuits. If the SEC is allowing the perpetrators to sidestep existing rules, and constantly reinterpreting their own rules to cover their own culpability in the fraud, what can be done to stop it, short of waiting for the inevitable collapse of the stock market system itself?

It's simple.....forget about the SEC regulations, forget about the self-regulating NASD, and forget about the DTCC's flawed trade settlement system. This is nothing more than good old-fashioned fraud, no different than any other type of fraud.

The news is filled with the stories of con artists convicted of internet fraud, mail fraud, or wire fraud:

A man in Salt Lake City pleads guilty to defrauding Internet customers of more than $200,000 by selling car parts that he didn't own, and THAT HE NEVER DELIVERED....he faces up to 20 years in prison.

A man in California is indicted for defrauding eBay users of more than $93,000 in auctions for sprorts tickets and rolex watches.....THAT HE NEVER DELIVERED.

In Maine, a man is convicted of accepting personal checks, bank checks, money orders, wire transfer payments and PayPal payments on eBay for merchandise THAT HE NEVER DELIVERED, and for failing to provide refunds. He was sentenced to six years in prison and forced to pay back his victims. (Is anyone else seeing a pattern here? On eBay, the buyer pays for their merchandise, and if the seller doesn't deliver it, they're arrested and they go to prison. It sounds simple enough, doesn't it?)

And just last month, a man right here in Oklahoma pleaded guilty to selling tickets to sporting events and concerts....THAT HE NEVER DELIVERED. Although he "only" defrauded his victims out of a total of $21,000, he faces up to 20 years in prison and a $250,000 fine.

The list goes on and on. In every case, the victims pay for their tickets, merchandise, or services, and in every case, the seller fails to deliver the items. There is absolutely no difference between the thousands of people convicted of these types of fraud and the brokers, hedge funds, and everyone else who is taking money from investors in exchange for shares of stock.....THAT THEY NEVER DELIVER.

When a stock transaction is conducted over the internet, and the stock is never delivered.....that's Internet fraud. The perpetrators should be arrested and sent to prison.

When a brokerage firm accepts money wired into accounts and buys stock with it that is never delivered.....that's wire fraud. They should be arrested, forced to pay restitution.....and sent to prison.

When an investor sends a check or money order to their stockbroker, and their broker uses the money from that check or money order to buy shares of stock that are never delivered to the investors' accounts.....that's mail fraud. They should be arrested, fined heavily.....AND SENT TO PRISON.

It's time we stop looking at stock market fraud as a practice that is immune to any law other than the SEC's own worthless regulations. It's time that every one of us demand delivery of the stock that is rightfully ours, while we still can. It's time we stopped allowing the brokers and hedge funds to play by their own rigged rules, and see this for what it really is....FRAUD, by any definition of the law.

(Editor's note: There is a demonstration planned in front of the Depository Trust and Clearing Corporation building at 55 WATER STREET, NEW YORK, NY 10041 on July 29th, 2005 at 10am. You can read more about it at

The Naked Truth on Illegal Shorting

By Karl Thiel
March 24, 2005

It's amazing how the word "naked" can liven up a discussion. Take naked short selling, for instance. The addition of this saucy little word turns the mundane act of borrowing and selling shares of stock in hopes of buying them back later at a lower price into a raging controversy fraught with conspiracy, secret identities, public recriminations, foreign intrigue, sports team owners, and now some of the top regulators in the land.

How can one word cause so much trouble? While legal short sellers must borrow the shares they sell, naked short sellers sell shares of stock they haven't borrowed, have no intention of borrowing, and that may not even exist. Not surprisingly, this activity is illegal and has been since the Securities and Exchange Act of 1934. But for a number of reasons, regulators have overlooked it in the past.

In response to a rising tide of complaints, however, the SEC recently introduced Regulation SHO, which went into effect Jan. 3. The idea was to put a stop to, or at least help control, abusive short selling practices. Unfortunately, the result of the SEC's effort so far has arguably been to turn rampant abuse into a spectator sport by simply providing a list of stocks being most abused… and doing little else.

Intrigue in the sock drawer
How bad is the problem? Listen to this story: On Feb. 3, a man named Robert Simpson filed a Schedule 13-D with the SEC describing his purchase of 1,158,209 shares of Global Links Corp. (OTCBB: GLKCE), "constituting 100 percent of the issued and outstanding common stock of the Issuer." As described in a story that ran on FinancialWire on March 4, Simpson stuck every single share of the company in his sock drawer -- and then watched as 60 million shares traded hands over the next two days.

In other words, every single outstanding share of the company somehow changed hands nearly 60 times in the course of two days, despite the fact that the company's entire float was located in Simpson's sock drawer. In fact, even as recently as last Friday, 930,872 shares of Global Links still traded hands. If Simpson's claim that he owns all shares is accurate, that is a staggering number of phantom shares being traded around by naked short sellers.

What we have here is a failure to settle
This is just one extreme example of a phenomenon a number of companies have complained about. Patrick Byrne, CEO of Rule Breakers recommendation Overstock.com (Nasdaq: OSTK), for instance, has noted seeing four and five times his company's float rack up in trading volume over the course of a day. Overstock has been on the Nasdaq Threshold Security List for weeks, indicating a consistent pattern of, um, settlement failure.

What exactly are settlement failures? In a legitimate short sale, shares must be delivered within three days of the transaction. If they are not, this is called (excuse the tortured syntax) "fails to deliver." Failure to deliver -- that is, a settlement failure -- could be the result of a bureaucratic snafu or clerical oversight. But consistent failure in large volume would seem to indicate something more nefarious, or at the very least, a major bureaucratic breakdown in desperate need of repair. Failures on the scale experienced by some companies go beyond any innocent explanation.

The Threshold Security List, published daily by Nasdaq, the NYSE, AMEX, and Archipelago (AMEX: AX), is the most visible aspect of Reg SHO. To make the list, more than 10,000 shares in a company or more than 0.5% of a company's total outstanding shares must fail delivery for five consecutive days. When a stock appears on this list, it is like a red flag waving, stating "something is wrong here!" When a hedge fund is actively shorting a number of stocks that just happen to be on the Threshold Security List, it would seem to be good cause for an investigation. To the extent that Reg SHO brings these issues to the attention of companies, investors, and regulators, it's doing a good thing.

Making the list
But many companies linger on the Threshold Security List, experiencing impossible trading volumes. Many are penny stocks like Global Links, but others include well-known names like Krispy Kreme Doughnuts (NYSE: KKD), Martha Stewart Living Omnimedia (NYSE: MSO), and Delta Airlines (NYSE: DAL). The issue has finally caught the attention of some members of Congress. At a March 9 hearing of the Senate Banking Committee, Sen. Robert Bennett (R-UT) brought up the subject of Reg SHO's shortcomings with SEC Chairman William Donaldson.

"Nearly as I can tell from my constituents who feel victimized by this," said Bennett, "it's not working." Summarizing how abusive practices might continue under Reg SHO, Bennett said: "I'm told that 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."

I really wish I could have heard how Donaldson would have replied. He began a recitation of the elements of Reg SHO before Bennett quickly cut him off. In a hurry to get to a vote, Bennett moved on to a new subject and Donaldson never really got a chance to comment. Pity.

One of Bennett's constituents is, probably not coincidentally, Patrick Byrne, whose company is headquartered in Salt Lake City. Naked shorting has become something of a cause celebre for Byrne over the past few months, not least because his company has apparently been subject to extreme levels of it. Byrne became interested in the subject after the company's now-famous fourth-quarter earnings conference call, when a man calling himself "Bob O'Brien" (he won't reveal his true identity for fear that angry hedge fund operatives will do him harm) described a pattern of manipulation of Overstock stock by naked shorts, and predicted the company would show up on the Threshold Security list. It did, the next day.

Cat and mouse
All of this raises an important question: If Reg SHO can pinpoint companies being manipulated, what can it do to stop the abuse? What are the teeth behind the regulation?

Glad you asked. 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.

While Reg SHO stipulates that a broker is supposed to locate shares prior to executing a short sale, there are certain exceptions to this rule. One is that if a stock appears on an "Easy to Borrow" list, this is considered "reasonable grounds" to assume the stock can be located for settlement, and the short sale may proceed without the broker contacting the source of the shares or specifically locating them. (A footnote in the SEC's discussion of the final rule [release number 34-50103] adds: "Of course, securities that are 'threshold securities' pursuant to Rule 203(c) should generally not be included on 'Easy to Borrow' lists." Geez, really? But sometimes it's OK for heavily manipulated stocks to be shorted further without locating shares?)

Another exemption is for "Bona-fide market making." Is it just me, or does the specification that bona fide market making is exempt -- versus sorta market making? --point to some possible wiggle room in interpretation? The SEC is quick to explain that, among other qualifications, "Bona-fide market making does not include transactions whereby a market maker enters into an arrangement with another broker-dealer or customer in an attempt to use the market maker's exception for the purpose of avoiding compliance with Rule 203(b)(1) by the other broker-dealer or customer." Thank goodness deliberately circumventing the rules is forbidden by the rules! That's kind of a tiny echo of Reg SHO itself, which is a set of rules about not breaking 71-year-old laws. I think history has shown us that the rules aren't terribly effective without enforcement.

Opportunity in slop
But in fairness, there is a reason why securities regulations around short selling have been, and continue to be, rather lax and loosely enforced. Remember that the stock market is an old and still largely paper-based system. While naked shorting has been technically illegal for a long time, that doesn't mean that brokers have always been expected to have borrowed shares in hand before executing a short sale. The Securities and Exchange Act of 1934 stipulates a settlement period up to three business days -- meaning in essence that any short can be a naked short for up to three days without a broker being expected to do anything about it. Getting high volumes of transactions completed has always meant acting first and settling later, and a certain amount of slop in the process has always been tolerated.

And where there is slop, there is opportunity. Brokers make money lending out shares, and any stock you own is subject to being lent unless it is held in an IRA or cash account. In fact, the commission brokers make on loaning out shares changes depending on how high the demand is for a certain stock. So when a stock goes into naked short territory, where there is potentially more demand than there are shares in existence, brokers stand to make a lot of money by executing short sales… even if they can't get their hands on the borrowed shares right away. It's one of those gray areas that doesn't necessarily indicate intentional wrongdoing on the part of brokers (at least on a small scale), but that arguably has come to be viewed with an increasing nudge and wink over the years.

Now enter the wackier part of this enterprise. If the borrowed shares are coming from overseas, that's a pretty good excuse for them to take more than three days to show up, right? Turns out a number of companies have suddenly found themselves listed on foreign exchanges without their knowledge. O'Brien raised this scam tactic in Overstock's fourth quarter 2004 conference call, but there is more to this than the opinion of one anonymous conspiracy theorist. A couple years ago, there were a number of biotech companies in just this situation, finding that their companies had been given German exchange listings without any request from management. And I'm sure that by the time I heard about this, the strategy had been around for a long while.

Parting thoughts
Believe it or not, there are actually defenders of naked shorting. By going beyond the normal system of supply and demand, the argument goes, naked shorting acts as a sort of pressure valve to price in negative sentiment on a company when the regular channels are too inefficient.

Thus, the usually upstanding website Investopedia actually offers this defense of naked shorting:

Critics of the new rule argue that if naked-shorting had not taken place during the micro-cap crime wave of the 1990s, such stocks would have climbed even higher before they crashed. Thus, the SEC's action to ban naked-shorting eliminated the only market force against over-hyped, or even fraudulent, small-cap and micro-cap stocks.

That's quite an argument. No one would dare suggest that the government should directly intervene to control the price of securities, but why not let prices be distorted by profit-seekers circumventing the law? Viva la Kleptocracy!

Can naked shorting really be so widespread? I don't like conspiracy theories, and there are some pretty good arguments as to why this problem would be a lot more apparent to rank-and-file investors if it were really so rampant. I'll discuss that in part 2 of this column next week. Plus, I'll look at some more of the specifics of naked shorting and what they mean to investors in the next issue of the Rule Breakers newsletter.

http://www.fool.com/news/commentary/2005/commentary05032407.htm

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