Friday, June 9

Congress Should Investigate Short Selling Records

Congress is eager to investigate all sorts of things these days; Oil companies for gouging, ExxonMobil (XOM) for it’s high profits and the NSA for it’s efforts to catch terrorists.

At the end of the day, they most likely will find no illegal activity and the report investigating alleged gouging has already come out noting that no evidence of gouging was found. I suggest that if Congress is serious about investigating and finding criminal activity, then their chances are much better if they direct their activities to investigate the practice of short selling.

For the longest time a small minority have been on a crusade to get the Government to investigate short sale activity for potential abuses, namely the shorting of stock without actually borrowing the shares they are selling short. So far they have only received minor interest. Now however there are two new groups, one of them getting ready to take their own action; Theses groups are the corporation’s themselves (not just concerned about rampant over voting and the brokerage’s hedge fund clients, the very clients that do the short selling.

Yes, this is partly about naked short selling. But a recent article by Bloomberg titled “Corporate Voting Charade” documents yet another abuse created by short selling, namely “Naked voting.”

When you purchase stock you also obtain voting rights, normally one vote per share. Shareholders vote on the appointment of directors, vote on shareholder proposals, and vote whether to accept takeover offers as well as countless other issues.

When you purchase stock on margin, your broker has the right to borrow the stock from (under) you and loan it to a short seller. (A short seller sells stock he does not own, betting that he can buy it back later at a cheaper price.) When your stock is borrowed, you lose your voting rights as that right stays with the stock. In addition, you also lose any dividend the stock pays, and instead receive a ‘dividend in kind’ (a payment equal to what you would have received as a dividend but you receive the payment from the short-seller, not the company.) The difference matters because the in-kind dividend payment is taxed at a higher rate.

While brokerages appear to be real good at borrowing stocks, they don’t seem to bother to keep track of the votes, instead sending voting material to all who hold the stock in their accounts according to the Bloomberg article. This can lead to rampant voting fraud as each share can be borrowed multiple times, being held in multiple accounts, but it still is entitled to only one vote. So 100 shares borrowed twice might result in 300+ votes. The Bloomberg article claims that brokerages are doing this on purpose because they do not want their clients to know the negative consequences of having a margin account.

Wall Street securities firms such as Goldman Sachs Group Inc., Merrill Lynch & Co. and Morgan Stanley lend shares from a central pool, and the brokerages don’t attribute loans to the accounts of particular clients. While the small print in a typical brokerage contract says a customer’s voting rights may be affected if the firm loans out stock, most brokerage customers likely don’t even notice when short sellers borrow stock because their accounts typically list the same number of shares as before. “Everybody’s reaction when they find out about this is that they can’t believe it happens,” says Anne Faulk, chairwoman of Swingvote LLC in Atlanta, which manages proxy voting for institutional investors who may own stock in thousands of companies. – Bloomberg ‘Corporate Voting Charade’ (PDF)

I am pretty surprised that they would be so careless with voting rights. Then again, it’s not too surprising, since nobody has bothered to pay attention to this in the past, and only in recent years has short selling become popular and an available trading option to most investors. After all, this is just a small loose end and it really just costs them a little for the extra annual reports. Who were they really hurting anyway? Many small shareholders never even bother to vote. It will be interesting to see if this angle gets any traction. I would think that it would not be too hard for some lawyers to come up with a good lawsuit on behalf of the corporations whose elections have been handed fraudulent votes by the brokerage houses. This must be a crime in some way.

There is another group that is considering legal action, the hedge funds who were paying for borrowed shares that they were shorting, but now believe that the shares were not actually provided at the settlement date, turning their trades into ‘naked’ shorts.

New York - Get your hankies ready: Hedge funds feel they're the newest victims.

A long-simmering issue may soon come to a boil, potentially putting Wall Street's largest firms on the hook for billions more in liabilities years after the research scandal that extracted $1.4 billion in legal fines from ten of the most influential investment banks.

This time, prime brokers face scrutiny for the fees they charge hedge fund clients, with securities lending being a particular focus.

Attorneys at plaintiffs' firm Milberg, Weiss, Bershad & Schulmanare investigating securities lending fees and other practices by the biggest prime brokers and are considering bringing a class-action lawsuit on behalf of hedge funds. - Forbes

I find it somewhat amusing that the group most responsible for the short selling mess is now complaining that the industry practices stink. This also appears to be a tacit admission that naked shorting is a fact and not the fiction Wall Street has been claiming it to be.

Securities lending is among the most lucrative of prime brokerage services to the banks, reaping some $10 billion in annual fees, and the business just keeps growing as more hedge funds pop up. But it is also among the most opaque of businesses, with plenty of opportunity for abuse, lawyers unconnected with the Milberg firm say.

Hedge funds have alleged privately for years that they are being overcharged for prime brokerage services or charged wrongly for services that haven't been performed. Most of the griping has to do with securities loaned but never delivered, the allegation being that the prime brokers are lending securities at high fees without actually having possession of the securities to lend in the first place. - Forbes

This activity might be signaling the end of short selling as a way to make a quick buck. After all, if the hedge funds are going to deliberately bring attention upon themselves (it is the hedge funds that the brokerage houses are doing this for.)

There has also been action by the NASD, which has suspended a broker for naked short trading of his own personal account.

Washington, D.C.— NASD announced today that Steven W. Norin, a broker who is currently registered with Citigroup Global Markets Inc. of New York, has been suspended for 90 days and will pay $400,000 to settle charges that he engaged in a pattern of improper short sales in his personal accounts.

NASD found that from March 2003 through November 2004, Norin executed 100 short sales in 22 different securities and improperly marked them as "long." NASD found that Norin wanted to sell certain securities in his personal accounts short because he believed they were overpriced; when he discovered that there was no available inventory or borrowable stock, he improperly marked the orders long in the firm's order entry system to defeat the system's ability to prevent improper short sales. - NASD

Makes you wonder what kind of accounting the brokerages do considering that he was doing this for over a year. You would think that they would also look at whose trades were resulting in fail to deliver at settlement time. From the looks of it, his employer either did not know what he was up to or knew and did nothing about it. I wonder, which is worse?

Then we have Former Broker John F. Mangan, Jr. who has been barred for Naked shorting:

Washington, D.C. — NASD announced today that John F. Mangan, Jr., a hedge fund manager formerly registered as a broker with Friedman, Billings, Ramsey & Co. (FBR) of Arlington, VA, has been permanently barred from associating with any NASD-registered firm and will pay a $125,000 fine to settle charges that he deceptively obtained shares in a PIPE transaction, improperly sold the shares short, and shared in profits from the shares without obtaining permission from FBR. - NASD

Looking at the NASD site, there is also the following: (Click on the link to read the whole disciplinary action statement for each firm. PDF Format.)

Dynamex Trading, LLC - NASD determined that the firm failed to show the correct execution price on brokerage order memoranda. Moreover, NASD found that the firm’s supervisory system failed to provide for supervision reasonably designed to achieve compliance with applicable securities laws, regulations, and NASD rules concerning trade reporting—Automated Confirmation Transaction Service (ACT) compliance, sales transactions— reporting accurate short sale indicators, and books and records. - May 2006

Merrill Lynch, Pierce, Fenner & Smith, Incorporated - The findings also stated that the firm failed to report the correct symbol indicating whether the firm executed transactions in eligible securities as principal, riskless principal or agent, and failed to report the correct symbol to ACT indicating whether transactions in eligible securities were “buy,” “sell,” “sell short,” “sell short exempt,” or “cross.” - May 2006

Fulcrum Global Partners LLC – The findings also included that the firm effected
short sales in a listed security below the price at which the last sale thereof, regular way, was reported pursuant to an effective transaction reporting plan, and failed to provide written notification disclosing that the transaction was executed at an average price to its customer. - April 2006

Direct Access Brokerage Services, Inc. - NASD found that the firm executed short sale transactions and failed to report them to ACT with a short sale modifier. NASD also found that the firm executed transactions based on a prior reference point in time, and failed to report each of these transactions
to ACT with a prior reference point modifier. - March 2006

Smith, Moore & Co. - Without admitting or denying the allegations, the firm consented to the described sanctions and to the entry of findings that it failed to report its short-interest positions in various securities to NASD. The findings stated that the firm’s supervisory system did not provide for supervision reasonably designed to achieve compliance with respect to the applicable securities laws and regulations concerning short-interest reporting. - March 2006

Prashant Biraj Bhuyan (Registered Representative, New York, New York) submitted a Letter of Acceptance, Waiver and Consent in which he was censured, fined $5,000 and suspended from association with any NASD member in any capacity for six months. In light of Bhuyan’s financial status, the imposed fine is $5,000, and it must be paid before Bhuyan reassociates with any NASD member following the suspension, or before he requests relief from any statutory disqualification. Without admitting or denying the allegations, Bhuyan consented to the described sanctions and to the entry of findings that he executed short sale transactions in a security listed on a national securities exchange at or below the current inside bid when the current inside bid was below the preceding inside bid on the security. The findings also stated that Bhuyan executed short sale orders and failed to properly mark the order tickets for those orders as short. The findings also included that Bhuyan executed short sale orders in a security and, for each order, failed to make an affirmative determination that he would receive delivery of the security on the customer’s behalf or that he could borrow the security on the customer’s behalf for delivery by the settlement date. Bhuyan’s suspension began on March 6, 2006, and will conclude at the close of business on September 5, 2006. - March 2006

Wave Securities, LLC Without admitting or denying the allegations, the firm consented to the described sanctions and to the entry of findings that it did not make and annotate an affirmation determination prior to accepting customer short sale orders; it relied upon a document that did not meet the requirements that any hard to borrow list include securities that are restricted pursuant to Uniform Practice Code Rule 11830, and the creator of the list attest in writing that the NNM or listed security not on the list is easy to borrow or available for borrowing; and the firm did not limit its use of the list to NNM and listed securities. The findings stated that the firm incorrectly classified a hedge fund customer account as a broker-dealer account. NASD found that the firm accepted short sale orders from the hedge fund customer and failed to make/annotate an affirmative determination. In addition, NASD found that the firm’s supervisory system did not provide for supervision reasonably designed to achieve compliance with respect to marking customer order tickets, bid test, prompt receipt and delivery of securities and ACT reporting. - February 2006

Ryan & Company, LP and Scott William Ryan submitted an Offer of Settlement in which Ryan was barred from association with any NASD member firm in any capacity, and the firm was expelled from NASD membership. Without admitting or denying the allegations, they consented to the described sanctions and to the entry of findings that they engaged in a scheme to create and maintain short positions in Over-the-Counter (OTC) equity securities on behalf of the firm’s client hedge funds, in that they willfully and intentionally effected short sale transactions. The findings stated that the firm failed to report option positions to NASD, and failed to report transactions and reported incorrect information to the Automated Confirmation Transaction ServiceSM (ACTSM). In addition, NASD found that the firm reported non-bona fide wash sale transactions to ACT, and failed to provide for supervision reasonably designed to detect and prevent NASD rule violations.

Are there going to be more cases like this? I am pretty sure there will be. Time will tell.

A Review of Current Securities Issues - US Senate
Corporate Voting Charade (PDF Format, but an excellent read) Bloomberg Markets
Hedge Funds: Got Kleenex? - Forbes
The Stock Market is Patently Unfair - The Street
NASD Suspends Broker for 90 Days - NASD

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