March 2006 –

Naked Shorting: How Common?
   (Continued from previous page)

The SEC has set some arbitrary limits on how long, and to what extent, any stock can remain in a failure to deliver (or FTD) condition. Above a certain threshold (10,000 shares failed), after 13 consecutive days, and with certain other criteria satisfied, the boys at the commission start flexing their muscles.

What do they do? They put that stock on a list.

Updated daily, it's called the Reg SHO Threshold Security List. Its namesake is Regulation SHO, established in 2005 as a means to reign in naked short selling. But like many government regulations, this one lacks teeth. It lists only the victims of the crime, not the perpetrators. Reg SHO instructs broker-dealers to "buy in" their FTDs when the threshold is exceeded. But it but provides for no penalty for those who don't. The daily list offers no information on which broker-dealers are in violation, or to what extent. Each of the stocks listed is understood to be above the 10,000-share threshold, but how far above?

Patrick Byrne produced a series of podcasts to explain the mechanics of naked shorting and the depth of the problem. They're well explained, understandable, and I daresay, convincing. Check them out at www.businessjive.com/nss.aspx.

In one podcast, Byrne reports on public comments made last year by Larry Thompson, Deputy General Counsel of the Depository Trust and Clearing Corporation. The DTCC, under the SEC, clears and settles perhaps 20 percent of the nation's stock trades. Thompson "graciously" sat for an interview with his own PR staff (no real media), in effect to "chat with himself" about the FTD problem. Perhaps his aim was to head off a public outcry, Byrne suggests.

Thompson didn't seem to consider FTDs much of a problem, however. Failures to deliver occurred in "only" about $6 billion of the $400 billion worth of trades processed daily by the DTCC, he said. That's "only" 1.5 percent.

But then a renowned Harvard economist, Dr. Robert J. Shapiro, responded publicly, saying Thompson's claim was misleading. The daily volume of DTCC-processed stock trades (excluding bonds and other securities) was more like $82 billion, not $400 billion. So the apparent failure rate was much higher than claimed. Furthermore, Shapiro noted, the majority of stock trades are cleared outside of the DTCC, in a process called "ex-clearing." To those trades, Thompson's figures don't apply. Their failure rate might be higher or lower than within the DTCC, but who knows? By using true assumptions about what's known and speculating about what's not, Byrne concludes it's plausible that the rate of failure among all short sales is 30 percent or more.

It's a guess, he admits. Unfortunately, the SEC has been extremely slow to share its data. "Getting anything out of them has been like pulling teeth," he says. "What has come out is certainly not reassuring."

How many fake shares are out there? Again, it's guesswork. Not because the information is unknowable, but because the SEC chooses not to disclose the data. In analyzing anecdotal evidence about the trading of Overstock shares, Byrne concludes it's possible that the ratio of real shares to fake ones is as low as 2 to 1, or worse. That is, in addition to the 18 million known good shares, there may be 9 million bad ones or more..

Several academics (cited in Byrne's podcasts) have examined whether naked short selling is truly a problem, or just an urban myth. A Fordham University economist, Dr. John Finnerty, determined that it "can routinely occur," that is has a "potentially severe impact," that it appears to be "pervasive," that it is "particularly effective and damaging," and that the U.S. stock market is "conducive to manipulative short selling." Finnerty's 73-page study is titled "Short Selling, Death Spiral Convertibles, and the Profitability of Stock Manipulation." It is posted on the SEC web site.

Other economists reached similarly damning conclusions: Failures to deliver are pervasive and usually intentional (or "strategic"). They are not random; they target certain stocks. And process safeguards created by the SEC generally don't work. One study is titled "Failure is an Option." Another is "Strategic Delivery Fails in U.S. Equity Markets."

Regulators Say Reg SHO is Working!

The subhead above isn't mine (only the punctuation is). It led off an optimistic SEC press release in early 2006. The commission announced that in January 2006, only 37 New York Stock Exchange securities appeared on the Reg SHO Threshold List. A year earlier, in January 2005, the number was 78. The release quoted an SEC official saying that 99% of all NYSE trades (measured in dollar value) settle on time and without incident.

Critics remain skeptical. The claim is made for NYSE stocks; but not for Nasdaq or Over the Counter Bulletin Board (OTCBB) stocks, which is where the trouble tends to be. (Nobody's picking on General Electric, for example, because there's no shortage of legitimate, shortable shares. The victims tend to be small cap stocks with a low public "float"--the number of freely traded shares.) And one percent of the NYSE's daily dollar volume may not sound like much. But one percent of it is something like $700 million. Even that wouldn't be so bad if the pain were distributed democratically. Instead, short sellers tend to gang up on isolated victims. That's how it works.

Mention "grandfathering" if you want to drive the foes of naked short-selling straight up a wall. The purpose of Reg SHO was to shed some light on the practice of naked shorting, and ultimately induce the buy-in of outstanding failures by the offending brokers. Yet the SEC said those responsible for FTDs existing before January 2005 would not be required to clean up their messes. Why? The commission said it was "concerned about creating volatility" (italics mine).

Translation: Ever seen a short squeeze? That's what happens, sometimes, when half the world is short a stock and its price starts to rise. The shorties panic, fearing huge potential losses if they don't buy to cover immediately. Suddenly everyone's buying, which can result in a stunning rise in price. (If you're long, it's a lot of fun.) The grandfathering clause, say the critics, protects the long-time naked-short criminals from their just desserts. Many of whom, of course, are heavy hitters on Wall Street. Forced short covering could create extreme market havoc, with the demand for some stocks, oversold for years, exceeding the supply by orders of magnitude.

In Byrne's podcasts, it's interesting to hear his observations on the relationship between government regulators and the Wall Street elite. He speaks of the phenomenon of "captured regulators"--government officials who are beholden to the industrial entities they're expected to reign in. Some SEC officials may be intimidated or simply awestruck by the power of Wall Street's biggest broker-dealers, hedge funds, and analyst firms. Some may fear for their jobs if they speak up. Some may hope for future seats on the boards of private firms, if they play their cards right today. Byrne admits to not know which of these explanations, if any, accounts for ineffectual regulation by the SEC. But government regulators have been in the back pockets of their industries throughout history, he says. Still, most SEC employees are honest and conscientious, Byrne asserts. It's just that the system is corrupted from the top down.

Wall Street analysts are no great fans of Overstock.com. The company has not yet had a profitable year, which itself is not an indictment for a high-growth tech company publicly traded for barely four years. But its losses worsened last year, exceeding the consensus expectations of analysts in three of the four fiscal quarters. The company lost $24.9 million, or $1.29 a share, for the year ended Dec. 31, 2005, compared with a year-earlier loss of $5 million, or 29 cents a share.

Byrne issues no quarterly profit-loss guidance, and makes no apology, directly, for missing the estimates of analysts. He attributes the year's larger loss partly to overruns in the cost of a massive upgrade of Overstock's information and sales processing technology. Years ago, he set a goal of 60-100 percent annual sales growth with break-even results at the bottom line, plus or minus one percent. Growth would level off after reaching $2 billion in annual sales, and the company would then start making money, according to Overstock's business plan. The company has done remarkably well in the sales department, where annual revenue grew from a couple of million dollars in the first year to an expected $1 billion in the current fiscal year. Last year's losing performance was a hiccup, says Byrne, and it won't be repeated.

Critics of Overstock often charge that the company lacks effective leadership. Byrne is obsessed with naked short selling, they say, at a time when he should focus on running the company. Clearly, the criticism is partly personal. But it comes not just from his enemies. His father, Jack Byrne, is a retired heavyweight executive who once headed Geico Insurance. The elder Byrne last year took the reins as Overstock's non-executive board chairman. Recently he was quoted as saying he may step down, due to disagreements with son Patrick over how much effort to devote to the short-selling issue.

It's all fair criticism, Patrick Byrne concedes. What’s not fair is to infer that he blames poor company performance solely on market manipulation. Or to believe that only weak, vulnerable companies can be hurt by naked short selling. But those activities amount to a powerful, unfair, illicit headwind for stock performance, he says. When asked to justify his pursuit of the perpetrators, Byrne has a pat answer: "What part of illegal don't you understand?"

(Continued)
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