Wednesday, November 30, 2005

The NASAA Conference - My Take

(NOTE: This morning, everyone's favorite hedge fund friendly/SEC apologist "journalist" Carol Remond wrote the expected 800 words of dreck we expect from her, and which was accurately predicted here. In the piece, which isn't worth sullying these pages with, she simultaneously ignores the 1.95 hours of input from the panel, and simply repeats the SEC's and NASD's "all is well" message. She spends half the piece slamming Jag Media and Universal Express, whose sum total of participation involved sitting and quietly watching the proceedings from the audience, and ignores that a former DTCC official point blank admitted that the only defense against "phantom shares" was paper certificates. She also ignores that not a single person on the panel denied that the issue was of huge import for voting and corporate governance reasons, and must have stepped out for a Gitane when the SEC and NASD were admitting that there is overvoting in most, if not all, stocks on the big board. Hey, who's got the time to mention that sort of thing when they can devote 350 words to who was in the audience?

Carol is a real piece of work - anyone that has an interest is seeing what a one-sided slam piece reads like should listen to the audio of the panel, and then contrast that with her fictionalized account. I've said in the past that Carol could convert the story of the mayor of a small town who pulls an infant from a frozen lake and administers mouth to mouth/CPR and some brandy while waiting for the paramedics, and make it read "Agitated Mayor seen in suspicious child fondling situation, alcohol on breath". It's an altogether not-rare (unfortunately) "talent" she demonstrates unique familiarity with.

So the barrage of revisionist history and spin articles commences (actually she started before the conference with another article in which she cobbled together a "story" in which she attempted to make it seem as though there was no NASAA concern over naked short selling - also rather clumsy, IMO). There are no new ideas.)


I listened with interest to the NASAA Naked Short Selling conference/proceedings today, moderated by Ralph Lambiase, which sought to discuss, define and probe the naked short selling crisis affecting our markets. Before I offer my summary, let me state that it was gratifying to hear that the perspective that guys like Dave Patch, and Dr. Byrne, and I have - namely that this is a real, ongoing, pervasive problem in our markets, and that the regulators are asleep at the switch, or compromised, or both - validated as reality by a panel of the foremost authorities on the subject.

I hope that wasn't lost on our fine media, who seem all too ready to buy into, and parrot, the line that we are all nutty as Christmas fruitcakes.

Turns out we aren't - we simply apprehend the problem accurately, and there is an entire industry intent upon creating smokescreens, to cloud that understanding. It was pretty clear as the conference went on that Ralph Lambiase also has more than an inkling as to what is going on, and I can't help but think that this conference was groundbreaking, as the same folks that went after the analyst scandal (the NASAA) held it - there was likely a reason for that. We shall see as events develop what that reason was.

First, bravo to Ralph for introducing a sense of humor to the event, and for asking the tough questions. Here are my takeaways:

1) The federal and SRO regulators all say that they are aggressively investigating, pursuing, monitoring and regulating, and that they are upholding the rules as best they can. Richard Shapiro summed up the obvious fallacy in this position best: "Uh, OK. But where's the enforcement?" He noted that we hear all the rhetoric from these guys, but the critical data is kept secret, and there is no actual evidence that any of them are doing anything. One of the other panelists noted "there is no such thing as an innocent fail" - and I agree. There isn't. And all of these guys know it, self-serving monologues about the intensity of their efforts notwhithstanding.

Of note was that after much of the mandatory and expected bluster and sanctimonious filibustering about how hard the SEC and NASD are working, and how concerned they are about protecting investors, etc., the statement that there has been "not one reprimand or sanction or enforcement action for violation of SHO," received a shocked silence from the regulators, and from the audience - it was so clear an affront that the entire room was speechless.

2) My position on the FTD/FST (Fraudulent Stock Trades) issue was echoed by all of the academics: We need to know what the fails are in order to trust the system. We need transparency, and the reason that the DTCC tenders to us for not providing transparency is that they have passed a rule against being honest about it, and disclosing the numbers. The fail to deliver problem is of unknown size by design (not because the information is unknowable), and the consensus was that this state of affairs is deplorable - investors deserve to know how large the fraudulent stock trade problem is, by company, and in the aggregate for the market.

Huh. You mean fair markets require transparency? What a novel concept. Who knew...

3) Voting rights are destroyed by FTDs, and the process by which shareholders have lost their "one share, one vote" rights is a disgrace.

4) The agreement was that the reason that the DTCC and the SEC don't tell anyone what the size of the FTD problem is is because there would be a collapse in faith in the markets if we knew the level of crookery that was endemic to the system. This was a key observation - all of the facile excuses about the protection of trading secrets is baloney at the end of the day - protecting illegal trading secrets never rang true, and the real reason is obvious to anyone with a brain: If the SEC and the DTCC admitted how large the actual numbers are, there would be cries for their heads, and lawsuits for years, and a complete and utter loss of confidence in the system. "How could Wall Street and the SEC do this to us?" is the question they are trying to avoid.

5) The SEC's position was that they welcomed comments about SHO, and would carefully consider any they received during their next review. Presumably they would carefully discuss those comments in the same way that they did in 2004 (when abundant cautions were sounded by everyone from the NASD and NASAA to economists to ordinary citizens), and then disregard them, as they did the first time around. This was talking-head bureaucratese of the first order, IMO, and nobody was fooled.

6) A legitimately shorted share, borrowed and then delivered to the new buyer, can then be relent to another short seller by the new buyer's broker - there is no limit. Contrary to all the rhetoric from my many critics, that take on this was verified as correct. One more for the Bunny.

7) The SEC's Brigagliano said that 4% of the listed companies were SHO list candidates under the grandfathering. He wouldn't or couldn't answer the question as to how many shares were grandfathered. Nobody asked the obvious question - what was the total dollars that 4% of listed companies represented, for which no deliveries had been made, or ever would? The responses as to grandfathering were jumbled, and I'm still a bit unclear as to what the 4% meant, but the SEC did concede that it was to placate the market - read "let Wall Street off the hook and let them keep investors' money"; money we had exchanged for shares we never received. Again, not to belabor this point, but there was no coherent good reason for allowing Wall Street to keep the money we were defrauded out of, other than to protect Wall Street's interests.

8) The panel seems to get it. They were clear that the lack of transparency was the largest problem, and that secrecy benefited nobody but the manipulators. The SEC made hollow-sounding assurances of regulatory enforcement, which were handily dealt with by Shapiro's cutting statements, and Lambiase's simple, "I was under the impression that there had only been 3 actions over the last 10 years." No rebuttal was articulated. At one point, the discussion seemed, to put it politely, a wee bit strained.

9) The same, tired, "grandfathering doesn't provide amnesty from enforcement actions" dross we have heard for a year now from the SEC - nobody said it did, Jimbo - was trotted out to do service here. Jim, babe, pay attention: what we've been saying is that it does give those that sold and never delivered anything a vacation from having to cover those fraudulently transacted, non-delivered trades, and allows the short sellers to keep the profits derived from illegally driving companies into the dirt - that was grudgingly conceded by the regulators. After much dancing around, they admitted as much. That's why you don't see the DTCC or the SEC doing these discussions in open forums - it's hard to argue against the obvious truth when it is presented by knowledgeable folks who you can't snow.

Important point: the SEC conceded that short sellers get access to the proceeds from sales where they never delivered the shares, as long as they can drive the stock price low enough - obviously encouraging everyone on the bad guy side to do so in a big way, if you are going to do it at all. Not surprisingly, the DTCC was invited to have a representative on the panel, but declined. Smart move.

10) FTD'ing destroys any sense of legitimacy of voting rights associated with shares. Every equity examined in one study had overage of votes/shares. Every one. This makes a mockery of common law ownership, the right to vote, and any semblance of honest dealings W/R/T property rights. Ralph was flabbergasted over the voting rights abuse - his statement was, "we've fought wars to protect the right to vote". Correct. We have. But we can't get Wall Street to stop abusing the American public. Ironic, no? Every day more Americans die in Iraq to supposedly protect the freedom and sanctity of voting rights, but we can't get it here, at home. He was stumped as to why no media has picked this up. So am I.

11) There was much discussion over the tax implications of leaving short positions open in perpetuity, which ignores that if the shorting occurred from offshore accounts any profits are tax exempt - offshore investors don't pay capital gains tax.

12) There was also discussion about the foreign exchange listings - in which the regulators dutifully addressed their own straw man contention that naked short selling was being conducted there, and happily ignored that nobody was making that claim - it's an arbitrage game, stupid. That lame spin on it was over in February, when we figured out that the game was to claim to be a foreign market maker, or that you were holding shares in a foreign account, or that you were hedging your position "over there." No naked short selling required on the actual exchanges.

13.) Some discussion about ex-clearing shenanigans took place, but unfortunately the one big one - wherein brokers not only lend each other shares, but enter IOUs into their back office ledgers instead of demanding delivery, or buying in the fail - wasn't. That is no surprise. Anyone that thinks the $6 billion per day of FTDs is a big deal - one panelist made the deadpan comment, "$6 billion a day, and pretty soon you are talking real money" - should run some mental numbers as to what the ex-clearing situation is like if I am correct on my take on the size of that problem. Especially in light of the newly confirmed accuracy of the information I've been disseminating thusfar about FTDs - my foreboding about ex-clearing might merit more than a shrug given that I have been dead on about the rest of this. Dunno.

14) The ECN's are hotbeds of short selling, as well as naked short selling - they are anonymous, and they don't have all the annoying rules that the mainstream exchanges do, thus they have seen a large increase as the venues of choice for this practice - which echoes the observations I've made during large short attacks on NFI and OSTK, namely that the selling ALWAYS comes out of the ECN's, in waves. Now we have academics on record describing why.

15) Owning paper shares, or using the Direct Withdrawal Custodian program is the only way to be assured that you actually own real shares, and aren't being conned by Wall Street. Period.

16) There is no mechanism for CEOs to know what their FTD levels are, even though it is an essential factor in company valuation and corporate integrity - and the DTC and the SEC aren't telling, well, just 'cause. That is also a disgrace, and should convince anyone who is unsure of how bad this is that it is as bad as the worst critics have made it out to be. Again, nobody from the SEC could explain why it was a good idea to keep the information from the CEOs - there were simply assurances that all input would be considered. Ha.

Here are my takeaways: Everything you've read here and on NCANS is solidly based in fact - it was all confirmed by the panel. The system doesn't punish those who use naked short selling as a manipulative practice; an endless supply of legitimate shorts can be created by the system via re-loaning stock from margin accounts; naked shorts are a huge problem concentrated in a relatively small number of stocks; there is no plausible reason that the FTD info shouldn't be public; the SEC and NASD and NYSE, for all their bluster, have no real impact on the problem (there was, as always, much discussion of "studying the matter further" and being "receptive to input", with the best line going to the NASD guy who pointed out that they are taking a "Giulliani approach of ticketing small infractions" - citing a meaninglessly small total number of dollars - $750K - they've levied to date); there are no meaningful penalties for FTD'ing like crazy; there are huge inequities in the reporting system which favor short sellers and market manipulators; and everyone of any substance in the business knows all of this. All of it. And nobody is doing anything - it is all being "studied" and "considered" while America's Main Street goes broke.

Surprised that the NASAA panel confirmed virtually every statement made here and at, that has been dismissed as silliness by the quisling media and the hedge fund apologists?

You shouldn't be.

I agree with Patrick Byrne, who said that when we look back at this we are going to say, "all the evidence was there, all along, and a few guys spelled it out in impossible-to-misunderstand language, and the regulators, and the government, stood by and did nothing, feigning innocence and ignorance."

One last comment: The SEC guy predictably tried to underscore what a small problem this is, purposefully ignoring the observation that the FTDs were concentrated in a very small number of companies. Just pretended he didn't hear it. Also sort of blah blah blah'd over the direct question Ralph framed over how companies could exist on the Reg SHO list for a year if any of the rules were being enforced - he committed to being willing to study it more, which by now should be well understood for SEC-speak for, "do nothing."

Ralph Lambiase deserves tremendous credit for being willing to tackle this. I have no doubt that he will be personally attacked sooner rather than later, and the panel's statements distorted, mocked, or ignored. That's how this system protects itself.

The positive is that now the problem has been validated by as august a body of academics and specialists as one could desire - it isn't all in my head, and yes, you should be worried.

The solutions for what should be done were best framed by Professor Finnerty: Tell us the size of the problem, and force settlement in a reasonable time. This isn't rocket science.

The more coherent summary is:

A) Improve the efficiency of the stock lending market.
B) Instill regulations mandating actual borrows be made before stock is sold short.
C) Don't let the short sellers have access to the cash untl the share is delivered.
D) Report short positions and FTD info, daily.
E) Eliminate the grandfathering.

And here's the short version:

Settle the trades. Tell us what's going on. And don't lie to us.

Bravo panel, and bravo Ralph Lambiase, my new favorite for regulator/lawmaker of the decade. In the 80's it was a tie between Giulliani and Ed Gray, in the 90's Giulliani had it locked, and for the millennium, we have Ralph Lambiase - Spitzer is all show, no substance, and pretends to be ignorant of what was shown today to be a pervasive fraudulent practice embraced by Wall Street.

For my money, Lambiase had it cold.

And shame on the SEC, and on Wall Street, for selling us down the river and allowing the rule of law to be a mockery outside of Main Street. What we heard today from our protectors was a hollow farce, and I hope that as Mr. Lambiase alluded to in his closing comments, that change will be a comming.

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.”


Wednesday, November 23, 2005

An Open Letter To NASAA

Update: A new Section has been added at the end of this entry and to the downloadable revisions - a list of proposed solutions has been included.
Tune in for the NASAA conference via live webcast at

On Wed, November 30, 2005. From 1PM to 3PM, Eastern Standard Time.

(Note: If this letter resonates with you, I would suggest that you send it to your State Regulator, your elected officials, and the SEC. A printable version of this entry in letter form can be viewed and downloaded here.

An abridged version of this entry, in a bullet-point letter format (which can be used as an attachment, for take-aways, or as a stand alone letter), can be read, downloaded and printed here.

Find your NASAA Regulator by going here and clicking on your state.)


North American Securities Administrators Association, Inc. (NASAA) 2005-11-24
750 First Street, N.E., Suite 1140
Washington, D.C. 20002

To the members of NASAA:

Ladies and Gentlemen of NASAA, thank you for taking the critical step of holding a conference focused on Naked Short Selling (in Washington, D.C. on Nov. 30). I am pleased that there is recognition at the state level of a pervasive, dangerous problem in our markets, and that NASAA is taking the lead in addressing this issue with this groundbreaking meeting, featuring an august panel of authorities. I have no doubt that it will be productive.

As I read your news release, I noted verbiage congratulating the SEC on their passage of Reg SHO. I presume that was a gracious tip of the hat to that agency, rather than a statement of the States' sentiment on the efficacy of Reg SHO. As I am sure you will hear during your meeting, the position of many outside of Federal regulatory chambers is less positive when discussing the agency's performance on this issue.

With that in mind, let me offer an observation or two about the SEC and Reg SHO, from the perspective of a shareholder advocate immersed in the subject.

Reg SHO A Provable Failure

My first observation is that Reg SHO has been a provable failure in curtailing this illegal and destructive manipulation tactic.

Provable, as naked short selling continues to be rampant - one glance at the infamous Reg SHO Threshold List turns up quite a few companies that have been on that list for approaching the entire year it has been published - a virtual impossibility if Reg SHO's rules were being adhered to or enforced, or if the rules themselves actually achieved any desirable effect.

To make matters confusing for many, all naked short selling is not illegal - some naked short selling is actually permitted under Reg SHO, which specifically allows many different entities to do so, with the SEC’s full support - even for companies on the Reg SHO List. As an example, NYSE specialists can not only naked short sell, but can maintain the unsettled trade for months, with the Exchange's blessing. Of course this blessing is given in secret, and nobody is told that it has taken place.

How can naked short selling be eliminated with loopholes like this? How do ordinary investors or victim companies benefit from these sweetheart deals and exceptions, which literally enable a host of participants to print an endless supply of stock at will? With specialists and market makers and foreign financial institutions all able to naked short sell legally, what real obstacle does Reg SHO present for a motivated fraudster with decent resources?

I think it is safe to say, after almost a year of ineffectiveness, that Reg SHO is worse than useless. I have yet to see a shred of evidence that it has achieved anything positive for investors, or the companies naked short sellers (market manipulators, really) target. On the contrary, it has created an environment where the practice is officially condoned and protected by federal regulators - via the numerous exceptions to the anti-naked short selling rules, the non-penalties for violation of the rules, and perhaps most onerous, Reg SHO's grandfathering provision. Which brings me to the second observation I'd like to tender:

What Does Grandfathering Accomplish In Reg SHO?

My second observation is that the "grandfathering" provision of Reg SHO violates Rule 17A - the Congressional mandate to clear and settle ALL trades in a prompt manner (including transfer of record ownership). While the SEC can apparently choose to disregard Congressional mandates, a fair question is what useful purpose is served by grandfathering, and who benefits/is protected?

The SEC's James Brigagliano admitted that the SEC grandfathered unsettled trades due to volatility concerns, which is a euphemism for wanting to avoid short squeezes - legitimate run-ups in price caused by unsettled trades being bought-in, returning the victimized stocks to levels consistent with genuine supply and demand. Why this upside volatility is to be avoided, and yet the downside volatility arising from naked short selling is rewarded by being grandfathered, is unclear, other than that it would place a financial hardship on naked short sellers.

Why it is acceptable for investors to be subjected to downside volatility from these "bear raids", and yet those violating the rules should be protected from upside volatility, remains a mystery. Perhaps Mr. Brigagliano can speak to this double standard, as well as help us all understand the desirability of limiting upside volatility/return to fair value, and protecting downside volatility/perpetually depressed prices by sanctioning a pool of failed trades which can remain undelivered in perpetuity.

Need For Clear Language and Clear Thinking

My third observation is that the language used by Wall Street to describe the offense is a deliberate obfuscation, designed to confuse the issue and make it less understandable for the layman. I think that is wrong, and needs to end. I'm not talking about rare episodes where certificates get lost, or the dog ate them, or someone died after making a trade and failed to mail their cert. When most investors use the term naked short selling, or failing to deliver, we mean deliberate selling of stock without delivering, in order to manipulate the price.

Stock manipulation is a time honored Wall Street tradition. In the 1900's to 1930's, stock manipulation "pools" were common, and share counterfeiting was well understood - the term for it was "watered stock" - unscrupulous manipulators then, as now, used share counterfeiting and naked short selling to create drops in stock prices, creating windfalls from their short positions. Some attribute much of the 1929 Crash's precipitous severity to this practice. Back then everyone understood that counterfeiting a stock certificate and delivering it in place of the genuine article was fraud - nobody argued that. Everyone also understood that taking money for a trade, and never delivering the stock, was also fraud. It is only recently that our moral compass was knocked out of kilter, and the terms failing to deliver and naked short selling were offered as descriptors. This less specific language was introduced and put into play, and soon selling something you didn't own was a delivery failure, a niggling little oversight, a licentious-sounding faux pas, a forgivable speed bump on a fast moving road.

Enough is enough. Let's start using appropriate terms for the acts that are being discussed, not flowery euphemisms devoid of any meaning for the average person.

The act of illegal naked short selling is simple fraud. Money is exchanged for shares, which aren't delivered. It is actually very straightforward at its essence - sales transactions are processed in order to cap or depress a stock's price, money changes hands, the participants are all paid their commissions, but the product is not delivered.

Why does our system, and our regulatory mechanism, have a lexicon of special terms which serve to disguise the nature of this fraud? Why don't we stop calling it naked short selling, or failing to deliver, and call it what it actually is: Fraudulent Stock Trades?

And why is the size and scope of this fraudulent activity kept secret? Who is served by this other than the fraudsters? Why does an entire system conceal the extent of the fraud, and why do our regulatory bodies accommodate this sham? Would we keep the number of bank robberies secret? The number of currency counterfeiting incidences secret? Why do we keep the number of Fraudulent Stock Trades secret, and why can't investors and companies get straight answers as to the number of transactions in their stocks that are fictions - frauds designed to depress their stock's price?

I think that if we use simple, accurate terminology, everyone can better appreciate what is occurring. When you advertise something for sale, take money for it, lower the selling price in the market by artificially creating an illusion of supply, and then don't deliver the item, that is fraud - and the motive is profit. Everyone can understand that. No need to soften it up so it is less repellent or ugly. We all understand defrauding folks for profit, and that it is illegal in every instance we can think of.

So let's just call it what it is: Fraudulent Stock Trades - FST.

Reg SHO Is Ineffective As A Prophylactic

Reg SHO is useless for protecting investors and victim companies. Gentlemen like Dr. Patrick Byrne and his father can't get confirmation of delivery of their shares for months, due specifically to fraudulent stock trades in OSTK, and neither Reg SHO nor the SEC have done a thing to protect them, nor any other shareholders, from those who knowingly and willfully abuse the rules (Dr. Byrne, and his father, purchased shares in the open market in August, 2005, while OSTK was on the SHO list – as it remains today – and it took approximately 60 days for Dr. Byrne to receive delivery of his shares, and almost 90 days for his father to receive his, during which time the price dropped by $10).

Because of the Byrnes' profile, this travesty receives visibility, but if not for their willingness to expose the hypocrisy and lack of enforcement that is the SEC's norm in this area, shareholders would continue to be routinely violated in silence. That is deplorable.

Reg SHO has failed in its essential purpose, and sections of it violate Congressional mandates, so it is inappropriate to view it as any sort of a solution.

The number of FSTs has remained in the centi-million per day range before and after SHO (per multiple FOIA disclosures cited in The Pipes Report, September 15, 2005), proving that the rule has had no measurable deterrent effect in curtailing this threat to our markets. The conceit that a pilot program is required to measure this lack of effect while investors continue to be robbed by unscrupulous participants who use FSTs as a trading strategy is insulting - the SEC fights any disclosure of the size of the problem, delays and stalls any meaningful reform by killing effective rules (like the NASD amendment intended to replace NASD rules 11830 and 3210, which WAS having an effect when implemented in early 2004, until supplanted by Reg SHO), and in general behaves more like an agency attempting to run interference for the industry it is chartered with regulating, rather than an agency attempting to make a good faith effort to address a crisis with the markets. This begs a critical and mystifying question:

Why All The Secrets?

The cult of secrecy surrounding the relatively mundane task of clearing and settling stock trades is alarming, and one must question the requirement for the existent opacity in the system, and ask who is served by this lack of transparency? Why is it desirable or necessary to keep the level of FSTs in a specific stock secret? Why does the plumbing of the system require the cloak of darkness to operate? What is being covered-up with self-important rules mandating secrecy? If millions of shares of a particular stock are being FST'd, who besides the market manipulators are shielded by keeping the information hidden from public view? Since when did understanding how many investors have been defrauded out of their funds, thinking they had purchased and received shares but instead received nothing, become something that investors shouldn't be told?

Exactly how big is the problem? And why is it so dangerous for the public to know? We are discussing delivery of shares that have been paid for, not the secret to building the A-bomb, so why is it all so shrouded in mystery? If investors and CEO's don't have the right to understand how many of the transactions in a given stock are fictions designed to depress the price, why not?

Some market observers state that thousands of companies have been put out of business by FSTs, their access to capital squashed in their infant or growth stage. Others reasonably assert that the amount of tax revenue lost from companies being de-listed or going out of business, the FSTs remaining open in perpetuity and thus never triggering a taxable event, numbers in the many billions. Why not put the speculation to rest and give investors a straight answer?

While we are on the topic of interrogatives the SEC avoids like the plague, here's my all time favorite simple, easy and reasonable Reg SHO question: How many FSTs were grandfathered in Reg SHO, representing what total dollar value of transactions (not current mark to market - actual cash exchanged for non-existent shares at the time of the transactions)?

Every FST grandfathered represents hard cash that was pulled out of the market, with no product ever delivered, leaving the rubes who paid their life savings for the sham FSTs holding nothing - the ultimate fraud. Why won't anyone tell us how many billions of dollars Wall Street manipulators took from the markets, delivering nothing in return? Where is the harm in investors knowing? The only answer I have been able to arrive at is that the number is so egregious, so much of a palpable violation to our reason, that there would be a full scale investor revolt if the number was known.

I have yet to hear a coherent or reasonable answer to these questions, so perhaps NASAA can obtain better responses. I am cautiously optimistic.

I applaud NASAA's willingness to tackle the FST problem, and sincerely hope that this is the commencement of a new era of understanding and genuine effort to curtail a destructive, illegal practice. In the interest of offering up some discussion points for the group's meeting, I'd like to comment on where I believe the major offenses in the FST process occur. It seems that the SEC prefers to ignore these, thus I thought it would be useful to review what is so studiously ignored - that way we can all understand the logic to selective enforcement, or rather complete non-enforcement, of the agency's own rules and regulations.

Anatomy Of A Fraudulent Stock Trade

When an FST occurs, a number of steps in the clearing and settlement process take place, and there are violations of rules/laws at every stage. Note that there are two offenders in an FST:

First offender : Selling broker, who has no shares to deliver.

Second offender : Buying broker, who posts shares into customer accounts (cash and margin) - despite having insufficient shares on hand, thus violating SEC 15c3-3.

Here is a list of the violations and a rough chronology of the sequence:

1) The Seller (or Seller's broker) fails to locate shares. This is a clear violation of NASD Rule 3370(b)(2)(B).

2) The Seller's broker fails to deliver shares to the NSCC (the contra party in all CNS trades) at T+13 (T+3 +10). This is a violation of 17A, and Reg SHO.

3) Alternatively, in the case of non-CNS system trades ("ex-clearing"), the Seller's broker fails to deliver shares to the Buying broker at T+13. Again, a violation of 17A, and Reg SHO.

4) The Buying broker treats these unsettled trades as delivered (rather than canceling the transaction and returning the funds, or buying in the FST Seller), and claims settlement to clients with IRA, 401k and other types of cash accounts (instead of advising them that he's failed to receive the shares, and that he has insufficient shares on hand to match the number of shares in cash accounts). Violation of 15c3-3[1]. Additionally, this misrepresentation on account statements of settlement to cash and retirement account customers constitutes mail and wire fraud, breach of fiduciary duty, and a breach of honest dealings.

5) If handled ex-clearing, there is a failure to tell the shareholder/buyer that nothing was delivered (by the buyer's broker). Also a 15c3-3 violation, and mail and wire fraud.

6) At the 10,000 foot level, the use of FSTs as described above as a manipulative trading strategy by unscrupulous hedge funds/brokers is a violation of 10(B)5, as it constitutes violating a host of rules and laws for the sole purpose of depressing the share price of the victim company - a nice definition of one type of stock manipulation, and a clear 10(B)5 violation.

A Crisis Of Catastrophic Proportions

My perspective is that the FST problem represents a systemic crisis for the U.S. equity markets. The combination of the SEC's non-enforcement of its own rules (as indicated above) along with its passage of Reg SHO, complete with loopholes large enough to drive a truck through and meaningless non-penalties for violations, creates an environment of lawlessness wherein investors are preyed upon by ever-bolder predators. What is the financial penalty to FST practitioners for violating the rules? What are the meaningful disincentives for defrauding investors in this manner? What is the SEC's track record of enforcement for this type of stock fraud? The answers to these questions are disturbing - there are no financial disincentives of note, and the SEC stands idly by as a nation is fleeced, making pretend rules and mouthing platitudes as the predators steal their next billion with impunity.

This situation cannot continue. The flagrant violation of 17A that Reg SHO's grandfathering represents (and its attendant concern that the problem is large enough to warrant grandfathering), combined with the cult of secrecy that characterizes the SEC's approach to the issue, leads me to conclude that years of ignoring the violations have resulted in a buildup of FSTs in the system that could devastate any faith in the market's integrity. The only possible explanations for grandfathering are:

A) The SEC recognizes that the scope of the problem represents a contingent liability of catastrophic proportions, and that any requirement that all the trades actually settle and shares get delivered would cause financial chaos; or,

B) The SEC is protecting the illegally generated profits of those who have been using FSTs as a trading strategy.

If A, the agency is making the classic mistake of hoping that the same industry that created the problem will fix it over time - a tactic that proved fatal in the S&L crisis. If B, the agency is acting as a protector of the industry versus protector of the investor, and requires the strongest possible censure, if not dismantlement and restructuring.

A Thought About "Ex-Clearing"

When the topic of FSTs comes up, generally what is being discussed is the trackable float of failure to delivers recorded by Reg SHO's Threshold List. The omission of the non-Continuous Net Settlement (CNS) system fails - the notorious "ex-clearing system" fails - from this discourse does everyone a disservice, as that system's FSTs likely eclipses the number that are existent within the official system.

For the casual reader, the DTCC (Depository Trust Clearing Corporation) has a mechanism at their subsidiary, the NSCC (National Stock Clearing Corporation), wherein the NSCC will process the clearing (exchange of moneys, including payment of commissions) portion of the trade, and leave the settlement portion (the actual delivery of the stock) out of the system, as an obligation to be handled between the selling and buying brokers. These off-balance sheet delivery obligations don't show up as FSTs on Reg SHO - the DTCC and the SEC take the position that they represent private contractual arrangements between two consenting adults, and they trust that the two parties will settle their trades honorably, in a timely manner.

The obvious problem here is that Wall Street's history is one wherein the participants have been known to behave in a less than honorable manner, especially when money is involved. Witness the analyst scandal, the specialist scandal, the mutual fund front-running scandal, REFCO, etc. etc. By allowing the ex-clearing system to create its own float of IOUs, which freely trade and are treated as genuine between the brokers involved, the SEC and DTCC have compounded the FST problem, and quite literally afforded the clearing brokers an opportunity to print the equivalent of shares of stock (without the annoying cost of goods that buying genuine shares entails), with no real restrictions or oversight. Nobody knows the number of FSTs that are floating around in ex-clearing. I've never seen any accounting for them. And yet we know they exist, as there is a mechanism for handling them at the NSCC, and the General Counsel for Bear Stearns references them in an ominous manner during his Reg SHO conference call (Fall, 2004).

Consider these questions, and you will understand the potential catastrophe lurking beneath the surface of Wall Street, residing in the ledgers in the back offices of the clearing brokers.

1) What is the size of the non-CNS system FST fail to delivers?

2) How are they accounted for by the participants? To whom are they accounted? What mechanism exists to ensure timely settlement? How is delivery tracked and verified? Who administers and regulates this?

3) If NASAA doesn't know how large the problem is (with verifiable data), and can't get access to the numbers, how can it regulate the markets effectively? How can it protect investors?

4) Does anyone know how large this contingent liability of undelivered stock is? If so, who, what data is being collected, and why isn't it being reported? If nobody knows how large it is, why not? Wouldn't this then represent a potentially cataclysmic liability, a float of IOUs of unknown size, collateralized in presumably vastly inadequate ways - essentially an unofficial stock counterfeiting scheme, carried on in Wall Street's back offices?

5) If this is the case, wouldn't that mean that nobody could ever be sure that they own genuine stock, and not just some IOU between brokers?

6) Wouldn't the existence of an undocumented, unregulated float of ex-clearing IOUs represent an industry-wide fraud perpetrated against investors, wherein their cash is exchanged, not for shares of stock, but for bogus markers of questionable actual value?

7) And wouldn't this result in an environment wherein Wall Street has powerful motivation to maintain depressed stocks at depressed levels, given that it is in the industry's best interests to never strain the inadequate collateralization of the ex-clearing FSTs?

8) Why is this NEVER discussed in an open manner, by any regulator? Is it so frightening in its implications that nobody wants to touch it? I've had private discussions where regulators admitted that they had been "told" that it wasn't "that big" a problem, but that they had never seen any data, nor been told exactly how big the problem was. Isn't that scary? If our regulators can't get access to how large the problem is, who is watching the store?

The non-CNS system FSTs could be many orders of magnitude larger than the Reg SHO FSTs, and it is disturbing in the extreme that nobody has any hard data on how pervasive or large the problem is. My belief is that the non-CNS system FSTs are the real iceberg, and the Reg SHO FSTs are simply the tip floating above the surface. Any regulator that chooses to ignore the implications of the 8 questions outlined above shouldn't be a regulator, IMO. Thusfar the SEC won't touch this. Now it is NASAA's opportunity to turn over the rocks, or follow in the SEC's footsteps, and ignore the problem entirely.

Contingent Liabilities

Finally, there is the logistical question of where the money will come from to cover the FSTs failed trades when they are forced to settle, as 17A, and any semblance of a reasoned system, mandates they eventually must. If many years of abuse have truly resulted in a secondary market of non-shares trading in the system, treated by the participants as genuine, then we could well be looking at the financial crisis of our lifetime, as the leverage inherent in hedge fund operations creates a situation where there isn't enough ready liquidity to settle the trades in an auction market.

Given that the difference in cash between the sale price of the FST and the current mark to market price of that undelivered share is available for use by the violator, and given that the cash was likely used to perform more of the same sort of highly profitable, albeit illegal, trades, it is likely that brokers are holding inadequate collateral for most or all the FSTs on their books, should the shares be required to be delivered (prices go up when artificial depressions due to artificial supply end, and the ten cents of collateral now in the account for the shares that will cost $20 tomorrow after steady buy-ins commence, is inadequate to truly settle the trades without damaging the broker or annihilating the violator.) This creates an environment wherein the industry has a vested interest in never settling the trades, and maintaining depressed stocks at depressed prices.

The fraudulent stock trading parties, their brokers, and the clearing and settlement agencies likely have enormous contingent liabilities arising from years of abusing the system, and from permitting unsettled trades to build with inadequate capital collateralizing the obligations. This might well explain the grandfathering, cloak and dagger secrecy, and the multitude of exempted parties - if the rules were enforced, most of the participants would be insolvent or badly damaged once the shares were bought in, thus new nonsense rules and a perpetual vacation from prompt settlement mandates were required - hence Reg SHO.

The question of whether the SEC understands the contingent liability issue, and has been forced to write ineffective rules in order to safeguard the survival of the worst offenders, or is merely protecting their illegally generated profits, is not necessarily a meaningful distinction for investors and companies victimized by this fraudulent practice. Either way, investors lose, and the fraudsters keep their ill-gotten gains.

Proposed Solutions

NASAA is in a unique situation to rectify the deficiencies in Reg SHO, by introducing rules and requrements at the state level which would then drive reasoned rulemaking at the federal level. Here are a list of proposed solutions which could eliminate the Fraudulent Stock Trade problem:

1. Eliminate partial settlement, and prohibit the release of any funds to non-delivering sellers (regardless of what the share price does), until all shares of the trade involved are delivered to the original buyer. This eliminates the current mark to market release of funds to Fraudulent Stock Traders, and prohibits them from using any portion of the proceeds until the shares are delivered. That terminates a large part of the financial reward for FSTs.

2. Hold back all commissions until the shares have been delivered.

3. Force buying brokers to inform their customers when delivery has failed.

4. Upon notification of delivery failure, give the buying customer the option to cancel the trade, and have his money returned.

5. If a customer decides not to cancel trade (presumably because the price has changed in his favor), require the broker to implement a buy-in.

6. Create a "Brokers With Current Delivery Violations" master list, itemized by security - brokers who have current unsettled trades for Reg SHO Threshold List stocks.

7. Implement a financial penalty for delivery violations for SHO Threshold List securities – 33% of the trade value would likely eliminate delivery failure as a trading strategy.

In Closing

Regardless of the motivations of the agency, as protectors of the investing public go, the SEC has failed with Reg SHO. Now it is NASAA's turn to fulfill its obligation to protect investors. I sincerely hope that NASAA will accept the challenges presented in taking responsible, meaningful and swift action, and return our markets to some semblance of the fair system we all hope to participate in.

Thank you for the opportunity to have the FST issue addressed by your group. It is reassuring that someone is willing to tackle this. Investors owe you a tremendous debt of gratitude for your efforts - I hope that they bear meaningful fruit.


Bob O'Brien

[1] Failure to segregate shares and keep fully paid shares in a reserve account (neither IOUs, Failure To Receives or cash count toward this - in the case of cash, IRA and 401K account holders).

Monday, November 21, 2005

Amazing Powers of Invisibility Available For Limited Use, Special Today Only...

(NOTE: This Just In. * SEC Probes Research Tied To Naked Shorting: Report * The Securities and Exchange Commission is investigating a financial research firm over allegations it conspired with a hedge fund to drive down the share prices of online retailer, according to a published report.
Interested parties can sign up for a free trial. So here is the independent confirmation from at least one media outlet that the story has been picked up and verified - but not by anyone in the mainstream financial media.) is up over 20% in 3 trading days, and if you aren't following the stock closely you would never know it.

The SEC is investigating the defendants in Overstock's lawsuit against Gradient and Rocker Partners, and the only way you would have heard about it is if you read the SLC paper, or this blog.

A former FBI agent, notorious for his role in the Sirhan Sirhan investigation, is going around intimidating Overstock employees, and nary a word is heard anywhere but at the Easter Bunny's little holiday den.

Apparently the mainstream NY financial press doesn't have the slightest interest in reporting some stories - specifically stories that paint OSTK in a favorable light, or the shorts accused of damaging OSTK's reputation and share price in a negative light.

One might well wonder aloud how that could be. It's not every day that we see internet retailers running up in price as though they just successfully completed phase 3 clinical trials for the cure for cancer, especially in today's lackluster market. It's not every day that the SEC opens formal investigations into what amounts to a who's who of the short selling hedge fund world.

And yet this entire episode is as invisible as if it was the Emperor on parade, nude as a newborn, shielded only by the hubris and collusion of a compromised media that believes that the US investing public is stupid enough to believe whatever it is told - or more specifically, whatever it is fed through a self-serving, selective filter.

If one reads the WSJ, or the NY Post, or tunes into CNBC, or happens across Barrons, one hears nothing. See no evil, speak no evil. Well, that isn't quite completely true, as the NY Post devoted much ink over the weekend to regaling that fine publication's readership with a story denigrating Overstock, from the perspective of the defendant in the lawsuit; and apparently the fact that the SEC is investigating that side of the conflict didn't merit a mention - you know, it just wasn't news.

Odd, you are thinking? Nah. On Friday, I wrote a Sanity Check that counseled readers to consider how these publications treat companies shorted by these turds, when an SEC investigation is launched into one of them - usually we read 10 Yahoo news items on the feed referencing full page articles expressing shock and outrage, and fanning the flames of any selloff that results.

But when the bad guys are the recipients of the scrutiny, it is dead silence.

I wasn't much of a conspiracy guy when I started my shareholder activist role a few years ago. I figured a couple of lowlife opportunists were gaming a stock I was involved in, and that I could combat their actions by disseminating accurate information about the company.

As I learned more about Wall Street's history, and connected the dots of how inter-penetrated many of the relationships on the Street are, I began to realize that what to the outside world could look like an impossibly complex and implausible conspiracy, was in actuality a dozen bent reporters and their compromised editors, a few co-opted regulators at the right levels in the right agencies, a few politicians and want-to-be politicians, and a group of scumbags small enough to fit into a medium-sized Holiday Inn banquet room.

The problem is that the group of scumbags had so gamed the system as to give it a terminal illness, and had made so much money doing so that they could literally buy favorable treatment at every level of the political and media spectrum.

The other problem is that Wall Street will kill its young for a buck, and the smug conceit that is the pervasive tone of those princes of finance lucky enough to be in the upper reaches of the financial system oligopoly forgives virtually any action, no matter how base or criminal, as long as big money is made. Because that is the name of the game.

I've written about the cult of socio-pathology that is the mindset for a certain segment of Wall Street. I've heard countless stories of coke fiend deci-millionaire 30 and 40-somethings who believe that because they have cheated the system for years, that they are above the law, are minor deities cut from a distinctly different bolt of cloth than the rest of we human refuse. We are viewed as bumpkins, slow, dim-witted sheep to be fleeced at their leisure, where there is no shame to stealing our retirements, and in fact a certain pride is evinced in being smart enough to realize that rules were meant to be broken, and that restrictions or ethics are for losers and peasants. The sheer amount of money to be had by cheating us, and the ease with which it can be had if one knows the right people, affords a society of spoiled sociopaths the ability to thrive at our expense.

No wildly implausible "Sith Lord" conspiracy is really required (although if one reviews Dr. Byrne's schematic one sees that what was actually described was fairly mundane and predictably structured). Rather, a deliberately engineered and orchestrated stock manipulation scheme the likes of which were common in the 1900's-1930's is what we are seeing, with the impact considerably larger due to the highly centralized nature of the modern financial media apparatus in the US (concentrated in just a few offices in Manhattan, really), coupled with the economics of out-of-control leverage which an industry struggling with ever-slimmer margins is willing to allow, in the interests of generating more almighty bucks. Toss in a seasoning of some international cheats and money launderers, and you have the components of the meal.

The same 5 editors and ten reporters (or so) can mold public opinion, the same few bent regulators can structure rules to maximum advantage of the crooks, the same compromised class action attorneys can bludgeon whatever the target of the day is, and the sheep, who represent everything West of NJ, are handily fleeced.

Doubtful? Skeptical? Open a newspaper or tune in CNBC, and pay attention to how invisible this story has become now that OSTK is climbing, and the SEC is finally embarrassed enough to have to investigate the perpetrators.

It is really and truly shocking how effective the cone of silence is once it has been lowered.

Figure it out, people. This is Jesse Livermore, circa 2005. Nothing more mysterious or original.

There really are no new ideas.

Sunday, November 20, 2005

Dirty Rotten Scoundrels

Bad Men Doing Bad Things

The Overstock lawsuit is heating up, as Friday's revelation that the SEC is investigating the defendants (see the immediately preceding Sanity Check) was followed by the Easter Bunny's coming into possession of a document wherein the Senior Vice President, Corporate Affairs and Legal, of, makes a formal demand of a gentleman by the name of E. Rhead Richards to kindly cease and desist from contacting current employees, presumably on behalf of the defendants.

The reason I found this interesting is that apparently Mr. Richards represents himself to be a current or former FBI agent, who claims to be investigating these employees - and has gone to the familiar if extraordinary length of contacting those employees' family members, indicating that their loved one is "under investigation."

The wives and parents of the employee(s) were presumably concerned about their loved ones being under investigation by an FBI agent - I'm not sure that distinctions like current or former were used, or that those fine nuances are immediately apparent to aged or agitated relatives.

One source indicated that they believe that this "gentleman" was being directed by a former employee who was discharged by Overstock for, among other things, allegedly spying on a female employee when, shall we put it delicately, she had every reason to believe that she was in a place and situation where her privacy was sacrosanct.

A formal legal demand has gone out to this Richards fellow to cease and desist, and further the company has demanded to know upon whose orders he was acting. I would expect to see this escalate should he refuse to cooperate, which is why this is material to the lawsuit - other than to provide everyone a glimpse of the sorts of characters who are apparently affiliated with those involved in the suit (assuming that Richards is working on behalf of the defendants, or a cutout for them). Stay tuned for more on this particular tangent.

So we have the SEC investigating the defendants/alleged perpetrators, and now questionable intimidation tactics being directed at OSTK employees.

I have no way of knowing for sure whether there is any connection between this episode and the legal wranglings of the hedge fund and research firm embroiled in this suit. But I can certainly make an educated guess. And my hunch is that this will get uglier before long. Anyway, I found it illuminating in terms of the tactics that are used by those claiming to be innocent victims, if indeed Richards is acting on behalf of the folks on the other side of the OSTK conflict.

Of course, I'm told that I am kooky for wanting to remain anonymous, as the bad guys in the naked short selling conflict presumably would never stoop to anything worse than sending nasty greeting cards on my birthday. Of course, none of these geniuses insisting I am not at risk has to take the bullet if they are wrong, but hey, when you are playing with other people's safety, what the hell, right? We had Jesse trespassing recently, contacting aged relatives in an effort to intimidate. We now have Mr. Richards trespassing, contacting aged relatives in an effort to intimidate (or perhaps it is to make new friends by identifying himself as an FBI guy?). Seems like a very familiar playbook. Very familiar.

Anyhow, this little vignette resonated with me.

Cone Of Silence Still In Place

On another note, I wonder why we haven't seen a slew of articles from all the usual NY-based financial periodicals on Friday's revelations about the SEC investigation into Gradient (and presumably by extension, our favorite hedge fund)? Why does the Salt Lake City newspaper have to be the one to break this story, and why is it getting exactly zero coverage in these supposedly unbiased rags? The WSJ runs full page articles when short plays like TASR get investigated, and yet here are far more serious charges being leveled by OSTK's CEO, and now we discover that the SEC is on the hunt with a case number and a number of sworn interrogatories, and yet not a peep out of any of them.

Odd that.

Rocker is given free rein to badmouth OSTK in a variety of forums, and yet the teensie weeensy little detail that his favorite research firm and alleged partner in, well, you know, is being investigated by the SEC (per the SLC paper) doesn't make it into print. The law firm that sued virtually every one of his known short plays is being investigated by the DOJ, Gradient is being scrutinized by the SEC, and yet mum's the word.

Am I the only one that thinks that is bizarre? Or is it only companies where shorts can make a quick 50% from the drop in price when the investigation is announced that warrant attention? Are they afraid that investors or bankers will freak out when this becomes common knowledge? I'm afraid it's a little late now - the message boards have been a-titter on this topic all weekend, so the cat is well out of the bag.

But it will be amusing to watch the studious non-comment from all of the hedge fund familiars. Their silence remains deafening. Carol is MIA. Herb has no thoughts on the topic. Seth is busy clipping coupons. Roddy can't seem to get around to it even as he credulously repeats Rocker's party line this weekend. Jeff's smirking propaganda mill is silent. The WSJ C section suddenly is uninterested in SEC investigations. Ditto for Barrons. Bethany has other fields to plow. I could go on, but we all know the players. None would comment on Dr. Byrne not getting delivery of his shares for two months, or his father, Jack Byrne, not getting his. Tut tut, that isn't news, apparently. Neither is the most prominent short seller in the business getting the case he is involved in peeled apart by the SEC. Noooo. Nothing to see there. Pay no attention to any of that.

Wonder when the counter-suit that will begin the serious discovery hits? Wanna bet the fifth of never? That Dr. Byrne's sentiment that the stalling will escalate to unbelievable lengths turns out to be correct?

I'll keep following up on this and keep everyone posted. You undoubtedly won't hear about this by opening your favorite NY paper...

Friday, November 18, 2005

Act 1, Scene 3, OSTK Suit, In Which The Defendant Is Invited To “Assist The Authorities With Their Inquiries…"

The big news today is that Gradient Analytics is apparently being investigated by the SEC, in conjunction with the OSTK lawsuit, and the associated affidavits (available for perusal at the OSTK website).

As an aside, Rocker Partners’ attorney has indicate that the statements contained in those affidavits and the suit itself are vicious smears against his clients’ allegedly good name, and as such are transparently baseless and without merit. Apparently not that transparent, though, as the SEC doesn’t launch these on a whim – there's a lot of heavy lifting that goes into initiating an SEC investigation, especially if it is a formal investigation.

For those unfamiliar with the vagaries of the terminology, there are two types of SEC probes:

1) Informal Inquiries, in which the SEC requests information about a company or situation, and which can be initiated relatively easily (although many hedge funds will ply their media quislings with dire and shrill cries that an SEC inquiry is a sign of the sky falling, many are nothing more than requests for clarification to establish the status of a given set of circumstances) by an SEC attorney. Informal Inquiries are relatively common at the Commission. Although publicly traded stocks beset upon by hedge funds will plummet on the well-publicized news of an informal inquiry, it is really the SEC’s mechanism to say, “hey, we’ve seen these articles or heard all this buzz, and we want to get some info about what the hell is going on.”

2) Formal Investigations, which signal that the SEC requires subpoena power, and that they have a fair-to-good idea as to what is going on (and that the interrogative is likely to be met with resistance, hence the subpoenas), and are suiting up and loading the riot guns. This is difficult to construe as positive (or even benign), just as an IRS audit is difficult to spin in the affirmative – one can always declare that one celebrates the opportunity that an audit can provide to clear one’s good name, but the truth is that they seldom end well for the celebrant. Formal Investigations are relatively rare, and signal a serious situation. In their reports, Gradient actually cites the danger of an Informal Inquiry escalating into a Formal Investigation as a primary reason for giving companies an F grade. It is a serious as a heart attack.

After contacting several folks who are in a position to know these things, I am of the opinion that Gradient is the subject of a Formal Investigation. I might be wrong, but I suspect not, and the SEC won't corfirm nor deny it, so we will have to use our best judgement in parsing this. But it has a case number, is active, and sworn testimony is being taken. Figure it out.

Now, in order to be fair, I have cautioned against pre-judging any of the evidence in this case, and further expressed a certain disdain for those who would act as judge and jury ahead of a full presentation of the facts in a court of law. I still maintain that is the rational approach to this story.

It is inevitable that opposing counsel will gnash their teeth and shake their fists at each other for the cameras – that’s their role in the media circus, after all. The defendants will predictably declare themselves to be free of any guilt, and decry the action as persecution.

No adult should be swayed by this theater – it is expected, predictable, and not particularly interesting. Criminals and innocents alike will insist that “I didn’t do it” or "I don't know anything about any of that", and we as spectators are left with parsing the available data for clues as to who is lying, and who is telling the truth.

Unlike some unscrupulous short sellers and their cronies in the media, who regularly cut a company’s stock price in half whenever an SEC investigation is launched, I believe that we shouldn’t interpret the commencement of such on its face as evidence that the defendants are in deep water that is now moving against them.

It is undeniable that if the hedge fund and research firm involved in the suit were publicly traded, notice of an SEC investigation would cause a rush for the exits by concerned investors, and a justifiable cooling of their business and banking relationships – for some companies, it can be a death blow.

But they aren’t publicly traded. So that isn’t something we can monitor.

It is also true that Gradient and the hedge fund are linked in the OSTK action - named jointly as perpetrators (alleged, of course), and that as such an investigation by the SEC into one equates to an investigation into both, at least to my amateur eye. Now, that could well be incorrect, but for us layman, if my buddy and I are sued in civil court by the owners of Booze Heaven for robbing their liquor store, and then my buddy is arrested in an investigation of the same “unfounded and baseless accusations”, most would correctly interpret that as meaning that the cops are looking at the totality of the “event”, and that I probably shouldn’t be planning a trip anytime soon.

But what do I know? That is only one fuzzy holiday bunny’s opinion. And anyone that would take a rabbit seriously is, well, you know….

It will be interesting to see how the quisling media brigade treats this latest bit of news. If the theories that they are compromised - bought and paid for (in a manner of speaking) - are accurate, this will either be completely ignored, or will be declared to be an outrage, or perhaps a welcome opportunity to clear the air, or an abuse of the system by evil CEOs and class action attorneys - anything besides what it clearly is.

As you read the follow-on coverage, I would invite you to consider the long list of companies the columnists and reporters in question have written about, when those unfortunate companies were hit with SEC investigations, and consider carefully their treatment of those companies’ situations, and further consider whether their treatment of this investigation is consistent with the others they’ve commented on. If not, ask yourself why not, without jumping to any conclusions. Remember, it is possible that there are innocent reasons for the media blackout on anything positive about OSTK/the suit/Byrne's inability to get his shares - although it is hard to comprehend why Rocker's denial of any wrongdoing got carried by 5 or 6 NY-based news outlets, whereas OSTK's filing of the amended complaint was ignored. Who knows how the NY financial press decides what stories are newsworthy? I'm sure it is innocent, and not a circling of the wagons.

I will say that this is nothing if not interesting. With the blowup of REFCO, and Dr. Byrne’s revelations about his inability to get his stock delivered, and now an SEC Investigation into Gradient, the last weeks have been eventful, to say the least.

Another day, another data point.

Most would agree that this one is a doozey.

Wednesday, November 16, 2005

New First Amendment Clause - The Right To Libel For Profit?

In a frankly perplexing turn of events today, the ever-industrious Carol Remond wrote an article about Gradient and Rocker Partners' response to the OSTK lawsuit (which accuses them of unfair business practices, doctoring supposedly unbiased research reports to make them as negative as possible, front-running those research reports, and other related and presumably illegal activities).

Rocker Partners got a lot of press a few months ago when they issued forth a press release indicating that their virtue had been assaulted, and that they intended to counter sue everyone and anyone that had ever said anything nasty about them - your's truly included. I have written about this, and changed my online moniker to The Easter Bunny in tribute to this important turn of events.

So it came as a surprise when today, Rocker Partners and Gradient filed their expected motion to dismiss (obligatory, really), and I got a chance to see, filtered through Ms. Remond's expert gaze, how they chose to respond.

There was no demand to overturn the suit on the basis of the charges being baseless. No affirmative defense indicating that they "din't do it." Instead, they don't deny any of it, but rather take the, IMO, arrogant position that their right to spread false and misleading information (if the charges are true) and profit by it is actually what the American Revolution was all about - that their God-given right to collude with disparate parties in order to make money (at the expense of long shareholders) is actually protected under the Constitution's First Amendment - our cherished Freedom Of Speech.

Why is this so surprising? Well, for starters Rocker sued a message board poster for making snide comments about him on Yahoo (the case was laughed out of court) - apparently his appreciation of Constitutional law has experienced an unexpected Renaissance now that he is under the microscope - and further has indicated that he intends to "counter sue" me for essentially the same thing. And yet, tut tut, apparently we are not cloaked in the protective mantle of God, Country and Grandma's Apple Pie that the First Amendment offers up. No, if we had been making untold millions by scheming to engineer price drops in stocks we were short, colluding with disparate entities in a manner eerily akin to what some have called racketeering (I take no position on these allegations, giving all parties the benefit of the doubt, and taking a neutral stance on the charges' merits until a court of law and jury has weighed in), then ostensibly we would have been celebrating our Freedom of Speech. But if we are critical of these folks' shenanigans in the financial markets, then we are fair game for the gunslinging attorneys from NJ and whatever muscle they can muster.


Who knew that is what the Constitution meant - Separation of Church and State, Right to Assembly, Freedom to Worship, and, oh, Freedom to Frontrun Research Reports Written and Edited to Destroy Stock Prices..

Let's just say that I expected something a bit meatier. Something that roundly declared that the defendants didn't do the things that the OSTK suit said they did - not that pretty much admits that they did, but then seeks to excuse it with a free speech defense.

Where are the Seths of the world now, who were saying that there was no merit to any of this as it was all a fabrication of Byrne's fevered imagination? Wasn't Barrons banging the "it's all in wacky Patrick's head" drum recently? Along with the WSJ? Guess what? Apparently it isn't - but if Gradient and Rocker are to be believed, it is now merely their artful celebration of the American way.

Apparently the defendants aren't disputing that they did what the suit claims they did. I can't find any evidence of that. No, they are taking the position that it is OK to do it, on account of our forefathers and such.

Best of luck with that in front of a jury of postal workers and auto mechanics and retirees and veterans. I'm sure they will be excited to hear that they fought in wars to protect Wall Street's right to denigrate stocks they are short. Hell, I'm feeling patriotic just thinking about it.

I may have to fly in just to hear the opening arguments. I'll bring a little flag. Maybe sing the national anthem..."By The Hedge Fund's Mad Glare...Ashtrays Whizzing Through Air..."

Perhaps little ribbons or plastic bracelets can help support the Wall Street "Freedom Fighters" protect our rights in their own special way. I have to stop now - I'm choking up...

Am I the only one scratching my head when I read Carol's piece, thinking "that's the best they could come up with?"




Monday, November 14, 2005

A "Viral" Email To Distribute To Your Contact List

I have been asked to create a "viral" email (NOTE: Viral refers to its ability to propagate in a logarithmic fashion, not to its containing any sort of virus) which can be used to raise awareness of the Naked Short Selling/Fail To Deliver crisis. A poster on the NFI message boards created a good model. I have taken the spirit of his email and used it to create my own. The art is in offering enough information to be credible and provide a basis for concern, but not overwhelm the reader. Hopefully I have struck the right balance. After reading some comments, I've created two revs - the short version and the longer version. Please send this to every person you know, and ask them to do the same:

Short Version:

Please immediately forward this email to everyone you know.

As you may have seen in this week's Time Magazine, Wall Street has been ripping off investors by selling them counterfeit shares of stock - and I'm mad as hell that it's been kept secret until now, and that the average shareholder has never heard of the practice.

Here's a link to Time's expose:,9171,1126706,00.html

You and I are being robbed daily by a well coordinated fraud, perpetrated by hedge funds and brokers, called naked short selling, or "failing to deliver". It's stolen hundreds of billions from investors, and is Wall Street's biggest dirty secret.

It's important that you forward this email NOW, so that we can get the word out, as much of the financial press won't cover this story. You can learn more at:

And the long version:

This week, Time Magazine ran an expose on a practice that I am very concerned about, which represents the theft of hundreds of billions of dollars of America's savings and retirement dollars by unscrupulous Wall Street operators. To view this landmark article, enter the following URL into your browser:,9171,1126706,00.html

The practice, known as Naked Short Selling, or Failing to Deliver, occurs when brokers process trades for sellers, who subsequently fail to deliver the stock they sold. Because of the way Wall Street compensates itself, all involved get paid before any stock is delivered - leaving actual delivery of the goods as an afterthought, and the buyer holding a brokerage statement that is a fiction - oftentimes it represents IOUs for shares, rather than the genuine article.

In any other business this is called fraud.

On Wall Street it's business as usual.

Obviously, if you can sell as many shares as you like without having to deliver them, you can drive stock prices down in targeted companies, reaping huge profits on short sales.

A legal short sale occurs when a short seller borrows a share before the sale transaction, delivering to the new buyer the share he borrowed - the short seller hopes to buy it back in the market at a lower price in the future, when he returns it to the lender, with his profit being the difference between the sale price and the later purchase price - sell high, buy low - a legal bet on a price decline.

A naked short sale is identical in that the short seller hopes to profit from the price decline, only he never bothers to borrow or deliver the stock - his broker just Fails to Deliver, and the buyer's broker accepts an IOU without ever telling the buyer. The naked short seller's profit comes when he has run the stock into the ground, and he buys shares for pennies and finally delivers, months or years later. This practice has the effect of creating counterfeit shares of stock (by allowing the IOU/markers to trade like genuine stock), which results in an unlimited supply of shares, inevitably depressing prices (fixed demand meets unlimited selling = price drop, and eventually disgusted investors will sell and move on).

There have been laws against Naked Short Selling/Failing To Deliver since 1934, when the SEC was formed. The reason it is rampant now is that the SEC has not enforced rules barring the practice, which creates a dangerous situation for investors, as well as for victimized companies. Billions of transactions have been processed, depressing the prices of hundreds of companies, and no shares have been delivered to the investors who bought the "stock". Investors like me, and like you, who naively believe we got what we paid for.

There is no way of knowing whether the shares you think you own, that are represented as yours on your brokerage statement, are genuine and have been delivered, or are IOUs, falsely represented to you as being real. You are left having to take your broker's word for it.

The same broker who may be misrepresenting the shares as being in your account in the first place.

Naked short selling represents the single largest threat to the American financial system in our lifetime - bigger than the S&L crisis, bigger than the mutual fund or analyst scandals. Until recently, the financial press has ignored it, hoping that the average investor will remain ignorant of the scope of the problem. Wall Street and the financial press have a lot to lose by the average person understanding this deliberate fraud - a public demand for justice could upset Wall Street's very lucrative apple cart, and that could cost the big players much of the money they have stolen from investors using this fraudulent practice over the last decade. The SEC refuses to divulge the total size of the problem, and won't discuss the number of failed deliveries - the information is a closely held secret, which should alarm even the most cynical observer.

I am writing this email to request that you do several simple, effective things:

First, read the referenced Time Magazine article - this is not some crackpot notion or conspiracy theory, it is very, very real.

Second, go to:

Read the Primer there, which offers a good overview of the crisis

Third, please send a copy of this message to every person you know, and encourage them to spread the word about this damaging and illegal practice.

As Naked Short Selling/Failure to Deliver becomes better understood by the investing public, Wall Street and Washington will have a difficult time pretending that it doesn't exist, or isn't a big problem. My goal in sending this message to you is one of attempting to educate as many people as I can to an insidious threat that could well result in another 1929-level crash, and ensuing meltdown. The only thing standing between that catastrophic scenario and our retirement savings is you and I, and our ability to interest others in understanding what is being perpetrated on our nation by a thin sliver of New York, with assistance from co-opted politicians, and compromised regulators in Washington.

I have not worked my entire life to watch it all disappear into the pockets of Wall Street, nor to watch our children's' futures jeopardized by the greed and larceny of a financial system run amok. Knowledge is power, and if enough people understand the extent of the problem, the outcry will force a solution before it is too late.

Once you have read the Time Magazine article and NCANS Primer, here are some suggestions as to what you can do:

1) Educate yourself. Take a look at the list of links below and browse at your leisure. If you should become as concerned as I am, then;
2) Educate others. Send this email to friends, contacts who you think might become interested or have a reason to care.
3) Turn up the heat. Complain to those in charge of keeping the system honest: Follow some of the links below for lists of regulators, legislators, and agencies.
4) Donate to, or volunteer for those fighting this fight on your behalf.

Please take the few minutes to replicate this email and send it to everyone you know. The Web creates phenomenal power to inform and to communicate - this is your chance to use it for positive change.

Thank you for your time, and please, distribute this to your email list. Individuals can make a difference. You can make a difference.

Please do.