The Anti-naked Short Selling Manifesto – Or Why There Needs To Be Market Reform
As I responded to a gentleman in one of our forums, I was struck by a glaringly obvious central point that all of the apologists for naked short selling want to avoid like the plague, and that drove me to jot down some thoughts on why I am opposed to illegal naked short selling, and why I believe the markets need to be reformed. So with no further preamble, here it goes:
1) Naked short selling (NSS) is fraud. FRAUD. That is what it is. A product is advertised for sale, the buyer’s money is taken, and the product is not delivered. Naked short selling = fraud – nothing else, no matter what terms are used.
2) The impact of the fraud on the company is immaterial to the fraud perpetrated against the investor – the fact that the first fraud is a central part of a different fraud, namely to depress a stock’s value (stock manipulation using NSS), doesn’t change the first, and core, fraud.
3) The arguments for naked short selling being good, or positive, ignore this simple truth. As does the SEC’s grandfathering. As do the euphemisms created by an industry that benefits directly from the fraud.
4) Apologists for the practice routinely float a number of arguments, each specious, and yet the arguments are floated credulously by the press as though they hold water. They don’t, and I’ll describe them briefly and explain why they don’t:
* Argument A – Good companies aren’t hurt by naked short selling; if they are solid, the company will ultimately do well.
Truth: Defrauding shareholders is fraud, and the impact on the company is a red herring. Either you are pro-fraud, or anti-fraud – arguing that fraud ultimately won’t hurt a good company deliberately ignores that shareholders are being defrauded, and attempts to shift the discussion to a different sort of fraud – stock manipulation using NSS, and the long-term success likelihood of the manipulation.
* Argument B – Naked short selling counterbalances crooked companies, and pump artists.
Truth: Defrauding shareholders is fraud, and arguing that one sort of fraud should be used to counter a different sort of fraud is lunacy.
* Argument C – Naked short selling isn’t a big problem – only 1% of all trades per day in dollar volume fail, thus it is insignificant.
Truth: 1% of those trades in dollars fail per day, meaning 1% of the money changing hands every day is being done so fraudulently - over a billion dollars a day of fraud. This fraud is not evenly distributed across the entire market - it is disproportionately concentrated in a handful of companies on the SHO list - thus a small number of companies have runaway fraud in the trading of their shares. And we have a list of which companies those are: The Reg SHO list.
* Argument D – Not all NSS is illegal, some is innocent.
Truth: Sure it is. Market makers, for instance, can NSS in order to provide liquidity – temporary liquidity. When market makers NSS in order to sustain a price depression, it shifts back into the fraud area. And because some is innocent (dog ate the certificate) doesn’t mean all is – and anyone arguing that it isn’t a large problem argues from ignorance – the SEC and DTCC won’t tell us how large the problem is, and how much is fraud vs. innocent. So it could be 95% fraud, 5% innocent, or the inverse, but nobody is talking. So the question is, how much fraud is OK, and why won't anyone provide definitive data as to the exact amount of fraud that is taking place? And why, in today’s Six Sigma world, is any fraud OK?
*Argument E – Only bad companies are victims of NSS.
Truth: Arguing that only “bad” companies’ shareholders are systematically defrauded, thus defrauding them is somehow OK, again, ignores that NSS is fraud. This argument is a variant of A, but seeks to place the blame for fraudsters defrauding investors on the targeted company – forgetting that the company’s shares are just the vehicle being used to commit the fraud. Sort of like saying stealing from “bad” stores is OK. Makes no sense.
*Argument F – By being anti-NSS, you are really saying you are anti-short selling, period.
Truth: This seeks to confuse a legal investment tactic with fraud, because the terms used to describe the two sound alike. Legal short selling involves borrowing a security, and selling it and delivering it to the buyer, hoping for a price decline before the seller has to buy a share in the market to return to the lender. NSS involves advertising something for sale, creating a sale transaction, debiting the buyer’s account, and then not delivering the product – again, simple fraud.
*Argument G – NSS increases liquidity, and liquidity is good.
Truth: Liquidity is good if you are in the business of being compensated for executing lots of buy/sell trades. Liquidity is meaningless if you are an investor holding shares – it only becomes an issue when you want to sell, or want to buy. Fraud does increase the number of transactions, and the APPARENT amount of sell-side liquidity (supply) – but again, arguing that fraud is good because of the end effects of it being perpetrated in large-scale manner, is specious. Fraud is fraud, and increasing liquidity by increasing the number of frauds is bad, for obvious reasons.
* Argument H – Speculators should avoid stocks that are on the SHO list, as they are being warned that there is a problem – they are bringing it on themselves.
Truth: Fraud is illegal, in all instances. Having a list of companies where the fraud is massive does nothing but highlight that massive fraud has taken place. Arguing that investors should avoid buying the shares of companies whose shares have been fraudulently abused is again, blaming the victim, and while it makes sense to avoid bad areas of town where the murder rate is high, it does not make sense to condone rampant murder – anywhere. Condoning lots of murder in some areas of town, versus eradicating it, is cultural chaos. Condoning fraud in the trading of certain companies is systemic chaos.
* Argument I – Nobody is hurt by NSS – investors can sell their shares instantly, even if fraudulently created IOUs, thus no harm done to the investor.
Truth: Argues that because the system is very efficient at trading in frauds, that fraud does no harm. Fraud is fraud, and is illegal. Whether or not a system exists for trading or perpetuating fraud does not change the nature of the crime. Property rights are protected by the Constitution, and arguing that because it is easy to defraud the next person in the chain, who buys your fraud, ignores the basic crime, and instead argues that fraud is OK as long as it is easy and efficient to commit. A completely separate absurdity is that this argument is very much akin to arguing that piracy doesn't hurt the companies being pirated, as there is a liquid market for pirated goods.
* Argument J – NSS doesn’t impact the share price long term, as demand will eventually return a company’s stock to fair value.
Truth: Argues for price action in a stock, rather than acknowledging that NSS is fraud, and thus bad. Also attempts to introduce a straw man – company fundamentals/stock price – rather than focus on NSS, and the basic fraud committed.
* Argument K – Getting paper certificates is foolish, or a waste of time, or will negatively impact you (difficulty in trading) or the market (decreased liquidity). Variations include arguments of low statistical likelihood of a broker failure resulting in a situation where veracity of shares is in question, or liquidity/valuation arguments.
Truth: Paper certificates are the only protection against being defrauded by a naked short sale (actually the Direct Registration System also can, but is esoteric). Arguments as to trading ease, or market valuation, ignore the effectiveness of certs as a prophylactic against being defrauded – if you have the asset in your hand, you have the asset in your hand. All other arguments are arguments against something different than the basic fraud of NSS, and seek to shift the discussion from that fraud, and how to avoid being a victim of it.
There are countless variations, but they all have the same quality: the arguments advanced attempt to ignore the basic fraud, and create straw man arguments that avoid or diminish the obviousness of the basic fraud.
With this newfound understanding of the core fraud, the SEC’s logic in Grandfathering is particularly onerous – how is it good for anyone but those that perpetrated the fraud, to be excused from ever having to make good on the commitment to deliver the goods? Isn’t that simply state-sanctioned fraud? I maintain it is.
Talking with an expert on this subject yesterday, another issue that became obvious is that in a share tender offer, the acquiring company inevitably goes down, even if the acquisition is accretive to the acquirer. Why is that? Well, because the system defrauds the acquirer. Imagine Bigco acquires Smallco, and that Smallco has 1 million shares outstanding, and another 1 million of NSS. Bigco issues one share of Bigco stock for each share of Smallco, which at the brokers and the DTC translates to changing all the Smallco shares to read Bigco. The problem is that now Bigco, who thought they were increasing the float of shares by one million, actually increased their float by 2 million, as the 1 million NSS are also changed to read Bigco. This is an invisible fraud against Bigco. One could argue that because the DTCC knows how many NSS shares there are, they are a party to this fraud against Bigco - they know how many in-system FTDs there are, and they know how many ex-clearing FTDs there are - they have to issue a special permission, charge for it, in fact - to take a transaction ex-clearing, thus know the number or can easily get it. This raises some interesting liability questions, I would think, and I would welcome hearing from some attorneys on the subject - I know a lot read these, so chime in here, understanding that your words do not consitute legal advice.
The reason that there needs to be Market Reform is because the current ideology seeks to obfuscate fraud, which begets a culture of fraud, at every level.
I think that it is necessary to bring arguments back to the central point, as the apologists for NSS always seek to ignore that point, or argue around it. Our job, as market reform advocates, is to keep it simple, and explain the basic fraud in a simple manner. One of the things I hear all the time is that eyes glaze over when you start talking about NSS or describing it. That is because we tend to lose sight of the basic truth – NSS is fraud, fraud is bad (and criminal). Keep it simple, and the average person gets it.
Comments?