[Congressional Record (Bound Edition), Volume 153 (2007), Part 14]
[Senate]
[Pages 19869-19872]
[From the U.S. 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.)

[[Page 19870]]


  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 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.

[[Page 19871]]

  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 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.

[[Page 19872]]

       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 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.

                          ____________________