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Jonathan G. Katz, Secretary
January 5, 2004 Submitted electronically to: rule-comments@sec.gov. File No. S7-23-03 Dear Secretary Katz: RE: Proposed SHO Rule: http://www.sec.gov/rules/proposed/34-48709.htm I strongly believe that short selling is a form of investor protection because it governs irrational valuations and imposes corporate governance and that the SEC must expend more effort to design the Proposed SHO Rule so it can be applied in this context by individual investors and market participants. Moreover, I encourage you to consider that properly developing the SHO Rule is a unique opportunity for the SEC to protect individual investors by eliminating insider advantages. After reading the Proposed SHO Rule and a fair number of comment letters, I salute the SEC for attempting to address problems associated with short selling and believe that elements of the Proposed SHO Rule will address some of the problems identified by commentators. Unfortunately from my perspective the Proposed SHO Rule fails to put individual investor interests first and it reads as policy initiative that intends to favor market participant and issuer interests over individual investor interests. Fundamentally the Proposed SHO Rule falls short because it does not require the system to provide individual investors real time information or transparency about short sale transactions. And, it also falls short because the Proposed SHO Rule continues enabling market participants to execute naked short sales while doing nothing to enhance an individual investor's capability to execute their own short sale investment strategy. These flaws must be addressed otherwise the Proposed SHO Rule does little more than create a unique regulatory regime of special privileges for market participants and issuers by putting their interests ahead of individual investors. The short version of my advice to improve the Proposed SHO Rule is that it must undergo another round of SEC staff review and content development to achieve an outcome where each section of the Proposed SHO Rule begins by explaining how the proposed elements:
From my perspective, this can be achieved by the SEC refining the Proposed SHO Rule to focus on four fundamental objectives: I. The first objective for the Proposed SHO Rule is that it must provide greater transaction transparency for individual investors by requiring that short sale transactions be reported in real time. Maintaining a fair market place can only be accomplished by providing accurate and real time information in formats that enable individual investors to make real time decisions about and adjustments to their investment portfolios. The current regulatory system allows information providers to report total share volume as a positive number. This reality is the foundation on which information providers can develop technology systems to deliver real time short interest reports. Any lower reporting standard leaves market participants and issuers in a privileged position and will indicate that the SEC has failed to reset the Proposed SHO Rule in favor of individual investors. Examples of real time information that should be reported includes but is not limited to:
Requirements for real time and daily reporting of short interest sales must be extended as far as possible to create transparency for individual investors. This encompasses requiring market participants to report short sale activity in real time and expanding the definition of short sale to include issuer generated sale of shares that they or their affiliates and service providers acquired below prices paid by third-party investors. In other words issuer and affiliate generated sales of securities that were acquired below prices paid by third-party investors are a form of short selling that must be addressed by the Proposed SHO Rule. Accomplishing real time reporting of short sale transactions requires the SEC to develop a comprehensive list of short sale definition categories and then articulate guidelines for information providers to report these unique data elements. One instinctively knows that market participants have developed analytical models and information gathering processes that they apply before executing a short sale. The Proposed SHO Rule must be refined so that it requires these analytical models, information formats and numerical reports to become real time short sale reporting formats otherwise market participants and issuers will continue to enjoy a regulatory regime of special privileges and this is not an acceptable outcome. Individual investor interests must be put first and real time reporting of short sale transactions is the starting point to provide the necessary level of transparency to achieve this objective. II. The second objective is that the Proposed SHO Rule must reset regulatory policy and market practices so that individual investor interests are put first and ahead of market participants and issuers. This requires ensuring that third-party investors can freely trade their shares and or/short against them. And, this must includes developing regulatory policy that puts more conditions on market participants and imposes more speed bumps on issuers to govern each one's short selling practices. Two primary problems are created by putting market participants and issuer interests ahead of individual investors. The first problem is created when investors buy expensive shares because irrational values are being generated by market hype. The second problem is created when investors experience the collapse of their share values because issuers or their affiliates and service providers are watering down the total shares outstanding and public float shares by either selling shares that they have acquired at prices less than the public investors paid or are selling short against shares that they have rights to acquire as part of their compensation for providing capital or services to the company. The problems can be addressed in two ways and the Proposed SHO Rule must be reworked to achieve these outcomes. The first problem can be addressed by leveraging an individual investor's ability to margin selling short securities that they hold in their own account. Allowing individual investors more margin leverage is the best way to put individual investor interests ahead of market participant's and issuer's interests. In reality the market functions by generating buy recommendations and the SEC appears to be reacting to the so-called manipulative aspects of short-selling because of a bias for buy-and-hold. Designing Regulation SHO so it instills short-selling incentives for vigilant investors can promote better corporate governance and limit abuses that are associated with overvalued market cap values. For example, lack of short interest in Enron and Worldcom prior to the collapse of their market cap value is evidence that current SEC short sale rules and policy do not provide proper incentives for individual investors to execute short sales as part of their investment strategy. This must be addressed in a refined version of Regulation SHO. In a situation where investors hold shares in their account and wish to sell short against those shares the SEC and other policy makers should undertake studies and pilot programs to determine how granting greater short interest margin allowances to individual investors can improve the market by imposing more rational market cap values. News reports lead one to believe that $5 trillion of market cap value was lost between the recent high and low. Given the magnitude of these investor losses the SEC must attempt through the Proposed SHO Rule to develop higher leverage short sale margin rules and education programs that empower individual investors to govern irrational valuations. And, these rules and programs must be designed to be applied to OTC securities that currently can't be margined by individual investors. As an aside the most egregious example of regulatory policy favoring market participant interests over individual investor interests is the situation that now exists where market participants can engage in naked short selling of OTC securities and individual investors cannot short sale OTC securities at all. The Proposed SHO Rule must be reworked to address this imbalance. The ideal outcome for the Proposed SHO Rule is that it must provide market participants and individual investors equal opportunity to engage in naked short sale transactions or not. Assuming that this outcome can't be achieved individual investors must be given greater short sale power, especially in OTC securities because it is simply not acceptable for SEC Rules to give market participants an unlimited ability to sell short via naked shorting while at the same time providing individual investors no ability to sell short on margin. One starting point can be an SEC study and pilot program to determine how allowing investors multiple margin allowance to short against OTC shares held in their accounts can help maintain an orderly market in development-stage OTC traded securities. Aspects of this study must focus on how short-sale incentives can empower vigilant investors to promote better corporate governance and limit other abuses that have been associated with overvalued market caps. As it applies to OTC securities for example, assume that one owns 10,000 shares of XYZ at $0.50 and new margin rules can be developed that allow this account to execute short sales at a 10X multiple with a time limit to buy shares to cover. Regulators can assume that this investor has a fair understanding about the value of their OTC stock and therefore may be in the best position to determine when it is over or under valued and act accordingly. These companies experience volatile share prices. Empowering investors to enjoy profit participation in these volatility cycles is one way to reduce the risk of losing their investments in development stage companies. I believe a study of this nature will prove that allowing leveraged margin allowance for OTC securities is necessary to reset the Proposed SHO rule in favor of individual investors. And, elements of this study need to be applied to exchange listed shares to ascertain if allowing scalable short margin multiples for individual investors can help govern irrational valuations in upper tier markets. Moreover, the notion of granting individual investors leveraged margin rights must be viewed in the context that market participants face no margin restraint when executing naked short selling and some balancing tool must be given to individual investors. The SEC must do more work on the Proposed SHO Rule to ensure that it favors individual investors, especially where there are distinctions between exchange listed securities and OTC traded securities as it regards applying short sale transaction rules, requiring short sellers in all equity securities to locate securities to borrow before selling and imposing strict delivery requirements on securities where many sellers have failed to deliver the securities. Moreover, the Proposed SHO Rule must be further refined to ensure that information associated with governing these practices is readily made available to individual investors. Finally, a portion of the Proposed SHO Rule must be added that requires SEC staff to work with all entities that develop investor education programs to help them create comprehensive information pieces to help individual investors learn how to execute short selling as part of their investment strategy. III. The third objective is that the Proposed SHO Rule must add more conditions, financial consequences and regulatory action on market participants in the form of short sale net capital rules and consequences for failures to comply with short sale regulations. One simple way to accomplish this objective is for the Proposed SHO Rule to require that outstanding naked short sale positions held by market participants be adjusted against their net capital once every 30 days. I recommend that the SEC develop within the Proposed SHO Rule a negative net capital adjustment report and require that it be filed with the NASD every 30 days by market participants that engage in naked short selling. I also recommend that the negative net capital adjustment be based on a 10:1 calculation for the highest priced share sold short to be applied to the total outstanding uncovered naked short shares per issuer that the market participant has held for more than 30 days. For example in a situation where the highest price of a specific issuer's share was $1 when the market participant executed its first naked short sale and they sold 10,000 total naked short shares, $1 x 10 would be the negative adjustment to net capital calculation. On the due date of this market participants 30 day net capital adjustment report to the NASD in a situation where they have not bought back 10,000 shares to cover their naked short position this market participant shall be required to negatively adjust their net capital by $100,000. And, when and if their adjusted net capital falls below the NASD requirement to maintain market maker status it must be revoked. Moreover, to address the situation where a market participant's assets are not sufficient to cover their outstanding naked short positions when the NASD revokes their market maker status the Proposed SHO Rule must be refined so that securities regulators can impose greater legal consequences than now exist on so called rogue naked short sellers who do not intend to comply with regulatory policy. And, this should include meaningful financial penalties and disbarment from the securities industry and injunction from handling investor monies. In other words, the Proposed SHO Rule should not attempt to prevent naked short selling by market participants. Instead the Proposed SHO Rule must ensure that naked short sold shares must periodically be bought in by market participants that engage in naked short selling. And/or in situations where market participants don't buy in shares that they sold as naked short sales the SEC must require that the NASD give greater scrutiny to their net capital and capability to buy outstanding naked short shares when a market participant no longer meets their adjusted net capital requirements due to outstanding naked short positions. And/or in situations where rogue naked short sellers fail to cover the Proposed SHO Rule must grant regulators more authority to impose harsher sanctions and penalty's. IV. The fourth objective is that the Proposed SHO Rule must refine and adjust regulatory policy so that it addresses a host of concerns associated with small issuers. Many comment letters regarding the Proposed SHO Rule seek to address issues associated with practices and problems that pertain to capitalizing entry-level, development-stage issuers and micro cap companies. One entity organized a band wagon of issuers claiming to be victims of "naked short selling". My own random sample of issuers listed by that entity revealed that many issuers had watered down their outstanding shares or public float but had not achieved a sustainable period of meaningful improvements in their financial metrics and/or many that had issued press releases about new business possibilities did not have a sufficient level of capital to significantly scale up their business operations. Simply stated rational investors should short companies in this situation and many market participants that did so were providing a level of investor protection. However, this problem must be viewed from a wider frame. The system for capitalizing entry-level, development-stage issuers is under stress and by some indicators may be broken. The Proposed SHO Rule can't be constructively applied unless its scope is widened to address the cause of excessive watering down of total shares outstanding and/or the watering down of total shares in the public float. Fundamentally the watering down of shares problem is caused because small issuers are required to grant large numbers of their shares to third parties for financial and other services and or insiders must sell shares to survive because their companies can't raise enough capital to execute its business plan. Market participants execute naked short sales to address the watering down of shares or public float. Investors can't and often times the long delays between reports prevent third party investors from knowing exactly how many shares are outstanding or in the public float and/or how these numbers are being watered down. Unfortunately the current trend of regulatory policy is driving small issuers away from being SEC reporting entities. And, past efforts to transform this segment into a listed market have failed. Fundamentally this reflects failing securities regulatory policy and it is resulting in a greater number of issuers and market participants operating in the OTC market place where there is little or no regulatory oversight unless fraud is committed, reported and prosecuted. The Proposed SHO Rule must be refined and broadened so that it addresses aspects of problems with securities regulatory policy that are preventing a viable entry-level, development-stage issuer capital market to develop and this endeavor must be undertaken in the public interest. It requires reversing course on setting standards so high that small issuers stop being SEC reporting entities, which is bad public policy and not in the individual investor's best interest and, ensuring that third party investors can resell their shares in a public market that is governed by regulatory oversight. The Proposed SHO Rule must bring forth the SEC, state regulators, NASD and small issuer market participants working on refining and harmonizing programs that can enable small business issuers to undertake small public offerings, provide secondary market trading for their investors and maintain SEC reporting entity status. At a minimum the scope of this work encompasses addressing problems that prevent small issuers from undertaking public offerings and they encompass:
In other words the Proposed SHO Rule must be improved by adding a small issuer content section. This can be accomplished by forming a SEC, NASAA, NASD and small issuer market participant workgroup. It must be tasked with responsibility for articulating a harmonized SEC/State/NASD "Right Sized" securities regulatory regime that creates a coherent and cost effective entry level system for small business issuers to raise capital, maintain a secondary market for their investors and provide ongoing quality information through the SEC reporting entity process. This workgroup's "Right Sized' securities regulatory regime must enable greater numbers of small business issuer public offerings, bring forth a greater number of small public company reporting entities and set higher conditions on issuers and their affiliates and service provider's ability to sell shares that insiders or affiliates have acquired at more favorable prices than those paid by third party investors. This scope of this work needs to encompass:
Thank you for considering my thoughts about improving the Proposed SHO Rule. My intent is very simple. Short sales can and should be encouraged to prevent irrational valuations. Investor interests must be put ahead of issuer and market participant interests. Real time information and short sale transaction transparency must be provided to investors. Market participants that engage in naked short selling must be required to periodically buy in their short positions or face consequences if they fail to cover their naked short positions. A unique securities regulatory regime must be developed that enables small issuers to more easily undertake public offerings and maintain SEC reporting status and the effort to create this "Right Sized" securities regulatory regime must become part of the Proposed SHO Rule initiative. Recipients of promotional shares must be required to hold their shares in escrow subject to defined conditions for release that cause them to hold cheap shares longer and release them into the market more slowly. A secondary market must be maintained for small issuer investors. And, parties interested in investor education must help investors acquire the knowledge to execute short sale transactions as part of their investment strategy. Sincerely, Brad Smith, President
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