Last year I wrote two editions on the problem of Illegal Naked Short Selling on the bulletin board market. Is The Pendulum Swinging In the Regulatory Community? was the April 19th edition. The follow up, entitled The OTC Rebellion, was published on May 18th.
If you are not familiar with the issues surrounding the debate over illegal naked short selling in microcap stocks, now would be a good time to click on either of those links and familiarize yourself with the story.
Last year the SEC began to take regulatory action in several instances where the market was manipulated by illegal short selling. Most of the abuses occurred in one of two specific areas: 1- where a "death spiral" financing has occurred, and a fund manager is illegally shorting against a future convertible security to force the price lower artificially or 2- where microcap stocks which cannot legally be shorted are manipulated by short sellers who execute their trades through Canadian brokerage firms. They get away with this practice because the Canadian firms are not NASD members, and therefore not subject to the same rules. In addition, certain flaws within the DTC (Depository Trust Company) allow the practice to go on. In the May 18th article I wrote about 80 small companies who had withdrawn from the DTC system to attempt to thwart the manipulation of their stock.
As it turns out, the regulatory pendulum is swinging towards dealing with this pervasive problem. Both the SEC and the NASD are in the process of changing the rules to close the loopholes.
The SEC's Proposed Rule Change
The SEC has proposed a rule change to help deal with the problem of illegal naked short selling. Proposed Regulation SHO was available for public comment up until January 5th, 2004. The comment period has passed, and one can assume a new rule will go into effect in the near future.
If you want to read the entire text of the proposal, simply Click Here, and you will be taken the the SEC's web page version of the new rule proposal.
The SEC has the following quote in the introduction to the new rule proposal:
Proposed Regulation SHO would, among other things, require short sellers in all equity securities to locate securities to borrow before selling, and would also impose strict delivery requirements on securities where many sellers have failed to deliver the securities. In part, this action is designed to address the problem of "naked" short selling.
In this excerpt, the SEC spells out the problem:
Many issuers and investors have complained about alleged "naked short selling," especially in thinly-capitalized securities trading over-the-counter. Naked short selling is selling short without borrowing the necessary securities to make delivery, thus potentially resulting in a "fail to deliver" securities to the buyer.
Naked short selling can have a number of negative effects on the market, particularly when the fails to deliver persist for an extended period of time and result in a significantly large unfulfilled delivery obligation at the clearing agency where trades are settled.
The proposed rule change requires broker dealers to take electronic delivery of shares they have purchased within two days of settlement date. On the surface, it would seem this rule will eliminate the massive "open fail to delivers" rampant within the DTC system, and prevent the illegal naked short selling which comes through Canadian broker/dealers.
I am not sure when this new rule will go into effect, but I will try to find out.
The NASD Takes Decisive Action
The NASD (National Association of Securities Dealers) has taken much swifter and more decisive action. A surprise new rule change was announced on January 20th. It effects all NASD broker/dealers, and has already been approved by the SEC.
New Rule 3370 goes into effect on February 20th 2004. This new rule could become the holy grail for bulletin board traded companies. The Rule requires NASD member firms to treat non-member broker dealers as if they were regular customers as regards delivery of any shares that have been sold through a US registered broker/dealer.
Up to February 20th, non NASD member broker dealers (for the most part Canadian brokerage firms) have not been treated as if they were regular customer. They have been awarded a special status which allowed them to keep "open fail to delivers" on their books. Rule 3370 forces the NASD member firms to treat the non-member broker dealers as if they were customer, and forces them to close out their trades in a reasonable time frame by delivering sold shares.
Conclusion
The 90's roaring bull market, which ended abruptly in March of 2000, led to excesses on the long side. The hangover has continued far beyond the fraudulent practices of Enron and MCI. It extended very deeply into the heart of the mutual fund industry.
The ensuing bear market of the 2000 to 2003 led to the same kinds of excesses on the short side. Manipulative practices of short sellers are much less widespread and more insidious.
Market Makers will still be able to take legal naked short positions to enhance the liquidity of the market, but the SEC has some language to try to prevent extensive abuses by market makers also.
The Regulators in the securities markets are not proactive; they are reactive. A problem is identified, and the machinery slowly starts up to deal with the problem. The wheels turn slowly, but they eventually the system works.
These new regulations are a major step in the right direction for the microcap market. The new regulations will enhance the liquidity of the more thinly traded stocks, making it easier for the companies to raise capital and maximizing their chance to successfully implement their business plans.
I believe the OTC Bulletin Board will evolve into a carbon copy of the NASDAQ Small Cap in the 80's and early 90's. The listing requirements were far less stringent back then, and many small stocks traded with a great deal of liquidity.
To paraphrase Yogi Bera: This is Deja Vu all over again.
Here's an article Dow Jones carried on the new NASD regulation which goes into effect on February 20th:
DJN: DJ IN THE MONEY: NASD Tightens Short Selling/Delivery Rule
NEW YORK (Dow Jones)--Taking most market participants by surprise, the National Associations of Securities Dealers has drastically tightened one of its rules governing short selling. Known as affirmative determination, the NASD rule stipulates that brokers and dealers engaged in a short sale transaction must make sure that shares can be delivered by settlement time, three days later.
"We closed a loophole," said Steve Luparello, executive vice president of Market Regulation at NASD. Until now, non-NASD members, like specialists, option markets and foreign brokers, weren't covered under the affirmative determination rule. That means that non-NASD members didn't have to represent to the NASD broker through which they conducted a short sale order that they would be able to deliver the stock by settlement date.
A short seller typically borrows stock from a broker to sell it into the market, betting that the share price will fall so that he can buy the stock back at a lower price and pocket the difference.
The amended NASD affirmative determination rule, which was recently approved by the Securities and Exchange Commission, will particularly affect short sales conducted through foreign brokers, most specifically Canadian brokers which have often been used by investors to sell short the stock of small U.S. companies trading on the Over-the-counter Bulletin Board or OTCBB.
Because it's often impossible to borrow the shares of companies trading on the OTCBB, investors and hedge funds looking to take negative bets on these often-overvalued development-stage companies have traditionally been trading through Canada where it's not required to borrow stock before selling it short. The practice is known as naked shorting. That trading avenue has now been effectively closed.
The new NASD rule doesn't cover Canadian brokers, since most are not members of the association, instead it makes it the responsibility of U.S. brokers trading with non-members to make sure that their counterparts will be able to settle a transaction before completing a short sale. "It's part of (a broker's) supervisory responsibilities," NASD's Luparello said, adding that a non-member's previous failures to deliver should be a good indication of whether or not it will in fact be able to complete the transaction by the settlement date. Market makers engaged in bone fide market making activities will continue to be exempt from affirmative determination.
Luparello said that, unlike a parallel SEC initiative to tighten short selling rules on the small-cap markets, the new NASD rules did not originate from worries over mounting failures to deliver stock into the national clearing system. But Luparello said the amended NASD rule fits nicely with the new short selling regulations now under consideration by the SEC. "I think it addresses a gap and (shows) that we, like the SEC, are looking at a variety of things in this area," Luparello said.
The NASD proposal was first submitted to the SEC in November 2001, well before alleged abuses of naked shorting became the focal point of a campaign lead by some OTCBB companies in the U.S that say they have been victimized by the practice. While some investors argue that short sellers provide a needed service to the markets, others have called for the complete abolition of short selling because of the undue pressure its puts on the shares of companies. While market participants in the U.S. and abroad are well aware of the new short selling regulations being put forward by the SEC, known as Regulation SHO, most said they knew nothing of the NASD's plan before it became final.
"It's taken us by surprise," said Richard Thomas, head of compliance at Canadian brokerage firm Pacific International. Although separate from it, the amended NASD rule fits tightly within the SEC's SHO which is now under review by the SEC staff after a period during which market participants were invited to comment on it.
As it stands, the new SEC short selling rules will make it easier to short large-cap stocks since they would do away with the "uptick" rule, which bans short selling on a stock when the price is falling. But it when it comes to the small-cap markets, where it's often impossible to borrow stock, the impact of SHO will be the opposite, making it harder to short sale stock. The new SEC rule sets a predetermined level of so-called clearing fails - cases in which a broker or investor cannot deliver stock within two days after settlement - which will trigger a 90-day blackout whereby the customer will not be allowed to short sell that security. That 90-day exemption would affect trading of U.S. securities in and outside the U.S.
The new NASD affirmative determination rule will take effect on Feb. 20.
If you are not familiar with the issues surrounding the debate over illegal naked short selling in microcap stocks, now would be a good time to click on either of those links and familiarize yourself with the story.
Last year the SEC began to take regulatory action in several instances where the market was manipulated by illegal short selling. Most of the abuses occurred in one of two specific areas: 1- where a "death spiral" financing has occurred, and a fund manager is illegally shorting against a future convertible security to force the price lower artificially or 2- where microcap stocks which cannot legally be shorted are manipulated by short sellers who execute their trades through Canadian brokerage firms. They get away with this practice because the Canadian firms are not NASD members, and therefore not subject to the same rules. In addition, certain flaws within the DTC (Depository Trust Company) allow the practice to go on. In the May 18th article I wrote about 80 small companies who had withdrawn from the DTC system to attempt to thwart the manipulation of their stock.
As it turns out, the regulatory pendulum is swinging towards dealing with this pervasive problem. Both the SEC and the NASD are in the process of changing the rules to close the loopholes.
The SEC's Proposed Rule Change
The SEC has proposed a rule change to help deal with the problem of illegal naked short selling. Proposed Regulation SHO was available for public comment up until January 5th, 2004. The comment period has passed, and one can assume a new rule will go into effect in the near future.
If you want to read the entire text of the proposal, simply Click Here, and you will be taken the the SEC's web page version of the new rule proposal.
The SEC has the following quote in the introduction to the new rule proposal:
Proposed Regulation SHO would, among other things, require short sellers in all equity securities to locate securities to borrow before selling, and would also impose strict delivery requirements on securities where many sellers have failed to deliver the securities. In part, this action is designed to address the problem of "naked" short selling.
In this excerpt, the SEC spells out the problem:
Many issuers and investors have complained about alleged "naked short selling," especially in thinly-capitalized securities trading over-the-counter. Naked short selling is selling short without borrowing the necessary securities to make delivery, thus potentially resulting in a "fail to deliver" securities to the buyer.
Naked short selling can have a number of negative effects on the market, particularly when the fails to deliver persist for an extended period of time and result in a significantly large unfulfilled delivery obligation at the clearing agency where trades are settled.
The proposed rule change requires broker dealers to take electronic delivery of shares they have purchased within two days of settlement date. On the surface, it would seem this rule will eliminate the massive "open fail to delivers" rampant within the DTC system, and prevent the illegal naked short selling which comes through Canadian broker/dealers.
I am not sure when this new rule will go into effect, but I will try to find out.
The NASD Takes Decisive Action
The NASD (National Association of Securities Dealers) has taken much swifter and more decisive action. A surprise new rule change was announced on January 20th. It effects all NASD broker/dealers, and has already been approved by the SEC.
New Rule 3370 goes into effect on February 20th 2004. This new rule could become the holy grail for bulletin board traded companies. The Rule requires NASD member firms to treat non-member broker dealers as if they were regular customers as regards delivery of any shares that have been sold through a US registered broker/dealer.
Up to February 20th, non NASD member broker dealers (for the most part Canadian brokerage firms) have not been treated as if they were regular customer. They have been awarded a special status which allowed them to keep "open fail to delivers" on their books. Rule 3370 forces the NASD member firms to treat the non-member broker dealers as if they were customer, and forces them to close out their trades in a reasonable time frame by delivering sold shares.
Conclusion
The 90's roaring bull market, which ended abruptly in March of 2000, led to excesses on the long side. The hangover has continued far beyond the fraudulent practices of Enron and MCI. It extended very deeply into the heart of the mutual fund industry.
The ensuing bear market of the 2000 to 2003 led to the same kinds of excesses on the short side. Manipulative practices of short sellers are much less widespread and more insidious.
Market Makers will still be able to take legal naked short positions to enhance the liquidity of the market, but the SEC has some language to try to prevent extensive abuses by market makers also.
The Regulators in the securities markets are not proactive; they are reactive. A problem is identified, and the machinery slowly starts up to deal with the problem. The wheels turn slowly, but they eventually the system works.
These new regulations are a major step in the right direction for the microcap market. The new regulations will enhance the liquidity of the more thinly traded stocks, making it easier for the companies to raise capital and maximizing their chance to successfully implement their business plans.
I believe the OTC Bulletin Board will evolve into a carbon copy of the NASDAQ Small Cap in the 80's and early 90's. The listing requirements were far less stringent back then, and many small stocks traded with a great deal of liquidity.
To paraphrase Yogi Bera: This is Deja Vu all over again.
Here's an article Dow Jones carried on the new NASD regulation which goes into effect on February 20th:
DJN: DJ IN THE MONEY: NASD Tightens Short Selling/Delivery Rule
NEW YORK (Dow Jones)--Taking most market participants by surprise, the National Associations of Securities Dealers has drastically tightened one of its rules governing short selling. Known as affirmative determination, the NASD rule stipulates that brokers and dealers engaged in a short sale transaction must make sure that shares can be delivered by settlement time, three days later.
"We closed a loophole," said Steve Luparello, executive vice president of Market Regulation at NASD. Until now, non-NASD members, like specialists, option markets and foreign brokers, weren't covered under the affirmative determination rule. That means that non-NASD members didn't have to represent to the NASD broker through which they conducted a short sale order that they would be able to deliver the stock by settlement date.
A short seller typically borrows stock from a broker to sell it into the market, betting that the share price will fall so that he can buy the stock back at a lower price and pocket the difference.
The amended NASD affirmative determination rule, which was recently approved by the Securities and Exchange Commission, will particularly affect short sales conducted through foreign brokers, most specifically Canadian brokers which have often been used by investors to sell short the stock of small U.S. companies trading on the Over-the-counter Bulletin Board or OTCBB.
Because it's often impossible to borrow the shares of companies trading on the OTCBB, investors and hedge funds looking to take negative bets on these often-overvalued development-stage companies have traditionally been trading through Canada where it's not required to borrow stock before selling it short. The practice is known as naked shorting. That trading avenue has now been effectively closed.
The new NASD rule doesn't cover Canadian brokers, since most are not members of the association, instead it makes it the responsibility of U.S. brokers trading with non-members to make sure that their counterparts will be able to settle a transaction before completing a short sale. "It's part of (a broker's) supervisory responsibilities," NASD's Luparello said, adding that a non-member's previous failures to deliver should be a good indication of whether or not it will in fact be able to complete the transaction by the settlement date. Market makers engaged in bone fide market making activities will continue to be exempt from affirmative determination.
Luparello said that, unlike a parallel SEC initiative to tighten short selling rules on the small-cap markets, the new NASD rules did not originate from worries over mounting failures to deliver stock into the national clearing system. But Luparello said the amended NASD rule fits nicely with the new short selling regulations now under consideration by the SEC. "I think it addresses a gap and (shows) that we, like the SEC, are looking at a variety of things in this area," Luparello said.
The NASD proposal was first submitted to the SEC in November 2001, well before alleged abuses of naked shorting became the focal point of a campaign lead by some OTCBB companies in the U.S that say they have been victimized by the practice. While some investors argue that short sellers provide a needed service to the markets, others have called for the complete abolition of short selling because of the undue pressure its puts on the shares of companies. While market participants in the U.S. and abroad are well aware of the new short selling regulations being put forward by the SEC, known as Regulation SHO, most said they knew nothing of the NASD's plan before it became final.
"It's taken us by surprise," said Richard Thomas, head of compliance at Canadian brokerage firm Pacific International. Although separate from it, the amended NASD rule fits tightly within the SEC's SHO which is now under review by the SEC staff after a period during which market participants were invited to comment on it.
As it stands, the new SEC short selling rules will make it easier to short large-cap stocks since they would do away with the "uptick" rule, which bans short selling on a stock when the price is falling. But it when it comes to the small-cap markets, where it's often impossible to borrow stock, the impact of SHO will be the opposite, making it harder to short sale stock. The new SEC rule sets a predetermined level of so-called clearing fails - cases in which a broker or investor cannot deliver stock within two days after settlement - which will trigger a 90-day blackout whereby the customer will not be allowed to short sell that security. That 90-day exemption would affect trading of U.S. securities in and outside the U.S.
The new NASD affirmative determination rule will take effect on Feb. 20.
