Update: New Alan Newman Crosscurrents article a must read.
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26) How can any one who borrows stock know that his borrow is not counterfeit?
Every borrowed share is part of the counterfeit scheme until the loan is repaid with bona fide shares. Actually, it’s the loaned shares that are phony. With the borrowed share comes the right to vote and the right to receive dividends. These rights are relinquished by the lender, according to industry practice. Unfortunately, industry practice has not included telling you about this. Read on.
27) What is your opinion on the effect that entitlements have had on the voting of proxies or where shareholders never get to vote their shares because the number of votes far exceed the outstanding shares?
My opinion is that it sucks for the shareholder! What I know about it is much worse than you may even realize. Here’s a link to a document put out by the Securities Industry Association that explains exactly how shareholder’s votes are NOT counted - and their plans to keep it that way: http://www.sia.com/2005_comment_letters/6136.pdf
Here’s a sampling of just how bad the situation of over-voting really is in 2006, as reported by the guys counting the votes.
If you don’t complain about this, if you don’t let out a “mighty yelp” then you will continue to read news articles with lines like this one from the Financial Times, published July 5 2006:
“…More obviously, somewhere along the chain, people would be hurting. For example, brokers, having to make their clients whole, would be kicking up a tremendous fuss. Since this does not seem to be the case, it is hard to believe naked shorting is the bogeyman some claim it to be.”
28) Why does the system not require/verify that a short seller actually has shares available, either owned or borrowed, at the INITIATION of the transaction, and prevent the transaction from proceeding if no shares are available?
The SEC generally believes that broker-dealers may need to facilitate customer orders in a fast moving market and so cannot tolerate the delays associated with actually obtaining shares for sale. In fact, even the “locate” rules as revised under Regulation SHO are full of exceptions to reduce the burden of complying with the locate rule. (The word “exception” appears 88 times in the 24 page final-rulemaking.)
29) Why does the SEC assist the DTCC in preventing the public from acquiring their own company trading information?
The answer to that question, unfortunately, may be in the political realm. From my own experience, the SEC doesn’t know much more about DTCC than you do. They surely know less about it than I do. DTCC simply writes rules that the SEC rubberstamps after a perfunctory comment period. Some people have suggested that because the major banks and brokers sit on the board of the DTCC, and management at the SEC often comes from the same group (or has designs on getting there after their tenure), top-level management does not wants to rock the boat.
30) What politicians in Congress do you feel are most responsible for holding back NSS reform?
Certainly the Banking Committee is at fault. The Securities Transfer Association and the Business Roundtable have made several attempts to get them to look at the proxy problems caused by short sellers and stock lending. That Committee has consistently rejected their request for help. The same goes for the Financial Services Committee. So take a look at who has served on those committees over the last 10 years and you’ll have the list.
31) How involved do you feel the White House is in solving the NSS issue?
I doubt anyone there will get past “naked” without a giggle-fest.
32) Do you believe Dr. Byrne/Overstock is moving in the best possible direction to resolve his problems with NSS? If not, what would you be doing?
Overstock has problems that go beyond Naked Short Sellers. If the problem were just short sellers, then the dilution of share value and shareholder rights could be corrected when the shorts are covered and the market price moved toward the real value of the firm. But when fails are added to the picture, then the shorts have no incentive to cover. The trade is allowed to remain unsettled indefinitely; there is no margin call because there is no loan. Finally, even where stock lending takes place, the problems are only compounded. Now not only does the original owner of the shares believe they have a right to vote and receive dividends, but the person who received borrowed shares at settlement thinks the same thing. And the SIA admits that they haven’t been telling customers that they don’t get to vote when their shares are on loan (even though the broker doesn’t have to tell the customer when they are lending the shares); and now the customer whose shares are lent is going to get a tax bill from the IRS because “payments in lieu of dividends” are not subject to the dividend exclusion.
I tell you as a fact: the Securities Transfer Association and the Business Roundtable have been fighting the proxy side of this for decades. They started at the exchange who told them that proxies are processed through DTCC so it isn’t the NYSE’s problem; they went through the DTCC who said they were only following rules approved by the SEC; and when they got to the SEC in 2004 they were told: “who cares who votes the shares?” The SEC’s philosophy is to intercept over-reporting before the issuers see the over-voting. In other words, they want to hide it away so they can go on denying there’s a rhino behind the couch.
A lot of other companies are being awakened to the problem of Naked Short Selling as a result of what they saw during this round of annual meetings. Once they are aware that the proxy problems are only the symptom of the broader issues of shorts, fails and loans, Dr. Byrne should find plenty of company moving in the same direction.
33) Do you think hedge funds are properly regulated? If not, what needs to change?
Marty Fridson (www.FridsonVision.com) recently wrote “‘Hedge funds to the rescue’ is reminiscent of ‘Milken is the savior’. The funds have avoided regulation thus far because many academics and politicians believe that they play some pivotal role in the capital markets. Marty declaims as myth the idea that “(t)he default rate will not go as high as in the past cycle because financing from hedge funds will enable many companies to avoid bankruptcy.”
34) What person or persons, have the most control over the DTCC ABOVE the DTCC BoD?
The BoDs at the member broker-dealers and banks.
35) Do you own stock in ANY company? If so, do you hold the certificates?
I have owned some shares of Xerox since about 1989. I do not have a certificate. I am directly registered as an owner with Xerox; that is, I have a book-entry account on the issuer’s records. This is commonly known as Direct Registration and thousands of companies offer this form of ownership.
36) A broker friend describes the NSS debacle as the "scandal of civilization". How bad do you think the situation is, and what is the worst case scenario if we continue down the track we are on presently?
The problem is more than naked short selling. The problem is three-fold: shorts, loans and fails. When a stock is sold, regardless of whether the trade is marked “short”, if the shares aren’t presented at settlement, there are problems created in the customer’s accounts when they are given what are called “entitlements”. If the fail (or legal short) is covered with borrowed shares, the situation is made worse when a voting or dividend record date passes because no one seems to be able to keep track of who owns what anymore.
If we continue down this path I see two outcomes. One is that companies and investors lose confidence in the capital markets and take their transactions private. We are already seeing a mass exodus of small and medium sized enterprises from public capital markets due to the high cost of Sarbanes-Oxley compliance. This leaves fewer choices in the market place for investors. Also, when investors understand that they are not being treated fairly under the rules of the capital markets, they will seek alternative investments (other assets, or perhaps foreign markets). With the departure of both issues and investors, liquidity will suffer as the markets become narrow and shallow.
The other outcome is that the manipulation allows criminals or others who may have the intention of disrupting the US economy to gain control of US corporations. There was a big fuss in the media and in Washington over foreign ownership of US ports. Yet there is nothing to stop anyone from taking control of a US corporation by generating enough phantom share entitlements that they could vote in changes in ownership and control (mergers, buy-outs, etc.).
37) As a simple "commoner", what are the top THREE things I can do to fight the NSS problem, BESIDES write my Congressperson and physically hold share certs?
1) Inform yourself; read Section 8 of the Uniform Commercial Code or a good summary of it; read Regulation SHO, including the footnotes. 2) Write letters to the editor when you see short sellers and hedge funds being displayed as saviors of the capital markets; or anytime you see the issues being misrepresented. 3) When I worked in Russia, if we had an important meeting that we had to take the Russian team members to, we always gave them one piece of advice: wear dark socks. Nothing looks worse than white socks under a black suit. Be careful of the impression you leave on the people you meet and talk to about NSS. Get to the facts when you talk to media, politicians, and neighbors. Don’t expect them to care about your problem as much as you do, so use the WIIFM approach: explain “what’s in it for me.”
One more thing: you limit the ability of regulators and politicians to respond to you when you try to sum up the problem as just “naked short selling”. It’s a nice piece of short-hand when you want to find out if someone has heard about it, but it doesn’t do justice to the real problem. Remember: shorts, fails and loans. Although a combination of shorts and fails without loans generates the same result as naked short sales, even one of the three alone can disrupt the financial system.
38) If the stock borrow program of the DTCC is designed to cover temporary difficulties in obtaining the stock, why is the duration of the borrow not limited to, say, 10 days?
This is a question that DTCC and the SEC should be made to answer. Unfortunately, since they can’t even seem to get trades to settle in any finite timeframe, it’s unlikely they’ll consider limiting the duration of stock loans.
39) We've heard words like "endemic" and "common" to describe FTD issues. Given that, what does that mean? Are there lots of FTD's but concentrated in a few stocks or is it a few FTD's spread all around?
As many of you may already know, Dr. Leslie Boni had access to data on fails from DTCC while she was a research fellow at the SEC. Using that report and additional data from the SEC and the stock exchanges, Dr. Robert Shapiro found “evidence that as few as 10 or less NYSE and NASDAQ threshold securities may account for as many as two-thirds of fails among exchange-listed threshold stocks, and 20 or fewer NYSE and NASDAQ threshold companies may account for as much as 75 percent of all fails among listed securities.” Clearly, some companies have more than their share of fails.
But don’t be fooled into thinking that means the problem is limited. What is happening to Overstock today could happen to Xerox tomorrow or Apple on Thursday. There is nothing in the infrastructure or regulation of the capital markets in the US that would prevent it. The only limiting factor being discussed by the experts is the total cash commitment necessary to take down a company (relative to how much cash the company needs to outlast the short sellers). With the trillions of dollars available in the hedge funds, the upper-limit may be quite high.
40) When these issues have been raised within the DTCC, what has been the reaction? As an SRO, how can they not act?
I was told “You can’t balance the world.” They trivialize the magnitude of the problem by, for example, comparing the value of failed trades on one day to all trades settled in a year. A Financial Times reporter recently wrote, “The Securities and Exchange Commission, for instance, says that the average daily 'fails to deliver' are down some 34 per cent from January 2005 to May 2006 compared with April to December 2004.” Why compare the activity of 17 months to that of 8 months? It looks like someone really had to stretch to find a comparison with a decline. So when trivializing doesn’t work, they go for obfuscation.
Don’t forget that a company like Bank of New York (BoNY) is a transfer agent, a broker and a bank. So the BoNY transfer agent lets out a might yelp about over-voting caused by short selling and stock lending. Meanwhile, the BoNY broker is making a killing on short sales and the BoNY banker is making money hand-over-fist on stock lending. These are the firms whose employees are on the Boards at the SROs. They have no incentive to change anything.
41) You set up clearing and settling for Russia. If you had carte blanche to reform the US system, what changes would you implement?
First, do not tolerate failure to settle – period. If it’s not finished by T+10, buy it in and if you can’t buy it, you have to bust the trade. Next, there has to be a time limit on stock loans; and under no circumstances should a loan remain open over a record date. Finally, require short sellers to go out and borrow the stock before the sale; with all the electronic interfaces around, I find it hard to believe that the two could not be done nanoseconds apart, thereby avoiding delays in trade execution.
These ideas only address the most urgent needs for reform. However, if we don’t fix the big leak, it will be too late to worry about the little cracks.
42) Many on Wall Street pay lip service to the idea that transparency makes for a more efficient market, though they don't seem to practice that. Would transparency in FTDs make for more efficient markets? What would the outcome be, in the short term, and after a few years of FTD transparency?
Eliminating trade failures as a trading strategy would make for a more efficient market. How long do you think a product market would survive if sellers were permitted to take money from customers and not deliver the goods? The purpose of demanding transparency in FTD data is to be able to combat the acceptance of trade failures as a business practice.
43) We've been portrayed as a bunch of nutcases. Are we?
I haven’t met all of you, so it’s hard to say. Jeffrey Dahmer’s neighbors thought he was a nice, quite young man…. I will say that this problem is very real, very dangerous and very difficult to fix.
44) What effect do non-US markets have on the FTD issue, and is there any aggregated data anywhere to determine that? Are foreign exchanges a red herring or a component with impact? If the latter, what reforms can be enacted to decrease that?
We are really struggling just to get data out of the US market on fails. The Japanese markets got a taste of the problem last year, but there is less emphasis on individual investor involvement in Europe than here so it’s less likely they will recognize the symptoms when they arise.