- Editorial Commentary -

August 13, 2009 (FinancialWire) (By Peter Chepucavage) — With origin’s dating back even before 2003-2004, when Overstock.com (NASDAQ: OSTK) CEO Patrick Byrne and his fellow crusaders Judd Bagley, Mark Mitchell, and ‘Forbes’ writer Elizabeth Moyer began to speak out — and picking up steam in July, 2008, as SEC chairman Christopher Cox to invoked a one-month ban against naked short selling in 19 battered financial stocks, including Goldman Sachs (NYSE: GS), Morgan Stanley (NYSE: MS), Citigroup (NYSE: C), Lehman Brothers (OTC: LEHMQ.PK), Credit Suisse (NYSE: CS), Merrill Lynch (DOA, as in dead on arrival), Bank of America (NYSE: BAC), J.P. Morgan Chase (NYSE: JPM), Fannie Mae (NYSE: FNM), and Freddie Mac (NYSE: FRE) — the “naked short-selling” issue seems to perhaps be finally approaching some sort of climax. And, of course, much debate is arising as a result, as is evident in this recent commentary from Plexus Consulting General Council, and FinancialWire(tm) contributor, Peter Chepucavage:

We have noticed with frustration the Commission’s recent actions’ confirmation of a change from pre-trade regulation to post trade regulation of abusive short selling. It’s an affirmation of the wisdom of unsafe sex if it can be fixed later. The essence of our argument is found in a recent courageous Dow Jones article by Joe Checkler (http://compliancex.typepad.com/compliancex/2009/08/even-with-new-rules-naked-short-violations-hard-to-enforce.html).  These arguments were also reinforced by CEO Neiderhauer of the NYSE who recently stated:

“But even if we get that done, the second part of your question is the important part. What was really broken in this country was not the trading rules. It was the borrowing, lending and delivery rules. They were not being enforced. People were not borrowing stock and had no intention of borrowing stock when they shorted. And that was our big issue with the SEC in the previous administration. Enforce the rules.

“(The) settlement’s supposed to be T-plus-three in this country, not T-plus-100. And there were a lot more aged fails than people thought. So I think tightening up those rules has made a big difference and has dramatically reduced the amount of naked short selling.

“Lastly, the intraday activity we’re never going to be able to stop. You’re not going to be able to stop it. I’m not going to be able to stop it, even as the biggest exchange. If someone wants to short a stock in the morning and cover it in the afternoon, that’s called day-trading, I’m not sure there’s much we can do about that. So I don’t really think that’s naked short-selling the way the media talks about it. I think that was short-selling where the customer had no intention of borrowing and delivering that stock.”

We believe this interpretation of day trading is incorrect in light of the Ko Securities case specifically highlighted in fn. 55 of the Reg SHO adopting release, but Neiderhauer’s general point is valid. Short term abusive short selling has been given a no-action letter. If the trade can be settled its OK. We think this is wrong and note the destruction of Bear Stearns in one week. The commission has promised a roundtable on September 30th to address pre-borrowing and other remedies. However we do not believe such roundtables can be productive in the near term. We see no estimated date for the reinstitution of a tick test and can foresee how the current market surge could justify a decision by the Commission to declare victory and go home on this issue. The pre-trade and post trade analysis is historically instructive.

The tick test was a pre-trade remedy but was eliminated in favor of an allegedly aggressive Reg SHO with its strongest element the post trade threshold list with exceptions. Our current posture is that the post trade close out has cured all problems because settlement is insured. But that settlement occurs with another naked short which must be hard closed in another three days. If you don’t borrow the stock pre-trade you create the equivalent of a stock loan Ponzi/Madoff scheme. But because the initial trade settles the Gods are pleased. This is why a pre-borrow limits the amount of rollovers that can occur. No stock-no trade. But if you limit the trades than you limit the big dog: LIQUIDITY. Is it liquidity or is it leverage? Note how much nicer the former word sounds today? So what price are we willing to pay for liquidity? We are willing to pay the price of eliminating pre-trade restrictions and allowing unfettered leverage on both sides. Lenders providing 5 locates for each stock and short sellers calculating that the most that will happen with an abusive sale is a fine five years later. It’s the difference between certain religions emphasizing forgiveness while others emphasize prohibitions. Extremism in defense of liquidity is no vice while pre-trade limitations in favor of fair markets is no virtue. We see this regulatory change in other areas such as flash trades and derivatives regulation. Perhaps the logical extension of this thinking is to change the basis of self regulation to conduct inconsistent with just and equitable principles of liquidity?

Source: Courtesy of Investrend Weblogs (http://infoescrow.net/f/?u=http://www.investrendweblogs.net).

Peter J. Chepucavage is General Counsel to Plexus Consulting Group (http://infoescrow.net/f/?u=http://www.plexusconsulting.com/) and the head of its broker-dealer/hedge fund compliance and expert testimony sections. He has 30 years of experience in both the public and private sectors of the securities industry. He has worked for the National Association of Securities Dealers (NASD) and U.S. Securities and Exchange Commission (SEC), as well as a private law firm and a major international investment bank, and is familiar with all aspects of broker-dealer and hedge fund regulation, including broker dealer operations and stock loans. More about Chepucavage is available at his Investrend Weblogs profile (http://infoescrow.net/f/?u=http://www.investrendweblogs.net/pchepucavage-profile/).

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