Madoff Inc. complained about possible SEC naked short-selling restrictions
Mark Graffis
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."
Market makers are provided the naked short exemption for bona fide market
making activities and are provided these exemptions regardless of whether the
market is a declining or advancing market. Thus, the SEC has provided legal
grounds to deliberately depress the price of a security for leverage and
profits. Elimination of this law will only increase those investors with this
would-be legal trading strategy.
In fact, in response to the Commissions consideration to eliminating the
grandfather clause, market makers responded with concern stating "This
[eliminating grandfather clause] is going to have a serious impact on our
ability to make markets," Mark Madoff, co-director of trading at the
family-owned Bernard
L. Madoff Investment Securities.
Madoffs comments imply that market makers rely on the leverage gained by
naked short selling, and the delays in the settlement process that comes with
such trades, to turn profits and minimize risk. Providing further leverage
beyond settlement delivery by allowing the short selling (naked or otherwise)
to take place into a declining market and into a down tick will be a recipe
for disaster.
http://www.sec.gov/comments/s7-21-06/dpatch6879.pdf
January 12, 2007
Ms. Nancy M. Moms
Securities and Exchange Commission
100F Street, NE
Washington D. C., 20549-1090
Ms. Norris,
As a follow-up to my previous memo regarding this proposal to eliminate the
tick test/ price test, I would like to further emphasize the concerns the
public has with regards to the regulations of market making activities as they
pertain to this proposed and all other short sale regulations.
As now presented in several comment of the memos to the SEC, bear raids do in
fact exist in our markets despite the assertions by the panel of "experts" the
SEC created to evaluate this very rule change and despite the assertions of
certain members of the Commission staff. Because the bear raid exists as a
trading strategy of these markets, the SEC must keep every current tool in
their arsenal active to slow down abuses until such time as real reform is
considered and ultimately created.
Part of that arsenal, outdated as it is in todays trading environment, is the
tick test/price test rule open for comments to eliminate.
Present guidelines to these rule may not have stopped the bear raid
altogether, as illustrated in the prior examples provided, but it may be
slowing some of the events down. Some traders on Wall Street may actually
comply with the intent of the rule itself.
Some!
One of the reasons the tick test/price test restrictions have become outdated,
for example, is because the SEC created an exemption to market participants in
adhering to such sell side restrictions for the sake of adding market
liquidity into every market environment including a declining market. Exempt
from the tick test/price test restrictions are the market makers who can sell
into a downtick or sell short below the previous price claiming exemption
under bona fide market making activities.
"How much fraud are you willing to accept for Liquidity?" Commentary of former
SEC Commissioner William Donaldson in a 2004 speech to the Federal Reserve.
Last summer, during a Securities Traders Association Conference NASD Vice
President Tom Gira, voiced concern over a segment of market making activities
and firms. Gira stated, "Our concern is that people are registering as market
makers just to get the [short sale] exemption."
Gira further stated that the NASD is seeing market makers that quote normally
on the offer, but use "stub" quotes on the bid. A stub quote is referring to a
posted bid that is far outside of any recognizable market (i.e. a bid of $0.01
in a $100.00 stock). Market makers must make two-sided markets in their
stocks, but the size of their spreads is not regulated. "Because of the
removal of the excess spread rule," Gira said, "it is very easy to hide in the
weeds and not contribute much."
Gira concluded that a true market maker is not "somebody who goes in the box
and all they do is sell."
Today however, the SEC is not only looking to remove present short sale
restrictions that have the intent to reduce sell side abuses, archaic as they
may be, but the SEC is also failing to take appropriate steps to beef up the
exemption laws and enforcement activities against market members who are
executing their own style of a market raid using present day exemptions to do
so.
Question for the SEC: Has the SEC investigated whether short selling
operations (investors/funds) financed market makers to set up shop to
explicitly circumvent the short selling rules including the stock borrow and
tick test/price test restrictions?
In 2005 the NASD bared Scott Ryan and his market-making firm Ryan and Co. for
illegally shorting stocks on behalf of three hedge funds and using the market
making exemption to orchestrate these short sales. The hedge fund managers
later were later charged with trading on insider information and illegal
shorting.
Question for the SEC: Has the SEC investigated the manner in which these short
sales were executed, relative to the uptick/downtick and price test
restrictions to determine whether the market making exemption to these
guidelines aided in further investor damages?
While the NASD had taken these steps against Scott Ryan, many of his peers
continue to remain in these markets, as stated by Tom Gira, and using short
sale exemptions to manipulate securities.
The raid on any company that comes out with any type of potentially negative
negative news is clear and decisive. Rarely is there any opportunity for
investors to come out of a raid with any shred of investment left. During this
activity, market makers with clients are executing the orders on behalf of
their clients wishes but, other market makers without client orders will
likewise see the frenzy of selling and use their bona-fide exemptions provided
to "pile on" in the selling hoping to make quick profits.
It is what they do.
This "pile on" is the bear raid that was the concern when this law was
created. Theoretically, in a declining market a market maker should be on the
buy side and not the sell side since the liquidity in the market is sell side
liquidity and what is missing is the buy side liquidity necessary to maintain
order in the market. For this reason, market exemptions to market makers
should not be in place during a declining market as there is no bona-fide
liquidity necessary in a declining market.
Question for the SEC: Has the SEC carefully evaluated the market making
activities in a declining market to insure that the exemptions provided
relative to bona fide market making, including exemption to the present price
test and locate requirements are not being used to manipulate our markets on
behalf of the firm or a client using such a firms exemptions?
Of greatest concern in the elimination of this rule would be to those
companies the economic studies highlighted as having the greatest impact,
small less liquid business issuers, and thus those most likely to see the
greatest levels of market making activities.
As the SEC pointed out previously, this rule was created some 70 years ago to
address the concerns of a bear raid as seen during the crash of 1929. In these
past 70 years the rules may not have changed but the markets around such rules
have. Exceptions have been created that may in fact be aiding in the operating
mechanics of the very fraud the laws intended to thwart.
Short selling, as a strategy is good for the capital markets because the short
sale will provide for price controls where such controls would otherwise not
exist. Short selling will furthermore add liquidity to the markets that allow
for investor ease in moving in and out of a position.
But short selling into a declining market, where price restrictions are
eliminated and where market makers have been given free reign to sell with
impunity without restriction can only have negative impacts on the investing
public. Trading such of this has no transparency and is protected by the
regulators as it is identified as a "proprietary trading strategy".
Consider that in the original SHO proposal of 2003 the SEC clearly identified
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."
Market makers are provided the naked short exemption for bona fide market
making activities and are provided these exemptions regardless of whether the
market is a declining or advancing market. Thus, the SEC has provided legal
grounds to deliberately depress the price of a security for leverage and
profits. Elimination of this law will only increase those investors with this
would be legal trading strategy.
In fact, in response to the Commissions consideration to eliminating the
grandfather clause, market makers responded with concern stating "This
[eliminating grandfather clause] is going to have a serious impact on our
ability to make markets," Mark Madoff, co-director of trading at the
family-owned Bernard
L. Madoff Investment Securities.
Madoffs comments imply that market makers rely on the leverage gained by
naked short selling, and the delays in the settlement process that comes with
such trades, to turn profits and minimize risk. Providing further leverage
beyond settlement delivery by allowing the short selling (naked or otherwise)
to take place into a declining market and into a down tick will be a recipe
for disaster. What leverage is available today has just been increased at the
expense of the issuer and the long investor.
As the Commission considers all the positive and negatives of this proposed
reform, consider one last thing:
Wall Street is not stupid. The Commission clearly and publicly identified that
this pilot was to test what would happen should these restrictions be removed.
The Commission identified the issuers involved in the test and Wall Street was
fully aware that such issuers trading activities would be under a high level
of scrutiny.
Dont think for a moment that playing nice for the short haul of the pilot was
not considered such that longer term opportunities may not be obtained.
If you think Wall Street isnt smart enough to find ways around your laws in
order to violate the publics interests, seriously consider Giras commentary.
Investors are setting up shop as market makers to take advantage of the
exemptions regulators created.
Rules must be updated to account for present market condition not eliminated.
Dave Patch