Short Tempers

Controversy surrounds a recent crop of lawsuits alleging abusive short selling. Now tempers are getting frayed as law firms gain clients for new cases, and at least one state sides with those who believe US capital markets are dangerously flawed. By Navroz Patel

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Broker-dealers accused by a consortium of US law firms of being party to alleged abusive short selling are dismissive of their detractors. Recent legal efforts have been passed off as the work of misguided conspiracy theorists by some, while others think the litigation smacks of cynical opportunism on the part of companies and lawyers.

Robert Shapiro, a Washington, DC-based economic consultant who has been employed by the main consortium of lawyers, says he is unfazed by the criticism. "I'm periodically subjected to ad hominem attacks, and our side of the debate has been dismissed as nuts. But that doesn't matter - what's at stake here is the integrity of our capital markets system," says Shapiro, a former undersecretary for economic affairs who helped shape US President Bill Clinton's economic policy in the 1990s.

The argument over whether US capital markets are riddled with abusive naked short selling - that is, market abuse associated with a trader's shorting of a stock where there is no attempt to actually borrow the security - has rumbled on for years. But the vitriol is reaching new levels, as both sides seek to get their point across at a critical time in the development of the legal and regulatory landscape surrounding short selling.

Wes Christian, a Houston-based lawyer at law firm Christian, Smith & Jewell, is representing a number of companies alleging that their share prices have been depressed by abusive naked shorting. He claims brokers have, in aggregate, perpetrated a fraud on an unprecedented scale. "They have a criminal mentality and will keep on doing this until somebody stops them. I know of in excess of 1,000 public companies that have been destroyed - others claim the true figure may be three times that."

It seems that some regulators, at the state level at least, are sympathetic to the allegations of widespread abusive shorting. At the end of May, John Huntsman, the governor of Utah, signed a bill into law that requires broker-dealers licensed in the state to notify Utah's division of securities within 24 hours of any failure-to-deliver involving the stock of a Utah-based company. Utah law SB 3004, which had originally been due to go into effect on October 1, imposes a minimum fine of $10,000 a day on firms that fail to comply.

Irrespective of the rights and wrongs of claims of abusive shorting, broker-dealers are peeved by this attempt to usurp the jurisdiction of the Securities and Exchange Commission (SEC), as it potentially undercuts the uniformity of US capital markets regulation. Indeed, the Securities Industry Association (SIA) has filed a complaint in Utah's central division district court. The suit is actually filed against Wayne Klein, in his official capacity of director of the Utah division of securities, and states that enforcement of SB 3004 would violate the US constitution and laws.

Speaking to Risk in early August, Klein said he was discussing with the attorney-general and the Utah governor's office what response to make to the suit. Subsequently, on August 11, the SIA and Utah agreed to a preliminary injunction - postponing the implementation of the law until June 1, 2007. In a statement, John Valentine, president of the Utah Senate, said the postponement allowed the SEC a "window of opportunity" to solve the problem of abusive short selling. "If acceptable solutions are not developed at the federal level, Utah stands ready to implement its statute after June 1, 2007," he warned.

Christian says he "salutes" the efforts of Utah's division of securities: "They are really trying to make things happen themselves, as are some other states. The SEC had better hurry up [and revise its anti-short-selling regulation] or the states will make them look like nincompoops."

However, Travis Larsen, a Washington, DC-based spokesman for the SIA, says the suggestion that the new law focuses on an illegal kind of activity - namely, abusive naked short selling - is false. "It actually sets a new requirement for all types of failures-to-deliver, which can happen for any number of legitimate reasons," he says, adding that the SIA is in no way attempting to defend abusive naked short selling.

Meanwhile, at the federal level, regulators have begun to discuss how current rules regarding naked short selling - referred to as Reg SHO - may be updated. "Clearly, many in the market-place believe abusive shorting is a problem, so we at the SEC have to look at it - which we are - and study the problem carefully," says Roel Campos, an SEC commissioner.

To that end, on July 12, the SEC released its proposed amendments to Reg SHO. According to Campos, the statistics examined by the SEC don't currently indicate a widespread problem with naked shorting. "But we do want to take away any gaps or potential areas where there could be abusive trading or manipulation through shorting," he adds.

Not before time, say critics of the current rule. "Reg SHO is deeply flawed, and has done little to solve the problem of abusive naked shorting," says Shapiro.

Under Reg SHO, the American Stock Exchange, the New York Stock Exchange (NYSE), the Nasdaq Stock Market and others must publish threshold lists - that is, lists of securities that may be subject to significant naked shorting. To get on to a list, at least 0.5% of a company's outstanding shares must have failed to deliver for five consecutive business days, and the figure must equal at least 10,000. Once a stock appears on the list, a broker from that point onwards must, within 13 business days, close out any subsequent new short sales for which they have fails-to-deliver. If the broker hasn't covered the shorts by this point, it is forbidden from handling further short sales of that share until it resolves the fails-to-deliver.

Chief among the flaws in Reg SHO, which went into effect in January 2005, is a grandfathering provision, says Shapiro. This refers to the fact that the naked short positions accumulated in the five business days leading up to a stock moving on to a threshold list are effectively ignored by the regulation's mandatory close-out rule. "It's an enormous loophole that can allow millions upon millions of shares to be naked shorted, before a stock even makes it on to a Reg SHO list," he says.

According to Shapiro's analysis, between January 7, 2005 and April 3, 2006, 427 shares that were not present on the original NYSE threshold list subsequently made an appearance; the figure for Nasdaq was 459. Similarly, Shapiro says brokers continue to maintain large numbers of naked short positions, as evidenced by extended stays on the threshold list by many securities. For example, 54 stocks were listed for at least 40 consecutive trading days, and 32 were listed for at least 60 consecutive trading days over the same period, says Shapiro.

The SEC's Campos denies that the regulators recent proposals are a tacit admission that Reg SHO is a lame duck. "Originally, it appeared that there was a need for these exceptions. It now seems there is no need for these exceptions to continue, so we are eliminating them - it's as simple as that," he says.

Stuart Goldstein, a spokesman for the New York-based Depository Trust & Clearing Corporation (DTCC), the pre-eminent US clearing and settlement institution, believes claims that abusive naked shorting is endemic in the US broker-dealer community are incorrect. "Plaintiffs' counsel may use all kinds of language outside of court, but haven't been able to demonstrate with any factual basis their claim - it's theatre," he says. In the past two years, the DTCC has been named in more than a dozen abusive shorting lawsuits - many of which have collapsed or stalled - where they were accused of complicity in the alleged market abuse of broker-dealers.

The driving force behind the wave of litigation is Texas-based lawyer John O'Quinn. Widely regarded as one of the most effective US trial lawyers, O'Quinn specialises in so-called mass tort litigation - such as asbestos and tobacco-related claims and medical malpractice.

According to Christian, who is O'Quinn's right-hand man, the consortium has around 20 cases ongoing, and claims momentum is building. "Our opponents voice the fallacy that the issue is about complaining small companies. Now extremely large companies that have fallen victim to short selling-related fraud are coming out and saying so."

Christian says the consortium is currently in discussions with several well-known companies - including California-based online DVD rental company Netflix - and expects ultimately to have around 50 cases ongoing, with the first coming to trial by mid-2007. The share price of Netflix, which has a market capitalisation of around $1.2 billion and is listed on Nasdaq, plummeted by just over 20% on July 25 to hit a 52-week low of $18.59 on that day, following the release of its second-quarter results. Beyond the question of alleged naked shorting, the fall was probably due, in some part at least, to analysts factoring in the company's negative outlook on its own performance for the remainder of the year.

A day after Netflix's stock nosedived, an even larger firm, which alleges it has suffered at the hands of market manipulation through short selling, filed a complaint in a New Jersey court. The lawsuit, filed by Fairfax Financial, a Toronto-based financial services group, seeks $5 billion in damages from a number of hedge fund managers - including SAC Capital and Rocker Partners. Among other things, the complaint accuses the hedge funds of spreading negative rumours that a company executive had absconded with corporate funds and was being pursued by the Royal Canadian Mounted Police, and sending tip-off emails (apparently authored by comic book character Dick Tracy) to Fairfax staff alleging senior executives were involved in corporate malfeasance. Those fund managers that have commented publicly on the suit say it is baseless, and that problems with Fairfax's business are what lay behind its poorly performing share price.

Shapiro says his original hypothesis, formed when he started investigating naked shorting several years ago, was that it is typically the result of a strategic fail - that is, brokers deciding they don't want to pay the cost of stock borrowing - or a client trader at a hedge fund or elsewhere colluding with a broker-dealer to manipulate stock prices. However, two separate anti-trust lawsuits brought in April have partly altered these assumptions.

The plaintiffs are the Quark Fund, a hedge fund manager, and Electronic Trading Group, a New York-based trading firm. In essence, the suits allege a group of prime brokers earned illicit profits from not covering short positions they put on for clients - short positions those clients were led to believe were covered. So, it is alleged, naked short positions were created unbeknown to the clients, and yet the prime brokers charged their clients as if they had covered those shorts. "Stock lending means big money for Wall Street. It was interesting to see that there's now the allegation that they have profited from short trades that their clients thought were covered," says Shapiro.

More recently, four firms were fined a total of $1.25 million by NYSE Regulation - the exchange's regulator subsidiary - for violations of Reg SHO. At the end of July, Daiwa Securities America, Goldman Sachs Execution and Clearing, Citigroup Global Markets and Credit Suisse Securities (USA) were penalised for "operational deficiencies and supervisory violations concerning Reg SHO".

Citigroup, for example, did not have procedures in place for resolution of failure to deliver in threshold securities that persisted for 13 days, NYSE Regulation said in a statement released at the time. All the censured firms consented to the penalties imposed without admitting or denying the allegations. Separately, traders told Risk that NYSE Regulation's member firm regulation division is quizzing exchange members about the nature of shorting activity associated with the precipitous decline in the share price of New Jersey-based internet telephony specialist, Vonage. Following its initial public offering on May 24 at $17, Vonage's share price dropped by 12% on its first day and was trading at under $7 in mid-August.

Shapiro views the recent enforcement activity by the NYSE, together with Utah's regulatory efforts and, most importantly, the SEC's proposed amendments to Reg SHO as part of a growing acceptance that concern over widespread abusive naked shorting is valid. He does, however, believe the proposed Reg SHO amendments have two problems: first, they don't address so-called ex-cleared trades - that is, large trades that are cleared between traders, outside of traditional clearing venues; and second, there's an extended phase-in period of 35 days - in other words, any previously grandfathered threshold security must be closed out during that period. "The SEC didn't admit they made a mistake (with the original Reg SHO), but the amendments amount to a complete reversal. I'll try to convince them they need to go a little further," Shapiro says. The comment period for the proposed changes ends on September 19.

Shapiro believes the SEC's proposals "refute the fundamental case the DTCC has been making for years - that this is not a significant problem". Christian, meanwhile, believes the DTCC should have done more in forcing participants in the clearing system to close out naked short positions.

The DTCC counters that it has no authority to force participants to buy-in shares to cover naked shorts. Goldstein says that, in his opinion, much of the litigation directed at the DTCC has been misguided. "I'll give them the benefit of the doubt that it was born out of a lack of understanding around how capital markets work - they seem to forget that failures to deliver happen for many legitimate reasons."

The SEC has supported the DTCC strongly throughout the wave of litigation, as evidenced by the regulator's filing of amicus briefs in two cases, argues Goldstein. Amicus briefs are documents filed in legal proceedings by a disinterested third party. "Their support suggests they are the regulator and we are in compliance with their rules. We provide information around Reg SHO, but they are the ones policing - we have no regulatory oversight responsibility or authority," he adds.

Leslie Boni, a managing director at California-based brokerage UNX, says she has been approached by both plaintiffs and defendants involved in abusive naked short-selling cases. As a visiting economist at the SEC in 2004, Boni gained unprecedented access to data from the DTCC, from which she wrote a paper that for the first time established that failures to deliver were much more long-lasting and widespread among US equities than had been thought.

Indicative of their ability to interpret statistics differently, members of both camps of the abusive short-selling debate cited Boni's paper, entitled 'Strategic Delivery Failures in US Equity Markets', as supporting their cause. "I see no reason whatsoever why the DTCC should not do as much as is in their power to open this up to as much sunlight as possible - everyone would benefit," says Boni. "They might need to protect anonymity, but it shouldn't be too hard to figure out some appropriate way to achieve transparency. I believe what people would find is that for many stocks, there simply isn't a problem."

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