From: John Rideout [jrideout@yahoo.com]
Sent: Tuesday, December 02, 2003 8:43 PM
To: rule-comments@sec.gov
Subject: S7-23-03:

Comments on Regulation SHO
Proposed Rule 203: Locate and Delivery Requirements

Introduction:
I believe that the proposed Rule 203 should be dropped
as it would severely deter naked short selling which
provides a valuable market function. If implemented,
Rule 203 would lead to an increase in pump and dump
stock fraud and more instances of overvalued
securities – overall, it would lessen market
efficiency while conferring no significant benefit. 
 
Naked Shorting and Stock Fraud:
At various times throughout history short selling
comes under attack and naked shorting in particular is
subject to the most virulent opposition. The current
attack appears to stem primarily from the efforts of a
less than illustrious group of companies trading on
the OTC Bulletin Board and Pink Sheets who have
lobbied the SEC for stricter rules. It is interesting
to note that in 1989, SEC staff testified before
Congress (addressing allegations of short selling and
market manipulation):

“…many of the complaints we receive about alleged
illegal short selling come from companies and
corporate officers who are themselves under
investigation by the Commission or others for possible
violations of the securities or other laws” and that
the SEC “frequently finds that the complaints of
downward manipulation that we receive from issuers or
their affiliates do not lead to sustainable evidence
of violations of the antifraud provisions of the
federal securities laws.” [prepared statement of
Richard Ketchum and John Sturc before the House
Committee on Government Affairs, Subcommittee on
Commerce, Consumer, and Monetary Affairs, December 6,
1989, pp. 434-435]

It is disappointing that the SEC now appears to have
acquiesced to the demands of a band of stock promoters
and their misguided followers by proposing Rule 203
that would make shorting of thinly traded penny stocks
(OTC Bulletin Board and Pink Sheets) even more
difficult than it already is.

A fallacy promulgated by penny stock promoters is that
their stock is falling because of naked shorting.
Almost without exception, the stock falls because it
lacks fundamental value and the insiders and promoters
are unloading their stock holdings on the public
investor. If naked shorting were really driving stock
prices to bargain levels, promoters and investors
would view it as an opportunity to acquire shares at
cheap prices. Their buying would either prevent the
stock price from falling in the first place or, in the
case of a supposed bear raid, their buying would mean
any price declines are temporary lasting no more than
a few minutes to a few days. Another argument put
forth by stock promoters is that a low and falling
stock price makes financing more difficult. This too
is an implausible complaint since equity financings
for small companies are almost always made at low
prices prior to the start of the stock promotion cycle
when no shorts are involved. If they were not corrupt
and so motivated by greed, pump and dump perpetrators
would not be using stock promotions to sell their
personal holdings but to raise additional funds for
their companies. 

Rule 203, if implemented, will serve to sharply
curtail naked short selling. However, there will not
be a commensurate offset by shorting with loanable
stock because there is usually no borrow available for
stocks traded on the OTC Bulletin Board and Pink
Sheets. Many of these stocks, especially during their
promotional run-up phase are tightly held by insiders
and promoters so without naked shorting, there will be
no foil to prevent their prices from being manipulated
higher. This will result in a significant increase in
the incidence of overvalued stocks. There will be more
pump and dump schemes foisted on the retail investor
as short sellers will not bother to research stocks
they cannot short and will not publicize their
findings to warn investors. Research sites such as
our-street.com and stocklemon.com are likely to be
shuttered without support from the short seller
community. Short sellers who post on public message
boards such as RagingBull.com or SiliconInvestor.com
will no longer do so as they will have no economic
incentive to warn prospective investors of stock
fraud. Without short-side research the SEC enforcement
arm will receive fewer tips on possible market
manipulations. Unfortunately, under existing rules and
structure, the SEC usually does not or cannot
intervene to prevent pump and dump schemes at the
formative stage and when they do intervene, it is
usually not before many investors have been duped into
losing their nest eggs. Short sellers, both naked and
covered, provide an important private sector,
market-based solution against stock fraud. Rule 203
severely weakens this solution.

Naked Shorting and Overvalued Stocks Without Fraud:
An important function of short selling is to help
prices adjust to their underlying fundamental values.
An economic justification for short selling is that
when prices are wrong, an economy’s resources become
misallocated. At certain times, stock prices reflect
overoptimistic assessments on the part of buyers. When
there are short sale constraints (caused primarily by
a lack of loanable stock) even the most obvious of
shorting opportunities can remain overpriced for
extended periods (e.g., Owen Lamont and Richard Thaler
“Can the Market Add and Subtract? Mispricing in Tech
Stock Carveouts”, Journal of Political Economy,
forthcoming). A current example is provided by the
elevated trading levels of shares in bankrupt
companies that are soon to be cancelled with no return
to stockholders. Such shares ought to trade near zero,
however, misguided investors bid up the price of these
shares, perhaps on the idea that bankruptcy will save
or protect the company from going out of business
while not realizing that the existing equity will be
cancelled with new shares issued only to creditors.
UAL Corporation, which is operating under Chapter 11
protection, traded at $1.43 at the end of November
with a market capitalization of $158 million. However,
the company on its website and in its SEC filings
warns investors: “We believe that UAL's equity
securities have little or no value and it is highly
likely that the equity in UAL will be canceled under
any plan of reorganization that we propose.”

Another example is provided by the case of
MCI/Worldcom, whose plan of reorganization has been
approved by the courts, and when it emerges from
bankruptcy sometime in the next month or two, its
currently issued shares will be extinguished with no
cash or new shares issued to their holders. Its two
tracking stocks (WCOEQ and MCWEQ on the Pink Sheets)
are trading at $0.025 and $0.075 respectively, and
while this pricing may appear low, the market
capitalization, at $83 million, is not. Thus we have a
market valuing worthless stock at $83 million. These
shares, and especially UAL, has been difficult to
borrow for shorting and shorts have endured many
costly buyins.
 
It is important to note that these securities are not
mispriced because investors lack publicly available
and publicized information about their true value.
Also, under the current rules, which some claim are
being abused through fails to deliver, short selling
has not been so prevalent as to fully correct these
obvious mispricings in the marketplace. To help
correct such mispricings I believe that the SEC should
be more accommodative to short selling. Rather than
implementing regulations which would end up
restricting naked shorting, the SEC could help by
reducing the minimum margin requirements (presently
$2.50 per share for equity shorts), by investigating
measures to encourage securities lending, and by
banning above market buyins (where fails to deliver
sometimes result in immediate buyins at 20% above the
market price).

Addressing Some Objections to Naked Shorting:
While the SEC proposal paper notes a number of
negative effects on the market that result from naked
shorting, I do not find any of these convincing
reasons for placing further constraints on short
sales. The first of these alleged effects is the
“significantly large unfulfilled delivery obligation
at the clearing agency where trades settle.” The paper
does not state why this in itself is a problem.
Presumably the buyer of the securities can sell these
securities in an electronic marketplace without
certificates. If delivery is demanded then buy-ins are
(or should be) effected. With respect to the loss of
voting rights of the buyer whose shares are acquired
from a naked short, this is I believe a much smaller
problem in practice than in theory. Firstly,
shareholder votes are typically held only once per
year in the context of the annual general meeting.
Thus most of the time, the shareholder’s vote is not
needed. Furthermore, small shareholders often do not
bother to vote because their economic interest is
insignificant and in many cases irrelevant where a
control block of shares is held by others (e.g.,
insiders and promoters in a pump and dump scheme).
 
Another negative cited in the paper is that “In effect
the naked short seller unilaterally converts a
securities contract … into an undated futures-type
contract, which the buyer might not have agreed to or
that would have been priced differently.” This is an
interesting and useful insight in that it compares a
naked short position to a short position in a single
stock futures contract. Such contracts are now
permitted and available for trading in many large cap
companies. The proposal does not state why stock
buyers in those companies would price the stock
differently as a result. Shorting (naked or covered)
does not by itself change the underlying value of the
security – its cash flows are unaffected and the
number of shares outstanding is the same. Plausibly, a
sudden increase is the supply of stock caused by naked
shorting could cause the price to be lower. However,
there is also an obligation to close out the position
in future so at some point in time demand for the
stock will be higher and therefore the price will be
higher as a consequence. It is difficult to see how
the investor is harmed through naked shorting as he
will be able to buy shares for a lower price than
otherwise and also because of the need to cover a
short position, he may have the opportunity to sell at
a higher price than would otherwise prevail because of
the covering of naked shorts (or close-out of short
futures contracts). 

The proposal paper goes on to state that “More
significantly, naked short sellers enjoy greater
leverage than if they were required to borrow
securities and deliver within a reasonable time
period, and they may use this additional leverage to
engage in trading activities that deliberately depress
the price of a security.” The number of instances in
which short selling has been used to manipulate shares
to deliberately depressed levels is extremely low in
comparison to those in which buyers are induced to
drive prices higher. A significant piece of evidence
for this is that all but a few of the SEC’s
enforcement actions have to do with upward price
manipulations.

This should not be surprising given that shorting is a
risky strategy and very little money is invested in
short strategies compared to long strategies. Given
the difficulties of securing a borrow (especially in
small or micro cap stocks) and the hazards of shorting
(squeezes and corners) and the additional hazard of
naked shorting (forced buyins, sometimes up to 20%
above market price), it is much easier for market
manipulators to pursue long side strategies instead.
Furthermore, short sellers target companies they
perceive as overvalued since they are much more likely
to earn profits that way. Indeed, most shorts are also
investors so they will buy stocks they perceive as
undervalued rather than short them.

A common objection of investors to naked shorting is
that it creates new stock out of thin air. This is a
fallacious argument, however, as the number of shares
outstanding on the company’s books remains unchanged.
The fundamental valuation of the company is
unaffected. Dividends are still paid to all owners
(the short seller is responsible for paying dividends
to the buyer so the company does not end up paying any
extra). Shorting, whether naked or covered, does
increase the gross number of shares held by investors
but because short positions are a liability of the
short, the net number of shares in the market is
unaffected. If these prove to be successful companies,
it is the short sellers who suffer not the investors.

If naked short selling were the plague on the small
cap markets that some people allege, one would expect
to see weak share prices on the OTC Bulletin Board. To
examine that hypothesis I used the Reuters Research
Screener to calculate the 52 week percent change of
all OTC Bulletin Board microcap stocks (defined as
having a market cap under $500 million). The average
52 week price change at the end of November was 112%.
This result compares to a 77% average increase in
microcap stocks listed on the NYSE, Nasdaq, and AMEX.
There is nothing in these results to suggest that
rampant short selling abuses are harming microcap
stocks. Instead it suggests that microcap stocks are
performing extremely well.

Dealing with Floorless Convertible Securities (Death
Spirals):
The proposal discussion goes on to discuss the death
spiral convertible financing as an example of where
naked shorting could be regarded as manipulative and
where the Commission recently brought a successful
enforcement action. In this type of financing scheme
the issuer makes its shares outstanding a variable to
be determined at some future point depending on its
stock price. The lower the stock price, the greater
will be the number of shares eventually outstanding
because more shares have to be issued in connection
with the conversion of the debentures. From an
economic perspective, the buyer of such an instrument
is fully hedged when he shorts the stock whereas the
stock buyer faces significant dilution risk. From a
manipulation perspective, the short selling can cause
the stock price to fall permanently. This result would
not seem to depend on naked shorting since if a borrow
is available the price will still be reduced by
shorting. Also, if the buyer was prohibited from
shorting under the financing terms or engages in wash
sales to disguise his trades then a manipulation case
is much more apparent. 

Successful enforcement action has been achieved in the
past without the proposed locate and delivery
requirements. Furthermore, civil remedies are also
available to the aggrieved parties. As an alternative
to Proposed Rule 203, the SEC could disallow holders
of floorless convertible securities from shorting the
underlying stock. This would address price
manipulation whether it was caused by shorting with a
borrow or shorting without one. At the same time, it
would permit issuers continued access to this type of
financing, which some issuers require as a last
resort.

Conclusion:
Substantial impediments to naked shorting already
exist including buyins (sometimes as much as 20% above
market), squeezes, corners, and the asymmetry of
returns (the maximum gain is limited but potential
losses are unbounded). New impediments would not
provide any net benefit to the economy or society at
large.

I recommend that the SEC not proceed with proposed
Rule 203 of Regulation SHO. It is in the interests of
investors that short selling not be further
discouraged by new constraints. Shorting, including
naked shorting, helps ensure that investors pay fairer
prices for stock by lowering the prices of securities
that have been inflated by irrational exuberance or by
fraudulent stock promotions.


John Rideout


______________________________________________________________________ 
Post your free ad now! http://personals.yahoo.ca