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Securities and Exchange Commission:
Dear Mr. Katz, Re: File # S7-23-03 I just got asked by a securities attorney to addressing to you whether or not naked short selling is indeed an effective way to combat the most common securities fraud of them all, the "pump and dump". He mentioned that the vast majority of comment letters sent to the SEC demanded the doing away with of naked short selling. He also mentioned that the defenders of naked short selling were almost unanimous in citing the beneficial effects of naked short selling on curbing "Pump and dump" frauds. I too have noticed that several of the Reg SHO comment letters that just made it in under the 1/5/04 deadline supported the thesis that without their ability to naked short sell shares, pump and dumpers will go nuts and run the PPS of scam companies up astronomically. This issue has been raised as a defense for naked short selling for the last two decades and is nothing new. If I could be allowed to dissect this thesis in greater detail. Theoretically, these proponents of naked short selling would fall into one of 2 camps. The first camp would contain those ultra-compassionate human beings that have a genuine concern for the victims of pump and dumps which are the naïve investors that paid way too much for shares only to watch the PPS fall out of bed once the pump phase had ended. The second camp would be comprised of those that just detest pump and dump fraudsters and want them stopped. Collectively these people are generously volunteering their "services" to the SEC to help address pump and dump frauds. Let's take a look at the prototypical pump and dump. "Acme" is run by a crooked CEO and is trading at 10-cents per share, which we'll assume is a fair market valuation. The crooked CEO hires a sleazy promoter to run the PPS up to $1 per share where both the crooked CEO and sleazy promoter intend to dump their shares upon naïve investors. The insiders had previously acquired most of the shares via legal or illegal means. They may or may not be filing the appropriate 13 (d), 16 (a) s and Rule 144 paperwork. The crooked CEO has 4 blatantly inaccurate press releases ready to go. The sleazy promoter starts spreading the false information and the pump is on. Now just what are these compassionate "shareholder advocates" volunteering to do for the SEC and these "about to become victims" of the pump and dump. They are basically volunteering to put on a pseudo-deputy's badge and step up to the plate and sell nonexistent entities into the buy orders of these "about to become victims" at let's say the 60-cent level. They don't own any shares and they didn't borrow or make the affirmative determination in writing of the "borrowability" of any shares. They are generously volunteering to take the new investor's money and introduce into the system "counterfeit electronic book entries" (CEBEs) that artificially increase the supply of shares that can be sold at any instant in time. This dilution, of course, does damage to not only the investment of the new investor, the object of this compassionate advocacy, but also the corporation itself as well as the investment of all preexisting shareholders. The question begs to be asked as to why a genuine "shareholder advocate" would take the money of the investor that he is trying to protect from the fraud. This "deputy's" machine gun seems to be locked on and the bullets are hitting everybody in sight. After this naked short sale, the "shareholder advocate" and the "about to become victim" that he is theoretically looking out for have goals that are 180 degrees diametrically opposed. The investor wants the price per share to go to the moon and the "shareholder advocate" wants the corporation to go bankrupt. So much for the wearing of a compassionate "shareholder advocate" hat. What would a genuine shareholder advocate do if he noticed a stock trading at $1 when he perceived it to be worth a dime? He'd probably E-mail the SEC and ask them to take a peak at the situation. He sure as heck wouldn't sell things that don't exist and do harm to the buyer of these nonexistent entities, other shareholders of the public corporation, and the U. S. corporation itself. Investors have the right to legally place bets against the future of a public corporation. This is called short selling and it involves borrowing "real" shares before they're sold. This thing we refer to as "naked" short selling, allows these compassion-filled "shareholder advocates" volunteering to take the investor's money, to place their bet in such a manner that the "odds" of winning the "bet" are enhanced BY THE VERY MANNER IN WHICH THEY PLACED THE BET i.e. by selling nonexistent entities that cause massive dilution because these nonexistent entities can in turn be sold by their purchasers at any instant in time. This activity, when done for a long enough period of time or by enough "compassionate volunteers" doing it with enough "compassionate zeal", leads to the self-fulfilling prophecy attached to naked short selling i.e. the insolvency of the preyed upon company. Is there any merit to the argument of these volunteers willing to deputize themselves and take the investor's money? Yes, the investor in question did get in at the 60-cent level instead of at perhaps the $1 level. But due to the nature of naked short selling, the investor handed his money to the naked short seller and got onto a down escalator heading toward the basement floor represented by the bankruptcy of the company. The naked short sellers are the "gatekeepers" of this "down" escalator. In betting on your horse against a buddy's horse, in common law the act of the placing of the bet does not allow you to poison your buddy's horse. The much more common scenario involving naked short selling is for these "volunteers" to come upon Acme while it is trading at $1 and in their infinite wisdom decide that the 10-cent or penny level would be more appropriate. After all, pump and dumpers don't make an announcement at the 10-cent level that we're starting a pump and dump. Thus the argument that it would have a deterrent effect on pump and dumps seems a bit weak. Naked short selling "bear raids" take on an all or none aspect. The price per share of a stock trading at generous market cap levels does not magically find its "appropriate" price level after the attack. These companies get crushed. What is really interesting about this whole issue is that Reg SHO could wipe out naked short selling once and for all if structured appropriately. Since the naked short selling "fraudsters", as opposed to their recently created "Reg SHO fighting cousins" the naked short selling "volunteers", have massive preexisting naked short positions, they have to fight this proposed regulation. If the truth be known, the very best friend in the world to a naked short selling fraudster IS the pump and dump artist. There is a phenomenon I refer to as the "hijacking of a pump and dump". All the naked short sellers have to do is identify and follow around crooked CEOS with a history of pump and dump orchestration and start selling these "Acmes" after they have made their 400% upside move, and then ride it all the way into the ground. The crooked CEO is the one guilty of the 10 b-5 misrepresentation frauds and he incurs the risk of criminal prosecution not the naked short seller. Imagine that, all of the benefits and none of the risk. When it's time to force the price per share into the dirt, the paid bashers will correctly point out the history of pump and dumps that this crooked CEO has been associated with. Now the public image of the naked short selling fraudsters and their paid Internet bashers is that of a credible hero that saved the day. Another glaring weakness in the "cure for pump and dumps" argument is this. After "dumping" their long positions, the pump and dump fraudsters typically go net naked short during the last half of the "dump" phase. That is, once their shares are gone they keep selling in a naked fashion. After accumulating a gigantic net naked short position, these corrupt insiders will typically reverse split the issuer's shares and watch the post-reverse split market capitalization and price per share fall completely out of bed. They then cover this naked short position via a death spiral convertible or just let the company become insolvent. THE BIG MONEY IS MADE IN GOING NET NAKED SHORT AFTER THEIR "REAL" SHARES ARE GONE AND NOT DURING THE FIRST HALF OF THE DUMP PHASE. THE ARGUMENT THAT NAKED SHORT SELLING IS A DETERRENT FOR PUMP AND DUMPS IS SHEER LUNACY. THE SECOND AND MORE LUCRATIVE HALF OF THE "DUMP" PHASE IS NAKED SHORT SELLING IN THE PROTOTYPICAL PUMP AND DUMP. If I was currently naked short thousands of micro cap companies and had billions of dollars at risk and I saw the Reg SHO proposed ruling coming at me I think I would also play the "It's a good cure for pump and dumps" card. What other cards are there to play in justifying the killing of thousands of U.S. micro cap corporations and the investments made therein by tens of millions of U.S. citizens? At a casual glance, it might make a little sense that naked short selling would be an appropriate antidote to "pump and dump" frauds but with further scrutiny this theory doesn't hold water. Part of the problem is that being a genuine compassionate "shareholder advocate" just does not pay very well and therefore you don't see much of this activity from naked short sellers or Internet bashers for that matter. In summary, if the Reg SHO issue did not present itself for public debate, these "volunteers" would not have to take on the unenviable task of prescribing to the SEC, with a straight face, that the best treatment for fraudulent pump and dumps is fraudulent naked short selling. After this Reg SHO issue simmers down, then the naked short sellers can go back to looking upon the pump and dumpers as being their "meal ticket" and not their enemy. Dr. Jim DeCosta |