[Congressional Record Volume 155, Number 96 (Wednesday, June 24, 2009)]
[Senate]
[Pages S6985-S6987]
From the Congressional Record Online through the Government Publishing Office [www.gpo.gov]



                             SHORT SELLING

  Mr. KAUFMAN. Mr. President, I rise again to speak out about the 
problems in the financial markets caused by abusive short selling 
activities, which includes naked short selling and rumor mongering. It 
can also include abuse of the credit default market by planting false 
suggestions that an issuer's survival is in doubt. My focus today, 
however, is on the first element--naked short selling.
  Let me be clear about my main point. The public believes and the SEC 
has yet to discount that the effects of abusive naked short selling 
practices helped cement the demise of Bear Stearns and Lehman Brothers, 
as well as made it significantly harder for banks to raise critical 
capital in the throes of this financial crisis. It is no exaggeration 
to say that abusive short

[[Page S6986]]

selling at a critical moment further endangered our financial system 
and economy and thereby help lead to taxpayer bailouts that have 
totaled hundreds of billions of dollars. We are still waiting for the 
SEC's enforcement response. It is likely we will continue to wait, as I 
will discuss, because current rules are ineffective and unenforceable.
  There is still a critical need for better SEC regulations that would 
help the enforcement division to do its job and stop naked short 
selling that is abusive and manipulative dead in its tracks.
  Yes the SEC in April proposed five versions of a return to the uptick 
rule, which I believe never should have been repealed in the first 
place, at least without putting something effective in its place. The 
uptick rule, which simply required stock traders to wait for an uptick 
in price before continuing to sell a stock short, was in effect for 70 
years--that is 7-0 years--until it was repealed in June of 2007. The 
comment period for the reinstatement of some form of the prior uptick 
rule is complete, and it is disappointing, but not surprising, to see 
that many on Wall Street now oppose that modest step. I continue to 
urge the SEC to move forward on that front.
  As I have consistently maintained in my communications with the SEC, 
however, reinstating some form of the uptick rule alone puts too narrow 
a frame on the problems associated with naked short selling. The 
problem at its root is that the current rules against naked short 
selling are both inadequate and impossible to enforce. A strict 
preborrow requirement would address the problem and end it once and for 
all. Yet the SEC still has done nothing to propose a preborrower rule. 
If we end up with no uptick rule and no preborrow requirement, the SEC 
will be bending to the will of an industry that has shown recklessness 
but clearly lacks remorse.
  There is a fierce urgency to fix this problem. Today, the financial 
markets are teetering on the brink of either continuing with a bull 
market rally or falling back substantially in what would be the 
continuation of a severely painful bear market. If the markets of 
certain stocks fall back precipitously again and if the bear market 
raiders act again using abusive naked short selling practices to damage 
and possibly destroy the stocks of banks and other companies, the SEC 
will have a lot of explaining to do--unless we see responses from the 
agency in the near term.
  I have been writing the SEC and talking about this issue on the 
Senate floor since March 3. It is now June 24, and the SEC has still 
done nothing. It is time for the SEC to act.
  Let me review the history of this issue and the evidence.
  Naked short selling occurs when a trader sells a financial instrument 
short without first borrowing it or even ensuring it can be borrowed. 
This converts our securities and capital markets into nothing more than 
gambling casinos since the naked seller purports to sell something he 
doesn't own, and may never own, in the expectation that prices of the 
instruments sold will decline before ever settling the trade. Because 
this activity requires no capital outlay, it also inspires naked short 
sellers to flood the market with false rumors to make the prediction a 
self-fulfilling one.
  This practice often leads to fails to deliver. If the seller does not 
borrow the security in time to make delivery to the buyer within the 
standard 3-day settlement period, the seller ``fails to deliver.'' 
Sometimes fails to deliver can be caused by human or mechanical errors, 
but those types of fails are only a small portion of the actual number 
of fails to deliver our markets confront continually.
  Selling what you do not own and have not borrowed gives a seller a 
free ride. It effectively says: Show me the money now and you will get 
your stock sometime in the future. By analogy, it is very much like 
giving access to the Super Bowl on the day of the game--in other words, 
giving someone a ticket to the Super Bowl on the day of the game--in 
return for a promise that the spectator will ultimately produce a 
ticket long after the big event has occurred.
  It is well known that abusive short selling has been linked to the 
downfall of two major financial firms--Bear Stearns and Lehman 
Brothers.
  According to Bloomberg News:

       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.

  Let me repeat that. ``Failed trades,'' according to Bloomberg News, 
``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.''
  The huge increase in naked short selling exacerbated the financial 
crisis. Listen to this. In January 2007, 550 million shares failed to 
deliver. By January 2008, 1.1 billion shares failed to deliver. And in 
July of 2008, 2 billion shares failed to deliver.
  These fails to deliver drove stock value down further than the market 
would have done by diluting stock prices. According to Clinton Under 
Secretary of Commerce Robert Shapiro in his recent comprehensive study:

       Before Bear Stearns collapsed, its fails to deliver went 
     from less than 100,000 to 14 million, significantly diluting 
     the values of its stock.

  As the Coalition Against Market Manipulation stated:

       Just as counterfeit currency dilutes and destroys value, 
     these phantom shares deflate share prices by flooding the 
     market with false supply.

  For example, according to EuroMoney, on March 14, 2008, ``128 percent 
of Bear Stearns' outstanding stock was traded.'' Let me repeat that. On 
March 14, 2008, 128 percent of Bear Stearns outstanding stock was 
traded. How can more than 100 percent be traded? It can only occur 
because of the absence of required borrowers and naked short selling. 
Without a preborrow requirement, in 1 day, multiple locates allow the 
same single share of a stock to be sold over and over. And without 
effective rules or enforcement, millions of shares of stock are sold 
short and not delivered as required.
  Lehman Brothers also faced a similar abnormal increase in fails to 
deliver before its collapse.
  According to Bloomberg:

       As Lehman Brothers struggled to survive last year, as many 
     as 32.8 million shares in the company were sold and not 
     delivered to buyers on time. . . .That was more than a 57-
     fold increase over the prior year's peak of 567,518 failed 
     trades . . .

  Many banks that help to drive the U.S. economy are particularly at 
risk from abusive short selling practices due to the importance of 
investor confidence in maintaining their capital.
  On September 19, 2008, the SEC implemented a temporary emergency 
order barring all short selling to protect 799 financial companies, 
which included many banks, because of the damage naked short selling 
had done in destroying their company and investor values. But barring 
all short selling is like throwing the baby out with the bathwater. 
Proper short selling provides the marketplace with greater liquidity 
and the prospect of meaningful price discovery.
  Naked short selling practices led to market disequilibrium and the 
SEC recognizing that the only way to protect these companies from 
unnecessary devaluation was to implement a ban. Many of these companies 
later moved under the Troubled Assets Relief Program, TARP.
  While new regulations issued by the SEC last fall were the first 
steps to protect companies, the SEC has not done nearly enough. If 
naked short selling is not policed and rules against market 
manipulation are not enforced effectively, naked short selling will 
continue to harm TARP banks and companies. If stronger regulations are 
not implemented, abusive short selling will impair the government's 
ability to invest taxpayer money into TARP banks and return them to 
health and thus limit the effects of the government's economic recovery 
plan.
  The SEC began addressing these issues 10 years ago with a concept 
release that eventually became known as Regulation SHO, a set of rules 
that has been amended several times. But a price extracted by 
Regulation SHO was the elimination of the 70-year-old uptick test.
  Reg SHO intended to curb naked short selling by requiring would-be 
short sellers to have merely a reasonable expectation they can deliver 
the stock when it must be delivered and imposing a post-trade 
requirement that would-be short sellers actually

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preborrow securities for future trades only if too many fails have 
already occurred. This is somewhat akin to a ``one free bite at the 
apple'' approach, something regulators attempt to avoid. The reason is 
because, in practice, it turns out to be a ``free bite at the apple'' 
each time a manipulative trader switches brokers--something a 
manipulative trader can easily do with no penalty.

  But this rule has proved effectively unenforceable according to 
former SEC Commissioner Roel Campos and others. Current SEC regulations 
allow traders to short a stock if the trader ``reasonably believes that 
it can locate and borrow the security by the settlement day.''
  Reasonableness includes merely glancing at a list of easy to borrow 
stocks, with no need to continue to locate even if the list is faulty. 
Let me repeat. Reasonableness includes merely glancing at a list of 
easy to borrow stocks, with no need to continue to locate even if this 
list is faulty. That rule, the mother of all loopholes, is much too 
vague to have any real effect. Any trader who passed Finance 101 could 
provide proof that he or she ``reasonably believed'' the shorted stocks 
could be located. In fact, the provision of a false locate is 
beneficial for generating commissions on the trade.
  Ultimately, many commentators and I believe the SEC cannot bring 
cases against the gravest violators of this rule, because it does not 
have the means to prove intent. The rule is, in effect, unenforceable. 
The SEC has, in fact, not brought a single enforcement case for naked 
short selling. We must change the rules so the SEC Enforcement Division 
can do its job.
  Even former SEC Chairman Christopher Cox said the SEC is:

     . . . concerned that the persistent failures to deliver in 
     the market for some securities may be due to loopholes in 
     Regulation SHO.

  It is too difficult to prove a trader's motives necessary for proving 
a fraud violation. I strongly believe the SEC needs to strengthen its 
rules, surveillance, and the enforcement regarding naked short selling 
to prevent market manipulation and loss of investor confidence.
  Again, according to Robert Shapiro:

     . . . there is considerable evidence that market manipulation 
     through the use of naked short sales has been much more 
     common than almost anyone has suspected, and certainly more 
     widespread than most investors believe.

  Furthermore, indicators the SEC typically uses to determine the 
effects of abusive short selling do not accurately reflect the extent 
of the problem. The so-called Threshold List provided by the SEC tracks 
sustained fails to deliver of over 10,000 shares, accounting for at 
least 5 percent of a company's outstanding shares.
  According to Shapiro, this list does not capture the naked short 
sales that occur frequently that are under this threshold, and it does 
not capture the large volume of short interests that can spike during 
the 3-day settlement period. Nor does it capture any trades that occur 
outside of the Depository Trust and Clearing Corporation, so-called ex-
clearing trades.
  Let us look to other countries. Other countries have taken proper 
steps to make sure rules that prevent naked short selling are clear and 
easy to enforce. According to EuroMoney, naked short selling is:

     . . . a situation specific to the U.S. markets.

  Alan Cameron, head of clearing, settlement and custody client 
solutions at BNP Paribas Securities Services in London, says he has 
seen little to indicate similar instances of fails to deliver in 
Europe. Some European countries such as Spain impose strict fines on 
failures to deliver. It's not an issue here in Europe.
  Therefore, I strongly believe that the SEC must adopt new policies in 
order to protect the damage to investor confidence and, yes, the damage 
to our economic recovery that is being caused by naked short selling.
  Today, along with Senators Isakson and Tester, and Representative 
Carolyn Maloney, who cochairs the Joint Economic Committee, I wrote to 
SEC Chairman Mary Schapiro on this subject. Our letter urged that the 
Commission establish a pilot program to study whether a strict 
preborrow agreement would work effectively to end the problem of naked 
short selling. Such a pilot program would lead to the collection of 
data about stock lending and borrowing and the costs and benefits of 
imposing a preborrow requirement on all short sales.
  Recently, Senators Levin, Grassley, and Specter, in connection with 
the release of a General Accountability Office study analyzing recent 
SEC actions to curb abusive short selling, called for the SEC to 
consider imposing a strict preborrow requirement on short sales as the 
best way to end abusive short selling.
  I strongly agree. As I have said, a preborrow requirement would 
address the problem at its most fundamental level and it should be 
urgently considered by the SEC as it rethinks its regulations and 
enforcement approach in this area.
  Moreover, the system by which stocks currently are loaned and 
borrowed can and should be greatly improved, improving efficiency and 
producing cost savings. For example, centralized systems for loaning 
and borrowing stocks might better enable the SEC to impose fair rules 
on stock loans and borrowers in connection with short sales as well as 
enhance the SEC's ability to provide regulatory oversight to prevent 
naked short selling.
  As one commentator has written in EuroMoney in December 2008, the:

     . . . SEC knows it has to introduce the pre-borrow rule if it 
     wants to eliminate fails to deliver for good. As long as 
     there are companies on the Regulation SHO list, then the 
     problem is not being solved. The only sustainable solution to 
     making naked short-selling is a rule requiring both pre-
     borrow and a hard delivery. . . . for Bear Stearns: only a 
     pre-borrow could put a brake on the naked short-selling.

  I urge the SEC to invite a balanced group of commentators, including 
members of the investing public, to air these issues publicly as it 
continues efforts to draft and promulgate additional rules to end 
abusive short selling.
  I know there are critics of a preborrow requirement who claim it 
would limit liquidity. This is not so, and there is no meaningful 
evidence to support this argument. Indeed, the recent study by Robert 
Shapiro disproves the claim. Other knowledgable sources, such as Harvey 
Pitt, former SEC Chairman and founder of LendEQS, an electronic stock 
loan transaction firm, believe the opposite would occur, because 
lending would increase.
  In Hong Kong, the imposition of a preborrow requirement has been 
quite successful. Hong Kong implemented the preborrow rule after the 
Asian financial crisis of 1997 to 1998, when its markets collapsed. In 
late 2008, while the United States saw an exponential increase in fails 
to deliver, Hong Kong avoided large spikes in short sales almost 
completely. Other countries, such as Australia and many other EU 
members, have also successfully maintained preborrow requirements for 
years. The United States must urgently address the issue of abusive 
short selling. If we want to protect our markets, investors, and 
companies from caustic manipulation, we need better rules.
  In closing, I urge the SEC to act decisively, both by following 
through and reimposing the substance of the prior uptick rule and 
through a pilot program to study the effects of a strict preborrow 
requirement. It is way past time to put an end to naked short selling, 
once and for all.
  Mr. President, I yield the floor, and I suggest the absence of a 
quorum.
  The PRESIDING OFFICER. The clerk will call the roll.
  The assistant legislative clerk proceeded to call the roll.
  Mr. REID. Mr. President, I ask unanimous consent the order for the 
quorum call be rescinded.
  The PRESIDING OFFICER. Without objection, it is so ordered.

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