[Congressional Record Volume 155, Number 48 (Thursday, March 19, 2009)]
[Senate]
[Pages S3536-S3539]
From the Congressional Record Online through the Government Publishing Office [www.gpo.gov]
FAIRNESS OF FINANCIAL MARKETS
Mr. KAUFMAN. Mr. President, I wish to spend a few minutes talking
about action that needs to be taken to restore the credibility of the
fairness of the American financial markets.
On Monday, Senators Isakson, Tester, and I introduced S. 605, which
directs the Securities and Exchange Commission to write regulations
that will deal effectively with abusive short selling.
One of the abusive techniques addressed in the bill is so-called
``naked short selling.'' Naked short selling is when traders sell
shares they don't own and have no ability to deliver at the time of
sale--which dilutes the value of a company's shares and can drive
prices down artificially.
Before the ink on our bill was even dry, we received a profoundly
disappointing report from the SEC's inspector general entitled
``Practices Related to Naked Short Selling Complaints and Referrals,''
a report detailing the results of an audit on the SEC Division of
Enforcement's policies, procedures and practices for processing
complaints about naked short selling.
An astounding 5,000 complaints about abusive short selling were sent
to the SEC's Enforcement Division between January 1, 2007 and June 1,
2008. There could be no mistaking the scale of the potential problem
that that number of complaints reflected. Incredibly, a mere 123
complaints were referred for further investigation. Worse, and I quote:
``none of the forwarded complaints resulted in enforcement actions . .
.'' five thousand complaints, zero enforcement actions.
Not surprisingly, the SEC inspector general has concluded that the
processes for dealing with such complaints need a fundamental overhaul.
Accordingly, the IG made 11 suggestions for improvements. And how did
the Enforcement Division respond? It agreed to one of the IG's
recommendations, and declined to move on the rest.
I have been around Washington and the Senate for 36 years, but rarely
have
[[Page S3537]]
I seen an inspector general's call for action so summarily dismissed.
In its comments to the IG report, the SEC Enforcement Division
stated:
there is hardly unanimity in the investment community or the
financial media on either the prevalence, or the dangers, of
``naked'' short selling.
I ask my colleagues: Why would the SEC Enforcement Division want to
wait until there is unanimity in the investment community and the
financial media to enforce the law? Why would the SEC Enforcement
Division in its comments to the IG report want to give a virtual
``green light'' to continued abusive naked short selling? That is an
enforcement division that is not worthy of its name.
In the IG's response to the Enforcement Division, the IG notes that
it is ``disappointed'' that the Enforcement Division only concurred
with one of the 11 recommendations in the audit report. The IG is
``particularly concerned'' that the Enforcement Division did not concur
in its first three recommendations--that the Division should develop a
written in-depth triage analysis for naked short selling complaints.
Moreover, the IG notes:
SEC has repeatedly recognized that naked short selling can
depress stock prices and have harmful effects on the market.
In adopting a naked short selling antifraud rule, Rule 10b-
21, in October 2008, the Commission stated, `We have been
concerned about ``naked'' short selling and, in particular,
abusive `naked' short selling, for some time.
Where does this leave us, Mr. President? We have an SEC that is
ostensibly concerned about abusive naked short selling, but we have an
enforcement division--after receiving literally thousands and thousands
of complaints about naked short selling--that has brought no
enforcement actions and doesn't take seriously an IG audit and
recommendations.
This is an outrage.
I want to be clear, this was the record from a review of last year's
examination of short selling complaints. This is an issue Mary
Schapiro, the new SEC chair, has inherited. She just got to the SEC.
But this is a strong indication of the need for real leadership at the
SEC. Unless and until that happens, investors will have reason to worry
that markets are not yet free of manipulation and abuse.
Of all the challenges confronting our financial system, none is more
important than restoring investors' trust and confidence in the
market--the belief that the game isn't rigged against them. After the
disastrous and unprecedented losses of the past year, millions of
Americans will refuse to put their resources back into the stock market
until they believe the system is once again sound, fair and adequately
overseen by the SEC.
In the not-so-distant past, a strategy of long-term buying-and-
holding offered a roadmap for comfortable living in retirement and the
ability to provide to our children and grandchildren that all-important
economic head start in life.
Then, the market valued companies based on economic fundamentals and
expected future profits.
Today, too many people view the stock markets as another gambling
casino, dominated by volatility and susceptible to predatory short
sellers who profit from false rumors and bear raids.
To restore faith in our securities markets, the Securities and
Exchange Commission urgently needs to reflect a clear commitment to
meaningful change.
It is time to restore the integrity, efficiency and fairness of our
securities markets by preventing manipulative short selling, ensuring
that the market fairly values the actual shares issued by a company,
and outlawing the creation of ``phantom shares'' by abusive short
sellers.
Let's remember how we got here. The opaque derivatives market allowed
some people to play a shell game by leveraging to the hilt and buying
and selling synthetic instruments that ultimately crashed in value. The
same thing happens through abusive short selling, when traders sell
shares they do not own and have no ability to deliver at the time of
sale.
It is like making copies of your car's title, and then selling the
title to the car three times, while hoping you can find other cars to
deliver if the buyer proceeds.
In some cases, the short interest in a particular company's stock on
a given day has spiked dramatically after false rumors have circulated
about the company. The data further show that ``fails'' to deliver are
large and problematic.
That is evidence of manipulation. It distorts the market. It must end
now.
Let me be clear: the problem isn't short selling itself, which can
enhance market efficiency and price discovery.
The problem is that, under current rules, short sellers can sell
stocks they haven't actually borrowed in advance of their short sale--
and with no uptick rule in place as a circuit breaker. The current
standard requires only a ``reasonable belief'' that a short seller can
locate the necessary shares by the delivery date; that is no standard
at all and subjects the market to rife abuse.
For the market to flourish again, the SEC must issue rules and
enforce them in a way that convinces investors the system is not rigged
against them.
One important step the SEC should take now is to reinstate the
substance of its former ``uptick'' rule.
The uptick rule served us well for 70 years until the SEC rescinded
it in July 2007. It required short sellers to take a breath and wait
for a sale at a higher price before continuing to sell short in
declining markets. According to one survey, 85 percent of CEOs, and
professionals at NYSE-listed companies favor reinstating it. Fed
Chairman Bernanke, bipartisan Members of Congress, and former
regulators favor reinstating it. The SEC should do that now.
Restoring the uptick rule is necessary, but not sufficient, to rein
in abusive short selling. If the SEC is to alter fundamentally the way
stocks trade today, it must also require--and enforce--short sellers
possessing at the time of the sale a demonstrable legally enforceable
right to deliver the shares--a so-called ``pre- borrow'' requirement.
We simply can't tolerate a market that permits short sellers to create
phantom shares that dilute a company's value, erode the value of
investors' holdings and manipulate share prices downward.
A recent Bloomberg news report based on SEC data confirmed that so-
called ``naked'' short selling contributed significantly to the demise
of Lehman Brothers and Bear Stearns. Those companies took horrendous
gambles and their share values had to reflect those serious missteps,
but in the absence of ``naked'' short selling both might nevertheless
have survived.
Abusive short selling is gasoline on the fire for distressed stocks
and distressed markets. And the knowledge that it is still tolerated
rattles small investors and shakes confidence in our markets.
Mr. President, I ask unanimous consent that this story be printed in
the Record.
There being no objection, the material was ordered to be printed in
the Record, as follows:
[From Bloomberg.com, Mar. 19, 2009]
Naked Short Sales Hint Fraud in Bringing Down Lehman (Correct)
(By Gary Matsumoto)
(Corrects levels of failed-to-deliver shares in second and
18th paragraphs.)
The biggest bankruptcy in history might have been avoided
if Wall Street had been prevented from practicing one of its
darkest arts.
As Lehman Brothers Holdings Inc. struggled to survive last
year, as many as 32.8 million shares in the company were sold
and not delivered to buyers on time as of Sept. 11, according
to data compiled by the Securities and Exchange Commission
and Bloomberg. That was a more than 57-fold increase over the
2007 peak of 567,518 failed trades on July 30.
The SEC has linked such so-called fails-to-deliver to naked
short selling, a strategy that can be used to manipulate
markets. A fail-to-deliver is a trade that doesn't settle
within three days.
``We had another word for this in Brooklyn,'' said Harvey
Pitt, a former SEC chairman. ``The word was `fraud.''
While the commission's Enforcement Complaint Center
received about 5,000 complaints about naked short-selling
from January 2007 to June 2008, none led to enforcement
actions, according to a report filed yesterday by David Kotz,
the agency's inspector general.
The way the SEC processes complaints hinders its ability to
respond, the report said.
Twice last year, hundreds of thousands of failed trades
coincided with widespread rumors about Lehman Brothers.
Speculation that the company was being acquired at a discount
and later that it was losing two trading partners both proved
untrue.
[[Page S3538]]
After the 158-year-old investment bank collapsed in
bankruptcy on Sept. 15, listing $613 billion in debt, former
Chief Executive Officer Richard Fuld told a congressional
panel on Oct. 6 that naked short sellers had midwifed his
firm's demise.
Gasoline on Fire
Members of the House Committee on Government Oversight and
Reform weren't buying that explanation.
``If you haven't discovered your role, you're the villain
today,'' U.S. Representative John Mica, a Florida Republican,
told Fuld.
Yet the trading pattern that emerges from 2008 SEC data
shows naked shorts contributed to the fall of both Lehman
Brothers and Bear Stearns Cos., which was acquired by
JPMorgan Chase & Co. in May.
``Abusive short selling amounts to gasoline on the fire for
distressed stocks and distressed markets,'' said U.S. Senator
Ted Kaufman, a Delaware Democrat and one of the sponsors of a
bill that would make the SEC restore the uptick rule. The
regulation required traders to wait for a price increase in
the stock they wanted to bet against; it prevented so-called
bear raids, in which successive short sales forced prices
down.
Driving Down Prices
Reinstating the rule would end the pattern of fails-to-
deliver revealed in the SEC data, Kaufman said.
``These stories are deeply disturbing and make a compelling
case that the SEC must act now to end abusive short selling--
which is exactly what our bill, if enacted, would do,'' the
senator said in an e-mailed statement.
Short sellers arrange to borrow shares, then dispose of
them in anticipation that they will fall. They later buy
shares to replace those they borrowed, profiting if the price
has dropped. Naked short sellers don't borrow before
trading--a practice that becomes evident once the stock isn't
delivered. Such trades can generate unlimited sell orders,
overwhelming buyers and driving down prices, said Susanne
Trimbath, a trade-settlement expert and president of STP
Advisory Services, an Omaha, Nebraska-based consulting firm.
The SEC last year started a probe into what it called
``possible market manipulation'' and banned short sales in
financial stocks as the number of fails-to-deliver climbed.
`Unsubstantiated Rumors'
The daily average value of fails-to-deliver surged to $7.4
billion in 2007 from $838.5 million in 1995, according to a
study by Trimbath, who examined data from the annual reports
of the National Securities Clearing Corp., a subsidiary of
the Depository Trust & Clearing Corp.
Trade failures rose for Bear Stearns as well last year.
They peaked at 1.2 million shares on March 17, the day after
JPMorgan announced it would buy the investment bank for $2 a
share. That was more than triple the prior-year peak of
364,171 on Sept. 25.
Fuld said naked short selling--coupled with
``unsubstantiated rumors''--played a role in the demise of
both his bank and Bear Stearns.
``The naked shorts and rumor mongers succeeded in bringing
down Bear Stearns,'' Fuld said in prepared testimony to
Congress in October. ``And I believe that unsubstantiated
rumors in the marketplace caused significant harm to Lehman
Brothers.''
Devaluing Stock
Failed trades correlate with drops in share value--enough
to account for 30 to 70 percent of the declines in Bear
Stearns, Lehman and other stocks last year, Trimbath said.
While the correlation doesn't prove that naked shorting
caused the lower prices, it's ``a good first indicator of a
statistical relationship between two variables,'' she said.
Failing to deliver is like ``issuing new stock in a company
without its permission,'' Trimbath said. ``You increase the
number of shares circulating in the market, and that devalues
a stock. The same thing happens to a currency when a
government prints more of it.''
Trimbath attributes the almost ninefold growth in the value
of failed trades from 1995 to 2007 to a rise in naked short
sales.
``You can't have millions of shares fail to deliver and
say, `Oops, my dog ate my certificates,' '' she said.
Explanation Required
On its Web site, the Federal Reserve Bank of New York lists
several reasons for fails-to-deliver in securities trading
besides naked shorting. They include misunderstandings
between traders over details of transactions; computer
glitches; and chain reactions, in which one failure to settle
prevents delivery in a second trade.
Failed trades in stocks that were easy to borrow, such as
Lehman Brothers, constitute a ``red flag,'' said Richard H.
Baker, the president and CEO of the Washington-based Managed
Funds Association, the hedge fund industry's biggest lobbying
group.
``Suffice it to say that in a readily available stock that
is traded frequently, there has to be an explanation to the
appropriate regulator as to the circumstances surrounding the
fail-to-deliver,'' said Baker, who served in the U.S. House
of Representatives as a Republican from Louisiana from 1986
to February 2008.
``If it's a pattern and a practice, there are laws and
regulations to deal with it,'' he said.
Fines and Penalties
Lehman Brothers had 687.5 million shares in its float, the
amount available for public trading. In float size, the
investment bank ranked 131 out of 6,873 public companies--or
in the top 1.9 percent, according to data compiled by
Bloomberg.
While naked short sales resulting from errors aren't
illegal, using them to boost profits or manipulate share
prices breaks exchange and SEC rules and violators are
subject to penalties. If investigators determine that traders
engaged in the practice to try to influence markets, the
Department of Justice can file criminal charges.
Market makers, who serve as go-betweens for buyers and
sellers, are allowed to short stock without borrowing it
first to maintain a constant flow of trading.
Since July 2006, the regulatory arm of the New York Stock
Exchange has fined at least four exchange members for naked
shorting and violating other securities regulations. J.P.
Morgan Securities Inc. paid the highest penalty, $400,000, as
part of an agreement in which the firm neither admitted nor
denied guilt, according to NYSE Regulation Inc.
Enforcement `Reluctant'
In July 2007, the former American Stock Exchange, now NYSE
Alternext, fined members Scott and Brian Arenstein and their
companies $3.6 million and $1.2 million, respectively, for
naked short selling. Amex ordered them to disgorge a combined
$3.2 million in trading profits and suspended both from the
exchange for five years. The brothers agreed to the fines and
the suspension without admitting or denying liability,
according a release from the exchange.
Of about 5,000 e-mailed tips related to naked short-selling
received by the SEC from January 2007 to June 2008, 123 were
forwarded for further investigation, according to the report
released yesterday by Kotz, the agency's internal watchdog.
None led to enforcement actions, the report said.
Kotz, the commission's inspector general, said the
enforcement division ``is reluctant to expend additional
resources to investigate'' complaints. He recommended in his
report yesterday that the division step up analysis of tips,
designating an office or person to provide oversight of
complaints.
Schapiro's Plans
The enforcement division, in a response included in the
report, said ``a large number of the complaints provide no
support for the allegations'' and concurred with only one of
the inspector general's 11 recommendations.
SEC Chairman Mary Schapiro, who took office in January, has
vowed to reinvigorate the enforcement unit after it drew fire
from lawmakers and investors for failing to follow up on tips
that New York money manager Bernard Madoff's business was a
Ponzi scheme. She has ``initiated a process that will help us
more effectively identify valuable leads for potential
enforcement action,'' John Nester, a commission spokesman,
said in response to the Kotz report.
Last September, the agency instituted the temporary ban on
short sales of financial stock. It also has announced an
investigation into ``possible market manipulation in the
securities of certain financial institutions.''
No Effective Action
Christopher Cox, who was SEC chairman last year; Erik
Sirri, the commission's director for market regulation; and
James Brigagliano, its deputy director for trading and
markets, didn't respond to requests for interviews. John
Heine, a spokesman, said the commission declined to comment
for this story.
``It has always puzzled me that the SEC didn't take
effective action to eliminate naked shorting and the fails-
to-deliver associated with it,'' Pitt, who chaired the
commission from August 2001 to February 2003, said in an e-
mail. The agency began collecting data on failed trades that
exceed 10,000 shares a day in 2004.
``All the SEC need do is state that at the time of the
short sale, the short seller must have (and must maintain
through settlement) a legally enforceable right to deliver
the stock at settlement,'' Pitt wrote. He is now the CEO
of Kalorama Partners LLC, a Washington-based consulting
firm. In August, he and some partners started RegSHO.com,
a Web-based service that locates stock to help sellers
comply with short-selling rules.
Postponed `Indefinitely'
Pitt began his legal career as an SEC staff attorney in
1968, and eventually became the commission's general counsel.
In 1978, he joined Fried Frank Harris Shriver & Jacobson LLP,
where as a senior corporate partner he represented such
clients as Bear Stearns and the New York Stock Exchange.
President George W. Bush appointed him SEC chairman in 2001.
The flip side of an uncompleted transaction resulting from
undelivered stock is called a ``fail-to-receive.'' SEC
regulations state that brokers who haven't received stock 13
days after purchase can execute a so-called buy-in. The
broker on the selling side of the transaction must buy an
equivalent number of shares and deliver them on behalf of the
customer who didn't.
A 1986 study done by Irving Pollack, the SEC's first
director of enforcement in the 1970s, found the buy-in rules
ineffective with regard to Nasdaq securities. The rules
permit brokers to postpone deliveries ``indefinitely,'' the
study found.
[[Page S3539]]
The effect on the market can be extreme, according to Cox,
who left office on Jan. 20. He warned about it in a July
article posted on the commission's Web site.
Turbocharged Distortion
When coupled with the propagation of rumors about the
targeted company, selling shares without borrowing ``can
allow manipulators to force prices down far lower than would
be possible in legitimate short-selling conditions,'' he said
in the article.
`` `Naked' short selling can turbocharge these `distort-
and- short' schemes,'' Cox wrote.
``When traders spread false rumors and then take advantage
of those rumors by short selling, there's no question that
it's fraud,'' Pollack said in an interview. ``It doesn't
matter whether the short sales are legal.''
On at least two occasions in 2008, fails-to-deliver for
Lehman Brothers shares spiked just before speculation about
the bank began circulating among traders, according to SEC
data that Bloomberg analyzed.
On June 30, someone started a rumor that Barclays Plc was
ready to buy Lehman for 25 percent less than the day's share
price. The purchase didn't materialize.
`Green Cheese'
On the previous trading day, June 27, the number of shares
sold without delivery jumped to 705,103 from 30,690 on June
26, a 23-fold increase. The day of the rumor, the amount
reached 814,870--more than four times the daily average for
2008 to that point. The stock slumped 11 percent and, by the
close of trading, was down 70 percent for the calendar year.
``This rumor ranks up there with the moon is made of green
cheese in terms of its validity,'' Richard Bove, who was then
a Ladenburg Thalmann & Co. analyst, said in a July 1 report.
Bove, now vice president and equity research analyst with
Rochdale Securities in Lutz, Florida, said in an interview
this month that the speculation reflected ``an unrealistic
view of Lehman's portfolio value.'' The company's assets had
value, he said.
`Obscene' Leverage
During the first six days following the Barclays hearsay,
the level of failed trades averaged 1.4 million. Then, on
July 10, came rumors that SAC Capital Advisors LLC, a
Stamford, Connecticut-based hedge fund, and Pacific
Investment Management Co. of Newport Beach, California, had
stopped trading with Lehman Brothers.
Pimco and SAC denied the speculation. The bank's share
price dropped 27 percent over July 10-11.
Banks and insurers wrote down $969.3 billion last year--and
that gave legitimate traders plenty of reason to short their
stocks, said William Fleckenstein, founder and president
of Seattle-based Fleckenstein Capital, a short-only hedge
fund. He closed the fund in December, saying he would open
a new one that would buy equities too.
``Financial stocks imploded because of the drunkenness with
which executives buying questionable securities levered-up in
obscene fashion,'' said Fleckenstein, who said his firm has
always borrowed stock before selling it short. ``Short
sellers didn't do this. The banks were reckless and they held
bad assets. That's the story.
`Market Distress'
On May 21, David Einhorn, a hedge fund manager and chairman
of New York-based Greenlight Capital Inc., announced he was
shorting stock in Lehman Brothers and said he had ``good
reason to question the bank's fair value calculations'' for
its mortgage securities and other rarely traded assets.
Einhorn declined to comment for this story. Monica Everett,
a spokeswoman who works for the Abernathy Macgregor Group,
said Greenlight properly borrows shares before shorting them.
Even when they're legitimate, short sales can depress share
values in times of market crisis--in effect turning the
traders' negative bets into self-fulfilling prophecies, says
Pollack, the former SEC enforcement chief who is now a
securities litigator with Fulbright & Jaworski in Washington.
The SEC has been concerned about the issue since at least
1963, when Pollack and others at the commission wrote a study
for Congress that recommended the ``temporary banning of
short selling, in all stocks or in a particular stock''
during ``times of general market distress.''
Airport Runway
On Sept. 17, two days after Lehman Brothers filed for
Chapter 11 bankruptcy, the number of failed trades climbed to
49.7 million, 23 percent of overall volume in the stock.
The next day, the SEC announced its ban on shorting
financial companies in 2008. The number of protected stocks
ultimately grew to about 1,000. On Sept. 19, the commission
announced ``a sweeping expansion'' of its investigation into
possible market manipulation.
The ban, which lasted through Oct. 17, didn't eliminate
shorting, according to data from the SEC, the NYSE Arca
exchange and Bloomberg. Throughout the period, short sales
averaged 24.7 percent of the overall trading in Morgan
Stanley, Merrill Lynch & Co. and Goldman Sachs Group Inc. on
NYSE Arca. In 2008, short sales averaged 37.5 percent of the
overall trading on the exchange in the three companies.
To date, the commission hasn't announced any findings of
its investigation.
Pollack, the former SEC regulator, wonders why.
``This isn't a trail of breadcrumbs; this audit trail is
lit up like an airport runway,'' he said. ``You can see it a
mile off. Subpoena e-mails. Find out who spread false rumors
and also shorted the stock and you've got your
manipulators.''
Mr. KAUFMAN. The new SEC leadership has the opportunity to make the
SEC a ``can do'' agency once more. The SEC is scheduled to meet on
April 8 to discuss the uptick rule and abusive short selling. The Chair
and commissioners should move quickly to adopt the uptick rule and a
pre-borrow requirement.
If not, Congress should do its part and direct the SEC to do that
quickly.
After yesterday's IG report and the Enforcement Division's response
to it, I am even more convinced that SEC Chair Schapiro needs to grab
the reins quickly at the SEC, and get back to standing up for investor
interests to restore confidence in the markets. If the SEC won't do it,
Congress should require them to do it.
Mr. President, I yield the floor.
The PRESIDING OFFICER. The Senator from Tennessee is recognized.
Mr. ALEXANDER. I thank the Chair.
(The remarks of Mr. Alexander pertaining to the introduction of S.
659 are printed in today's Record under ``Statements on Introduced
Bills and Joint Resolutions.'')
The PRESIDING OFFICER. The Senator from Michigan is recognized.
Ms. STABENOW. Mr. President, before the Senator from Tennessee
leaves, I wish to say how much I enjoyed his comments, and I think no
matter which side of the aisle we are on, we get up in the morning
wanting to try to make a difference. So I appreciate his sentiments and
I appreciate his comments very much, as it relates to what we hope we
will all instill in our students and teachers and those who love our
country. I appreciate his comments.
____________________