Counterfeiting? Fraud? Maybe...But There's More!!!

I've been asked numerous times what the brokers are doing when they put a security entitlement into an investor account, and then, when the share the investor bought doesn't show up, just leave the entitlement there, falsely leading the investor to believe that he has his share. They never break the trade or alert you that you didn't get the goods - rather, they allow you to believe you got what you paid for, even though you didn't.

For a long time I struggled with the various descriptions and explanations I'd heard - counterfeiting shares, naked shorting, fraud...

All of them fit, but somehow fell short of describing precisely what was being done.

I think I've got the answer, though, and I want to share it with you. It is multi-part, but follow along with my reasoning and try to poke a hole in it. Attorneys are encouraged to try to do so - I'd love some input on where I ran off the reservation with this.

First, consider what a security entitlement is, and isn't.

UCC8, the body of rules that defines a security entitlement, requires that there be an expectation of prompt delivery of the underlying security to make the entitlement a bona fide entitlement. It actually requires a one-for-one ratio of genuine securities held by the broker for each security entitlement, or the expectation of a prompt delivery within reasonable time frames - in this case, reasonable being T+3.

So, what happens when T+3 comes and goes, and no share is delivered?

Is there any presumption of prompt delivery any more? Nope, that came and went with no share delivered. So we can assume that a security entitlement absent an underlying security, or the expectation of delivery by T+3, stops being that which UCC8 (the governing body of law) defines as a security entitlement.

Thus, we know what it isn't at that point. What it isn't is a security entitlement as defined by UCC8, which actually gives birth to the animal.

So what then is this thing in our accounts? For the answer, we have no further to look than the Securities Act of 1933.

Before we go much further, I'll tell you what the brokers are doing, and why it is illegal, and what specific area of law they are violating, and why.

Brokers who represent securities entitlements absent underlying securities as "bona fide," and who trick their clients into believing that they own genuine stock (by showing on their screen, or on their account statement, shares of XYZ, when they never received them), and create problems like the ubiquitous over-voting problem, are committing a felony.

What is the crime?

The sale of unregistered securities.

What? How did I get there?

Again, we know what that thing represented to the investor at T+4 isn't, if no stock showed up. What it isn't is a bona fide security entitlement - which as covered before requires delivery of stock on a one-share-per-entitlement basis.

So what is it? I maintain what it is is a "security" as defined by the 1933 Act - not the security the investor thought he was buying, but a different one - a promise, open-ended, of delivery of a genuine share at some unknown and unspecified point in the future.

Consider Section 2 of the 1933 Act, item a, under "Definitions" - number 1:

"1. The term "security" means any note, stock, treasury stock, security future, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a "security", or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing."

Yup. That fits the bill, alright. A promise of future performance for delivery of a security, is actually also a security. That's what it says...

So our forefathers understood what constituted a security, and defined it pretty clearly. So far so good. A promise of future performance meets that sniff test, and has all the necessary qualities of a security, per the Act.

But then, who issued the security? Not the company. The company issued genuine shares of stock. That isn't what this item is. This is a different kind of security, one that is a futures contract of sorts, with a commitment at a future unspecified point in time to deliver one of the company's securities.

So who issued this IOU for shares, which the investor believes to be the genuine article?

Well, the broker did.

Which makes the broker the "issuer." Follow? Again, from Section 2, Definition #4:

"4. The term "issuer" means every person who issues or proposes to issue any security; except that with respect to certificates of deposit, voting-trust certificates, or collateral-trust certificates, or with respect to certificates of interest or shares in an unincorporated investment trust not having a board of directors (or persons performing similar functions) or of the fixed, restricted management, or unit type, the term "issuer" means the person or persons performing the acts and assuming the duties of depositor or manager pursuant to the provisions of the trust or other agreement or instrument under which such securities are issued; except that in the case of an unincorporated association which provides by its articles for limited liability of any or all of its members, or in the case of a trust, committee, or other legal entity, the trustees or members thereof shall not be individually liable as issuers of any security issued by the association, trust, committee, or other legal entity; except that with respect to equipment-trust certificates or like securities, the term "issuer" means the person by whom the equipment or property is or is to be used; and except that with respect to fractional undivided interests in oil, gas, or other mineral rights, the term "issuer" means the owner of any such right or of any interest in such right (whether whole or fractional) who creates fractional interests therein for the purpose of public offering."

Huh. So the broker, by issuing this security (which meets all the criteria of a security per the act), acts as the "issuer" as defined above. He's issuing "securities" as defined in 1 and selling them to the public. Sounds like an issuer to me.

It really is simple. The issuer sells (also defined in number 3 of the same Section) the investor a security he has issued.

But there's a problem in all this.

The security he sold the investor, misrepresenting it as a genuine company share, hasn't been registered anywhere. It is thus an unregistered security.

What does the 1933 Act have to say about the sale of unregistered securities? Well, it is a huge no no, a criminal act, really. Felony time.

But where does that bring us, the investors harmed by the sale of unregistered securities? Can't the SEC just exempt these unregistered securities the brokers are issuing from any requirements, and then call them "exempted" securities, thereby letting the industry off the hook to comply with the law of the land?

Nope. The SEC is only allowed to exempt things when it is necessary for investor protection. I'd love to see them argue in court that exempting the sale of unregistered securities by issuers falsely representing them to investors as genuine somehow protects investors. I'd take the other side of that bet in a challenge.

No, believe it or not, brokers are subject to the 1933 Act just as everyone else is. Just as the SEC is. That's who the Acts were actually written to rein in - Wall Street. There aren't any complex jurisdictional issues in play, or free speech, or any of that. There is simply the sale of unregistered securities, which is illegal.

Now, the SEC could also argue that because they call these unregistered securities "security entitlements" even though they lack the basic essence of a bona fide entitlement - the underlying share - the SEC is somehow conferring upon this unregistered security some power as a bona fide entitlement. But the SEC doesn't have that power. It can't by waving its bureaucratic hand exclude unregistered securities from the 1933 Act by calling them something different.

No, we are back to the sale of unregistered securities by the brokers, who are acting as the issuers.

So what rights do we, as investors, have, having been sold these unregistered securities, falsely represented to us as genuine?

Well, the most obvious is rescission.

We have the right to demand our money back, immediately.

Why is that a big deal?

Well, aside from the criminal and civil sanctions for selling unregistered securities, imagine if every person who was holding these unregistered securities, in say, Overstock, who had paid $65, or $55, or $45, or $35, demanded their money back and went to court to get it.

There's no way to stall a simple rescission issue. It either is the genuine security they bought and paid for, or it isn't. If not, they get their money back.

Think that one through. Think it through for OTCBB companies who have billions of unregistered securities floating around their brokers simply refuse to give them certificates for.

What is the likely interest from the prime brokers in allowing their hedge fund customers to take all the cash difference between their original sale at $65 and today's mark to market price of $15, if the brokers are going to be liable to give every penny of it back to those they have so far smugly tricked?

Want to bet it is zero?

That kills the whole financial driver for tunneling the price of a security by creating massive artificial volume. If the brokers are going to have to disgorge 100% of the cash via rescission, they will lose interest in letting crime pay for their hedge fund clients.

That, and some folks will likely go to jail, unless Congress decides it is suddenly OK to sell unregistered securities.

I'm no lawyer, so I don't know if brokers are allowed to sell unregistered securities whenever they feel like it. But my hunch is that the 1933 and 34 Acts say it isn't, as my read of it leads me to believe.

My thinking is that there should be class actions on behalf of every Reg SHO list company's shareholders, suing the prime brokers for simple rescission, unless they can prove that 100% of the entitlements they are representing to their clients as genuine securities entitlements, have the requisite one-for-one shares tucked away in their name at the DTC. Ditto for companies on the OTCBB who cannot get their certificates.

We know from Byrne's presentation that in OSTK, the prime brokers and MMs don't have one-for-one shares for claims on shares (unregistered securities)..

And that means they now have a really big problem, IMO.

Question is which class action guys will be the first to file? There's everything one needs - deep pockets, clearly wronged parties, an easy-to-define crime, punitive damages, interest due on the cash they defrauded investors out of by selling them these unregistered securities, criminal penalties the DOJ can come at them for...

Thoughts?