In its edition of May 11, 1987, Business Week described an intriguing new development in the struggle between microcap-stock promoters and short-sellers. An article by veteran financial writer Chris Welles reported that brokerages under attack by short-sellers, particularly naked short-sellers, had been fighting back. “The infighting is ‘very bitter, very personal, and very ugly,’” the magazine reported. The owner of a firm called Creative Securities, which went belly-up in 1985, supposedly because of concerted stark-naked shorting, had filed lawsuits against a brokerage and a journalist accused of being in cahoots with the shorts. Another victim of rapacious shorts, the “small New York firm” Haas Securities, was cited by Welles as an example of how “firms have successfully resisted apparent bear raids.” Despite a negative (and, BW implied, short-inspired) article in Barron’s, the prices of Haas stocks hadn’t budged.
Why had the shorts behaved so horribly? Why were they persecuting innocent small companies and blameless brokerages? BW ’s explanation: Microcap fraud was a thing of the past. “The bull market has not produced a lush supply of the shorts’ perennial favorites—tiny, overhyped OTC stocks,” said Welles. As a result, shorts were “having to bend their criteria and get involved in companies that are more legitimate.” Not to worry. The justifiably outraged brokerages were fighting back—and taking their battle to Washington.
It was a remarkable article that would probably have gotten you good and mad—if you happened to be a customer (a better word might be victim) of the brokerage mentioned so favorably in the article. As later emerged in civil and criminal cases, the “small New York firm” that had “successfully resisted” shorts, Haas Securities, was in the midst of a $644 million stock-rigging scheme involving all of the Haas stocks cited by BW as bear-raid victims. Haas president Stanley Aslanian Jr. later pleaded guilty to securities fraud, and he and his cohorts served prison terms. * It seems that Haas had indeed successfully resisted the shorts—by engaging in the classic investor-gouging, market-manipulating techniques of the microcap-stock fraud that Welles said wasn’t happening anymore. As for the lawsuits filed by that feisty guy from Creative Securities—all were later thrown out of court. Another co-founder of Creative was convicted of stock fraud and sentenced to prison.
The short-bashers did manage to get Washington’s attention, albeit briefly. After a couple of years of robust pressure, the House Banking Committee held hearings in December 1989 on short-selling abuses. It was a gala event. Typical of the irresponsible rhetoric that was thrown around at the hearings, a Republican congressman named J. Dennis Hastert, the future Speaker of the House of Representatives, described short-selling as “the most blatant thuggery we’ve had come before this committee in a long time.” That caused economist Owen A. Lamont to wonder aloud, in his Yale study of long-short battling years later, “Who was the victim and who was the thug?”
During the hearings, the SEC’s associate director of enforcement, John Sturc, testified that “many of the complaints we receive about alleged illegal short-selling come from companies and corporate officers who are themselves under investigation by the Commission or others for possible violations of the securities or other laws.” Officials from three public companies testified against short-selling. In subsequent years, Lamont noted in his study, the presidents of two of these three companies were prosecuted for fraud. Sturc’s rebuttal of the short-bashing testimony was so effective that one committee member, California congressman and future SEC chairman Christopher Cox, remarked, “Is this subcommittee being snowed?”
The answer was yes. Though naked shorting was against the rules, it was widely viewed by the self-regulatory pyramid back then as a kind of necessary evil—to be tacitly tolerated, and prosecuted only on rare occasions. In the face of this benign regulatory indifference, fueled by the sleaziness of some anti-shorting loudmouths, the anti-short forces faded away. Regulators publicly took the position that naked shorting was a rare occurrence in the markets. This was, in a sense, a position the regulators had to take. Naked shorting was, after all, not permitted by the rules governing the markets. So they just turned a blind eye to it.
In mid-1987, for instance, an NASD official told Barron’s that the NASD had received only “ten or so” complaints about naked shorting since the fall of 1986, and couldn’t substantiate a single one of them. Imagine that. No naked shorting at all—despite all the shorting that was taking place, as the SEC later acknowledged, against the unborrowable stocks involved in the massive Haas scam?
It was ludicrous—a clear case of regulatory nonfeasance. However, anyone who wanted to keep the stock scamsters at bay could only hope that this nonfeasance would continue forever. There was every reason for optimism. After all, apathy and denial are the two mighty left arms of the self-regulatory pyramid. Put the brakes on short-selling? You couldn’t expect the pyramid to do that, even if it were a good idea.
Restricting naked short-selling of microcap stocks, the only free-market mechanism capable of taking on stock scamsters, was a bad idea in 1989. It was a bad idea in 1990, and 1991, and every year without exception up to and including 2004. By then it was an even worse idea—because, as we’ve seen, the microcap market was exploding in the years after the market declines of 2001 and 2002. The dangers of microcap fraud, and the beneficial impact of shorting on stock schemes, were even more widely known than they were in the late 1980s.
Yet something happened in the intervening fifteen years that had gotten the self-regulatory pyramid to start up its engines, click into high gear, and rush into a brick wall. In July 2004, the SEC passed something called Regulation SHO, which effectively put an end to naked short-selling. By early 2005, the most thinly traded, abuse-prone microcap stocks were effectively immunized against the only market force capable of countering the rampant hype and stock-rigging schemes that infest the microcap market.
Why had the SEC done something so dumb? What could possibly have motivated this agency to take such an abysmally ill-advised action, fully fifteen years after its own deputy head of enforcement had testified that complaints about naked shorting tended to come from crummy companies seeking to shift the blame for their own inadequacies?
The reason is a little frightening. The SEC was knuckling under to an aroused quasi-public. Not a genuine public, but rather a phony public, and what makes it scary is that the SEC couldn’t tell the difference. A motley coalition of microcap-company officials, deluded investors in doggy microcap stocks, stock promoters, and OTC stock publicists exerted pressure on the self-regulatory pyramid and, ultimately, won. They won, but you lost, if you are foolish enough to venture into the microcap market.
In the process, they provided an excellent example of how a pressure group with nothing on its side—not the facts, not a great many people, nor even a particularly massive amount of money—can carry the day with our self-regulatory pyramid. You just have to be smart—and know what buttons to push. No, I take that back. You just have to know what buttons to push.
After the 1989 House hearings, the campaign against naked shorting went into a kind of remission. There was an occasional flurry of anti-shorting publicity during the 1990s, but nothing much came of such things. Occasionally, cruddy microcap companies would seek to torpedo the shorts by asking their shareholders to request the stock certificates for their shares from their brokers. Doing that screws the shorts by forcing them to close out their positions. * However, through most of the 1990s there was no concerted anti-shorting campaign of the kind that had flared up in the 1980s. The only anti-short activist of note in the mid-to late 1990s was a stock promoter named Ray Dirks, who occasionally publicized the “Shortbuster’s Club”—the name he gave to stocks he was pushing on the basis of their high short interest. However, Dirks’s aim was to distribute propaganda about marginal stocks pushed by a brokerage firm with which he was associated, not to change the system. Dirks’s blathering received little attention, and the self-regulatory pyramid continued to do nothing.
It probably didn’t help the short-bashers that Haas’s successors in the stock-scam business continued to bear out Sturc’s point, by being the ones to scream the loudest about short-selling. The short raid on Hanover Sterling got some media attention, but it didn’t rise to the cloud-cuckoo level of the Haas coverage in 1987. Similarly, the media paid little attention when a firm with a name as dishonest as its sales practices—State Street Capital Markets Corp. †—complained in 1996 that naked short-sellers were attacking its stocks. It later was revealed in extensive civil and criminal proceedings, including a March 2000 indictment of several Mob figures, that State was controlled by Mob-linked scam artists, and that its stocks were manipulated up the wazoo.
It didn’t hurt the shorts (though it didn’t help much either) that academic studies continued to demonstrate throughout the 1990s that short-selling was a positive force in the markets. One significant academic probe of short-selling, published in 1997, examined shorting on Nasdaq at a time when there were no restrictions on selling during market declines. Researchers at three universities concluded that criticism of short-selling simply had no basis in fact: Shorts, they found, did not destabilize markets by selling into falling markets and exacerbating price drops. As usual, this study and others like it received little attention outside academia.
Then came the market downturn of 2001 and 2002. Nasdaq stocks were pummeled, OTC volume collapsed, and so did the prices of OTC stocks. A few distant rumblings could be heard, as the short-bashers began a new campaign aimed at blaming everybody but the scuzzy companies themselves for their falling share prices. Beginning in 2002, it was almost as if the loony “long-versus-short” days of 1987 were being played out again. Company after company began to call for investors to obtain the stock certificates for their shares as a way of manufacturing short squeezes.
Among the most voluble of the OTC short-bashers were two obscure companies, Universal Express and GeneMax. In 2002 and 2003, these two companies were putting out scads of press releases railing against naked short-sellers. They also commenced lawsuits against brokerages and others the two companies blamed for conspiring with the shorts to push down their share prices, and the suits generated still more press releases. These companies were unrelated, and their campaigns against short-sellers were separate and uncoordinated. They had only one thing in common: a hatred of short-sellers. No, make that two things in common: a hatred of short-sellers and the fact that their stocks weren’t very good investments. Both were dogs as stocks and money losers as companies. Even one of Gayle Essary’s rent-an-analysts could cough up only a “speculative” rating on Universal Express in its last analyst report in July 2003.
A lot of the anti-shorting noise was blaring from a stock-promotion firm that handled GeneMax’s investor relations, and was so cozy with GeneMax that it had the same address. The name of that firm was called Investor Communications International. ICI, which represented a bunch of other OTC firms in addition to GeneMax, formed a National Association Against Naked Short-Selling. Its membership included GeneMax and other ICI clients. By January 2003 the NAANS had a Web site up and running and spewing forth the following line of drivel:
This is a call to action for all OTC Bulletin Board listed public companies…
Corporate America is under siege! Not by terrorism, but rather by an unethical market practice that is destroying emerging public companies and undermining the trust of small investors. It’s called naked short selling and it is illegal, according to the rules of the NASD and US Securities and Exchange Commission (SEC). The problem is that this fact hasn’t stopped the broad group of Market Makers, Clearing Houses and Securities firms that are still using this practice to ruin hundreds and hundreds of companies across the country all in the name of profits.
It was a repetition of the hooey that was pushed, without success, by the anti-short people in the late 1980s. But there was something new. The appeal had a clever twist.
What followed—under the heading “What can you do to defend your company?”—was mainly a description of what the NAANS could do, and indeed was about to do. What it had in mind had only rarely been attempted by the short-haters: a concerted campaign of old-fashioned, all-American flesh-pressing, buttonholing, and lobbying. In addition to meeting with members of Congress and “leading government representatives to rally support from within the highest levels of government,” NAANS planned to start a PR campaign to “win the support of the government and the investing public.”
It was a stroke of public-relations genius. After all, short-selling was inherently unpopular, and its impact on the microcap market was not widely known or understood, making it ripe for attack. By March 2003, the NAANS had come up with an even better way to spin naked shorting. It was a “devastating counterfeit stock scheme.”
It was so brilliant, so imaginative, and so downright wrong that the staid Wall Street paper-pushers at the Depository Trust & Clearing Corporation, a not-for-profit company that handles the mechanics of trading for Wall Street firms, had to post a rebuttal on its Web site vigorously denying this off-the-wall accusation—which had been raised in a lawsuit against DTCC that had been tossed out of court.
The DTCC noted, just as the SEC’s Sturc had pointed out to Congress years before, that many of the firms that were hollering about naked shorting had “little or no revenue, according to their financial reports, and substantial losses, for periods of seven or eight years.” The DTCC pointed out that one of these companies had been cited for failing to file financial statements since 2001. Another had been chided by the SEC for press releases that spun fairy tales about nonexistent business plans. “They will do anything they can do that takes people’s attention off that kind of record,” said DTCC first deputy general counsel Larry Thompson, “especially if they can convince a law firm to take the case on a contingency basis, which is what has happened.”
The DTCC was right—not that it mattered. The hysterical stock-counterfeiting charge was so enticing that it appeared to pique the interest of the news program Dateline NBC, according to emails and posts that flooded the Web in 2004 and 2005. The story went out over the Web throughout the early part of 2005 that NBC had put together a massive exposé of stock counterfeiting. There was even an “airdate”—April 10, 2005—that was repeatedly trumpeted on Gayle Essary’s FinancialWire and even a Universal Express press release. When that day came and went without the show being aired, the short-bashing community howled in protest, and some saw the hidden, invidious hand of the dastardly Depository Trust & Clearing Corporation.
Only a small number of people were spreading these silly tales. Gayle Essary pushed the anti-naked-shorting line hard in his FinancialWire news service, hacking away at naked shorting as a “national financial scandal.” Gayle’s contribution to the cause was a drumbeat of “coverage” and a label, “StockGate,” which was catchy enough but didn’t get much attention except from the true believers. Still, Gayle made good use of it. “In yet another stunning development in the StockGate saga that has roiled the financial industry,” was how Gayle, a master of understatement, began an April 2005 FinancialWire item on naked shorting. Gayle also made considerable hay from the nonairing of the Dateline NBC report, a routine delay he slammed as a “First Amendment issue.” Gayle named the “powerful and reclusive” DTCC as a “prime suspect” in what he described as the “sudden and inexplicable ‘indefinite postponement’” of “what was expected to have been a shocking expose of the DTCC’s purported role now and over the years in the counterfeiting of electronic certificates supporting illegal naked short sales.”
Another major anti-shorting campaigner was Richard A. Altomare, CEO of the short-fighting Universal Express. Altomare’s company was at least as adept at putting out press releases as it was at its core business of shipping stuff. Universal Express churned out a bunch of increasingly outraged statements throughout 2003 lashing out at the curse of naked short-selling. One missive that Universal sent out to the media in October 2003 exhibited the kind of cool, dispassionate reasoning one had come to expect from the short-bashers. This one called naked shorting “economic terrorism” and announced that Altomare was heading to Washington, in suitably Capraesque fashion, to press his case with lawmakers and the SEC.
In late 2003 and early 2004, this invigorating picture of folksy populism was darkened. Word crept out on the Internet, and was picked up by the media, that the president of ICI was named in SEC documents as a stock promoter named Brent Pierce, who was barred for fifteen years by securities regulators in Vancouver. * ICI’s links to GeneMax also were publicized, as was the relationship between GeneMax’s sometime CFO James D. Davidson and a stock-touting newsletter publisher called Agora Inc.—which Davidson founded and which was charged with stock fraud by the SEC in April 2003. (Davidson wasn’t charged, and Agora was still fighting the charges two years later.)
Similar difficulties befell the shipping-and-press-release magnate. The SEC sued Altomare, his company, and others for stock fraud in March 2004. The suit sought to bar Altomare from serving as an officer of any public company in the future, asserting that Universal issued a series of false press releases from May 2002 to April 2003, and “thereafter made other false statements in public interviews, press releases, and Universal’s filings with the Commission.” The SEC also said that the company’s claims of naked short-selling were unsubstantiated.
Well, you can rest assured that none of this had any effect on the flow of anti-shorting propaganda from Universal Express or its crusading CEO. The SEC suit made Universal Express even more teed off. The company erupted with outrage at what it described as SEC retaliation for its outspoken anti-naked-shorting stance, and the rest of the short-bashing community rallied around. If anything, the rhetoric climbed up a notch, as Universal publicized its own suit against the SEC, filed a few weeks before the SEC legal salvo in March 2004. No, the company asserted in legal papers, that was not a preemptive move. Clearly it would take more than a mere SEC lawsuit to deter people quite so dedicated and persistent.
For a long time it seemed that the short-bashers’ vigorous pursuit of publicity was a failure. There was little of the half-witted press coverage of the kind that had been bestowed on the short-bashing stock swindlers at Haas years before. In retrospect—given the short-bashers’ effectiveness and the harm they ultimately caused to the microcap markets—there probably should have been media attention, but not the kind of media attention desired by the anti-shorters. The exceptions to the near-universal media indifference were sparse, and included Forbes, Carol Remond of Dow Jones Newswires—but not her corporate brethren at the Wall Street Journal—and Herb Greenberg of MarketWatch.com. * Another rare voice of reason came from the Internet blog of Mark Cuban, owner of the Dallas Mavericks and a critic of the campaign against naked shorting. Barron’s, which practically owned the story in the late eighties, didn’t have much to say on the subject this time around. The New York Times weighed in with a gently critical piece on the anti-naked-shorters, but only after Regulation SHO was a reality.
The ICI and its “coalition” faded away during 2004, but the anti-shorting campaign was taken up by others, grabbing the flag before it touched the ground. Cynically dishonest Web sites appeared with misleading watchdog-type names, such as investigatethesec.com, aimed at advancing the harebrained “stock counterfeiting” cock-and-bull story. Anti-shorting emails flowed like a Niagara of raw virtual sewage to the media, regulators, and anyone who seemed even slightly interested, or not interested at all.
Their contents were the usual combination of lies, exaggerations, and sheer fantasy. A typical 2004 missive, churned out by one of the leading Patrick Henrys of the anti-short campaign, read as follows:
At the present time everybody from President Bush, into the halls of Congress, through to the Department of Justice and settling in the Chair of Bill Donaldson are aware of the abusive practice of Naked Shorting and the impact this is having on small business. Wall Street has completely rewrote the economics of supply and demand as it relates to Securities trading and has created massive imbalance on the books of our Broker Dealers by overselling small business stocks without ever settling the trades. The SEC went so far as to admit that stocks were oversold to a point where trade settlement failures exceeded the entire float of publicly traded companies.
The endless stream of repetitive, shrill, and increasingly bizarre arguments might have made it seem, to those on the receiving end, as if they were working as USDA inspectors at an Oscar Mayer meat-processing plant. It was like the old TV commercial jingle, “My baloney has a first name, it’s N-A-K-E-D. My baloney has a second name, it’s…” It was just baloney, more baloney, and still more baloney—and as it continued through 2003, the sheer weight of it all was beginning to take effect. The opponents of naked shorting were doing more than just sending tired arguments and idiotic rhetoric by email. They were personally delivering their baloney to the SEC and members of Congress.
On October 28, 2003, the SEC caved in. The pinnacle of our self-regulatory pyramid decided that the time had come to shut down K Street and hold a Baloney Festival. The SEC published for comment a rule proposal that would put the brakes on naked short-selling. Regulation SHO was born.
Now, it must be underlined at this point that the only thing that had changed from previous years was the Baloney Blitzkrieg I just described. This is crucial, because it speaks volumes about the impact of a sustained campaign on the self-regulatory pyramid. Nothing else had happened to warrant Regulation SHO. There had been no sudden spate of naked shorting, no new evidence, no gigantic scandal in the headlines, no market crash that demanded a scapegoat, no dramatic academic or GAO or regulatory study that demonstrated graphically how the microcap-stock market was in the grips of naked short-sellers. In fact, the SEC rule writers were unusually succinct when it came to describing the evidence that there was an actual problem they were trying to fix.
That’s because there wasn’t any evidence.
Although the rule proposal made reference to “increased instances of ‘naked’ short selling,” the SEC was able to site a grand total of only one naked-shorting case in the rule proposal. That involved a hedge fund called Rhino Advisors, which allegedly manipulated downward the shares in a company called Sedona to cash in on a debenture. Hardly a bear-raid situation or an example of “stock counterfeiting”—a bit of sheer crapola nowhere mentioned in the SEC rule proposal, or, for that matter, anywhere outside the fantasies of the short-bashers.
If the SEC bureaucrats were going to get those persistent baloney-pushing short-bashers off their backs, they would have to get the Street on their side, or at least not in opposition. After all, our self-regulatory pyramid knows who’s boss—they don’t call our system of securities regulation “captured by the industry” for nothing. The SEC softened any impact on the Street by including in its proposal a two-year suspension of enforcement of the uptick rule—which bans shorting when prices are falling—for the largest and most widely traded stocks. (To be exact, the SEC proposed a technical change in the uptick rule, and a pilot program suspending all restrictions for the biggest stocks.) By so doing, the SEC was able to keep the Street happy, because large firms do a lot of short-selling of large companies but only rarely short-sell microcaps.
Bill Donaldson’s SEC could breathe a sigh of relief. Wall Street’s reaction was mixed. While the Street clearly preferred the status quo, it could live with naked-shorting restrictions, with some minor changes that were incorporated in the proposal. Not a word was said in favor of naked shorting as a curb on market abuses—not by the Street establishment, not by the Securities Industry Association, and not by the large Street firms that sent in comment letters.
In contrast to the Street’s mild reaction, and the polite, deferential responses the SEC usually gets to its rule proposals, the bulk of comments were mass-produced from supposed members of the public and had all the subtlety, and intellectual finesse, of email spams—which is precisely what some of them were. By 2003, the SEC was accepting comments by email. They didn’t have to be signed. They didn’t even have to make sense. One person was free to use five, six, a dozen, or a hundred email addresses to push the same repetitive argument, and the SEC had no way of knowing.
So this is what the SEC got, by the dozens:
Dear Sirs,
THE SEC (THE BIG QUESTION MARK—PROACTIVE REACTIVE—IDLE??)
For those living the battle cry of positive pro-active reforms out of the Securities and Exchange Commission, may expect to wait a long time. The fact is, the SEC, as recently observed, cannot bring them selves to enforce existing rules or enact appropriate legislation to curtail the rampant fraudulent practices of Wall Street.
The SEC received 21 comment letters/emails with that precise wording—the agency’s comment compilers called it “Letter Type B”—as well as dozens of others conveying the same elegant-as-peanut-butter message in boilerplate letters from people who were all fired up about naked short-selling but didn’t quite know why. In all, the SEC received 462 comment letters/emails, the vast majority of which were produced by the Baloney Brigade. The SEC found itself having to prepare a sixty-two-page summary of the baloney barrage, most of which had a common denominator. “Despite contrasting opinions,” the SEC summary said, “the comments appeared to share an underlying concern with the use of manipulative devices as a means to control stock prices.”
The status quo, tempting as it might be, could not remain unchanged in the face of all this supposed public outrage—when, that is, it could be addressed without discomfiting the regulators’ friends and future employers on Wall Street. Meanwhile, the villains of this regulatory drama, the supposed utilizers of “manipulative devices” to “control stock prices”—the naked shorts—were caught in a vise. They were violating the rules. They couldn’t exactly admit to doing that, could they? One can go on and on about how naked shorting helps the free market, but going public with a defense of naked shorting won’t do you any good if it means that you have to fend off the SEC or NASD as a result. A couple of shorts contributed cogent but—hardly helping their case—anonymous comment letters via email, and there were letters from law firms representing understandably unidentified clientele.
The few comment letters opposing Regulation SHO had a sad, pathetic, almost pleading tone. Is this really happening? Is it really necessary to tell the SEC that cutting back on naked shorting will hurt, not help, the markets, and that the main problem with microcap stocks—one that the SEC itself had proven time and again—was not short-selling but rather upward price manipulation?
The Washington law firm of Pickard and Djinis, representing an unidentified Canadian investment dealer, made a rare rational argument by noting that Regulation SHO “will remove an important market constraint on pricing inefficiencies and upward manipulations attempted or occurring with respect to such securities.” In fact, said the firm, the proposed rule “plays directly into the hands of such manipulators. Indeed, the regulation actually would have the effect of encouraging manipulative tactics that involve restricting the supply of securities.”
The few intelligent comments pointed out the utter absence of evidence that naked shorting hurt the markets. There were only “sketchily alleged and apparently unproven ‘abuses’ by short sellers,” said the law firm of Feldman Weinstein LLP on behalf of a client or clients unknown. The firm went on to plead with the SEC not to put “a series of new tools at the hands of the promoters of penny-stock ‘pump and dump’ schemes to work their frauds.”
At the very moment those soon-to-be-ignored words were being fruitlessly committed into writing, the SEC had plenty of evidence to rebut the wild accusations of the short-scapegoating baloney purveyors. One study was in the process of being conducted for the SEC by a visiting economist, Leslie Boni of the University of New Mexico. She found that Regulation SHO would hurt the liquidity of the market as a whole—with OTC and Pink Sheet stocks among the hardest hit. Boni found that naked shorting took place more frequently than had been previously believed, and that cutting back on it would mean “illiquid, expensive-to-borrow stocks may be more likely to experience temporary short squeezes and increased price volatility.”
Microcap-stock pushers and the Baloney Brigade may not care, but you should care—and the SEC is legally obliged to care—about that kind of stuff. Lack of liquidity is always bad for investors. This evidence of Regulation SHO’s potential harm to the market* was published after the dirty deed was done, but the intellectual vacuity of Regulation SHO was obvious long before it was proposed. Besides, you don’t need a study by the Physics Department of the Massachusetts Institute of Technology, replete with Venn diagrams and foot-pound calculations, to know that gazing down the hose of a running vacuum cleaner is not a good idea.
The fundamental flaw with the Boni study and the few anti-SHO letters was that they were true and contained facts—and such irrelevancies were ground into dust like the French army in 1940 by the persistent, well-organized Baloney Blitzkrieg. In July 2004, exactly nine months after Regulation SHO was proposed—a veritable rapier-thrust by SEC standards—the rule was adopted, with some changes but with its most damaging anti-shorting provisions intact.
The new rules didn’t completely outlaw naked short-selling, but made it costly and troublesome, effectively crippling it as a microcap trading strategy. Beginning on January 3, 2005, a broker could not allow a short sale of a stock unless he had “reasonable grounds to believe that the security can be borrowed so that it can be delivered” when due. Just to make sure that the shorts didn’t sleaze their way around that requirement, the SEC cleverly required regulators farther down the pyramid to publish lists of “threshold” securities—stocks in which there are an abundance of “fails to deliver.” That is, stocks sold but not actually delivered. That includes naked short sales—because you can’t deliver a stock you didn’t borrow in the first place. (Fails can be caused by a lot of things other than naked shorting, however—something foes of short-selling usually ignore.)
Clearing firms—the big outfits that handle trades for the smaller brokerages—were now required to close out fails involving threshold stocks if the fail persisted for ten days. The SEC had proposed two days, but the Securities Industry Association, speaking for the Street, had said that was too short and ten days would be better—so ten days it was. However, the SIA had no objection to the threshold lists, so that was that. The threshold lists remained.
Short-sellers who engage in microcap shorting tell me that the rules were a snazzy contrast to much of what emerges from the SEC. Regulation SHO was well-drafted and effective. Shorts who bet against unborrowable microcaps now risked being squeezed like a lemon, and that was not a risk worth taking. Even the stocks that could be borrowed became costly to borrow. Thanks to this gratuitous SEC meddling with the free markets, brokers started charging for the privilege of loaning out scarce small-cap stocks to short-sellers, making the whole process uneconomical for vast numbers of stocks.
The wretched impact of Regulation SHO became evident well before the worst parts of the new rule took effect in January 2005. By then, the shorts had already quietly folded up their tents and stalked off without a word, leaving the microcap market to the promoters, paid-research hype-masters, and fraudsters. After Regulation SHO, shorts quietly confined themselves to shorting stocks that they could borrow. The worst stocks, the manipulated stocks, couldn’t be shorted anymore because they couldn’t be borrowed, so the shorting in them dried up. Today a Hanover Sterling would be unmolested by shorts, free to rip off the public.
You can’t blame the shorts for cutting out. The free market is not a charity bake sale. Market participants are in it to make money for themselves—whether their impact is bad, indifferent, or, as in this case, good for the markets and good for small investors.
It was a clear victory, but the short-bashers weren’t satisfied. The Baloney Brigade rolled on, crushing the white flags of the enemy beneath the treads of their Sherman tanks.
The reason victory had not brought peace was that the victors had not, and would never, achieve their objective—which was to elevate the prices of the worst stocks in the world. With the short-sellers all but extinct, anticipated short squeezes did not take place, so prices of slimeball stocks usually did not go up. Still, that was no reason to stop the Baloney Blitzkrieg. On the contrary, there was every reason to continue it. Naked shorting was more necessary as a scapegoat than ever before. It was a permanent war for the sake of having a permanent enemy and a permanent scapegoat, very much as in George Orwell’s 1984.
So the war continued. It is still being waged as I write these words, and it will no doubt be waged after these pages have turned yellow with age, and will be waged when your children and grandchildren bounce their great-grandchildren on their knees. Great battles are like that, particularly when they are waged in the realm of fantasy.
Among the leaders of the anti-shorting forces in the post-victory offensive, standing upright in a staff car, was the press-release-happy OTC shipping magnate Rich Altomare of Universal Express, wearing his multipronged SEC litigation as a badge of honor. In April 2005, his company issued a press release announcing positive developments in its lawsuit against the SEC. Compensatory damages in the suit were “now estimated to exceed $1.4 Billion.” The suit “will now be considered by the United States Court of Appeals for the Eleventh Circuit, the second highest Court in America. We anticipate that this venue will be less expensive with a shorter deliberation outcome than a full Jury trial of such importance, which would have been appealed inevitably by either side.” The reason the suit was moving to an appellate court was not mentioned—it had been thrown out of a lower court. A mere detail when massive fraud was under way!
“Imagine that trillions of shares,” the press release continued, “questionable compensation to the SEC, billions of dollars of un-owned securities stolen from thousands of companies and hundreds of thousands of stockholders should all be ‘grandfathered’ simply because the SEC decreed it should, without financial settlement of these massive illegal short stock positions!”
It had to be imagined, because it wasn’t happening.
In the early months of 2005, after it became apparent that ending naked shorting wasn’t having an immediate and visible price-boosting effect, the Web page of something called the National Coalition Against Naked Shorting materialized out of the clear blue sky. NCANS billed itself as a “grassroots advocacy group composed of small investors who are tired of the predatory hedge funds on Wall Street violating the rules against naked shorting.” Note another old scapegoat, hedge funds, being hauled into the picture. There were plenty of reasons to be concerned about hedge funds, but naked shorting wasn’t one of them. As for that “grassroots” thing, the roots were in the soil of the great state of Utah, where NCANS was funded by a businessman named Patrick Byrne. He ran a firm called Overstock.com that was an innocent victim of perfidious naked shorting.
Byrne swiftly emerged as the Douglas MacArthur of the Baloney Blitzkrieg. His Tojo, the villain behind what he claimed was naked shorting of Overstock, was what he described as a “Sith Lord”—a character from the Star Wars movies. Some scoffed, but it made perfect sense. Naked shorting was an imaginary problem. So why not blame it all on an imaginary villain?
The short-bashers focused their still considerable energies on the lists of stocks that were supposed to have shouted “Squeeze me!”—the threshold lists. Since these were not being squeezed like a roll of Charmin in those old TV commercials, resentment was building.
One of the short-bashers’ 2005 poster children was the donut-franchise company Krispy Kreme. The company’s stock was on the threshold lists in early 2005, and yet its price remained stubbornly depressed. How could that be?
There were two possible reasons:
Well, I don’t have to tell you which of these two possible explanations was the one pushed by the Baloney Brigade, do I?
The NCANS Web site, after pointing out that Krispy Kreme was “down 85% since last fall and 40% since it became a threshold security,” went on to observe:
This indicates to me at least that the covering of the fails is being done at the expense of the investor, wherein the market makers and specialists systematically abuse their privilege, and drive the prices of the SHO companies into the ground to shake out the small investors, thereby providing the necessary shares to solve their big customers’ problems.
True, and it could also mean that the shorts were not being squeezed because there were no shorts to squeeze.
With the NCANS, Altomare, and Byrne leading the way, the increasingly surreal, comical-if-it-wasn’t-so-dangerous struggle against naked short-selling marched on. Byrne’s bankroll meant that the short-busters could occasionally run full-page ads in newspapers such as the Washington Post, and that they had an ally in Utah Republican Senator Robert Bennett, who grilled a hapless Bill Donaldson on Regulation SHO at a Senate Banking Committee hearing in April 2005. Still more senators and members of Congress—a few, but that was all you needed—enlisted in the Baloney Brigade.
In mid-2005, the foes of naked shorting made the mistake of consuming their own baloney, and deluded themselves into thinking that there really was a “grassroots coalition” of “investors” who were upset about naked shorting. Demonstrations were organized in Washington and New York in June 2005, at which only a handful of people showed up. A mere dozen could be rustled up to make fools of themselves in front of the NASD building in New York, according to an account in Reuters. Not that it mattered. As advocates of bad causes around the world can tell you, if Reuters shows up, it’s a success. So another demonstration was planned, this one in front of the headquarters of the evil DTCC.
The Baloney Blitzkrieg marshaled its forces in front of the DTCC headquarters, at 55 Water Street in lower Manhattan, on July 29, 2005. Providence smiled upon these silly people, bestowing upon them an entirely undeserved break in a heat wave that was plaguing the city. The forces of baloney came prepared with their own camera crew—a fellow named Oscar, who had obtained the police permit for the demonstration, was on hand to film a documentary about this blight upon the nation’s markets. The demonstrators were dressed as they would for a backyard barbecue, and proceeded to skewer the truth for a few hours as they paraded in front of bored office workers, carrying yellow-on-black signs with slogans such as COUNTERFEITING STOCKS IS A CRIME and COUNTERFEIT SECURITIES ARE DESTROYING AMERICA. A brochure was handed out—“WALL STREET’S NEXT NIGHTMARE! FINANCIAL TERRORISM”—as New York police, diverted from watching for the real thing, looked on impassively.
The spectators, mostly office workers on rational errands such as obtaining coffee from the takeout across the street, were puzzled by all the bizarre anger being directed in their general direction. “Naked shorting? We don’t do that here,” said one puzzled gent, an older man, to his friends. He might have been from DTCC or he might have been from Standard & Poor’s, which occupies space in the same building. Whichever his employer, his sentiments were, of course, correct.
The paid-research guy Gayle Essary was there—not joining the demonstration, he told me, as befits a newsman—handing out leaflets on his own crusade against DTCC, which he blamed for his FinancialWire “news” service being yanked by a newspaper that distributed it over the Yahoo! wire. Gayle was dressed with dignity in a gray suit, and another man showed respect for the occasion by coming to the demonstration in an undertaker-dark suit, smoking a cigar, accompanied by his similarly attired son, both as somber as professional mourners. He described himself as a self-employed provider of financial services, and railed against naked short-selling as I took notes and the two of us were filmed by Oscar’s cameraman.
It was a good-natured crowd—people who had a cause, and were exercising their right to demonstrate. These people cared about their cause. One of them had composed a country song, “The Ballad of Naked Shortee,” or words to that effect, and it blared on occasion from a speaker, giving the whole demonstration a kind of tailgate-party, down-home, festive air. These were people who, thankfully, did not take themselves too seriously. I doubted—until I talked to them—that they truly believed the nonsense on their signs. One female participant in the demonstration wore a realistic-looking bare-behind prosthesis and a sign saying DTCC—COVER YOUR SHAME! Another participant, who described himself as a “self-employed security consultant,” drove up in a black Ford Focus, upon which were scrawled the words STOCKGATE and THE SEC SUCKS and DO YOU OWN REAL STOCKS? and GOT CMKX?
CMKX was the stock symbol of a Las Vegas company called CMKM Diamonds, and appeared to be a subject of angst for these demonstrators. I learned that most of them were participants in an online chat room devoted to CMKM and its woes—its persecution by the SEC, the “counterfeiting” of its stock. The plight of CMKM was on caps and on signs as well as on the Ford Focus, and one fellow—who would give me his Internet handle but not his name—had it emblazoned on a red T-shirt.
The Ford Focus guy, Barry Shipes, explained that he had bought the company with that particular stock symbol about a year before, and that the stock had declined. He blamed the shorts. “I absolutely feel in my heart of hearts that this company has been naked-shorted on a daily basis by millions and millions of shares.” My suggestion that this alleged short-selling presented a buying opportunity was rejected by Mr. Snipes. Later I found out that he had some basis for this position. The stock’s days in the market were, apparently, numbered.
The SEC had ordered a temporary trading halt in the company’s stock in March 2005, claiming that CMKM had not filed the annual and quarterly reports required by law. The last time it had done so, in September 2002, the company’s financial statements had a charming, piggy-bank quality to them that would arouse the paternal feelings in most any investor, because most any investor not residing on skid row would have more money in the bank. At the time, CMKM had total assets of $344, all in cash, and total liabilities of $1,672. The absence of financial statements since then did not bother the people on the picket line, but this did: In May 2005, SEC administrative law judge Brenda P. Murray had held a hearing to determine whether the registration of the company’s shares should be suspended or revoked.
Several demonstrators made angry references to the hearing, but it wasn’t until after I looked up the decision that I could understand what they were talking about. Then it was my turn to be puzzled. By my reading of Murray’s decision, it was a little surprising that the demonstrators were picketing DTCC and not the CMKM headquarters in Vegas.
They might have had trouble finding it. According to Murray’s decision, CMKM’s supposed executive offices were “occupied only by a hot rod shop.” Murray did not even seem to buy that the company had an actual business, saying it was “purportedly engaged in the business of mineral exploration.” CMKM’s chairman, CEO, and cochairman of the two-person board of directors, Urban Casavant, refused to testify, invoking his Fifth Amendment right against self-incrimination.
None of this troubled the demonstrators. Neither did the SEC judge’s finding that CMKM had not been totally honest and forthcoming with either the people on the picket line or the agency. Murray ruled that the company had told the SEC it didn’t have to file with the agency when it really did. She said it had “deprived shareholders and investors of material information,” and “promoted the company to investors through informal news releases and public statements that contained false information,” and “operated in secret, revealing scant information to the investing public regarding its purported multi-million dollar transactions and stock issuances.” Murray said a lot more in her fourteen-page decision, all unflattering stuff like that, which had nothing to do with naked shorting and hence did not bother the demonstrators.
What made the demonstrators’ indifference even stranger was that this decision had not been handed down somewhere in the dim mists of time. It had been issued on July 12, 2005, a little more than two weeks before.
Assuming these were actual investors in the company and not paid shills—I had no reason to assume the latter—then people who had innocently purchased shares in a crummy company had channeled their rage against a nonexistent enemy. It was weird. No, it was more than weird. It was sick.
There is a silver lining to all this. There has to be, if one has any faith in the existence of a merciful, forgiving Supreme Being presiding over an orderly universe. The short-bashers’ Baloney Blitzkrieg demonstrates how the immobile, status quo-loving self-regulatory pyramid can be pushed into action if pressured to do so—even by a small band of self-interested loudmouths. Imagine what can happen if broad numbers of investors, representing the thousands of ripped-off and teed-off investors, were to use the same techniques of the phony, cynical—but dismayingly effective—short-bashers, this time to protest real abuses, not victimless, craftily manipulated baloney. The mind boggles.