S EC U R I T I E S & E XC H A N G E

Naked short selling distorts shareholder control.

The ‘Phantom
Shares’ Menace
B Y J OHN W. W ELBORN
The Haverford Group

I
n 1985, the National Association of Securities icant for small and medium cap companies than for large cap
Dealers (nasd) commissioned Irving M. Pollack, a companies with greater liquidity.
securities law expert and former Securities and There is currently much controversy surrounding so-called
Exchange commissioner, to conduct a comprehen- “naked short selling,” about which Pollack also warned over
sive review of short selling in nasdaq securities. two decades ago. Some companies, investors, and academics
The nasd sought to determine what, if any, addi- see naked short selling and the delivery failures that can result
tional short selling regulation was needed for the as harmful (and illegal) wealth destruction mechanisms.
nasdaq market. The result was the now-famous “Pollack Skeptics claim that naked short selling, as an issue, is buoyed
Study,” which described the short selling landscape of the day only by poor-performing companies and investors seeking a
and made important recommendations regarding the disclo- scapegoat for stock price declines.
sure, reporting, and settlement of short sales. Unfortunately, the drama associated with this clash has
Pollack concluded that short selling was a vital source of liq-
uidity and a valuable mechanism for efficient price discovery.
He added, however, that without proper institutions to guar-
antee prompt clearance and settlement of short sales, short
selling was open to abuse. Of the settlement regime, he cau-
tioned that it “effectively insulates the clearing corporation
and brokers from fails to deliver and receive by contra-parties;
but it permits fails to deliver and receive to develop without an
automatic check.” He issued a sober warning:
The fail-to-deliver/fail-to-receive problem has the
potential for causing serious difficulties in a lengthy
bear market. While the evidence does not suggest that
delivery problems exist in many securities, the fact
that there is no automatic mechanism preventing the
substantial buildup of short positions at the clearing
corporation and of fails to receive in brokerage firms
carries the potential for serious problems, particularly
in the event of crisis market conditions.
The phrase “short positions at the clearing corporation”
refers to “failures to deliver” (ftds), which effectively increase
the net supply of an issue in circulation and, by definition,
depress price. This price depression is, of course, more signif-

John W. Welborn is an economist with the Haverford Group, an investment firm.

52 R EG U L AT I O N S P R I N G 2 0 0 8
 drawn attention away from the uncomfortable fact that illegal, ties intermediary or the security intermediary’s creditors.”
unsettled trades are a large and growing problem in U.S. equi- Today, investors trade in securities entitlements while phys-
ty markets. Those unsettled trades threaten the corporate vot- ical certificates are held in “fungible bulk” at the dtc. As Erik
ing system, the viability of small companies, and market Sirri, director of the sec’s Division of Trading and Markets,
integrity as a whole. Large unsettled trades persist because of explained at a 2007 symposium on proxy processing:
loopholes in stock market institutions and apathy on the part
Broker participants in dtc own a pro rata interest in
of those charged with enforcing existing regulations.
the aggregate number of shares of an issue held by
D E M AT E R I A L I Z AT I O N A N D
dtc. And their beneficial owners, the end customer,
owns an interest in the shares in which the brokers,
SECURITIES ENTITLEMENTS
themselves, have an interest. Consequently, there are
Physical stock certificates are an anachronism in modern stock
no specific shares directly owned by either broker par-
markets. Today, stock ownership changes are reflected in elec-
ticipants, dtc, or the underlying beneficial owner. As
tronic book-entry movements among broker-dealers’ accounts
a result, the beneficial owner’s ownership cannot be
at the Depository Trust Company (dtc), a central stock depos-
tracked to a specific share, but rather, his ownership
itory and member of the Federal Reserve System. The dtc acts
interest is represented as a securities entitlement at his
as a custodian for the majority of securities issues.
or her own broker dealer. Each of these beneficial
The dtc emerged in response to the “paper crisis” of the
owners don’t own the actual shares that have been
1960s, when stock transfer volume in the United States grew
credited to their account, but rather, they own a bun-
so large that issuers, transfer agents, exchanges, and broker-
dle of rights defined by Federal and State law and by
ages were unable to process efficiently the paperwork associ-
their contract with the broker.
ated with stock trades. The marketplace was overwhelmed by
paper and timely transfer became impossible. The securities That bundle of rights is represented by security entitle-
industry created the dtc in order to make stock transfer effi- ments in investor brokerage statements. Most investors, how-
cient and orderly. ever, believe that a security entitlement is an electronic claim of
The dtc modernized markets through “dematerialization”: ownership on a given number of shares of an issue. That belief
the transition from physical stock certificates to electronic book- is incorrect.
keeping. With dematerialization came major revisions to the The dtc is a subsidiary of the Depository Trust and
Uniform Commercial Code in 1977, and later in 1994. Those Clearing Corporation (dtcc), which acts as a central coun-
MORGAN BALLARD

revisions introduced “security entitlements” to our markets, terparty for U.S. exchanges and markets for equities, bonds,
which took the place of direct share ownership. Strictly defined, U.S. Government treasuries, and other securities. The dtcc
a security entitlement “guarantees an entitlement holder a pri- manages the clearance and settlement system for U.S. equities
ority in the financial assets held in [an] account over the securi- through its subsidiary, the National Securities Clearing

R EG U L AT I O N S P R I N G 2 0 0 8 53
 SECURITIES & EXCHANGE

Corporation (nscc). While physical pay-

ment and stock transfer occur within Ta b l e 1
the dtc, it is the nscc that provides
final settlement instructions to cus- Failures to Deliver on Major Exchanges (2006)
tomers and participant firms. Exchange Peak FTDs Peak Date Average Volume FTDs as % of
Average Volume
FA I L S T O D E L I V E R
NYSE 172,707,364 31-Jan-06 1,701,643,478 10%
Short selling is a bet that a stock price NASDAQ, OTCBB
will decline. A short seller borrows stock and pink sheets
1,337,784,073 13-Mar-06 15,455,938,738 9%
and then sells it, hoping to buy back the SOURCES : SEC, Exchanges
same amount of stock later, at a lower
price, for return to the lender. Though
sometimes controversial, short selling is a legal and vital source paid money for something that failed to be delivered to their
of liquidity and efficient price discovery. Executing short sales accounts. That is because retail customers’ brokerage account
without borrowing or delivering shares, however, can lead to statements do not reveal whether delivery takes place; even
delivery failures. when no shares are delivered at settlement, share entitlements
Naked short selling involves selling without first borrowing are still credited to the buyer’s account. Those credited share
stock (or even locating stock to borrow). If a naked short sell- entitlements then trade in the market as if they were real shares
er does not borrow the stock he sells, he will be unable to issued by the company.
deliver that stock to the buyer to settle the trade. Intentional Though part of the Federal Reserve System, the dtcc is col-
naked short selling is illegal, though market makers are cur- lectively owned and operated by the large U.S. brokerages. As a
rently allowed to naked short temporarily when engaged in result, dtcc operations are technically overseen by the sec. In
bona fide market making. (Even market maker ftds, howev- fact, the dtcc operates with minimal sec oversight. Until
er, are illegal when delivery failure exceeds 13 days.) recently, the size of past (but not current) ftds in given equity
In U.S. equity markets, settlement occurs within three days issues could only be obtained through petition to the sec’s
of a trade. In the case of both long and short sales, if shares are Freedom of Information Act office, which must request the
unavailable for delivery then the settlement process can be information, in turn, from the dtcc. This process took months
complicated by ftds and “failures to receive” (ftrs). To the and resulted in the release of stale market data. The sec recent-
extent that ftds and ftrs are only occasional and temporary, ly made available for Internet download limited ftd data for all
trade in security entitlements rather than physical shares helps securities listed on U.S. equity markets. As this article goes to
to keep markets liquid and efficient. print, however, only ftd data from the previous fiscal quarter
Delivery failures are problematic, however, when they are are available (starting with August 2007). The dtcc claims to
large and persistent. In those situations, ftds act as “phan- support limited disclosure of ftd data, but no additional data
tom” or counterfeit shares that circulate in the system as real have been disclosed beyond that offered by the sec.
shares. Just as counterfeit currency dilutes and destroys value, The data released through Freedom of Information Act
phantom or counterfeit shares deflate share prices by flooding requests reveal that ftds represent a significant percentage of
the market with false supply. average volume in the major exchanges and select issuers, as
Retail brokerage customers generally never learn that they shown in Tables 1 and 2. The dtcc claims that ftds and

Ta b l e 2

FTDs of Select Securities (2004–2006)

Issuer Peak FTDs Peak date Average FTDs as % Shares FTDs as %
volume of average outstanding shares
volume on peak day outstanding
Cal-Maine (CALM) 2,498,529 10-Jan-05 430,102 581% 23,682,000 10.55%
Global Crossing (GLBC) 2,387,641 21-Jan-05 660,604 361% 22,054,000 10.83%
iMergent (IIG) 289,054 2-May-05 303,852 95% 12,124,200 2.38%
Inhibitex (INHX) 3,129,627 7-Apr-06 20,738 15,091% 30,243,300 10.35%
Krispy Kreme (KKD) 4,652,372 28-Mar-05 4,359,081 107% 61,756,000 7.53%
Netflix (NFLX) 4,959,482 3-Jan-05 2,578,794 192% 52,732,000 9.41%
Novastar Financial, Inc. (NFI) 3,223,846 10-Nov-04 409,272 788% 6,357,000 50.71%
Overstock.com (OSTK) 3,800,172 20-Mar-06 932,835 407% 20,536,000 18.50%
Vonage (VG) 5,662,925 30-May-06 1,681,333 337% 154,727,000 3.66%
SOURCES: SEC, Bloomberg

54 R EG U L AT I O N S P R I N G 2 0 0 8
ftrs sum to $6 billion daily, or 1.5 percent of The dtcc asserts that cns has “eliminated
Ta b l e 3
the dollar volume. But that $6 billion is only the need to settle 96 percent of total obliga-
the present (“marked to market”) value of tions.” If the dtcc processes $400 billion in
failed trades and perhaps represents just a
Threshold List trades daily as claimed, then $384 billion are
Total number of days
fraction of the total problem. Because many netted out and only $16 billion require delivery.
on the list, January
failed trades go undelivered for months or In a 2005 letter to the dtcc, Robert Shapiro,
2005–January 2008
years, they effectively depress prices by creat- former undersecretary of commerce for eco-
ing false supply. Days # of Securities nomics, observed that the $6 billion in ftds
Delivery failures are not confined to the 13+ 4164 that exist on any given day is 37.5 percent of the
equity markets. According to the Securities 25+ 2695
$16 billion in trades that require delivery—“25
Industry and Financial Markets Association times the 1.5 percent reported by the dtcc.”
50+ 1478
(sifma), at the end of the second quarter of Notably, the ftd data do not include “ex-
2007, nyse member firms had over $42 bil- 100+ 625 clearing” transactions—that is, trades cleared
lion in ftds and $150 billion in ftrs. It is 200+ 172 directly by brokers that bypass the dtcc.
unclear what portion of those fails represents 400+ 22 Those trades are also referred to as “non-cns”
equities and what portion represents fixed 600+ 4 in that they occur external to the nscc and
income, derivatives, or other securities. The SOURCE: Buyins.net
are reported differently. Neither the sec nor
sifma Fails Working Group wants to develop the exchanges will disclose the names of the
a Standard Fail Report so that broker-dealers institutions failing to deliver on the grounds
can effectively report fails to trade counterparties. that “fails statistics of individual firms…is proprietary infor-
mation and may reflect firms’ trading strategies.” That state-
CNS In equity markets, the origin of ftds is obscured by the ment seems odd; what is proprietary about data on illegal
Continuous Net Settlement (cns) system, operated by the trading activity? Moreover, how are ftd data more proprietary
nscc. The cns constantly nets stock trades among broker- than short interest data, which are reported twice monthly?
dealer accounts at the dtc. In a dematerialized world, the
cns allows trades to settle promptly and efficiently, and helps R E G U L AT I O N S H O
to provide liquidity when there are occasional and temporary The little that is known publicly about ftds is available as a
ftds. According to Sirri, through cns the nscc effectively result of Regulation sho, implemented by the sec in January
“steps in between two parties to a trade and nets each party’s 2005 to curb abusive naked short selling and reduce ftds.
obligation to trade over multiple trades, so that each obliga- Regulation sho requires exchanges to publish daily lists of
tion to receive or deliver, and an obligation to deliver or receive, firms with ftds that exceed a pre-determined threshold. That
can be combined together into one.” He adds, list is known as the Regulation sho Threshold List. According
to sec chairman Christopher Cox,
If the broker fails to deliver to nscc, nscc allocates that
fail using a random distribution algorithm to the bro- The need for Regulation sho grew out of long-stand-
ker that is due to receive securities of that issue. This ing and growing problems with failures to deliver
innovation in netting process precludes identifying or stock by the end of the standard three-day settlement
tracking which specific customer or broker fails to period for trades…. Selling short without having stock
receive shares. The broker that did not, in fact, receive available for delivery, and intentionally failing to deliv-
securities because of this allocation will nonetheless er stock within the standard three-day settlement peri-
credit the securities positions to his customer accounts od, is market manipulation that is clearly violative of
even though no shares appeared in their dtc account. the federal securities laws.
This creates an imbalance between the number of shares
According to the sec, 11,345 securities have “graduated” from
credited to the broker’s dtc account and the number of
Threshold Lists since January 10, 2005, “representing 8.2 billion
shares credited to the broker’s customer accounts.
shares in fails.” Public data aggregated from the exchanges reveal
By cloaking delivery failures in anonymity, cns opens up the that 6,555 unique securities have appeared on Threshold Lists
settlement system to abuse and fraud. Pollack remarked in since Regulation sho was adopted (there are roughly 15,000
1986, “While the cns system…has substantially increased the total publicly traded equity issues in the United States). Thus, as
efficiency of the clearing process, the unlimited mark-to-the- shown in Table 3, many companies have been on the Threshold
market procedures also permit brokers to postpone delivery List more than once; some have been on for hundreds of trading
indefinitely, unless the purchasing broker initiates buy-in pro- days, belying the sec’s 13-day settlement rule.
cedures.” Forcing delivery and payment from trade counter- In response to questions submitted by the House Financial
parties through such buy-ins is, however, exceptionally rare in Services Committee in June of 2007, the sec claimed that
the stock market because of the resulting reputation effects. In Regulation sho had reduced fails. The sec compared a pre-
a 2005 analysis of 69,000 stock transactions, economists Regulation sho period (April 1, 2004 to December 31, 2004)
Richard Evans, Christopher Geczy, David Musto, and Adam to a post-Regulation sho period (January 1, 2005 to May 31,
Reed found that buy-ins occurred only 0.12 percent of the time. 2007) for all stocks with aggregate ftds of 10,000 shares or

R EG U L AT I O N S P R I N G 2 0 0 8 55
 SECURITIES & EXCHANGE

more as reported by the nscc. In that period, the sec found: increased in the face of Regulation sho, but ftd positions in
certain public companies have grown large and persistent.
■ The average daily aggregate ftds declined by 27.0 percent.
That finding is consistent with a 2005 paper by University of
■ The average daily number of ftd positions declined
New Mexico finance professor Leslie Boni, who researched
by 14.0 percent.
the ftd issue for the sec and found that fails were concen-
■ The average daily number of threshold securities
trated in hard-to-borrow stocks. Pollack wrote that the same
declined by 38.0 percent.
was true 20 years ago: “When extensive short selling occurs,
■ The average daily fails of threshold securities declined
stock is not readily available and sometimes cannot be bor-
by 50.8 percent.
rowed at all. In these cases, the incentive to deliver securities is
However, the sec’s choice of time periods was selective, substantially less, and there may be an incentive to avoid or
and appears to mask what subsequent data show is a serious postpone delivery.”
and growing problem. First, the sec’s assertion that aggregate
ftds are decreasing is false. As depicted in Figure 1, nscc LOOPHOLES
data on aggregate fail-to-deliver positions across the New York Serious loopholes in Regulation sho have perpetuated settle-
Stock Exchange, nasdaq, bulletin boards, and pink sheets ment failures. In a 2006 public hearing, Cox spoke candidly of
show that fail levels are highly volatile and, on the whole, “abusive naked short sales…which can be used as a tool to drive
increasing. down a company’s stock price to the detriment of all of its
By comparing the average of this time period with the aver- investors. The Commission is particularly concerned about per-
age of the pre–Regulation sho time period, the sec appears to sistent failures to deliver in the market for some securities that
make a statistical error. To see this, consider the incentives may be due to loopholes in the Commission’s Regulation sho.”
faced by broker-dealers and other market participants with
large ftd positions pre–Regulation sho. The final rule was GRANDFATHERING One such loophole is Regulation sho’s
announced on July 28, 2004, with a compliance date of January “grandfathering” of ftds that occurred prior to January 2005.
3, 2005. Without knowledge of how Regulation sho would be The regulation also allows ftds that do not remain open long
enforced, it is likely that those firms tried to reduce fails in the enough for the issuer to appear on the Threshold List.
sec’s pre-Regulation sho comparison period (April 1, 2004 to The sec voted to eliminate the grandfather clause in August
December 31, 2004). Once it was clear that enforcement would 2007. That rule change became effective December 5, 2007.
be minimal and compliance unnecessary, fails increased again
in 2005. That scenario yields ftd averages consistent with OPTIONS MARKET MAKER EXCEPTION The second loophole
both the sec’s claims and the recent increase in fails. is the options market maker exception. In theory, stock mar-
Second, not only have the aggregate ftds in the system kets are made more efficient by intermediaries who “make

Figure 1
■■■■■ Total FTDs
Trend
FTDs for All Markets January 2005–March 2007 ■■■■■

1,400

1,200
FTDS (Millions)

1,000

800

600

400

200

0
1/3 2/3 3/3 4/3 5/3 6/3 7/3 8/3 9/3 10/3 11/3 12/3 1/3 2/3 3/3 4/3 5/3 6/3 7/3 8/3 9/3 10/3 11/3 12/3 1/3 2/3 3/3
2005 2006 2007

SOURCE: “SHO Underperforms in Reducing Fails,” by David Patch. June 27, 2007.

56 R EG U L AT I O N S P R I N G 2 0 0 8
markets” in order to smooth price and volume fluctuations. A tions…. For example, options market makers’ practice
market maker poses as a buyer or a seller, acting as a temporary of “rolling” positions from one expiration month to
counterparty when needed to create market liquidity. Ideally, the next potentially allows these options market mak-
market maker positions last minutes or hours; generally, posi- ers to not close out fail to deliver positions as required
tions are closed out at the end of each day. In the process of by the close-out requirements of Regulation sho.
making markets, market makers may temporarily need to sell
stock they do not have. For this reason, Regulation sho has Though the comment period for the proposed elimination
allowed options market makers an “exception from the uni- officially ended in September of 2007, comments are still being
form ‘locate’ requirement…for short sales executed by market accepted by the sec and no action has been taken.
makers…including specialists and options market makers, but
only in connection with bona-fide market making activities.” L O C AT E R E Q U I R E M E N T Another crucial loophole in
Not surprisingly, market participants have abused this Regulation sho lies in the nebulous wording of the “locate”
exception. There is clear evidence that, when shares in a stock requirement, which allows a broker-dealer to execute a short
are hard to borrow, sophisticated short sellers illegally “rent” sale with only “reasonable grounds to believe that the securi-
the exception in order to obtain phantom shares that they can ty can be borrowed so that it can be delivered.” The locate
sell into the market as real shares. For example, in July 2007 the requirement originated with sec proposed rule 10b-21 (1973),
American Stock Exchange disciplined two options market which said one “had to borrow or have reasonable grounds to
makers for precisely this violation of Regulation sho; aggre- believe the stock could be borrowed” prior to effecting a short
gate fines and penalties totaled $8 million. sale. That rule was withdrawn, but the concept later evolved
In response to overwhelming evidence of abuse, the sec into nasd Rule 3370, which requires that “prior to accepting
proposed amending Regulation sho to narrow or eliminate a short sale order…a member must make an affirmative deter-
the options market maker exception in August 2007. The sec mination that the member will receive delivery of the security
writes: from the…broker-dealer or that the member can borrow the
security on behalf of the…broker-dealer for delivery by the set-
We are concerned that persistent fails to deliver will
tlement date.” This vague standard makes meaningful enforce-
continue in certain equity securities unless the
ment nearly impossible; the “reasonable grounds” condition is
options market maker exception is eliminated entire-
easy to meet and difficult for a prosecutor to refute.
ly.…The ability of options market makers to sell short
Regulation sho includes important exceptions to the
and never have to close out a resulting fail to deliver
locate requirement. Besides the options market maker excep-
position, provided the short sale was effected to hedge
tion discussed above, there is an exception for stocks on so-
options positions created before the security became a
called “easy-to-borrow” lists. Regulation sho states:
threshold security, runs counter to the goal of similar
treatment for fails to deliver resulting from sales of “Easy to Borrow” lists may provide “reasonable
securities and may have a negative impact on the mar- grounds” for a broker-dealer to believe that the securi-
ket for those securities. ty sold short is available for borrowing without directly
contacting the source of the borrowed securities. In
In the proposed amendment, the sec suggests that the
order for it to be reasonable that a broker-dealer rely
options market maker exception has been misread and abused:
on such lists, the information used to generate the
[T]he current options market maker exception only “Easy to Borrow” list must be less than 24 hours old,
excepts from Regulation sho’s mandatory 13 consecu- and securities on the list must be readily available such
tive settlement day close-out requirement those fail to that it would be unlikely that a failure to deliver would
deliver positions that result from short sales effected by occur…. [R]epeated failures to deliver in securities
registered options market makers to establish or main- included on an “Easy to Borrow” list would indicate
tain a hedge on options positions established before the that the broker-dealer’s reliance on such a list did not
underlying security became a threshold security. Thus, satisfy the “reasonable grounds” standard of Rule 203.
it does not apply to fails to deliver resulting from short
Broker-dealers also create “hard-to-borrow” lists, but “the
sales effected to establish or maintain a hedge on
fact that a security is not on a hard-to-borrow list cannot sat-
options positions established after the underlying secu-
isfy the ‘reasonable grounds’ test” of Regulation sho.
rity became a threshold security.
Moreover, the sec admits that the exception is being used T H E I M PA C T O F F T D S
improperly to roll failed positions: ftds threaten market integrity in at least three ways:
■ They undermine corporate voting mechanisms.
[It] has become apparent to us during the comment ■ They damage and destroy firms.
process that the language of the current exception is ■ They increase the possibility of systemic collapse.
being interpreted more broadly than the Commission
intended, such that the exception seems to be operat- On the first point, large and persistent ftds lead to more
ing significantly differently from our original expecta- claims of ownership than there are shares to own and vote,

R EG U L AT I O N S P R I N G 2 0 0 8 57
 SECURITIES & EXCHANGE

resulting in chronic over-voting and undermining our corpo- is lax (and difficult), some market participants are apparently
rate voting system. According to Sirri, “Hopefully, in time the unafraid of intentionally failing to deliver.
broker who fails to deliver will deliver shares to dtc and cor- Shapiro, who now is a consultant for lawyers representing
rect the imbalance. If the broker does nothing to rectify this some of the alleged victims of naked short selling mentioned
imbalance, the firm may ultimately end up casting more votes above, said in a 2007 Bloomberg Television special report on
than actually he is entitled to vote based on the number of unsettled trades that as many as 1,000 public companies were
shares it has at dtc.” Bob Drummond of Bloomberg Markets damaged by naked shorting prior to enactment of Regulation
Magazine reported in April 2006, “In close contests with little sho:
room for error, the results of high-stakes company decisions A lot of those companies are gone. A lot of them died.
may hinge on the invisible influence of millions of votes that This was a fatal attack. Now, some of them were weak
shouldn’t be counted.” According to Thomas Montrone, ceo when they were attacked. Some of them would have
of Registrar and Transfer Co., “It is an abomination…. A lot of failed anyway. Others wouldn’t have. Again, it’s not up
the time we have no idea who’s entitled to vote and who isn’t. to the naked short sellers to decide. It’s up to the
It’s nothing short of criminal.” Another securities consultant investors that play by the rules.
notes, “There are votes cast twice on almost every matter of
substance…. It definitely can and does, in my experience, affect Skeptics argue that many (if not most) companies harmed
the outcome of corporate elections and proposals.” by naked short selling suffer from performance problems or
Bloomberg Markets also reported on a review of proxy vote poor business models. The sec’s own “Key Points about
counts conducted by a large stock transfer agent in 2005. That Regulation sho” contains this warning:
review, originally made public by the Securities Transfer
There also may be instances where a company insider
Association, a trade group for stock transfer agents, tabulated the
or paid promoter provides false and misleading excus-
results of all proxy votes submitted by banks and brokers in
es for why a company’s stock price has recently
2005. For 341 equity issues, attempted over-voting—the submis-
decreased…. [T]hese individuals may claim that the
sion of too many ballots—occurred in all 341 cases. Arbitrageurs
price decrease is a temporary condition resulting from
are exploiting this crack, suggests Drummond; one source notes,
the activities of naked short sellers…. Often, the price
“It appears to be the case where there are opportunities to game
decrease is a result of the company’s poor financial
the system.” Drummond concluded that until these problems
situation rather than the reasons provided by the
are fixed, “double and triple voting on one share will continue to
insiders or promoters.
make a mockery of shareholder democracy.”
On the second point that companies and shareholder value Following the sec’s lead, the dtcc has responded to law-
are destroyed, former sec chairman Harvey Pitt claims: suits from companies challenging its role in settlement failures
by attacking those companies’ financials. dtcc general coun-
Naked shorting harms the market and market partici-
sel Larry Thompson writes, “According to their own 10K and
pants, particularly when fails persist for substantial
10Q reports financial auditor’s disclosure statements, many of
periods, as they clearly have. Naked short sellers effec-
these firms have admitted that ‘factors raise substantial doubt
tively gain more leverage than if they were required to
about the company’s ability to continue as a going concern.’
borrow securities and deliver within a reasonable peri-
They have had little or no revenue…and substantial losses.”
od of time. And this additional leverage may be used
Nevertheless, fraud and illegal manipulation are never justi-
to drive down a stock’s price. In addition, naked
fied, even in situations where an issuer has genuine perform-
shorting effectively dilutes the pool of real securities.
ance problems.
Phantom shares created by naked shorting are analo-
Moreover, fails in thinly traded equity issues are far more
gous to counterfeit money. In a stock market corollary
toxic than fails in thickly traded treasuries or other securities.
to Gresham’s law, the more phantom shares of an
At a high enough concentration, such ftds could threaten
issuer’s stock that circulate, the more they drive out or
market integrity. Some 500 million shares remain unsettled at
devalue an issuer’s real shares to the detriment of
the dtcc on any given day. Bradley Abelow, a former dtcc
investors and issuers alike. Fails associated with naked
director questioned under oath for confirmation as New Jersey
shorting harm investors in other ways, for example, by
treasurer, described failures within the settlement system as
depressing stock prices to the point that shares may
“occur[ing] as a matter of course with great regularity,” adding
not be marginable, denying shareholders the ability to
“fails to deliver of securities is endemic.” Boni describes the
borrow against them.
ftds as “pervasive.” In fact, according to the sec, “The grand-
Boni shows that many ftds are strategic—that is, concen- fathering provisions of Regulation sho were adopted because
trated in a subset of issues. The distribution of those failures the Commission was concerned about creating volatility where
is inconsistent with the hypothesis that they occur through there were large pre-existing open positions.” That concern
random human error. As Boni put it diplomatically, persistent may have been justified. If ftds result in more claims of own-
fails “are more likely the result of strategic fails rather than ership than physical shares of an issue, what happens when fail
inadvertent delivery delays.” That is, they are intentional. data are made public? What happens if the fail data reveal that
Because regulations are loose and (as we will see) enforcement the imbalance exceeds the liquidity in the system?

58 R EG U L AT I O N S P R I N G 2 0 0 8
R E G U L AT O R Y FA I L U R E hand, are not unified and it is expensive for individuals to gath-
On the topic of “massive naked short sales,” Shapiro writes: er information, organize, and lobby the sec as the sifma does.
Not surprisingly, the grandfather clause and the options
[T]his type of stock manipulation has occurred in market maker exception were suggested by sifma members
many hundreds and perhaps thousands of cases over and the options exchanges, respectively. No members of the
the last decade…. Illicit short sales on such a scale or public had opportunity to comment on those “loopholes”
anything approaching it point to grave inadequacies before they were made law. Furthermore, the original
in the current regulatory regime. Regulation sho proposal suggested penalties for failing to
deliver. After strident objections by sifma-member firms, that
The answer to why these “grave inadequacies” exist lies in the proposal was dropped.
structure of the sec, in the design of the rule-making process, Though there are loopholes, Regulation sho is not as
and in the incentives faced by sec staff. nugatory as some critics maintain. The regulation clearly states
The sec Division of Trading and Markets (formerly the that fails must be closed out after 13 days and even options
Division of Market Regulation) provides daily oversight of market makers may not fail in issues with enough ftds to be
major securities market participants, including exchanges and on the Threshold List. Regulation sho also has clear reporting
self-regulatory organizations, broker-dealers, clearing agen- and order marking requirements. Enforcement of even those
cies, stock transfer agents, proxy processing services, and cred- watered-down rules has been weak, however. The sec itself
it rating agencies. The Division of Trading and Markets also acknowledges that rule violations are extant, but in response
proposes and adopts new sec rules. Rule proposals go through to the 2007 review by the House Financial Services Committee
three stages: the Commission admitted that, “To date, there have been no
Commission enforcement actions announced involving
■ Concept release, where the sec describes a general
Regulation sho.”
area of interest and asks for guidance from the public.
The exchanges have taken some action. In July 2007, the
■ Rule proposal, where the sec puts forward a specific
American Stock Exchange fined two options market makers
proposal and solicits formal comment from the public.
for Regulation sho violations. The year before, the New York
■ Rule adoption, where the sec considers the public
Stock Exchange brought four Regulation sho enforcement
comments and formulates the final rule.
actions, censuring and fining Daiwa Securities America,
If all five sec commissioners vote to adopt the rule then it Goldman Sachs Execution and Clearing, Citigroup Global
becomes regulation and is incorporated into the Federal Markets, and Credit Suisse Securities (USA) for operational
Register. deficiencies and supervisory violations concerning Regulation
The 2003 sec short sale rule proposal was broad and sho. The cases resulted in total fines of just $1.25 million.
instructive. The proposal provided historical context for short Notably, those cases focused on the actions of the broker-
sale rules (including the now-eliminated “tick test”), short dealers and not their clients. For example, Goldman Sachs
sales in connection with a public offering (Rule 105), Execution and Clearing was sanctioned for repeatedly accept-
short/long order marking requirements, market making and ing clients’ faulty locates and allowing those clients to mis-mark
rule exceptions, and preconditions for effecting short sales. short trades as long (in order to avoid compliance with
The proposal asked for public comment on short sale abuses Regulation sho). But the stock exchanges’ jurisdiction extends
and delivery failures connected with naked short sales. only to member firms. Institutions and investors fall outside of
The Regulation sho comment period lasted over six that jurisdiction, but within the purview of the sec, whose
months, until July 2004. Public comments were divided and inaction therefore shields institutions and investors.
voluminous. The broker-dealer community, both individually Why has the sec Enforcement Division taken no action
and through its trade group, the Securities Industry when the sec admits that there remain “large and persistent
Association (now sifma), favored a permissive regulatory fail to deliver positions?” One explanation may be that certain
regime that refrained from punishing those who failed to provisions of Regulation sho are too imprecise for meaning-
deliver on the grounds that such leniency would maximize liq- ful enforcement. (For example, what is meant by a “reasonable
uidity. In addition to submitting letters, sifma organized con- grounds to believe” that a security can be borrowed prior to
ference calls and meetings with sec staff. Retail investors and selling short?) Another hurdle is that Regulation sho contains
members of the general public, on the other hand, submitted no mention of penalties for those who violate the rules. Those
passionate but generally less polished opposing views. For rea- explanations, however, are belied by the nyse and amex
sons unknown, few issuers commented. enforcement decisions noted above. Those decisions followed
The contrast between sifma and retail investors—and their the text of Regulation sho and found violations so flagrant
relative influence over the sec rulemaking process—reflects the that even brokers acting on behalf of clients were sanctioned.
classic dispersed costs and concentrated benefits model of polit- It is also possible that, in the wake of prominent fraud and
ical action. It is economical for broker-dealers to unite and lobby accounting scandals, the Enforcement Division has become
the sec for favorable regulations. sifma meets with sec staff focused on issuers and largely ignores broker-dealer miscon-
regularly, both to discuss specific proposed rules and to offer duct. That would be ironic given that the 1933 Pecora
guidance on future sec actions. Retail investors, on the other Hearings (which predated the 1933 Securities Act and the

R EG U L AT I O N S P R I N G 2 0 0 8 59
 SECURITIES & EXCHANGE

1934 Securities and Exchange Act) expressly investigated the The oig investigation into Aguirre’s allegations was
actions of brokers and speculative investment “pools,” which flawed from the beginning and hindered by missteps
were notorious fonts of long- and short-side market manipu- during the entire process…. One of the major prob-
lation, including both penny stock scams and “bear raids.” lems with the oig seems to be the perception within
Institutional inertia may also be a factor. A recent the sec regarding the independence of the office and
Government Accountability Office report revealed serious whether or not employees who approach the oig are
operational flaws in the sec’s Enforcement Division and the treated fairly. The sec needs to take immediate action
Office of Compliance, Inspection, and Examination. As Sen. to restore the independence, competence, and confi-
Chuck Grassley (R-Iowa) summarized in a September 2007 dence in the oig. One area in need of attention is the
memorandum: oig’s independence from sec management…. [F]acts
and circumstances do not suggest a sufficient degree
The gao report…found that two-thirds of the sec’s
of independence…. Congress passed the IG Act in
cases had been open for more than two years, one-
1974, with the goal of ensuring that the public would
third had been open for more than five years, and 13
have faith in government by providing an impartial
percent had been open for more than 10 years. Many
arbiter tasked with independently overseeing the oper-
of these cases “had not resulted in an enforcement
ations at an agency, protecting the integrity and pro-
action and were no longer being actively pursued,”
moting the efficiency of government…. [T]he oig at
according to the gao. The gao also found that the
the sec seems to have failed in its mission.
sec’s system for tracking cases was “severely limited
and virtually unusable.”
Walter Stachnik, the first and only sec inspector general at
A more sinister explanation is that sec investigators face that time, resigned the day after the report’s release.
political pressure and other incentives not to pursue Regulation On March 4, 2008, the sec proposed a new anti-fraud rule
sho cases. The gao report was requested by the Senate Judiciary directed at “misrepresentations in connection with a seller’s
Committee, which was investigating serious allegations of mis- ability or intent to deliver securities by settlement date.” In
conduct and corruption in the firing of former sec attorney theory, the rule would offer the sec Enforcement Division
Gary Aguirre. Prior to his dismissal, Aguirre led an insider trad- additional tools to curtail manipulative naked short selling
ing investigation that implicated Pequot Capital and led to John and the delivery failures that can result. The rule proposal is
Mack, ceo of Morgan Stanley. When Aguirre tried to subpoe- now in a public comment period. It remains to be seen what
na Mack, the investigation was terminated. Aguirre’s superior, the final text of the rule will be and how it will be enforced.
branch chief Robert Hanson, said in an e-mail that the investi-
gation would be problematic because Mack’s legal counsel had CO N C LUS I O N
“juice.” Shortly thereafter, Aguirre was fired. Unless action is taken to reform regulations governing the set-
In May of 2006, Aguirre wrote ranking members of the tlement system, unsettled trades will multiply. As they do, vot-
Senate Finance Committee, describing serious oversight prob- ing will be further corrupted, companies will be destroyed, and
lems at the sec and the return of 1920s-style speculation to the the pre-conditions for a systemic event will be fed.
American capital markets. Aguirre also described how naked Unfortunately, the impetus for reform will not come from
short selling emerged as an important component of his inves- the securities industry itself. Hedge funds and the prime bro-
tigation into Pequot and Morgan Stanley: kers that serve those funds benefit from unconstrained naked
short sales. Hedge funds benefit because they can short with-
The [market manipulation] prong of the investigation
out paying to borrow stock first. Prime brokers benefit by
involved two classes of suspected violations: wash sales
loaning out the same securities multiple times to different
and naked shorts. Some of my colleagues believed this
clients. As of the third quarter of 2007, hedge fund assets were
prong held a greater potential to severely injure the capi-
$2.68 trillion and growing, as was the demand for shares to
tal markets. Evidence indicated that hedge funds used
borrow. Securities lending generates $16 billion annually, and
wash sales to spike stock prices just as unregulated pools
prime brokerage is among the most lucrative businesses for
used wash sales to spike stock prices in the 1920s. The
broker-dealers.
investigation of both wash sales and naked shorts led to
Harvey Pitt recommends the following to solve the ftd
the hedge fund’s prime broker, a large investment bank.
problem:
After an extensive investigation and several public hear-
ings, the Senate Finance and Judiciary Committees issued a ■ The secs needs actively to pursue ongoing chronic and
joint 711-page report that confirmed all of Aguirre’s claims. serial short selling infractions.
The report criticizes the sec for its failure to act in the face of ■ Meaningful penalties have to be imposed for violations
clear evidence that Pequot and Morgan Stanley had engaged in of existing Regulation sho requirements.
manipulative conduct. More importantly, the report excoriates ■ The sec should define and punish abusive naked short
the sec’s Office of the Inspector General (oig), which is tasked selling practices as securities fraud.
with evaluating the sec’s “compliance with policies, proce- ■ The sec should eliminate the option market maker
dures, laws, or regulations”: exception. It is not demonstrably of any value, and it

60 R EG U L AT I O N S P R I N G 2 0 0 8
 risks facilitating illegal activity. Readings
■ Regulation sho should impose firm locate require- ■A Review of Investor Protection ■ “Phantom Shares,” by

ments as a condition precedent to all short sales. and Market Oversight with the Jonathan E. Johnson III.
Five Commissioners of the Washington Times, November 21,
■ Chronic and unjustified violations of settlement rules
Securities and Exchange 2007.
should be punished. Commission,” prepared by the ■ “SHO Underperforms in
■ Exchanges in other markets should be required to Committee on Financial
Reducing Fails,” by David Patch.
report the securities on daily Threshold Lists and Services, U.S. House of
June 27, 2007.
Representatives. June 26, 2007.
aggregate daily volume of fails for each such security. ■ “Short-sale Regulation of NAS-
■Address to the Coalition
DAQ Securities,” by Irving M.
Against Phantom Trading, by
Numerous economists, the U.S. Chamber of Commerce, Pollack. July 1986.
Harvey Pitt. November 16, 2007.
members of Congress, public companies, and hundreds of ■ “Short Selling, Death Spiral
■ “Corporate Voting Charade,”
retail investors have urged the sec to amend and enforce pro- Convertibles, and the
by Bob Drummond. Bloomberg
visions of Regulation sho. Whether the sec will close the Profitability of Stock Market
Markets Magazine, April 2006.
Manipulation,” by John D.
loopholes giving vague license to a highly profitable crime is ■ “Failure Is an Option: Finnerty. March 2005.
yet to be determined. To borrow a phrase from Sen. Daniel Impediments to Short Selling ■ “Strategic Delivery Failures in
Patrick Moynihan, the sec has an unfortunate record of and Options Prices,” by Richard
U.S. Markets,” by Leslie Boni.
“defining deviancy down”—that is, making rules to accom- B. Evans, et al. May 5, 2003.
June 25, 2005.
modate existing market practices, regardless of how offensive ■ “Married Puts and Reverse
■ “The Firing of an SEC
those practices may be to law or common sense. Conversions on the Chicago
Attorney and the Investigation
Stock Exchange,” by John W.
The sec and the dtcc defend occasional naked short selling of Pequot Capital Management,”
Welborn. October 9, 2007.
and delivery failures on the grounds that they foster “liquidity.” prepared by the Minority Staff
■ “Naked Short Selling and the of the Committee on Finance
Such arguments reveal that these regulators and professionals
Stock Borrow Program,” by and the Committee on the
have forgotten that a price is a mixture of scarcity, risk, and value; Larry Thompson. DTCC First Judiciary, United States Senate.
unlimited liquidity obliterates scarcity and undermines the price Deputy General Counsel, 2005. August 2007.
system. As William Donaldson, Pitt’s successor as chairman of ■ “Phantom Shares,” a

the sec, once remarked, “How much fraud are you willing to tol- Bloomberg Television Special
erate for liquidity? I think the answer is zero.” R Report. Air date: March 14, 2007.

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