So the SEC is meeting to consider changes to Reg SHO.
Mark Faulk has a great article out at thefaulkingtruth.com today, in which he pointed out that the Commission had changed its mission statement and omitted the word “honesty” – which had been in prior iterations of its mission statement.
That seems fitting.
Here is what the SEC needs to consider, in simple terms:
Reg SHO ostensibly seeks to end or control illegal naked short selling – the processing of sales orders, taking of investor money, and failure to deliver that which was bought and paid for. As we have discussed numerous times in the past, in every other business that is called fraud. On Wall Street, it is failure to deliver.
The problem is of unknown size and scope. The public is not told how large the problem is. It is described in cryptic terms by the DTCC, who issues forth periodic, often conflicting, attempts to reassure the public that it is a small glitch.
How can the system allow it to happen in the first place? I mean, why not just buy in anything that remains undelivered for any length of time?
Therein lies the problem.
First, let me propose 5 small steps that the SEC could implement that would virtually eliminate the problem overnight.
1) Require shares in hand before a short sale is made (or a long sale, for that matter). The short has to borrow and GET the shares before he can short. The long has to have them in his account. Simple. No selling what you don’t have.
2) Establish meaningful penalties for violating that requirement. I like 30% of the value of the trade, as a deterrent.
3) Require automatic buy-in at T+5. No T+13 nonsense in this day and age of computer trading and electronic book-entries. There’s no reason for it. Eliminate it.
4) Eliminate access to investor cash until delivery is made. The current scheme of allowing the delta between the sale price and the current price, regardless of delivery, is an open invitation to rip off investors – why wouldn’t you, if you could target thinly traded companies, and sell relentlessly to keep their price depressed in perpetuity? No delivery? No cash. Again. Simple.
5) Establish meaningful penalties for abuse of the bona-fide market maker exception, and police it. If a prime broker is failing like mad, selling into a declining price, that isn’t market making. That is stock manipulation and abuse. That should be punished. Right now it isn’t. And investors lose. Stamp out abuse by market makers, who are effectively renting their exemption to hedge funds using convoluted derivative strategies to do so.
These five steps would solve the problem on a going-forward basis.
Note that SHO was originally written to require a borrow, but that the Securities Industry Association lobbied long and hard to get the word “locate” inserted – a loophole as big as the Gobi Desert. Instead of borrowing, you could simply locate shares, and then when you couldn’t get them after the fact, you were in the clear.
That is BS. Everyone in the business knows it. It isn’t rocket science to see why.
How about doing the inverse: Don’t require cash to buy shares. Just require that the buyer has located funds. I’d like to buy stock like that – I could buy endless amounts, causing prices to rise, showing only that I have located funds to pay for it. Imagine how much money I could make if I could just keep buying, as long as I could locate "more" - say by paying a "locator to "claim" funds were "available." As the prices rose, I could take the difference between what I bought the shares for, and the current price, and put that money in my pocket. It’s perfect. And it is antipodal to the system currently in place for shorts under Reg SHO.
Given that there is no meaningful penalty for failing to deliver, one can see why the industry embraces it. Everyone benefits except the issuing companies and the investors. The brokers benefit – more trades equal more commissions. The DTCC benefits, as they get a per transaction fee. Even the SEC gets a fee from the trades. And the hedge funds benefit big, as they can effectively tunnel a company’s stock by selling relentlessly, and have access to investors’ cash without ever delivering – as in my buying example, the hedge funds have access to the difference between the price the shares were sold at, and the current mark-to-market price – whether or not they ever delivered.
That places the investor at an inherent disadvantage, and encourages larceny.
As an aside, the DTCC is a huge part of the failure to deliver problem. The Stock Borrow Program is a mockery of what 17A requires, which is the prompt clearance and settlement of shares – settlement being delivery. The SBP allows stock to go undelivered indefinitely, and treats all fails as innocent, regardless of the track history of the failing broker/seller. I maintain that the DTCC violates its mandate as an SRO at multiple levels – it claims to be powerless to buy in its member/owners. It claims to be powerless to enforce delivery ex-clearing. It claims to be powerless to enforce timely settlement.
How marvelously convenient for the owners of the DTCC – the brokers – that the DTCC claims to be powerless to do anything to curtail those same owner/brokers’ rampant failure to deliver. And it isn’t that they are rendered powerless by external forces. The DTCC has DECIDED to be powerless. Even though it is chartered with policing the business conduct of its members.
Crooks love it when the cops say they can’t go out and enforce the law. That’s the police force the crooks on Wall Street dream of, and that is the police force they have created in their SRO, and with the SEC.
The SEC can also, in their deliberations, inform the public under what specific authority they were empowered to suspend delivery requirements, in perpetuity, for failure to delivers that occurred prior to a security showing up on the list.
I’ve looked for it, and spoken to numerous securities scholars, and nobody can find any evidence that they have that authority.
So by what right do they give a hall pass to timely settlement of trades? Who authorized them to create a float of unknown size, of transactions for which no shares were delivered, and for which the buyers have, in perpetuity, been defrauded of the rights they thought they had bought? Rights like the right to vote. Rights like preferential dividend tax treatment. Rights like property rights.
Perhaps the SEC can explain to folks - who made them the entity to decide which buyers could be defrauded of these basic rights? That is what they did under the grandfathering clause.
When one reads the original 1934 Act, one sees that the intent was clearly do eliminate the ability to sell vapor, with no delivery. Clearing and settlement are linked. No settlement, no payment.
Somewhere the SEC lost its way, and became subordinate to the desires of the Wall Street crooks. The DTCC’s creation was an important step in that process, as was the passage of Addendum C, which created the Stock Borrow Program. It was intended to address SHORT TERM legitimate failures, and instead has been turned into a stock printing factory. The SEC seems fine with that, and the DTCC has decided it is powerless to stop it.
So, with all due respect, I have just indicated how SHO can be fixed, at least partially – enough to eliminate a lot of the obvious crookery and abuse.
Now the question is, does the SEC have any interest in fixing SHO, or does their allegiance lie with protecting the rich participants – as Gary Aguirre contents?
I suspect we will find out, yet again, soon enough.