Tuesday, September 30, 2008

Naked Shorts Alive and Well

For an up-to-date listing of failed-to-deliver stocks whose (short) sellers have failed to deliver securities to buyers to such an extent that they meet the requirements for enhanced enforcement, have a look at the Regulation SHO list promulgated by NASDAQ. ACAS is still on this list, interestingly. Over 18% of ACAS is shorted, and the shorts apparently can't find (or haven't bothered to find) ACAS certificates to borrow in order to deliver them.

As I feared, the SEC isn't prosecuting failure to deliver. It's business as usual at the federal agency that Congress has charged with regulating the securities markets. If I were buying tires and they weren't delivered, I'd have a good suit under Texas law for deceptive trade practices, and I could get treble damages and my attorney's fees. It's a case so good that attorneys might take it on contingency -- exactly as the legislature intended with it passed the Deceptive Trade Practices Act decades ago. In Texas when you buy things, you can expect them to be delivered.

The fact that federal securities regulators can't be bothered to enforce something like the requirement to deliver securities is so bizarre that it passes understanding. It enables blatant price manipulation; cautious investors frequently place good-'till-cancelled limit sell orders to "protect" gains in a stock, or to limit losses, and short-term price movements caused by naked short positions' creation can trigger real sales by genuine investors unaware of the nature of the market activity in their stocks. (There are still market participants who make investments on the basis of balance sheets, and not geometric images superimposed on price charts. The SEC needs to go talk to some retail investors.) Once a cascade of real sales is underway, the selling pressure quickly exceeds the selling pressure created by normal exit interest: in addition to ordinary liquidation interest, and the liquidations of investors whose price thresholds have been reached, the market must absorb all the phantom shares "created" when the short-sellers entered the market.

In a simple exercise of market mechanics, it is possible to demonstrate that as immediate-term supply becomes infinite, the immediate-term price one can get for a marginal unit offered for sale will approach zero. Limitless cost-free shorting can destroy markets in any security in which there is a serious short effort: as price declines trigger legitimate sales, the resulting equity erosion will create liquidity emergencies in the accounts of investors who expect markets to enjoy the regulation set forth in the Rules. (It's not as if Google (GOOG) displayed some sudden shortage of cash during the last minutes of trading on September 30.)

If sellers were simply required -- as the rules purport -- to deliver securities they offered for sale, short-sellers would be forced to undertake effort to borrow shares, and the shares' loan would not be cost-free. In a regulated market, demand by shorts to borrow would act to create value: shorts required to borrow from a finite pool of share certificates would be forced to compete with each other to borrow the shares, and would bid up share rental fees commensurate with borrowing demand. The shorted shares would not be free, and the cost to maintain a short position would increase with the unavailability of certificates. If the delivery rules had any real meaning, the market would regulate itself.

Contrast the current situation, in which it is possible for two individuals to purchase more than 110% of a publicly-traded company's total outstanding shares, when short-sellers so swamp the market with phantom stock that share prices don't even change noticeably even immediately following a 350-1 reverse stock split. Share price and market capitalization can impact companies' ability to borrow (and trigger prepayment obligations and credit termination), owners' ability to maintain consistent management in the face of raiders, and investors' life savings. The problem doesn't exist because of some evil cabal of nefarious shorts, it exists because the market isn't doing what it promises: delivering securities to buyers.

As long as regulators facilitate cheating of this kind, the blame for gaming the system must fall back on regulators. If federal law didn't displace state law in the field of interstate securities markets, buyers would sue for common-law fraud when sellers didn't bother to deliver, and they'd win. Instead, Congress vests exclusive power to regulate this market in a tribe of monkeys that expects the forest to rain free bananas forever. We've taken a market that once had the power to regulate itself and, by making a game of the rules requiring delivery, we've made a game of the market itself.

Tell these monkeys you want human rule over the market, with traditional human market expectations like the delivery of what was paid for. The solution is as elegant as it is simple: sellers must identify -- in their own accounts, if they own them, else in an account in which they have permission to borrow the securities in question -- the securities the seller promises for delivery. The identification must be good at the time of the transaction, or the seller has no bona fide intent to deliver and the proposed transaction is a fraud at inception.

This is a rule that could readily be enforced by brokers. A secondary market in securities for loan should materialize quickly for securities in high demand by sellers who don't own the shares, and brokers would benefit from that market as intermediaries. The enforcement of the rule would have the salutary effect of restoring order to a marketplace by simply entering the most basic rule participants expect in markets: sellers mean to deliver whatever is bought.

Is it so hard just to enforce the rules?

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