[Congressional Record Volume 153, Number 117 (Friday, July 20, 2007)]
[Senate]
[Pages S9646-S9649]
From the Congressional Record Online through the Government Publishing Office [www.gpo.gov]
NAKED SHORT SELLING
Mr. BENNETT. Mr. President, after all the fireworks and contention on
some previous issues this week, I rise to speak about something that
has very little interest to most Americans but tremendous interest, I
believe, to a certain portion of our economy. I want to use this
opportunity to call it to the attention of the Senate.
I am talking about a practice that occurs in the stock market that
has the very interesting name of naked short selling. That conjures up
all kinds of interesting images in many people's minds, but this is
what it is: It is a practice where somebody sells short a particular
stock and never ever has to cover the sale.
Now, even that may be too much stock-market-type jargon for people to
understand what I am talking about. So let me quote from an article
that appeared in the Wall Street Journal a few weeks ago.
Mr. President, I ask unanimous consent that the article be printed in
the Record at the conclusion of my remarks.
The ACTING PRESIDENT pro tempore. Without objection, it is so
ordered.
(See exhibit 1.)
Mr. BENNETT. Quoting from the article, it says:
The naked [short selling] debate is a product of the
revolution that has occurred in stock trading over the past
40 years. Up to the 1960s, trading involved hundreds of
messengers crisscrossing lower Manhattan with bags of stock
certificates and checks. As trading volume hit 15 million
shares daily, the New York Stock Exchange had to close for
part of each week to clear the paperwork backlog.
As an insert in the quotation, I remember those days. I was trading
in the stock market at the time, and having the market shut down to
clear the back office paperwork was not an unusual experience. Going
back to the article:
That led to the creation of DTCC--
Those are initials for the Depository Trust and Clearing
Corporation--
which is regulated by the SEC.
If I might, as an aside, I do not think that last statement is true.
I am not sure that the SEC has control over the DTCC.
Almost all stock is now kept at the company's central
depository and never leaves there. Instead, a stock buyer's
brokerage account is electronically credited with a
``securities entitlement.'' This electronic credit can, in
turn, be sold to someone else.
Replacing paper with electrons has allowed stock-trading
volume to rise to billions of shares daily. The cost of
buying or selling stock has fallen to less than 3.5 cents a
share, a tenth of paper-era costs.
But to keep trading moving at this pace, the system can
provide cover for naked shorting, critics argue. If the stock
in a given transaction isn't delivered in the 3-day period,
the buyer, who paid his money, is routinely given electronic
credit for the stock. While the SEC calls for delivery in
three days, the agency has no mechanism to enforce that
guideline.
This is where the practice of naked short selling comes in. I did not
really understand it until I had some investment bankers--not the kind
you find on Wall Street but the more modest kind you find in Salt Lake
City--sit me down in front of a screen and show me what happens with
stock trading. To put it in the simplest terms, someone who wants to
sell short--that is, sell stock he does not own--will place a sale
order.
Now, when I first sold short as a participant in the market, my
broker gave me this crude little poem to remember. He said: ``He who
sells what isn't his'n, must buy it back or go to prison.'' He said:
You have to understand, if you sell a stock short, the time is going to
come when you are going to have to buy it back to cover that sale by
delivering shares. In the days the Wall Street Journal talked about,
that meant buying a crinkly piece of paper--a stock certificate--and
delivering it so you have covered your short sale.
Today, that is not the case because all of the stock certificates are
gone, and the crinkly pieces of paper have been replaced by electronic
impulses in a computer. So this is what happens. A short seller enters
the market and says: I want to short--I want to sell--1,000 shares of
XYZ stock. That means at some point he has to produce 1,000 shares to
cover his sale. How do you do that? You borrow the shares, and then you
buy them back at some future time.
All right. From whom do you borrow them? The DTCC. They have all the
shares on deposit, and so you go to the DTCC and you say: I want to
borrow 1,000 shares of XYZ stock. They say: Fine, we have them on
deposit. We will lend them to you so you can use them for your short
sale.
All right, everything is fine--except in this electronic age, it is
possible for you to keep shuffling around the electronic impulses that
represent the stock and never ever have to buy it back.
Stop and think about that. That is a pretty good business plan. You
can sell as much as you want and never ever have to pay for it. If a
stock is trading at $5 a share, you could go in and sell 1,000 shares,
and you get paid $5,000 for selling 1,000 shares, and you never have to
buy them. Because you are constantly moving around the electronic
impulses that represent those shares, you never have to cover.
Now, when you talk to the DTCC people, they say: No, we always make
sure there is a delivery. And if there is not, it is not our fault. It
is not our responsibility to police this. It is up to the brokerage
houses to do this.
The SEC has spent enough time looking at this and enough time talking
to me that they issued to me a three-page letter outlining the steps
they have taken to stop the practice of naked short selling.
Mr. President, I ask unanimous consent that their letter be included
in the Record at the conclusion of my remarks.
The ACTING PRESIDENT pro tempore. Without objection, it is so
ordered.
(See exhibit 2.)
Mr. BENNETT. I think the SEC letter goes a long way--the SEC actions
go a long way. Without getting too technical about it, they have taken
a number of steps to prevent what are called ``fails to deliver'' and,
therefore, to try to stop the naked short-selling situation.
But I have discovered something that appears to be a way around the
SEC rules. Here is the transaction: Broker A shorts 1,000 shares. At
the end of 13 days, which is the period he has to produce the shares,
he has been unable to find any--probably hasn't even looked--but he has
this requirement under the SEC rule to produce 1,000 shares. So he goes
to broker B and says quietly: Sell me a thousand shares. Broker B says:
I don't have any. Broker A says: It doesn't matter, sell me a thousand
shares so I can cover. Broker B: All right. I will sell you a thousand
shares so you can cover and there will be no passage of money; this is
a deal between the two of us--a rollover. At the end of 13 days, broker
B has to deliver a thousand shares, so broker A
[[Page S9647]]
sells the same 1,000 phantom shares back to broker B, and they ping-
pong these back and forth for as long as they want.
So you can have a situation where people are selling shares that
don't exist, taking commissions on the sale, and the profits of the
sale, and never, ever having to produce the shares.
I think it is serious enough that we ought to have a hearing about
this in the Banking Committee. I have spoken to the chairman of the
Banking Committee, Senator Dodd, and asked him if it wouldn't be
possible for us to have such a hearing at some point in the future. He
has expressed a willingness to do that. I understand we can't set a
time for that right now; there are too many other things going on in
the Banking Committee. But I am delighted to know he is willing to
cooperate with us in examining this issue.
I would like to suggest several things I would like to discuss at
that hearing. First, by the way, I want the officials of the DTCC to
have the opportunity to come in and explain how it works. I have seen
letters to the editor in the Wall Street Journal, where they say this
article is inaccurate, and I don't want to be relying on this article
if it is inaccurate. I think a congressional hearing is a good place
for those who are running the DTCC to explain to us how it works. I
would like the SEC to come in and give us their background and
information as to how their rules are working to try to stop the naked
short selling. But I have these two additional recommendations that I
would hope we could get done by regulation and, if not, I am prepared
to introduce legislation to deal with them.
First, I think there should be a rule which says there cannot be
borrowing, that brokers cannot borrow for short sales more stock than
is on deposit with the DTCC. I think that is obvious. If there are 3
million shares of XYZ Company on deposit at the DTCC, people should not
be able to short sell 4 million shares. I have seen the situation where
people with these small companies--and all this happens primarily in
little companies--people with small companies, in an effort to defend
their stock against the short sales that are rolling over, are buying
stock, and it is electronically credited to them and end up on paper,
or at least on computer, owning more shares than exist. How can that
be? If somebody buys the stock for his company and ends up owning 110
percent of the issued stock, and people are still selling that stock,
you know you are dealing with phantom shares.
So my first recommendation would be that the DTCC cannot make
available as loans for short sellers more stock than they have on
deposit. Once they have reached the point that 100 percent of the
shares they have on deposit have been loaned out, they can't loan out
any more. I think that is an obvious commonsense recommendation, but it
doesn't apply now.
Secondly, I think there ought to be a rule which says a broker cannot
be paid a commission on a short sale until the shares are delivered.
Back to the business model. The broker sells $5,000 worth of stock. He
can do it every day. He can get $5,000 every day, without ever having
to cover the stock, and he gets a commission on making the sale. So if
you say, no, there will be no commissions paid until the stock is
delivered, you will have a significant impact on stopping this
activity.
Now, people who hear the complaints about naked short selling say: It
only represents a tiny percentage of the trillions of dollars' worth of
trading activity that goes on in American markets every day. They are
right. It is only a tiny percentage. But that is small comfort to those
who have gotten a few dollars together, formed a business, gone to the
market to try to raise some capital to support the business, put on the
marketplace, say, 25 percent of their shares, holding the other 75
percent for themselves, and then getting some support in the market so
that the shares edge up from 25 cents to 50 cents to $1, to $1.25 and
then suddenly see the short sellers come in and say: OK, we will drive
that stock back down from $1.25 to 2.5 cents, and we will do it by
selling stock that doesn't exist and in the process we will ruin the
company.
The one thing that convinced me this was real was when the investment
bankers sat me down in front of a screen and showed me the stock
trading of a company that has been out of business for 3 years, and the
stock trades regularly, every 13 days. You know exactly what they are
doing. The brokers are rolling the stock back and forth every 13 days,
so they are meeting the SEC requirements--they are delivering--but the
shares they are delivering to each other back and forth do not exist.
The company was driven out of business by the short sellers who made it
impossible for them to go to the capital markets.
As I said in my opening remarks, this is a tiny matter. It does not
involve very many people, but to the people who are involved, it,
frankly, can be a matter of life and death. There are enough of them
starting businesses and creating entrepreneurial activity in the United
States that we owe it to them to find out exactly what is going on with
respect to this activity. That is why I have asked Chairman Dodd to
consider a hearing on this matter to let us hear from the SEC, to let
us hear from the DTCC, and to let us hear from those in the marketplace
who have actual experience and see if the present SEC rules are
sufficient or if we need to do additional things along the lines of the
two items I have suggested.
I yield the floor.
[From the Wall Street Journal, July 5, 2007]
Exhibit 1
Blame the ``Stock Vault''?
Clearinghouse Faulted On Short-Selling Abuse; Finding the Naked Truth
(By John R. Emshwiller and Kara Scannell)
Depository Trust & Clearing Corp. is a little-known
institution in the nation's stock markets with a seemingly
straightforward job: It is the middleman that helps ensure
delivery of shares to buyers and money to sellers.
About 99% of the time, trades are completed without
incident. But about 1% of the shares valued at about $2.5
billion on a given a day--aren't delivered to the buyer
within--the requisite three days, for one reason or another.
These ``failures to deliver'' have put DTCC in the middle
of a long-running fight over whether unscrupulous investors
are driving down hundreds of small companies' share prices.
At issue is a nefarious twist on short-selling, a
legitimate practice that involves trying to profit on a
stock's falling price by selling borrowed shares in hopes of
later replacing them with cheaper ones. The twist is known as
``naked shorting''--selling shares without borrowing them.
Illegal except in limited circumstances, naked shorting can
drive down a stock's price by effectively increasing the
supply of shares for the period, some people argue.
There is no dispute that illegal naked shorting happens.
The fight is over how prevalent the problem is--and the
extent to which DTCC is responsible. Some companies with
falling stock prices say it is rampant and blame DTCC as the
keepers of the system where it happens. DTCC and others say
it isn't widespread enough to be a major concern.
The Securities and Exchange Commission has viewed naked
shorting as a serious enough matter to have made two separate
efforts to restrict the practice. The latest move came last
month, when the SEC further tightened the rules regarding
when stock has to be delivered after a sale, But some critics
argue: the SEC still hasn't done enough.
The controversy has put an unaccustomed spotlight on DTCC.
Several companies have filed suit against DTCC regarding
delivery failure. DTCC officials say the attacks are
unfounded and being orchestrated by a small group of
plaintiffs' lawyers and corporate executives looking to make
money from lawsuits and draw attention away from problems at
their companies.
historic roots
The naked-shorting debate is a product of the revolution
that has occurred in stock trading over the past 40 years. Up
to the 1960s, trading involved hundreds of messengers
crisscrossing lower Manhattan with bags of stock certificates
and checks. As trading volume hit 15 million shares daily,
the New York Stock Exchange had to close for part of each
week to clear the paperwork backlog.
That led to the creation of DTCC, which is regulated by the
SEC. Almost all stock is now kept at the company's central
depository and never leaves there. Instead, a stock buyer's
brokerage account is electronically credited with a
``securities entitlement.'' This electronic credit can, in
turn, be sold to someone else.
Replacing paper with electrons has allowed stock-trading
volume to rise to billions of shares daily. The cost of
buying or selling stock has fallen to less than 3.5 cents a
share, a tenth of paper-era costs.
But to keep trading moving at this pace, the system can
provide cover for naked
[[Page S9648]]
shorting, critics argue. If the stock in a given transaction
isn't delivered in the three-day period, the buyer, who paid
his money, is routinely given electronic credit for the
stock. While the SEC calls for delivery in three days, the
agency has no mechanism to enforce that guideline.
``phantom stock''
Some delivery failures linger for weeks or months. Until
that failure is resolved, there are effectively additional
shares of a company's stock rattling around the trading
system in the form of the shares credited to the buyer's
account, critics say. This ``phantom stock'' can put downward
pressure on a company's share price by increasing the supply.
DTCC officials counter that for each undelivered share
there is a corresponding obligation created to deliver stock,
which keeps the system in balance. They also say that 80% of
the delivery failures are resolved within two business weeks.
There are legitimate reasons for delivery failures,
including simple clerical errors. But one illegitimate reason
is naked shorting by traders looking to drive down a stock's
price.
Critics contend DTCC has turned a blind eye to the naked-
shorting problem.
denver lawsuit
In a lawsuit filed in Nevada state court, Denver-based
Nanopierce Technologies Inc. contended that DTCC allowed
``sellers to maintain significant open fail to deliver''
positions of millions of shares of the semiconductor
company's stock for extended periods, which helped push down
Nanopierce's shares by more than 50%. The small company,
which is now called Vyta Corp., trades on the electronic OTC
Bulletin Board market. In recent trading, the stock has
traded around 40 cents. A Nevada state court judge dismissed
the suit, which prompted an appeal by the company.
DTCC says the roughly dozen other cases against it have
almost all been dismissed or not pursued by the plaintiffs.
Nanopierce garnered support from the North American
Securities Administrators Association, which represents state
stock regulators. The group filed a brief arguing that if the
company's claims were correct, its shareholders ``have been
the victims of fraud and manipulation at the hands of the
very entities that should be serving their interest.''
dtcc's defense
DTCC General Counsel Larry Thompson calls the Nanopierce
claims ``pure invention.'' DTCC officials say the main
responsibility for resolving delivery failures lies with
the brokerage firms. DTCC nets the brokerage firms'
positions but it is the brokerages that manage their
individual client accounts and know which client failed to
deliver their stock.
DTCC officials say that Nanopierce had internal business
problems--including heavy losses--to explain its stock-price
drop. DTCC received support in the suit from the SEC, which
filed a brief defending the trade-processing system and
arguing that federal regulation pre-empted state-court
review.
In January 2005, the SEC made an initial swipe at the
naked-shorting problem by requiring that if delivery failures
in a particular stock reached a high enough level, many of
those failures would have to be resolved within 13 business
days. But some failures weren't covered by the rule. The SEC
action in June aimed to cover those remaining delivery
failures. Naked shorting could ``undermine the confidence of
investors'' in the stock market, SEC Chairman Christopher Cox
says.
However, it doesn't seem likely that the SEC's latest move
will end the debate that has been raging in the market for
years. While lauding the SEC action, critics are questioning
whether it is sufficient. The SEC still hasn't taken all the
steps necessary to ensure ``a free and transparent market''
as required under federal securities laws, says James W.
Christian, a Houston attorney who represents several
companies that claim to have been damaged by naked shorting.
Among other things, authorities need to make public much
more trading data related to stock-delivery failures, he
says.
Critics contend that DTCC and the SEC have been too
secretive with delivery-failure data, depriving the public of
important information about where naked shorting might be
taking place. Currently, DTCC's delivery-failure data can
only be obtained through a Freedom of Information Act request
to the SEC, which has released some statistics that are
generally two months old.
In light of the controversy, DTCC has proposed making more
information available and the SEC says it is looking at
releasing aggregate delivery-failure data on a quarterly
basis.
____
Exhibit 2
This memorandum has been compiled by the staff of the SEC.
This document has not been approved by the Commission and
does not necessarily represent the Commission's views.
memorandum
To: Mike Nielsen, Office of Senator Robert F. Bennett.
From: James A. Brigagliano, Associate Director, Division of
Market Regulation; Victoria L. Crane, Special Counsel,
Division of Market Regulation.
CC: Josephine Tao, Assistant Director, Division of Market
Regulation.
Re: June 20, 2007 Meeting.
Date: July 13, 2007.
I. Introduction
During our meeting on June 20, 2007 regarding various short
sale-related items, Senator Bennett requested that we prepare
a memorandum outlining initiatives taken by the Commission
and staff of the Commission's Division of Market Regulation
(``Division Staff') that we discussed during the meeting.
Accordingly, this memorandum discusses: (a) remarks by
Chairman Cox at the June 13 Open Commission Meeting regarding
rulemaking related to abusive ``naked'' short selling, (b)
the expansion of short interest reporting requirements to
over-the-counter (``OTC'') equity securities and the
increased frequency of short interest reporting, (c) public
disclosure by the Commission of fails to deliver data, (d)
proposed amendments to eliminate the options market maker
exception to the close-out requirements of Rule 203(b)(3) of
Regulation SHO, (e) amendments to Rule 105 of Regulation M,
and (f) examinations by self-regulatory organization
(``SRO'') and Commission staff to ensure that options market
makers are complying with the close-out requirements of
203(b)(3) of Regulation SHO.
After you have reviewed the below information, please let
us know if there is any additional information you would like
us to provide.
II. Discussion
A. Remarks by Chairman Cox at the June 13 Open Commission
Meeting
On June 13, 2007 at an Open Commission Meeting at which the
Commission considered recommendations by Division Staff
related to short selling, Chairman Cox stated that he had ``.
. . asked the staff to examine whether the market would
benefit from further rulemaking specifically designed to
correct the practice of abusive naked short selling. Such a
rule holds the potential of streamlining the prosecution of
this form of market manipulation and, if today's measures
leave any doubt, would direct still more Commission power
to stamping out such abuses. With its recommendation, the
staff should report the level of fails pre- and post-
adoption of the rules we consider today so we can assess
their effectiveness.''
Pursuant to Chairman Cox's request, Division Staff is
currently examining whether or not the market would benefit
from such further rulemaking.
B. Short Interest Reporting
On February 3, 2006 the Commission approved an NASD rule
proposal to amend NASD Rule 3360 to expand monthly short
interest reporting to OTC equity securities. The approval
order is available on the Commission's website at http://
www.sec.gov/rules/sro/nasd.shtml, or in the Federal Register
at 71 FR 7101.
Recently, on March 6, 2007 the Commission approved rule
proposals by the NASD, New York Stock Exchange LLC, and the
American Stock Exchange LLC to increase the frequency of
short interest reporting requirements from monthly to twice
per month. The SROs requested, and the Commission approved,
an implementation date of 180 days following Commission
approval to allow firms sufficient time to make any necessary
systems changes to comply with the new reporting
requirements. The approval order is available on the
Commission's website at http://www.sec.gov/rules/sro/nasd/
2007/34-55406.pdf, or in the Federal Register at 72 FR 4756.
C. Public Disclosure of fails to Deliver Data
In response to requests from the public that the Commission
has received regarding disclosure of fails to deliver data,
including inquiries from various members of Congress, the
Commission is considering whether to post on its website
aggregate fails to deliver data that the Commission's Office
of Economic Analysis receives from the Depository Trust and
Clearing Corp. The data would not include confidential broker
information and would likely be on a delayed basis.
D. Proposed Amendments to Eliminate the Options Market Maker
Exception
On July 14, 2006, the Commission published proposed
amendments to limit the duration of the options market maker
exception to the close-out requirements of Rule 203(b)(3) of
Regulation SHO. The Commission proposed to narrow the options
market maker exception in Regulation SHO because it is
concerned about large and persistent fails to deliver in
threshold securities attributable, in part, to the options
market maker exception, and concerns that such fails to
deliver might have a negative effect on the market in these
securities.
Based, in part, on commenters' concerns that they would be
unable to comply with the amendments to the options market
maker exception as proposed in the 2006 Proposing Release,
and statements indicating that options market makers might be
violating the current exception, on June 13, 2007, the
Commission approved re-proposed amendments to the options
market maker exception that would eliminate that exception to
the close-out requirements of Regulation SHO. In addition,
the proposed amendments seek comment on two alternative
proposals to elimination of the options market maker
exception that would provide a narrow options market maker
exception that would require excepted fails to deliver to be
closed out within specific time-frames.
The proposing release has not yet been published on the
Commission's website or in the Federal Register. We
anticipate that the
[[Page S9649]]
release will be publicly available within the next few weeks.
The Commission approved a shortened comment period of 30 days
from publication of the release in the Federal Register.
E. Amendments to Rule 105 of Regulation M
Rule 105 governs short selling in connection with a public
offering. It is a prophylactic anti-manipulation rule that
promotes a market environment that is free from manipulative
influences around the time that offerings are priced. The
rule fosters pricing integrity by prohibiting activity that
interferes with independent market dynamics prior to pricing
offerings, by persons with a heightened incentive to
manipulate.
The current rule prohibits persons from covering a short
sale with offering securities if the short sale occurred
during a defined restricted period (usually five days) prior
to pricing. The Commission is aware of strategies to conceal
the prohibited covering and persistent noncompliance with the
rule. Thus, in December 2006, the Commission proposed
amendments that would have prohibited a person selling short
during the Rule 105 restricted period from purchasing
securities in the offering.
On June 20, 2007 the Commission approved amendments that
would generally make it unlawful for a person to purchase in
an offering covered by Rule 105 if the person sold short
during the restricted period unless they made a bona fide
pre-pricing purchase meeting certain conditions. The
amendments will be effective 30 days from the date of
publication of the release in the Federal Register.
F. Options Market Makers and the Close-Out Requirement of
Regulation SHO
As we discussed in more detail during our meeting, SRO and
Commission staff are currently examining options market
makers for compliance with the close-out requirements of Rule
203(b)(3) of Regulation SHO.
Should you have additional questions, please do not
hesitate to contact Matt Shimkus in our Office of Legislative
and Intergovernmental Affairs at (202) 551-2010.
The ACTING PRESIDENT pro tempore. Under the previous order, the
Senator from North Dakota is recognized for up to 30 minutes.
____________________