Monday, November 28, 2005

Liar's Poker - Dr. Patrick Byrne on the Media's Specious Cries For "Proof" - And Their Steadfast Determination To Ignore The Obvious

Normally, I write the Sanity Check editorials that appear at this blog. Occasionally, something comes to my attention that I feel is so significant that I elect to post it here - and Dr. Byrne of OSTK's comments from the Motley Fool message board today qualify for that distinction, in spades. In the following message, he addresses the requests for "proof" of the assertion that there is likely an ominous and significant crisis in the system caused by delivery failures - naked short selling, or as I like to call it now, Fraudulent Stock Trades (FST).

Before you we launch into his missive, consider a somewhat off-topic, but nonetheless interesting observation, sent to me by a good friend - NFI, and OSTK, two completely unrelated and different companies (one is a sub-prime securitizer of mortgage backed securities, the other an on-line discount retailer), traded in an eerie sort of tandem today, unrelated to the market. That is odd, in and of itself.

If one pulls out and looks at the charts for months, they also eerily march in lockstep - and the only similarity is that they're both significant short positions for Rocker Partners (documented as such from his interviews and from the put positions he has/has had) and have been the beneficiaries of Gradient's fine research handiwork. Here is today's chart, and here is the longer view, with the indexes thrown in for balance.

Both have been on the Reg SHO list for almost the entire time there's been a list. Isn't that curious, how two dissimilar companies can trade in perplexing tandem? But nobody sees anything odd. At least, no one at the regulators does. Always nice to see the system hard at work ignoring the statistically impossible in favor of chalking it all up to coincidence, or even better, making the observation that while it looks damning, there's no "proof" that anything untowards is going on - which segues nicely into Dr. Byrne's piece.

Here are Dr. Byrne's comments - I found them noteworthy due to my consideration of the chart action of the two companies, and the wide eyed innocence that the media always affects when you point out how unlikely it is that these two companies trade so similarly, for so long, due to random chance.

Dr. Byrne, quoting another poster and then responding to his observation:

"By the way, this issue could easily be cleared up if regulators would just come forward to explain what the balance sheets have to say. Thank goodness that we have someone like Patrick who is willing to risk being wrong in an effort to pressure these people to come clean. "

Heart of the Matter, Nice work. You have exactly the right feel for what is going on. These guys will always ask for "proof" and then deride whatever is submitted (even before they get a chance to review it: see how the 5 or 6 lapdog journalists in New York blared against our affiants before they ever read the affidavits). But the truth is, when it comes to Refco, or the more general harm that naked shorting is doing to the markets, I don't feel we have proof: all we have is a lot of data that, taken collectively, create a foreboding picture. The only people who have the complete picture are the SEC (though there is even doubt about that).

However, the SEC's refusal to be forthcoming on the facts, and their stiff-arming every attempt to acquire proof one way or another, does not fill me with confidence that, were all the facts known, we would rest easy at night.

Take Refco (please). It is absolutely true that we don't have proof that the $431 million liability buried underneath Refco is a barrel of naked shorts.

All we know is that the Sedona case was one of the only times the SEC stepped in on the side of the company being abusively sorted, so one could assume the abuse was particularly egregious; we know that Refco's name was all over the case for accepting instructions to "short Sedona mercilessly" for Rhino Advisors, whose trades they cleared. We know Sedona was naked shorted (estimate: 50 million to 200 million shares); we know that Rhino Advisors saw criminal charges then blew up; we know that the SEC investigation of Refco centered on Bennett and Santo Maggio; we know Maggio's duties included the stock lending desk; and we know the SEC spent a couple years “negotiating" a suitable penalty with the Refco. We know that Michael Garcia, the US Attorney for the Southern District of New York, said that the liability was marked-to-market every day but that he would not disclose what it was. We can watch the subsequent trading in Sedona and see that a certain European bank crosses the market every day, offering stock below the bid so that the stock can never trade up (though this be illegal), almost as though someone fears a squeeze. And we know that all parties have bent over backwards to prevent the details of the $431 million liability from leaking.

Together, all these facts lead some people suspect that there is a barrel of toxic waste underneath Refco marked, "naked shorts: SDNA". Party hacks demand, "Where's the proof?" in an attempt to distract you from the simple truth that the facts are knowable in this case, someone knows them, and those people are doing everything in their power to prevent the facts from becoming known to the public.

For the newbies: why is this so significant? Sedona has about 87 million shares of common stock issued. Pretend for a moment that there really are 100 million naked shorts, buried underneath Refco. Since it trades at 14 cents right now, Refco might be carrying that as a $14 million contingent liability. Suppose they try to clean it up someday. They take $14 million into the market and try to buy 100 million shares. The stock currently trades about 50,000 shares/day. Buying all the volume, it would take 2,000 trading days to cover their short. More realistically, the stock would squeeze and its price would rise, and buying those 100 million shares would take not $14 million, but …. Who knows? $140 million? $500 million? By extension, if a significant amount of the $431 million is made up of these types of liabilities, "marked-to-market" but not "marked-to-where-the-market-would-be-if-Refco-actually-had-to-deliver," the process of actually settling these trades, or the >$6 billion like them apparently scattered throughout the system, could be greater than the liquidity in that system.

Are we right about the possibility that the overhang of naked shorting has destroyed companies and represents a serious threat to the stability of the market, and that the SEC has its thumb on the scale in favor of hedge funds and against entrepreneurs? Again, the answer is knowable, someone does know it, and that someone is sitting somewhere in the SEC. But getting the data out of the SEC that would confirm one way or another is difficult (thus allowing the same guys to parrot the party line over and over: "You see, you don't have any proof!") Yet what the party line hacks miss is that what we don't know is nearly as instructive as what we know.

Let me give you some examples, starting with Overstock's case and then going more broadly. In each of these points I will try to be clear about what I know and what I don't know, and ask the reader to keep in mind this question: does the boundary of Byrne's knowledge make one more or less confident that this is a problem that can safely be ignored?

1) Given that we are on the Reg SHO Threshold list, and have been since January 27 (with, as I recall, a couple weeks absence in March-April), I know that there are FTD's (naked shorts) in OSTK.

2) OK, so we are on the Reg SHO Threshold list. How many naked shorts are there?

Well, I know that our threshold was set to be .5% of our shares outstanding (which is close to 20 million, so call this 100,000) + however many unsettled naked shorts existed on Jan 3, 2005. How many was that? The SEC and NASDAQ, do not say (refuse to, actually). All I know about it is that it is some number. And how far over the threshold are we?

Again, the SEC and NASDAQ will not disclose this, so again, all I can say for sure is that it is some other number.

So thanks to the SEC's heroic efforts to crack down on this practice by passing Reg SHO, I now know that OSTK's level of FTD's equals some number that is over our threshold by some other number, and that this threshold is itself equal to 100,000 plus some other number. Great.

Got that? And yet the party line guys want to say that my lack of knowledge on the subject of how many naked shorts there are in the system, precisely, should count as a point against me. To which I respond, at some point, doesn't this nonsense count as a point against the system? If it were a de minimus amount, would it be this hard to find out that amount?

3) Overstock is not, of course, alone on the Reg SHO list. There are a couple hundred companies in the same situation. In June, a Freedom of Information Act request revealed that by day, every day on NYSE and NASDAQ, 100 million - 250 million shares fail to settle (about 5%). This has permitted some decent people to perform the following analysis (some strangers did it, and got in touch with me to tell me this: I have not checked their work closely but it seems pretty solid on its face). They measured how much the FTD's moved every day, backed out of this number the trading in the very lightly traded stocks on the Reg SHO list, and came to the conclusion that 125-130 million or so of FTD's were concentrated in 30-35 stocks. That comes to about 4 million FTD's per company. Earlier in this message I walked through the math on what might happen if folks were required to deliver on all their FTD's in Sedona. If you want to know what might happen if they were forced to deliver on all outstanding FTD's of all these companies, you could probably take the Sedona calculation, and square it.

4) Anyone who follows this so far can see that it establishes prima facie grounds for suspecting this might be a pretty deep problem. I, for one, think that it points in the direction of the proper understanding of the construction of Reg SHO, in particular, its grandfathering of past FTD's and its apparent bias towards the hedge funds engaged in naked shorting. The explanation is simply that the problem is so deep that the SEC fears that the system might implode if they actually forced these FTD's to settle, and that they are temperamentally inclined to favor the interests of Wall Street over the interests of Main Street anyway.

But still, the party line guys will say, “But where is the proof?! Where is the proof?!?!?” They seem to forget that evidence plus reason is a kind of proof, especially in the absence of countervailing arguments, as we are experiencing today. However, if they insist on proof that this is not all some madman's fantasy, I suggest they turn to the FAQ's of the website itself, and a discussion to be found there on Reg SHO.

Why did the SEC grandfather all failures-to-deliver up to January 3, 2005? In the SEC's words (IV F):

“The requirement to close-out fail to deliver positions in threshold securities that remain for 13 consecutive settlement days does not apply to positions that were established prior to the security becoming a threshold security. This is known as 'grandfathering.' For example, open fail positions in securities that existed prior to the effective date of Regulation SHO on January 3, 2005 are not required to be closed out under Regulation SHO.

“The grandfathering provisions of Regulation SHO were adopted because the Commission was concerned about creating volatility where there were large pre-existing open positions.”

OK, check. I believe that the system might implode if they forced these trades to settle. The SEC's own words are that they grandfathered the level of failures on January 3, 2005 because they were “concerned about creating volatility where there were large pre-existing open positions.” I believe that is the “evidence” these guys are demanding.

Where is the evidence that they have their thumb on the scale in the favor of hedge funds? Again, they are pretty explicit about it in the same FAQ (V 11):

“The fails statistics of individual firms and customers is proprietary information and may reflect firms' trading strategies. The release of this information could be used to engage in unlawful upward manipulation of the price of the securities in order to 'squeeze' the firms improperly.”

Again: check. As far as the SEC is concerned, the decision by some to naked short is simply a “trading strategy,” and it is not the SEC's place to reveal a firm's proprietary trading strategy.

The thing is, there is a technical term for trading strategies that rely on selling something that you don't own, don't borrow, and don't deliver.

That term is, “illegal.”

It is “illegal” to collect money for selling something that you don't own, borrow, or deliver. Selling the Brooklyn Bridge when you don't really own it, for example, would be, “illegal.” And because some hedge funds have made doing something that is “illegal” the core of their “trading strategies,” the SEC is refusing to reveal the size of the hole that those funds have dug in any particular stock because that might reveal something about their illegal trading strategies, and that would be “improper.”

They even give an example of one way it might be "improper": in the case of stocks that had seen this kind of heavy manipulation downwards, releasing the size of the naked shorts would let some people see how the stock had been artificially watered down, which would perhaps lead some to buy the stock believing that there was an artificial mis-price, and this would create a situation where the stock…. went up. In the eyes of the SEC this would be “improper”: after all, we know that hedge funds who use illegal trading strategies to generate high levels of naked shorts can count on not even the size of those naked short positions being disclosed, because that might allow others to reverse engineer their proprietary illegal trading strategies. And it might even make some to recognize that a stock had been manipulated downwards, leading them to buy it at what they would perceive as an artificially low price, thus creating the risk that stock would go up. Which is, as we all know, improper. How could it be proper? The hedge funds' illegal trading strategy aims to make the stocks go down: how could the SEC allow them to go up, if that would run against the grain of the firms' proprietary illegal trading strategies?

Everyone got that?

Can anyone say, “captured regulator”?

I knew before I launched that I would be going down a few rabbit-holes, and that some would call me a nut-job for doing so. But can anyone read this Alice-in-Wonderland stuff from the SEC and not begin to wonder which way is up? I know I am coloring outside the lines at times (going on TV and calling the SEC “captured regulators” is not a strategy often recommended by securities lawyers as one designed to curry favor, for example). But as far as I can tell, there are no lines for the bad guys, at least as far as the SEC is concerned: forcing the bad guys to respect lines would create “volatility,” and revealing the degree by which they were ignoring the lines would reveal their proprietary illegal trading strategies, and might even let the stocks they were shorting go up, which would be “improper,” naturally.

And they call me “nuts.”

So, take heart, Heartofthematter: these guys keep asking for proof, but at this point I am not sure what they really mean. It is out in the open: in the SEC website, in a FOIA response, in the footnotes to the Refco story, in the daily Reg SHO list itself. Our opponents will always pretend not to see how these all add up, and instead blindly parrot a party line that is getting more hackneyed with each passing week.

To the unthinking repetition of their mantra, “where's the proof?” you should simply rejoin, “Settle the trades.”



Blogger rvac106 said...

Would it be possible, or feasible, for Dr. Byrne to have a news conference, timed to precede by a couple of hours, or even a day, the NASAA meeting on November 30th. I believe you said the meeting would begin at 1:00 PM? If Dr. Byrne could use a 10:00 AM news conference as a sort of preamble if you will, a primer to whet the appetites of a few newspeople, to publish excerpts in their on line publications, and commentary, of course. They won't even have to research. Just repeating the questions will draw a larger audience to the hearings. I'd originally thought to recommend the good Dr. to actually attend the hearings, but, I believe the pre-conference to be a better idea. Leave the actual conference to function as it will. DDD has already listed the phrases that will give away the ultimate thrust of the session, either to support the status quo, or actually try to get at the reality. Maybe the pre-conference would help direct the course towards maximum exposure, and disclosure.

10:58 PM  
Blogger mfairview said...

I'd be wary of Dr. Byrne over saturating himself such that people think "oh it's Byrne prattling his naked shorting again". What I'd like to see are other company executives of other companies (e.g. NFI, KKD, MSO, etc.) stand up and cry foul as well. One voice will not sound as harmonious as many. While sending an email to senators, and congressmen, one might cc the operators of their favorite RegSHO stock as well.

On another thread, Roddy responded to another posting of mine in another blog regarding Patrick's post and the bizzaro "I am king, hear me roar" rule the NSCC wrote for themselves. For the record, I think Roddy is a good guy playing both sides; a difficult position to be in.

His response was "mfairview, I cannot make heads or tails of the SECs statements regarding this issue. I wish i could. Moreover, i wish i had some sense of whether any of this matter to them. but i dont."

The reason I point this out is that I've written a few writers on the matter and they all pretty much say the same thing over specifics; basically, I'm not sure what's going on at the SEC and Caveat Emptor. I believe at this point in the game, many have conceded that some "funny business" does exist but are quickly dismissive that it's not that big of a deal. To that I say, then why is there a need to grandfather prior violations?

3:51 AM  
Anonymous Anonymous said...

Take a look at this article

It is Bonu$ time on Wall $treet again! Some 20 Billion being passed around from firms that are essentially bankrupt on this FTD mess. Hold the bonus and start buying the FTD's in. These are the people fleecing the lambs one at a time - transaction by transaction. Deserving - I think not. There are the funds here, its just a matter of having them applied in the right place.....

6:09 AM  
Blogger Chet said...

The "proof" argument is analgous to "proving" that electrons exist even though nobody has ever seen one.

8:08 AM  
Blogger rvac106 said...

I agree about the oversaturation. However, in light of the fact that there is only one Dr. Byrne, who is the only CEO with the unique properties to actually engage in this sort of hoopla without endangering his stock, I don't think we'll see any others step up. Not until the FST issue becomes a lot more 'mainstream.' It looks as though the code of 'those who complain about the naked shorting issue are probably good targets for the shorts' is still very much alive and well. A vice president of DAL, or one of the other SHO list regulars who've already had to declare BK would be great, but I don't think we'll see an NFI exec come out on this right now.

If the NASAA conference produces any useable sound bites, it might be a really good idea to set up a couple of 1/2 page NCANS ads to further the agenda. IF.....

I don't think there's been enough main stream repetition of the Byrne (Lad and Dad) inability to receive certificated shares from their brokers. That's a real slap in the face, that I think everyone can understand, inside Wall Street, as well as outside. I flew Delta this past weekend, worrying all the while whether the planes were maintained properly, whether the pilots were happy, whether my family would arrive safely, etc. Employees preoccupied with financial woes tend to become inefficient. It shouldn't be happening, but, it is.
I don't think they know what we do. I think they should.

8:39 AM  
Anonymous Anonymous said...

Two things, not directly related to this latest blogpost:

First, one of the harms rarely described on this blog but still significant is the effect on small companies that want to go public in order to obtain capital for growth. An acquaintance has said that her auditor and accountant advised her not to go public with her small tech company due not just to SOX costs and IPO expense, but also the huge risks related to naked shorting attacks. They recommended other financing alternatives. So, I wanted to provide this example to show there is an awareness among some accounting professionals and advisors that this problem harms the basic function of our capital distribution system.

Second, I finally just realized something (I think). Critical mass was finally obtained in my dull mind. Please tell me if I am misunderstanding. If Reg SHO were to have been enforced in January, or if shares are in the future unequivocably required to be delivered, EVEN WITH A GRANDFATHERING CLAUSE, the short squeezes would begin, maybe slowly at first, but they would. There would be no shares available to short with in order to balance the action, and so pressure could only be up, and would build upon itself.

This implies that the problem can hardly be checked, and in fact must grow. (Am I wrong? Argue here.)

It is not an investing "strategy" any more. It is now the only way these guys keep their heads above water. A weak check on them, such as Reg SHO, probably is hurting them, but not stopping the continued naked shorting in Reg SHO stocks that is necessary for them to survive.

If shares must be delivered, numerous hedge firms would go bankrupt. The LTCM collapse (which required the Fed and many large banking institutions to coordinate to prop up to avoid general market mayhem) would probably be small in comparison.

So, having realized this, if it is right, it makes it possible to guess what the future holds. This is more tenuous. A good knowledge of the history of the S&L bailouts, the LCTM bailout, and the events leading up to the 1929 depression would be helpful (which I don't have). But here is my guess: The problem will keep building, until (a) we enter a huge, deep, and long depression, in which case new selling pressures from elsewhere might allow the hedge funds to cover, and they could be made to do so if regulatory authorities used this as an opportunity to make the system legitimate again. If they still can't cover, their collapse won't matter as much in view of larger problems.

Or (b) the political pressure builds to the point where regulatory authorities step in, which they will probably do ONLY if they can find a way to simultaneously bail out the most central players whose collapse would severely hurt the overall market. The "bailout" would require some method of appropriating the money of someone who cannot defend themselves, for example, through taxes, or through Bob's previous idea about pennies on the dollar for each share, which would legitimize this theft from the retail investor, or through delisting of stocks as though they were the fraudulent party.

Or (c), the regulatory authorities never truly bow to the pressure of the blog/Byrne/etc., but Reg SHO and related actions do eventually come to serve as an efficient check on the problem, preventing any significant growth in naked shorting outside the list of current SHO-listed stocks. The hedge funds struggle with low returns until they either fail, the SHO-listed stocks fail due to starvation of capital, or these hedge funds find legitimate ways of making money again.

Or (d) the regulatory authorities never bow to political pressure, and never provide an efficient check to the problem, and the problem thus builds to a point where it is no longer sustainable, the market crashes, and this sets into effect the deep depression described in (a).

11:56 AM  
Blogger Tommy said...

"EVEN WITH A GRANDFATHERING CLAUSE, the short squeezes would begin, maybe slowly at first, but they would. There would be no shares available to short with in order to balance the action, and so pressure could only be up, and would build upon itself."

I agree with most of what you say. And you hit upon at least 3 and possibly 4 issues with your statement above.

1. There are no sever penalties for violating REG SHO
2. Every 13 days, the FTDs can be rolled over. That is, FTDs can be closed out with more naked shares, resetting the clock for another 13 days.
3. Legal naked shorting allows for shares that are not fully paid for to be relent an infinite amount of times.
4. Shares to borrow can be coming from brokers violating 15c3-3 and lending fully paid for shares illegally.

Item #3, in my opinion, will always be the ultimate defense against any lawsuits.

Brokers, the DTCC, NSCC - anyone - can just say, "But your honor, these high short interest numbers come from legal shorting, as there is no theoretical limit to shorting so long as margin accounts exist. THere is nothing illegal about it."

"And further, all FTDs that put the security on the REG SHO list are by SEC exempt entities - all legal. Your honor, please stop this fishing expedition."

"There is no reason to believe or proof that anyone is violating SEC 15c3-3"

And they'd probably get it thrown out, IMHO.

If any one violation is proven, then the "But your honor.." arguments hypothesized above would fall apart and further digging and discovery would be warranted as illegal activity would be proven.

Are the naked selling brokers really exempt by the SEC?

Why is the buying broker not advising the client of the unsettled nature and allowing him to cancel the trade? Is it not the fiduciary duty of the broker to do that, as it would be in the best interest of the client - if the price goes against him?

etc....but merely pointing to a high Si number will not win the day in court - at least one broker must be caught violating - preferably 15c3-3 - and we'd be off to the races.

6:53 PM  
Anonymous Anonymous said...

Isn't a taxpayer bailout about what the people who elected the (at best ignorant) Congress deserve?

5:29 AM  
Blogger rvac106 said...

re: anonymous

The perpetrators deserve jail. Their assets deserve to be liquidated. Their families should be poor.

Congressional members deserve Connecticut and Maine's campaign finance reform, (public funds ONLY,) and strict term limits.

The stock market will always be a crap shoot. However, the laws and regulatory agencies should be able to detect, and punish, those who use loaded dice.

Glad to see Dr. Byrne, in response to my suggestion, put out a news release this morning, at about 11:00 am Eastern. It was flag waving of a measured and controlled amount. Drew attention to the conference, and Byrne's (and our) concerns. Low key, but very visible.

Will we see any follow up ads from NCANS?

8:59 AM  
Blogger ikarus47 said...

It is nice to see an estimate of the number of FTD's and FTD's per SHO list stock,
and intuitively the number of 4 million of FTD's per stock seems to be at least in the right order of magnitude.
It still may be off by a factor of 2-4, but probably not off by a factor of 10.

Can you reveal the source and assumptions behind those calculations?


4:18 PM  

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