Fellow Investors,
I received an e-mail last night informing me that this web site lacked the information necessary to make a conscious and informed decision on whether to sign the petition or not. The individual asked that I address specifically whether naked shorting is illegal and if so, what specific laws were being violated.
Since the site has been up and running for several
years now I have to admit that basic information has become lost in the maze of
other commentary and documents.
So here are some simple answers:
Question: Is naked shorting illegal?
Answer: It depends.
There is legal and illegal naked shorting and the difference is relative
to the foundation of the trade itself
Ø Market
Makers making a bona-fide market in a security can legally
sell stock they do not have in inventory, nor have they entered into a contract
to borrow, in order to provide liquidity in a market where liquidity may
otherwise not exist. The SEC defines
this as a temporary condition where for example, large and unusual buy side
interest comes into a security with only limited sell side interests. Regulators have created the market making
exemption to allow the market makers to sell into this demand so as to not
over-inflate the stock in this temporary buy side environment.
Ø Market
Makers who are shorting a stock in a house account, without meeting the
standards of bona-fide market making and use the exemption to avoid a borrow on
the short sale are executing an illegal trade.
The failed trade is an illegal naked short.
Ø Broker-Dealers
who execute client short sale orders without a proper locate and fail to
attempt to borrow a share to meet the 3-day settlement window are executing an
illegal naked short sale.
Question: What specific laws are being violated when an
illegal naked short sale is executed.
Answer: There
are several laws that become involved in the short sale process and the
settlement process.
Ø Exchange
Act of 1934 Section 17A (http://www.law.uc.edu/CCL/34Act/sec17A.html).
This section pertains to the requirements of broker-dealers and clearing firms
in the execution and settlement of a trade.
It requires that for the safety of the investor and the markets, all
trades must settle promptly and accurately.
Ø Exchange
Act of 1934 Rule 15c6-1 (http://www.law.uc.edu/CCL/34ActRls/rule15c6-1.html). This rule defines the settlement cycle for
a trade execution. The rule requires
that a broker or dealer shall not effect or enter into a
contract for the purchase or sale of a security (other than an exempted
security, government security, municipal security, commercial paper, bankers'
acceptances, or commercial bills) that provides for payment of funds and
delivery of securities later than the third business day after the date of the
contract unless otherwise expressly agreed to by the parties at the time of
the transaction
Ø Exchange
Act of 1934 Rule 15c3-3 (http://www.law.uc.edu/CCL/34ActRls/rule15c3-3.html). This rule again applies to the broker
dealers and requires that they take all necessary steps to obtain prompt
custody of , and thereafter protect, all securities which have been purchased
and paid in full by the client. When a
naked short is executed, the purchaser is being denied protection under this
rule as their broker dealer has failed to enforce the contracts of 15c6-1 and
has failed to obtain the prompt custody of a share paid in full.
Ø NASD
Rule 3370. This is the
Affirmative Determination rule that requires that in the execution of any short
sale the selling broker-dealer representing the short seller or house account,
must have engaged in a locate of a share available for borrow before the
execution of that trade is made. Once
the trade is executed, to be in compliance with rules 15c6-1 of the Exchange
Act of 1934 the firm must then borrow those shares to settle the trade. To locate the shares without the intent of
the borrow for settlement would be a contract violation of 15c6-1.
Ø Chairman
Cox Opening Remarks to SHO Reform June 13, 2007 (http://www.exchange-handbook.co.uk/index.cfm?section=news&action=detail&id=67616
). “Finally, in addition to today's measures, and because abusive
"naked" short selling is illegal under the general antifraud
provisions of the federal securities laws, I have asked the staff to draft a
recommendation for a future rule proposal that would specifically state that
abusive "naked" short selling is fraud. Such a rule holds the
potential of streamlining the prosecution of this apparently rare form of
market manipulation and, if today's measures leave any doubt, would direct
still more Commission power to stamping out such abuses.”
So the Issue:
The SEC has made many statements such as that of
Chairman Cox above but the Commission does not walk the walk to the comments
made.
In 2003 when the SEC proposed the short sale reforms
under SHO the SEC never presented an option for a “grandfather clause” to past
persistent settlement failures. The
public did not have opportunity to vote on such a reform and comment on the legalities
of the proposal itself. By all rights
these fails raise doubt as to whether they all fall under the “legal” standards
allowed for a trade to fail settlement.
By 2005 the SEC had aided the fraud in the industry,
as the grandfather clause became law despite the questionable legality of the
law. By allowing a free pass to these
large and persistent fails the SEC violated their own laws regarding prompt
settlement of securities and the legal terms of a contract in the execution of
a trade. Consideration is also being
given that the SEC violated shareholder 5th Amendment rights by
taking the property of one (shares fully purchased) and giving such property to
another (failing broker dealer) without providing compensation for such.
The question posed is, does the SEC have the legal
authority to decide for all shareholders whether or not each should promptly
receive what was fully paid for?
The SEC mission is that of investor advocate. Yet taking the property rights of investors and giving them up to protect the financial liabilities of industry members who choose, for financial reasons, not to enforce the contracts required under securities laws is a direct contradiction to such advocacy.
During the June 13, 2007 hearings on SHO reforms,
members of the Commission staff repeatedly confused forcing the settlement
failures with market manipulation through a short squeeze. The SEC feared pricing volatility and upward
movements associated with the settlement of these failed trades despite the
SEC’s admittance that a failed trade can be illegal and can be used to
illegally depress the price of a security.
Under the Exchange Act of 1934 the SEC does not have
the authority to price fix securities in this manner as price fixing is
considered stock manipulation. The SEC
engaged in price fixing nonetheless and did so to put the interests of those
who manipulated our markets with excessive and abusive trades into settlement
failures above those who purchased into these trades.
It is for these reasons above that we, the
administrators of this petition, request your support in asking Congress to
look at the possible criminal activities of the members of the SEC. Our nation can only survive and grow if our
capital markets are considered fair and safe.
Companies will choose alternative to going public and investors will
place investments elsewhere if the markets are considered rigged and dangerous.
Our communities thrive over a tax based generated by
employed citizens and the companies that employ them. Destroying investor portfolios and destroying
public companies based on market induced and regulator ignored fraud will have
a lasting impact on these communities where such abuse took place.
These markets are here for the investing public and
not the investing public is here for these markets. The SEC needs to understand this
accountability and we seek to enforce it.
This is a very complicated issue made so by the
political gibberish of the SEC. I hope this simplifies it somewhat.
Thank-You
Dave Patch
For more information and presentation on naked
shorting please direct your attention to www.thesanitycheck.com.