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CFAW-GIC First Annual Investment and Regulatory Conference, September 23, 9am
Investment & Regulatory Conference
August 27, 2010First Annual CFAW-GIC Washington Investment and Regulation Conference September 23, 2010, 9:00am - 1:00pm
Location: Arnold & Porter, LLP
555 12th Street, NW
Washington, DC 20004Join CFA Society of Washington, DC and the Global Interdependence Center in this first annual conference focusing on financial regulatory reform and the forthcoming 2010 mid-term elections. GIC and CFAW, along with the CFA Institute, are partnering to hold the First Annual CFAW-GIC Washington Investment and Regulation Conference at the law offices of Arnold & Porter. The conference will precede the start of the 2010 Society Leaders Conference, which brings together CFA society leaders from around the world.9:00 -9:15am: Welcome and Introduction
Speaker:Roel C. Campos, Partner Cooley, Godward, Kronish, LLP and former Commissioner of the Securities and Exchange Commission9:15-10:30: Financial Regulatory Reform Panel Discussion- Jim Allen - Head of Capital Markets Policy, CFA Institute
- Alex Pollock-Resident Fellow, American Enterprise Institute
- James Angel, PhD - Professor, Georgetown University
- Matt Moran-Vice President Business Development, CBOE
- Carlotta King - Assistant General Counsel, Managed Funds Association
10:30 am - 11:45 am: How Will These Developments Affect the Investment Cycle? - Panel Discussion
- Michael Farr - President, Farr Miller, LLC
- Shawn Dubravac - Chief Economist, Consumer Electronics Association and current CFAW President
- Dave Resler- Chief Economist, Nomura Securities
- Peter Tanous-President & CEO, Lynx Investment Advisory
12:00 pm - 1:00 pm: Luncheon
Click Here to Register.
Keynote Speaker: Senator Ted Kaufman (D-DE)Back to Top
Future CFA Society of Washington Events- Annual Member Reception at the World Bank, Thursday, September 9
- Detecting Financial Shenanigans, Speaker: Dr. Howard M. Schilit, Wednesday, September 15
- Real Estate Outlook: A Light at the End of the Tunnel? Speaker: Peter Linneman, Thursday, October 14
- European Sovereign Debt: Risks and Opportunities, Speaker: Willy Kiekens, Tuesday, October 19
- Chasing Bernie Madoff: Due Diligence Lessons Re-Learned. Speaker: Harry Markopolos, Tuesday, November 2
- Bond Market Outlook and Recognition of New Charterholders Speaker: Dan Fuss, Wednesday, November 10
- 23rd Annual Fannie Mae Help the Homeless Walkathon, Saturday, November 20
Please visit www.cfawashington.org for registration and information regarding the events.
Cancellations must be made 72 hours in advance of the event for a full refund.
File no.4-605-Petition Request for rulemaking to exempt securities offerings up to $100,000 with $100 maximum per investor from registration
This petition proposal is worthy of serious consideration because of its simplicity and potential benefit. Many businesses can be started with a small sliver of equity. http://online.wsj.com/article/SB10001424052748703720504575376664285510930.html?mod=WSJ_hpp_RIGHTTopCarousel_1 .See http://www.sec.gov/rules/petitions/2010/petn4-605.pdf for rulemaking petition.
However it may be more useful to adopt a targeted offering registration in order to allow the states to also accept it. We can envision a short registration document that included a set of unaudited financials, a five page business plan and a list of officers and current owners that is filed with both the states and the SEC and reviewed by the SEC'S Small Business Office. While this may entail excessive SEC resources we think significant reliance on the states is appropriate. But the real benefit would be to bring into the open what is clearly already going on at even a higher level. A 10 page document with significant warnings about potential losses and lack of liquidity that is on file at the federal and state level would also provide needed information about this micro market. We expect that this would be a direct offering until the commission addresses the finder issue and provides some relief in that regard. providing finder relief in this context would be useful There is no doubt that unscrupulous individuals would abuse this process but we think that is happening already. We have noted before the need to raise capital in these difficult economic times and as the comments suggest this would be a useful methodology for the small business community. While we would also support the exemption requested we think the small documentation suggested is a more effective way to accomplish the goals intended. There is a need for a sense of proportionality in the small business capital raising function. We think as the authors do that a maximum loss of $100 per person allows for some flexibility in government regulation and with the filings and notice that regulation can come after the fact.
Those of us who have frequently attended the yearly small business forum can attest to the yearly frustration over the issue of finders and other small changes to the regulatory system. Promises are continually made and the following year a new staff member will reiterate the same promise. This independent proposal can be a focal point for encouraging the commission's attention to the need for small business flexibility and should be incorporated into a formal rulemaking procedure.
Peter J.Chepucavage
Executive Director,CFAW
General Counsel
Plexus Consulting LLC
1620 I St. N.W.
Washington,D.C.20006
202-785-8940 ex 108
www.plexusconsulting.com
www.iasbda.com
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DF Title IV - Accredited Investor Standard:
From: Peter Chepucavage
Sent: Wednesday, August 04, 2010 3:38 PM
To: '
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Subject: DF Title IV - Accredited Investor Standard:
The new standard excludes personal residences from the net worth test of an accredited investor. There has been some discussion in the media about the effect of mortgages on a personal residence and the corporate finance department stated as follows in CDI 179.01 and 255.47
The new CDI reads:
Question: Under Section 413(a) of the Dodd-Frank Act, the net worth standard for an accredited investor, as set forth in Securities Act Rules 215 and 501(a)(5), is adjusted to delete from the calculation of net worth the "value of the primary residence" of the investor. How should the "value of the primary residence" be determined for purposes of calculating an investor's net worth?
Answer: Section 413(a) of the Dodd-Frank Act does not define the term "value," nor does it address the treatment of mortgage and other indebtedness secured by the residence for purposes of the net worth calculation. As required by Section 413(a) of the Dodd-Frank Act, the Commission will issue amendments to its rules to conform them to the adjustment to the accredited investor net worth standard made by the Act.
However, Section 413(a) provides that the adjustment is effective upon enactment of the Act. When determining net worth for purposes of Securities Act Rules 215 and 501(a)(5), the value of the person's primary residence must be excluded. Pending implementation of the changes to the Commission's rules required by the Act, the related amount of indebtedness secured by the primary residence up to its fair market value may also be excluded. Indebtedness secured by the residence in excess of the value of the home should be considered a liability and deducted from the investor's net worth. [July 23, 2010]
This interpretation does not clarify indebtedness that may have been invested in another asset class and whether that must be excluded as part of net worth. An example would be a second trust taken out 5 years ago and invested in a vacation home that has appreciated in value. We suggest that the correct answer is that the second trust must be excluded from the value of the second home or whatever asset was purchased. But this may not be necessary under the CDI and legislation and may be difficult to calculate. The staff should provide clear guidance on whether such debt must always be offset since its not offset if spent other ways. In other words if you squander it there is no deduction under the CDI forthe related amount of indebtedness secured by the primary residence up to its fair market value . But if you invest it wisely there may be? Such a reading would seem to penalize the investor unfairly.
Peter J.Chepucavage
Executive Director,CFAW
General Counsel
Plexus Consulting LLC
1620 I St. N.W.
Washington,D.C.20006
202-785-8940 ex 108
www.plexusconsulting.com
www.iasbda.com
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File Number 4-606 study Regarding Brokers, Dealers and Investment Advisers
Peter J.Chepucavage
Executive Director,CFAW
General Counsel
Plexus Consulting LLC
1620 I St. N.W.
Washington,D.C.20006
202-785-8940 ex 108
www.plexusconsulting.com
www.iasbda.com
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-----Original Message-----
From: Peter Chepucavage
Sent: Tuesday, August 03, 2010 4:00 PM
To: '
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'
Cc: brad smith; brock; 'Frank. Mcauliffe (E-mail)
Subject: File Number 4-606 study Regarding Brokers, Dealers and Investment Advisers
We respectfully suggest that the issue here is not the standard of care but the standard of disclosure to retail customers as to what financial services they are receiving. The Commission has tried to solve this issue in the past only to be rebuffed by the courts but it now has full authority to do so in a simple way. Customers need to understand whether they are purchasing executions or advice. They need to understand whether its a one night stand or a relationship. They do not understand that now. We believe that three simple principles could clarify and solve the problem. The commission should:
1) make very clear that unsolicited transactions especially internet trades are not subject to either suitability of fiduciary duty.
2) insist that using the word adviser /advisor requires a fiduciary duty
3) insist that customers acknowledge that a trade is unsolicited and that they are not getting financial advice for a special fee or else the fiduciary duty requirement applies and the seller must register as an investment adviser. Additional disclosures that might be useful would include "we don't pay you for margin account stock loans and we may facilitate short sales in stocks we heavily recommend." Those actions should also raise serious questions under the fiduciary standard for advisers affiliated with brokers..
Retail customers today especially those facing near term retirement have the most discretionary wealth for investment. But their decisions are also the most consequential as they face a significant shortfall in retirement and complex healthcare decisions along with declining or stagnant real estate investments. Issues like reverse mortgages and annuities are more complex then the financial decisions of their parents. This may suggest that the rules in this regard be different for individuals over 50 years of age.
But most importantly the Commission should try to simplify the message that customers receive when they engage a broker or adviser. We think most customers want a relationship but may not want to pay for it, just as most psychiatric patients need therapy but drugs are cheaper and less time consuming for the therapist. Brokerage execution is cheaper than brokerage advice but too many customers do not understand the difference and too many brokers do not explain it. Our point is that these customers and brokers do not care about the standard but instead the service. The customer may need broker time and the broker needs executions. Of course many large brokers are shipping the less than $100,000 asset customers to call centers where these explanations are surely more limited.
We believe that most members of the financial services industry are honorable but are also stretched by certain regulatory policies intended to reduce costs but which must of necessity reduce services. See the Grant Thornton study in this area.
www.GrantThornton.com/IPO <http://www.GrantThornton.com/IPO>. In this regard we do not believe there are many suitability or fiduciary cases out there but the Commission should disclose them in this rulemaking. A comparison of these cases to the recently announced subprime crisis settlements against big firms would be instructive. The number of cases in relation to the reduction in execution costs/broker profits is asubject especially worthy of study and especially sensitive to small bd's and advisers. The time honored phrase comes to mind;" you get what you pay for". Customers must therefore understand that if you want an adviser to study your entire financial situation including your nursing home future you must pay for it.
Having said this we also note that discretionary accounts at brokers should not be subject to adviser registration for the same reason-customers paying only commissions are not paying for advice and this service should be available as long as its adequately disclosed. Some customers like this concept and they should be allowed to use it as long as they are told that the only thing the broker does is to manage a certain amount of money and not do the financial analysis done by an IA..We suspect that the staff will learn nothing new with this study but that intense pressure will be applied to avoid the disclosures listed above. One alternative way to view this problem is to allow the customer to choose where he wants to be with enforced disclosure. Today its too often the broker who forces the customer into the bd regime when the customer may want to be in the IA regime and may think he is. The goal of the study and the rulemaking should be that every customer makes a conscious choice of who his financial doctor will be.
Finally the Commission must not overlook the pricing pressures it has imposed on small bd's and advisers while asking them to adopt a fiduciary standard. Cheap executions and intense regulation do not equal comprehensive financial counseling. It reminds of the famous Viet Nam phrase -"we had to destroy the village in order to save it." This issue is rarely if ever addressed in discussions about the appropriate standard. Competition is necessary unless we want all middle class investors directed toward a call center. The Commission should therefore be prudent in imposing standards on small brokers and advisers fighting to survive and consider the need for a vibrant small firm financial services community. See the intense debate for the small member seats on Finra's board of governors. http://www.investmentnews.com/article/20100730/FREE/100739987/-1/INDaily01.
Investment News has also reported extensively on the declining number of small brokers. http://www.investmentnews.com/article/20100627/REG/306279981. Small brokers and advisers are vital to the serious financial advice needed by those facing retirement.They should not be disadvantaged by a blanket desire to make everyone a fiduciary.If a customer wants a fiduciary he has to pay for that service and understand the difference.
Peter J.Chepucavage
Executive Director,CFAW
General Counsel
Plexus Consulting LLC
1620 I St. N.W.
Washington,D.C.20006
202-785-8940 ex 108
www.plexusconsulting.com
www.iasbda.com
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Limiting the Paul Anka Finder's Exemption.
The Division of Trading and Markets issued the following finder letter to Brumberg, Mackey & Wall, P.L.C. May 17, 2010 and unfortunately in our view again chose not to clarify its previous positions in this area. The letter focuses on the representation that non-securities lawyers would refer interested clients to an issuer but would not engage in a sales effort. The staff noted that the introduction of only those persons who had an interest in investing implies pre-screening and pre-selling. As noted below Anka was allowed because he had a reasonable belief in their accredited investor status but no personal contact with the investors. This would appear to distinguish Anka on personal contact but there is no reference to Anka in the request or denial. Based upon other statements by the staff we think they have concluded that transaction based compensation alone requires bd registration and they should say that directly.See especially fn 3 of the recent letter.We respect the position but do not understand why it cannot be clarified. A personal contact would appear to be as little as a country club discussion where the finder says to an affluent friend "I gave your name to someone with a good investment idea". Putting aside the difficulty in enforcing such a subjective test, the small business capital raising function should not depend on the continuing lack of clear and precise guidelines. Small business should not have to hire lawyers to read through 30 years of letters as they struggle to survive.We note that ironically the officers and directors of the issuer are free to make this approach but not free to pay for a referral. The staff should follow the recommendation of the SEC's Small Business Forum and ABA Task Force with regard to private placement brokers. 'http://sec.gov/info/smallbus/gbfor28.pdf page 15.This same recommendation has been made at the Forum every year in one form or another over the last 10 years.The no act letter is at
http://sec.gov/divisions/marketreg/mr-noaction/2010/brumbergmackey051710.pdf Cf. Paul Anka, 1991 Fed. Sec. L. Rep. (CCH) P79,797 (avail. July 24, 1991): A 1.8 percent shareholder entered into an agreement with a Canadian hockey team to provide the Canadian team with the names of prospective purchasers of its limited partnership units. Each prospective purchaser would be a person that the shareholder reasonably believes to be an accredited person as that term is used in Regulation D. In reliance on Rule 3a4-1, directors, officers, or employees of the hockey team then could approach potential investors
Anka agreed to furnish the Senators with the names and telephone numbers of persons in the United States and Canada whom he believed might be interested in purchasing the limited partnership units. Anka would neither personally contact these persons nor make any recommendations to them regarding investments in the Senators. It is noteworthy that in Mr. Anka's original proposal letter to the SEC he would have made the initial contact with prospective investors, but the SEC would not issue a no-action letter under those facts. In exchange for his services, Anka would be paid a finder's fee equal to 10 percent of any sales traceable to his efforts. Important factors identified in theAnka letter include:
- He would not advise on valuation
- He had never been a broker-dealer or registered representative of a broker-dealer.
§ Mr. Anka had a bona fide, pre-existing business or personal relationship with these prospective investors.
§ He reasonably believed those investors to be accredited.
§ He would not advertise, endorse or solicit investors.
§ He would have no personal contact with prospective investors.
§ Only officers and directors of the Senators would contact the potential investors.
§ Compensation paid to the Senators' officers and directors would comply with 1934 Act Rule 3a4-1 (governing compensation to issuer's agents).
§ He would not provide financing for any investors.
§ He would not perform due diligence on the Senators' offering.
See http://www.sec.gov/litigation/admin/2009/34-60149.pdf for the Commission's recent but infrequent enforcement of this issue where it also failed to clarify/distinguish the Anka fact pattern.
.
Peter J.Chepucavage
Executive Director,CFAW
General Counsel
Plexus Consulting LLC
1620 I St. N.W.
Washington,D.C.20006
202-785-8940 ex 108
www.plexusconsulting.com
www.iasbda.com
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Shining a light on the naked short seller - Washington Times
http://www.washingtontimes.com/news/2010/jun/18/shining-a-light-on-the-naked-short-seller/
The attached discussion highlights and updates the current debate regarding abusive short selling by noting 3 remedies all of which Wall Street has opposed.The alternative tick test,the pre-borrow and more real time disclosure.But countries around the world are acting to prohibit abusive short selling while the financial press without fail refers to these actions as anti-short selling.There can be only two explanations for this;either the press does not understand or they want to deliberately conflate the two.We also do not believe the press recognizes that the whole world is concerned about this issue because you rarely see actions by other countries described in a positive light.The recent German action against naked short selling was described as if it were something radically beyond what is already illegal in the U.S.But the Germans simply added a pre-borrow. We don't see the Germans as radical regulators and we believe that like many issues,the U.S. can and should choose the best of world wide regulatory efforts.
JOHNSON: Shining a light on the naked short seller
It appears that U.S. political will for financial reform will fall short of requiring that short sellers first pre-borrow the stocks they sell short. Despite our own fears of banning so-called naked short selling, Germany banned the practice in May in some of its financial stocks. Germany is considering whether to extend the ban to all stocks, and other EU exchanges are eyeing similar initiatives.
True to form, many leading U.S. financial publications have railed against this approach to ending naked short-selling abuses, labeling it a "ban" on all short selling. Unfortunately, their efforts and those of Wall Street's lobbyists seem to be succeeding: U.S. politicians and regulators give no sign they are considering these sensible measures being adopted in the European Union. That's regrettable.
To be clear, while a ban on naked short selling is a good idea, a ban on legitimate short selling is not. Legitimate short selling - in which a short seller sells a share he has borrowed or at least located to borrow - is a critical component of efficient price discovery in the stock market. To ban legitimate short selling would be like banning left turns for cars. But naked short selling - in which a short seller sells a share he does not own, has not borrowed or even located to borrow - is something quite different. Because of the nature of the trade-settlement system in the U.S., current rules allow prime brokers and large institutional traders to sell stock short without first borrowing it.
A pre-borrow requirement in the United States would put an end to naked-short-selling abuses in the U.S. as it has in Germany with respect to the covered stocks. Absent a pre-borrow requirement, naked short selling no doubt will continue to plague American markets, as we saw in the dislocations of 2008 and as recently as the one-day minicrash on May 6.
Even with rule changes implemented by the Securities and Exchange Commission (SEC) in the fall of 2008, as recently as April the average net fails-to-deliver per day at the stock clearinghouse were 400 million shares - with a daily worth of $1.5 billion. Many of these fails are the result of naked short sales, and contrary to popular belief, they are not all in penny stocks or foreign stocks. While Russell 3000 stocks are 5 percent of the daily fail volume in the United States, they account for 20 percent of the value of these fails. Similarly, exchange-traded funds, or ETFs, account for roughly 5 percent of the volume of fails, but they are more than 50 percent of the average daily fails value.
Unfortunately, the SEC's 2008 rule changes cannot prevent a resumption of the huge and destructive fail-to-deliver volumes reached in the summer of 2008. On one day in July 2008, fails-to-deliver exceeded 2.2 trillion shares. These problems will persist and compound until naked short selling is eliminated from our markets through a pre-borrow requirement.
That said, if the political will only allows for something less than pre-borrow, then let's at least do something meaningful. One alternative under discussion deserves every consideration regulators and Congress can muster. I refer to the real-time reporting of short and long volume without disclosing the identity of the long or short seller.
Currently, U.S. exchanges report trading activity in real time but do not disclose whether trades are short or long. Real-time disclosure of actual short and long sales would allow investors and analysts to incorporate meaningful data into market- and security-specific analyses. Such disclosure also would add considerable support to the SEC's proposal to have a consolidated audit trail for all trades. Furthermore, public and instantaneous trade transparency would help legitimate short sellers and other Wall Street institutions dispel doubts about short selling. A real-time disclosure proposal also has the general support of many of the exchanges and the Financial Industry Regulatory Authority.
Finally, this real-time disclosure alternative is cheap, easy and efficient. Traders are already required to mark trade tickets short or long, so the technology is in place that would allow trades to be reported as "short," "market maker short," "buy" or "buy-to-cover" in real time through the Consolidated Tape electronic data system. Moreover, this subtle change wouldn't require a new regulatory apparatus. If the SEC (or Congress) amended the Regulation National Market System, this new disclosure rule could be implemented tomorrow.
When regulation fails (or when a lobby is too powerful), sometimes sunshine is the best disinfectant. It's time to open the windows on Wall Street and let in the sunshine.
Jonathan E. Johnson III is the president of Overstock.com.
© Copyright 2010 The Washington Times, LLC. Click here for reprint permission.
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Real Time Marking and Reporting of Short Sales
We believe the enclosed proposal has great merit and ask that you support it by letter to the Chairman's office if you agree. We would also be interested in knowing what the downside if any would be. While progress has been made in abusive short selling we think this proposal is a winner for all. Thank you for your support.
June 14, 2010
The Honorable Mary L. Schapiro
Chairman
Securities and Exchange Commission
100 F Street, NE
Washington, DC 20549-1090
Dear Chairman Schapiro,
While the SEC recently enacted a modified version of the so-called “uptick rule,” I believe that the SEC should do more to protect investors and issuers from abusive market manipulation. I am particularly concerned about naked short selling and large and persistent fail-to-deliver positions which continue to harm issuers, investors and market integrity. When you directed an SEC working group to study how to improve the audit trail of short sale executions, you recognized that the revised uptick rule by itself is not enough. As you noted, improving the audit trail would establish the expedient tracking of short sale executions to origination.
I urge the SEC to adopt rules that require the exchanges and all trading platforms to report total short and long volume through the Consolidated Tape in real time as a simple and inexpensive means to promote needed transparency in the markets.
This simple requirement would help the SEC to regulate by bringing sunlight to a dark area. As you know, aggregate volume is already reported in real time. Prompt reporting of aggregate long and short trading volume by security will accomplish the following:
· Congress, the SEC and other regulators will be able to monitor, assess, and respond to market events and discourage manipulative trading.
· Investors and analysts will better understand stock activity and stock prices.
· Issuers will be able to reply with more certainty to questions about the nature of trading in their stock.
· Wall Street firms and hedge funds will be able to use this short volume data to dispel any inaccurate myths regarding short sellers and short sales.
· Academics will have more complete and timely data with which to analyze market microstructure.
Importantly, this requirement would not reveal or compromise individual traders’ positions and strategies.
This request can be accomplished without new legislation through the SEC’s existing authority by amending SEC Regulation NMS to require that all trades printed to the Tape be marked “short”, “market maker short”, “buy” or “buy-to-cover.” It is critical that this requirement apply to trades on all exchanges.
The cost to implement real time reporting on the Tape is minimal because currently SEC Regulation SHO requires that all trades be reported short/long, so this information is already collected by the exchanges at time of execution. As Michael Gitlin of T. Rowe Price told the SEC short selling roundtable last year:
The real time tagging and display of short sale executions on the consolidated Tape would provide market participants with a more in-depth understanding of trading activities in any given security on any given day. By marking short sale executions as short on the consolidated Tape, we are creating an equal and fair marketplace whereby long sales would necessarily be recognized as having been sold long . . . We believe the benefits of the Consolidated Tape reporting for short sales outweigh any additional costs.
Given the severity of the economic crisis that resulted from the emergence and manipulation of exotic and opaque trading practices, there should not be serious objections to more transparency and information for investors, issuers, regulators, Congress and academics. Options activity, both puts and calls, is already disclosed to the market at the time of trade. Retail trades (short/long) are known to brokerage firms at time of execution. Real time tagging and disclosure of short and long sales by ticker would level the playing field for all investors. Additionally, short and long sale disclosure by ticker is less onerous than short sale disclosure by firm (or client), a rule the SEC is currently weighing.
While some argue that opponents of abusive short selling wish to treat short selling differently than long buying, that is not my purpose. In fact, it is just the opposite. I advocate short reporting be done the same as long reporting. The SEC should require full transparency for both, especially in volatile or crash markets. The recent flash crash is troubling not only because of its size, but more importantly because neither regulators nor investors understand it. The possibility that short selling could have played a part in the flash crash requires the full and real-time transparency for which I am advocating.
Issuers who were severely impacted should know the dynamics of long and short selling. Investors should know whether large amounts of aggressive short selling are legitimate or abusive. The disclosure I am advocating would allow the private sector to join with the regulators in their enforcement efforts. It may also allow private sector issuers to alert the SEC to unusual patterns, including naked short selling coupled with rumor mongering. Those closest to a stock may be able to spot subtle trading pattern differences and inform regulators and/or initiate civil action. The Wall Street Journal reported on June 4th at page C1 the testimony of certain veteran traders at the recent SEC roundtable on high speed trading:
“Some fast-moving computer-driven investment firms are getting an edge by trading on market data before it gets to other investors, according to market players and researchers who have studied the trading. The firms gain that advantage by buying data from stock exchanges and feeding it into supercomputers that calculate stock prices a fraction of a second before most other investors see the numbers. That lets these traders shave pennies per share from trades, which when multiplied by thousands of trades can earn the firms big profits.” See also <
Some of these veteran traders went so far as to test and prove their theories by various bait and trap initiatives with counter parties. Clearly, the private sector can be helpful when it has information about suspicious trading patterns.
I therefore ask the SEC to initiate promptly a rulemaking proceeding to require real time reporting by the exchanges and all trading platforms of short and long sales through the Consolidated Tape.
Thank you for your consideration and your continuing efforts to address abusive short selling.
Sincerely,
Peter J.Chepucavage
Executive Director,CFAW
General Counsel
Plexus Consulting LLC
1620 I St. N.W.
Washington,D.C.20006
202-785-8940 ex 108
www.plexusconsulting.com
www.iasbda.com
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short selling and the plunge= unlimited fear
We have argued for some time that current short selling rules would be ineffective in a crisis and last week we seem to have had one. Much selling occurred very rapidly and we question whether the locate rule was the first priority for those involved in the high speed selling. Yet the reaction seems extraordinary to us when viewed in the context of past arguments that short selling should no more be limited than long selling. In other words if last week's spike was upward rather than downward would the SEC have scheduled today's meeting or the House subcommittee scheduled tomorrow's hearings. Indeed we had a huge upward spike at today's open and everyone was fine. We submit that downward plunges in today's environment are viewed very differently than they have been. A few months ago the Commission split on the application of a circuit breaker test for the imposition of an alternative tick test. But today the Chair of the Commission released the following statement;
"This morning, SEC Chairman Mary Schapiro had a constructive meeting with the leaders of six exchanges - the New York Stock Exchange, NASDAQ, BATS, Direct Edge, ISE and CBOE - and the Financial Industry Regulatory Authority to discuss the causes of Thursday's market events, the potential contributing factors, and possible market reforms."As a first step, the parties agreed on a structural framework, to be refined over the next day, for strengthening circuit breakers and handling erroneous trades."
Senator Kaufman has warned for many months that high speed trading was an unknown and dangerous new element in our system and the plunge seems to have confirmed his fears. But circuit breakers can only postpone the actions of aggressive high speed short sellers who balance immediate profits against monetary fines imposed years later. We argue again that a pre-borrow or hard borrow is a better limitation tool than circuit breakers that produce temporary relief but huge uncertainty. It would therefore be important for the Commission and Congress to find out how much of the plunge was short selling and how much of that was without the required locate. We understand that the first response from many will be there is no evidence that short selling caused the plunge and our response would be lets find out how much occurred and then determine impact. A fundamental premise about naked short selling is that it can flood the market with extra shares at a time when the market may be sensitive to other downside worries.It is in other words unlimited. We submit the Commission and Congress owe the investing public the assurance that abusive short selling was not a factor and that transparency of high speed trading is very important.This assurance is especially important because some are already suggesting a manipulation http://www.aim.org/aim-column/manipulation-not-error-behind-market-plunge/ George Soros has made the point that unlimted short selling should not be allowed in either the stock or bond market and the plunge may also confirm his reasoning because of the natural human fear that it had no limits.In the debate between risk and uncertainty this is clearly uncertainty:
Up until the crash of 2008, the prevailing view -- called the efficient market hypothesis -- was that the prices of financial instruments accurately reflect all the available information (i.e. the underlying reality). But this is not true. Financial markets don't deal with the current reality, but with the future -- a matter of anticipation, not knowledge. Thus, we must understand financial markets through a new paradigm which recognizes that they always provide a biased view of the future, and that the distortion of prices in financial markets may affect the underlying reality that those prices are supposed to reflect. (I call this feedback mechanism "reflexivity.")
The first step is to acknowledge that being long and selling short in the stock market has an asymmetric risk/reward profile. Losing on a long position reduces one's risk exposure, while losing on a short position increases it. As a result, one can be more patient being long and wrong than being short and wrong. This asymmetry discourages short-selling.
The second step is to recognize that the CDS market offers a convenient way of shorting bonds, but the risk/reward asymmetry works in the opposite way. Going short on bonds by buying a CDS contract carries limited risk but almost unlimited profit potential. By contrast, selling CDS offers limited profits but practically unlimited risks. This asymmetry encourages speculating on the short side, which in turn exerts a downward pressure on the underlying bonds. The negative effect is reinforced by the fact that CDS are tradable and therefore tend to be priced as warrants, which can be sold at anytime, not as options, which would require an actual default to be cashed in. People buy them not because they expect an eventual default, but because they expect the CDS to appreciate in response to adverse developments.AIG thought it was selling insurance on bonds, and as such, they considered CDS outrageously overpriced. In fact, it was selling bear-market warrants and it severely underestimated the risk.
The third step is to recognize reflexivity, which means that the mispricing of financial instruments can affect the fundamentals that market prices are supposed to reflect. Nowhere is this phenomenon more pronounced than in the case of financial institutions, whose ability to do business is so dependent on trust. A decline in their share and bond prices can increase their financing costs. That means that bear raids on financial institutions can be self-validating.
Taking these three considerations together, it's clear that AIG, Bear Stearns, Lehman Brothers and others were destroyed by bear raids in which the shorting of stocks and buying CDS mutually amplified and reinforced each other. The unlimited shorting of stocks was made possible by the abolition of the uptick rule, which would have hindered bear raids by allowing short selling only when prices were rising. The unlimited shorting of bonds was facilitated by the CDS market. The two made a lethal combination. And AIG failed to understand this. http://www.georgesoros.com/articles-essays/entry/one_way_to_stop_bear_raids/
Peter J.Chepucavage
Executive Director,CFAW
General Counsel
Plexus Consulting LLC
1620 I St. N.W.
Washington,D.C.20006
202-785-8940 ex 108
www.plexusconsulting.com
www.iasbda.com
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Plexus quoted on recent hard close case.
NYSE Imposes First ?Hard Close? Penalty?On Goldman
May 5, 2010
John Hintze
Goldman was fined $450,000 for multiple infractions of the rule. Rule 204T requires self-clearing broker-dealers facing stock delivery failures in long or short sales to either purchase or borrow the same quantity and type of security by the start of the first trading day after settlement, which occurs three days after the transaction (T+4).
"This was the result of a manual processing error following the change in Rule 204T close-out requirements in October 2008," Goldman Sachs said, in response to an inquiry from Securities Industry News. "There was no financial impact on our clients. We now have improved, automated processes in place to avoid future errors."
Violations of the rule place the clearing firm and its customer in the ?penalty box,? requiring them to pre-borrow the security in order to continue shorting it.
The SEC adopted Rule 204T two days after Lehman Brothers filed for bankruptcy, and the stock prices of especially financial stocks were plummeting. Almost immediately after, the New York Stock Exchange?s and Nasdaq?s ?threshold? lists rapidly shrank. Those lists are of stocks that have experienced delivery failures exceeding 0.5 percent of an issue?s total shares outstanding.
NYSE?s threshold list fell from about 100 securities in August 2008 to three by Dec. 1, while Nasdaq?s fell from 300 to 30 or so in the same time period. (See SIN, Dec. 10, 2008)
The quick reduction in stock delivery failures occurred because clearing firms tightened up their policies pertaining to securities lending, which enables broker-dealers to borrow securities to support customers? short sales.
Goldman?s violations, however, suggest clearing firms? efforts were far from perfect.
Goldman?s first cited violation, in which it failed to close out positions in 22 securities because it had purchased too few shares in those securities, occurred Dec. 9, 2008. The second incident occurred
over the 16 days after Jan. 6, 2009. It involved similar failures to close out transactions as well accepting 385 short sales without pre-borrowing the securities, even though Goldman and its customer were in the penalty box for those securities.
The NYSE Regulation hearing board attributed both violations to clerical-type errors. A NYSE spokesman said the ?penalty is appropriate to the violations.?
Nevertheless, the hearing board states in the description of its action that Goldman had committed similar violations to Regulation SHO in 2006. It was fined $350,000 and consented to a censure.
Peter Chepucavage, general counsel at Plexus Consulting Group and a former SEC attorney who worked on the development of Reg SHO, notes that whether the errors where clerical or not, Goldman continued to take orders while it was in the penalty box, presumably because it was making money on those transactions.
?And yet NYSE Regulation makes no attempt to identify whether profits were made? much less incorporate that information into the penalty, he says, adding, ?Sometimes it?s to a firm?s advantage not to pursue a hard close,? in which the transaction is closed out by T+4.
Chepucavage said the penalty suggests the hard close rule may not be the full answer to the issue of securities delivery failures, and that regulators ?still believe a short-sale violation can be bought off without mentioning profits, by imposing a fine that looks big to normal human beings but is nothing for a big Wall Street firm.?
He added that such fines are ultimately paid by the firm?s shareholders, and more appropriately should be paid from the bonus pools of brokerage firms? executives.
Short Selling Disclosure-The SEC now emphasizes it.
The big case involving CDS's on CDO's is subject to many interpretations but we have not seen anyone note that the facilitation of short sales by big banks without disclosure has been going on for a long time with the acquiescence of the SEC and its continued repetition of the important role short sellers play. This case involves the equivalent of naked short selling through the equivalent of puts on synthetic securities. It should be compared to its famous Chicago sister Magnetar which was different because it involves married puts- buy the CDO equity and the swaps.
The players in big case just bought the swaps with the SEC alleging in section G of the complaint that the one disclosed important sponsor was led to believe that equity was also purchased by shortie.How material that was to the purchasers is a unique question and we have yet to see the presence of a legal opinion that blessed it. .We read that Bear's lawyers passed on this one and we doubt that any lawyer would give anything but a reasoned opinion on it.
"What sort of ethics and compliance program can you enforce to prevent that? This isn’t a rhetorical question; at least some companies succeed at it sometimes, because P approached Bear Stearns with his mortgage-shorting scheme, too, and Bear Stearns took a pass on it <http://blogs.wsj.com/deals/2010/04/16/before-the-goldman-sec-suit-there-was-the-greatest-trade-ever/>. P’s mammoth bet against the housing sector is detailed in the book The Greatest Trade Ever <http://www.amazon.com/Greatest-Trade-Ever-Behind-Scenes/dp/0385529910>, which quotes senior Bear executive Scott Eichel pretty clearly: P’s proposal “didn't’t pass the ethics standards; it was a reputation issue, and it didn’t pass our moral compass.”
http://www.complianceweek.com/blog/kelly/2010/04/18/goldman-analysis-lessons-for-ccos/
But we ask how really different is this lack of disclosure from the following;
- Its become well accepted that big firms will short their own account for the products they are selling to investors.
- Its become well accepted that short sellers can naked short and then talk a stock down without disclosure for at least 3 days.
- Its become well accepted that big firms borrow margin securities to lend to short sellers without disclosure to their customers that they are conspiring against themselves.
- Its become well accepted that PIPES investors can short their investments without disclosure.
- Its become well accepted that secondary purchasers can hedge their purchase as long as they don't cover with their purchase without disclosure.
- Its become well accepted that large short sellers do not need to identify themselves to the investing public.
In short, no pun intended, disclosure of big firm facilitation of shorts was off the radar screen for a long time. Big case suddenly demands that fairly sophisticated buyers had to know that a rascal was involved in setting up a short opportunity without any long position like sister Magnetar.But this is the environment that was accepted by the continued blessing of the short sellers as important in providing liquidity. Perhaps you can think about how that reasoning looks with big case. We think the SEC complaint is well reasoned but a juror may ask why this theory has just arrived. As a skeptical commenter notes;
Moreover, is there anything illegal or improper about any company considering a request to offer a securities product based upon the request or urging of a third party? Absent more, the answer is "no," and, frankly, it's a fairly common occurrence. Third parties often approach Wall Street investment bankers with proposals to make money. Present investment banking clients or desired ones wield much influence when pitching deals to Wall Street. It's hard to even imagine a deal where the public isn't being sold something that may have many fathers -- of which none is disclosed. Indeed, there are many bastard children of Wall Street. Did big case have a legal obligation to disclose shortie's exact "role" in the portfolio selection process or the hedge fund's adverse economic interests? Ahh...now we have the crux of this landmark case.
http://www.brokeandbroker.com/index.php?a=blog&id=373
Our view therefore is that shortie needs a lot more disclosure in both the equity and fixed income markets and if its so valuable why is disclosure fought so hard. Director Khuzami is to be applauded for big case but the long history of regulator praise of short selling may haunt his valiant efforts. The commission should use this case to study whether the investing public truly understands how short sales are facilitated and the money made in doing so.
Peter J.Chepucavage
Executive Director,CFAW
General Counsel
Plexus Consulting LLC
1620 I St. N.W.
Washington,D.C.20006
202-785-8940 ex 108
www.plexusconsulting.com
www.iasbda.com
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IDD Story Plexus Quoted.
Can Huge Fines and Scolding Curb Risk?
IDD Magazine
April 9, 2010
What's it going to take to avoid another Lehman Brothers-type fiasco?
It may be as simple as increasing fines to such a degree that they have more bite and publicly chiding an investment bank and its managers, one senior risk-management executive at a Wall Street firm told IDD.
That executive - who has worked in the financial services industry for 30 years and spoke on the condition of anonymity - said that fines leveled at investment banks have not deterred bad behavior because they have been minuscule compared to the large profits earned by such firms. In short, he said, they are considered the "cost of doing business."
"The fines need to be significant to have any real impact," this seasoned risk manager said.
He cited the Securities and Exchange Commission's $150 million settlement with Bank of America Merrill Lynch in February as a perfect example of a fine that may have extra sting.
B of A has $2.4 trillion in assets. The company lost $194 million in the fourth quarter, but it earned $6.3 billion last year.
According to specialists who focus on regulatory matters, fines leveled at banks are generally less than $1 million.
Hefty fines and increased public scrutiny of what brought them about could ding a firm's reputation, and that is something that has become more important amid the credit crisis, according to this risk management specialist.
Investment banks firms have been criticized by politicians and the general media in the wake of the credit crisis, and that onslaught has led some to warn that reputational risk could impact their bottom line.
A case in point: Goldman Sachs highlighted reputation risk in February as an important issue within risk management.
In its 2009 annual report, Goldman said legal liability or significant regulatory action against the firm could cause "significant reputational harm to or adversely impact the morale and performance of employees, which in turn could seriously harm our businesses and results of operations."
According to the Wall Street investment banker, "most firms classify reputational risk right up there with their market risk and credit risk they are taking [on]." When it comes to fines, he said, they "shine a bright light on certain issues" within the firm.
Interestingly, the Street executive said that hefty fines will not completely take away the taste for risk. "Can it [halt banks from] getting involved in riskier asset classes? I don't think so," he said. William Burck, a partner at Weil Gotshal & Manges LLP and ex-deputy counsel to former President George W. Bush, agreed that the singed reputation that comes with a large fine may be one way to regulate Wall Street banks and their managers.
"There is nothing more important than reputational risk for regulating risky behavior by financial institutions," Burck said. "Protecting their brands is essential to maintaining their reputation for integrity and their access to the right customers and markets, so it's vital that they maintain their reputation."
Echoing the concerns brought up by Goldman, Burck warned that a firm with a tainted reputation could face a run on both customers and talented employees.
"Folks that work in financial services really do not want to be associated with entities that fail because of fraud or allegations of fraud. If your institution's reputation is ruined or besmirched in some way, you run the risk of employees making a rush for the exit door," Burck said.
Not everyone believes that larger fines are an effective way to manage Wall Street investment firms and their managers.
Often, the fines handed down to banks have hardly approached the value of losses incurred by the financial institution when something goes wrong, said Peter Chepucavage, a consultant with Plexus Consulting Group, a Washington firm that has advised financial services companies on regulatory matters.
"There is a long history of the SEC broadcasting serious action and in the end there's a monetary fine against a huge investment bank that is meaningless. That money is being taken away from the bottom line," said Chepucavage, a former attorney fellow at the SEC from 2001 to 2005. He said executives of institutions that are fined do not actually have to pay the fine out of their pockets, and it is the shareholders who are left to pay the tab.
"This whole area of regulatory sanctions is bewildering to most people," Chepucavage said.
That sense of bewilderment cropped up when B of A and the SEC reached a settlement that has the Charlotte banking behemoth paying a $150 million settlement; the fine was tied to the payout of bonuses to Merrill Lynch employees.
The judge overseeing the case, Jed Rakoff, wrote in his Feb. 4 opinion that individuals who failed to disclose details about the bonuses were not actually paying the fine and said the settlement was likely to have a very "modest" impact on corporate practices. He characterized it as "half-baked justice at best."
A more meaningful way to limit risky behavior, Chepucavage suggested, would be to have managers of investment banks pay the fines out of their own pockets. "If you want to have an effective remedy imposed you would say that the fine would have come out of the senior [executives] bonus pool," he said.
"This communication is intended solely for the addressee and is confidential and not for third party unauthorized distribution"
SEC Let Politics Spur Short-Sale Decision, Sirri Says (Update1)
Subject: FW: SEC Let Politics Spur Short-Sale Decision, Sirri Says (Update1)We find it unusual to see a former division director criticizing a rule as political which he was responsible for proposing.This is especially true in light of the fact that the commission has still not told us whether the investigations into the demise of Bear and Lehman evidenced any abusive short selling.The interview notes as follows:
When the SEC asked large brokers for "a name or trade we can go on" to track down allegedly abusive short sales in the fall of 2008, no information was provided, Sirri said.
"I'm not saying it didn't happen, but there was nothing actionable that came back," he said.
That statement clearly suggests that nothing abusive was found -but the commission has yet to say that and their silence now allows former senior staff to speak for them while criticizing their judgment as political.This cloud over the rulemaking process needs to be addressed quickly.The commission should declare those investigations regarding abusive short selling concluded if nothing actionable has been found.If they are ongoing then clarification is needed.Finally we ask where is the evidence that investor confidence will not be improved and note the following;
New short sale curb will help investors: Nasdaq
The Securities and Exchange Commission rule is scheduled to go into effect in November, more than two years after the height of the financial crisis and plummeting markets prompted cries for more curbs on short sales.
"We generally support what the SEC has put forward," Nasdaq Chief Financial Officer Adena Friedman said on Wednesday at the Reuters Global Exchanges and Trading Summit in New York.
"I think that having a very clear short sale rule will help boost investor confidence," she said.
http://www.businessweek.com/news/2010-03-30/sec-let-politics-drive-decision-on-short-sale-curbs-sirri-says.html
SEC Let Politics Spur Short-Sale Decision, Sirri Says (Update1)
March 30, 2010, 2:19 PM EDT
(Adds comment from Security Traders Association in 16th paragraph.)
By Nina Mehta
March 30 (Bloomberg) -- The U.S. Securities and Exchange Commission's decision to restrict short selling was a political decision rather than one based on evidence, according to a former agency official who says it may set a precedent for future decisions.
Commissioners who voted for curbs when a given stock falls 10 percent from the prior day's closing price did so without proof that it would improve markets, said Erik Sirri, who ran the SEC's division of trading and markets during the credit crisis that began in 2007.
The agency temporarily banned short sales on more than 900 financial stocks in September 2008. The Standard & Poor's 500 Index went on to plunge more than 40 percent through March 2009. The SEC reintroduced limits on the practice last month that will be implemented later this year. The proposal followed more than 4,400 comment letters, most asking for restrictions on short selling, and Morgan Stanley Chairman John Mack blaming bearish bets for driving his company's stock down in 2008.
"The SEC is going to have to decide how political it's going to be," Sirri, who ran the trading and markets unit from August 2006 until April 2009 as an appointee of Republican President George W. Bush, said at a conference yesterday. "It's not exactly the case that short sellers were wrong" to bet against banks in 2008, he added. "Short sellers were making those prices more efficient. They were right."
Best Performance
Short sellers, who borrow stock and sell it on hopes of capturing a profit by replacing the shares after prices fall, had the most success among hedge funds in 2008, gaining 28 percent on average, according to Chicago-based Hedge Fund Research Inc. The S&P 500's 38 percent decline that year was the biggest drop since 1937. Only 24 companies in the index rose.
Sirri said the "political character" of this round of short-selling regulation is "atypical" even though the commissioners are political appointees. He spoke yesterday at a Capital Markets Consortium conference in New York. The agency's short-sale rulemaking will alter "how people are going to approach the commission in the future," he added.
SEC spokesman John Heine declined to comment.
The SEC is "concerned that excessive downward price pressure on individual securities, accompanied by the fear of unconstrained short selling, can destabilize our markets and undermine investor confidence in our markets," SEC Chairman Mary Schapiro said on Feb. 24.
Not Enough Data
The SEC pursued short-selling curbs without the sort of data it relied on in the past, according to Henry Hu, director of the SEC's division of risk, strategy, and financial innovation.
"Right now there isn't enough data out there that would allow this type of quantification" about investor confidence, said Hu, speaking on Feb. 24 at the commission's meeting to rule on short sales. "Inevitably there's a judgment call involved."
The commission approved the new rule because, it said, investors who own stock should be able to exit positions before short sellers, which would alleviate rapid downward pressure and give investor confidence a boost. The two Republican commissioners, Kathleen Casey and Troy Paredes, voted against the rule. The two Democrats and one Independent voted for it.
Investor confidence is a new justification for policymaking at the SEC, Sirri said. He also questioned the agency's attitude toward giving "priority" to owners of stock at the expense of those betting against the same companies.
Supreme Court
"The Supreme Court is also politically influenced, but that doesn't mean their rulings are inappropriate," said Howard Ward, fund manager at Gabelli & Co. in Rye, New York, which oversees $26 billion. "The bottom line is that we need to have additional regulation regarding short sales. If the process is less than ideal, that's the way it is."
He added about the new rules: "If anything I don't think they're strong enough. We need to focus on restoring integrity to the markets."
The Securities Industry and Financial Markets Association, which represent 600 broker-dealers, banks and asset managers, told the SEC "no empirical evidence has been produced" to question the commission's previous elimination of short-sale restrictions. The Investment Company Institute, whose members include mutual funds and other asset managers, said in September it did not support new short-selling restrictions. Both organizations are based in Washington.
'Questionable Rationale'
The Security Traders Association, a trade group based in Darien, Connecticut, told the SEC yesterday that its decision on short sales was "based on inadequate analysis, a lack of empirical data, and questionable rationale." The organization added, "We are concerned that this could become a rulemaking standard."
The commission had removed all limits on short sales in 2007 after several studies established that the markets were not likely to be negatively affected. Sirri, the top markets regulator at the time, had been chief economist at the SEC in the late 1990s under Democratic President Bill Clinton and is currently a finance professor at Harvard Business School and on leave from Babson College in Babson Park, Massachusetts, where he has taught since 1995.
Commissioners are appointed by the U.S. President and approved by Congress. No more than three of the five can be from the same political party, which usually means the president's political party holds a 3-2 majority in the group.
When the SEC asked large brokers for "a name or trade we can go on" to track down allegedly abusive short sales in the fall of 2008, no information was provided, Sirri said.
"I'm not saying it didn't happen, but there was nothing actionable that came back," he said.
--With assistance from Lynn Thomasson in New York. Editors: Joanna Ossinger, Nick Baker
To contact the reporter on this story: Nina Mehta in New York at This e-mail address is being protected from spam bots, you need JavaScript enabled to view it .
To contact the editor responsible for this story: Nick Baker at This e-mail address is being protected from spam bots, you need JavaScript enabled to view it .
The value of such "liquidity" has been vastly oversold
We have argued for some time that liquidity was not as important an argument against regulation as has been suggested by the regulated. Roger Lowenstein hits that point forcefully and eloquently in yesterday's Times.
The Way We Live Now
Who Needs Wall Street?
Mike Mayo is a veteran of six Wall Street banks. In the wake of the street’s disaster, he found refuge at a boutique brokerage and has lately taken to startling his peers with the question “What part of Goldman Sachs <http://topics.nytimes.com/top/news/business/companies/goldman_sachs_group_inc/index.html?inline=nyt-org> is good for the country?” Regular people will be tempted to answer, “None of it,” but the question reminds us that, at least in theory, Wall Street serves society (not the other way around). And as opposed to Harrah’s <http://topics.nytimes.com/top/news/business/companies/harrahs_entertainment_inc/index.html?inline=nyt-org>, Trump Casino and their ilk, Wall Street is endorsed and regulated - with marked restraint - so as to let it perform an important task.
Because some people have savings and others need capital, some unifying force must bring the two together. Royalty once taxed its citizens and chartered corporations. Wall Street privatized this function, aggregating the savings of disparate individuals through the sale of stocks and bonds. Industry thus gained access to capital; what’s more, public markets performed a miracle of equivalence. Quotations on the stock exchange effectively calibrated, down to the penny, how many hours’ worth of wages would afford a share of General Motors <http://topics.nytimes.com/top/news/business/companies/general_motors_corporation/index.html?inline=nyt-org>.
Since the street stood at the intersection of capital and savings - or, if you will, of insiders and Main Street - the potential for conflict was rife. No firm better resisted the temptations than Goldman, which, from its founding in 1869 through recent decades, epitomized, with only rare slip-ups, the best of American finance. Serving the client was its lodestar, and its bankers were pillars of society, more conversant in literature than in the vagaries of, say, mortgage securities.
Wall Street’s emphasis began to change in the ’90s, as financiers devised new securities - the more incomprehensible, or so it seemed, the better. These instruments, in the main, did not involve selling bonds so that a DuPont <http://topics.nytimes.com/top/news/business/companies/du_pont_de_nemours_and_company_e_i/index.html?inline=nyt-org> could build new factories; they were rearrangements - new permutations, new alignments of risk - on flows of cash that already existed. Most famous was the trading that stemmed from complex derivatives <http://topics.nytimes.com/top/reference/timestopics/subjects/d/derivatives/index.html?inline=nyt-classifier> (like mortgages) with only a remote connection to the underlying product. For all the trading in mortgage-backed securities, homeownership increased only a trivial amount.
The benefit to Wall Street was far more direct. The point of these and many other new financial instruments was to charge a hefty fee and to furiously trade them, and no one was in a better position to do that than their Wall Street creators.
If trading was, for society, a zero-sum game (someone wins, someone loses), it was, for the street, a gold mine. Greater emphasis on trading affected a subtle change in the culture, in particular at Goldman. In 1999, it sold shares to the public, diluting its long-term ethos. Its traders, formerly restrained by bankers, clamored for more of the firm’s capital.
In 2006, when Lloyd Blankfein <http://topics.nytimes.com/top/reference/timestopics/people/b/lloyd_c_blankfein/index.html?inline=nyt-per>, a onetime gold salesman, assumed command, the coup was complete. But it did not become so stingingly clear until this year, when Blankfein was induced to bare his soul before the Financial Crisis Inquiry Commission <http://topics.nytimes.com/top/reference/timestopics/organizations/f/financial_crisis_inquiry_commission/index.html?inline=nyt-org>.
Asked about mortgage securities that Goldman both sold to clients and bet against, Blankfein, while expressing regret for what he admitted was improper behavior, added: “In our market-making function, we are a principal. We represent the other side of what people want to do.” He went on to say that when Goldman sells a security that subsequently goes up (i.e., on which the other party makes money), “we wish we hadn’t sold it.” So much for putting the customer first.
For much of Wall Street, capital-raising is now a sideshow. At Goldman, trading and investing for the firm’s account produced 76 percent of revenue last year. Investment banking, which raises capital for productive enterprise, accounted for a mere 11 percent. Other than that, it could have been a hedge fund.
Brokers recite, endlessly, that trading is vital because, without it, there wouldn’t be a way for shareholders to exit, thus investors would fear to commit capital in the first place. Within limits, this is true. Thus, at modest levels, the willingness of traders to buy and sell from the rest of us gooses confidence.
But the value of such “liquidity” has been vastly oversold. The notion that ever more trading makes for successively better markets is one of Wall Street’s great myths. People think liquidity will keep markets stable, but the crisis of 2008 says otherwise. In a crisis, liquidity disappears.
Modern markets are more likely afflicted with too much trading. Think of oil and its dizzying fluctuations. As the volume from speculators and momentum traders dwarfs that of long-term investors, prices gyrate further from fundamental value. Raising capital thus becomes, to paraphrase John Maynard Keynes <http://topics.nytimes.com/top/reference/timestopics/people/k/john_maynard_keynes/index.html?inline=nyt-per>, the byproduct of a casino.
The casino charge is most plausibly leveled at credit-default swaps <http://topics.nytimes.com/top/reference/timestopics/subjects/c/credit_default_swaps/index.html?inline=nyt-classifier>, the bête noire of A.I.G. <http://topics.nytimes.com/top/news/business/companies/american_international_group/index.html?inline=nyt-org>, Greece and others. Such swaps let traders bet on the odds of default (of a corporate or, indeed, a sovereign bond). If swaps traded in Las Vegas - if bets against, say, Goldman’s bonds swamped the casino, causing Goldman’s lenders to refuse it credit - an uproar would ensue. This actually happened to banks in 2008.
The social utility of credit-default swaps is ostensibly the insurance function. (Fear that a bond will default? Buy a swap that pays out in the event.) But most traders do not own the bond, and they have nothing to “insure.” Like the fellow who takes a policy on his neighbor’s house, they are simply betting on disaster.
Swaps are used by banks as a hedge against risky loans, but the effect is problematic. The danger of hypertrading is that it affords an illusion of a continuously available exit; investors feel less need to scrutinize their assets. So it is with bankers. If every loan can be traded away, why worry about risk? Thanks to swaps, banks write more suspect loans and, over all, society is more exposed. At least in an actual casino, the damage is contained to gamblers. The street’s undertow is more serious. Following the debacle, the economy lost eight million jobs.
The question is whether the social balance would improve if Wall Street were less devoted to games of chance. In the 1970s, James Tobin, a future Nobel laureate, proposed a transfer tax to throw “sand in the gears” of currency markets. Tobin feared that too much trading could destabilize currencies (he has often been proved right).
The idea of a transfer tax, on financial trading generally, has resurfaced. European leaders, like Gordon Brown <http://topics.nytimes.com/top/reference/timestopics/people/b/gordon_brown/index.html?inline=nyt-per> in England, are in favor. Timothy Geithner <http://topics.nytimes.com/top/reference/timestopics/people/g/timothy_f_geithner/index.html?inline=nyt-per>, the U.S. Treasury <http://topics.nytimes.com/top/reference/timestopics/organizations/t/treasury_department/index.html?inline=nyt-org> secretary, has resisted the idea. The ideal of a frictionless market is so instinctual that we have lost sight of the peril that comes with speed. Maybe it’s time to slow the markets down.
Roger Lowenstein, an outside director of the Sequoia Fund, is a contributing writer for the magazine. His book “The End of Wall Street” will be published next month
Peter J.Chepucavage
Executive Director,CFAW
General Counsel
Plexus Consulting LLC
1620 I St. N.W.
Washington,D.C.20006
202-785-8940 ex 108
www.plexusconsulting.com
www.iasbda.com
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Lehman and Sarbox.
We have long argued that SARBOX should not be applied to small firms and have suggested that it may not be working with the big firms.When we raised the issue with a congressional staffer in the fall, in connection with Lehman, we were told that Lehman involved underwriting excesses.The following analysis confirms our concern that something is missing and this is another issue the financial press can't seem to find. Yes this is a type of pre-emptive law that we said last week was justifiable but not necessarily justified for all size issuers. Professor Peterson's analysis of what society will allow is on point and the doctrine of proportionality comes to mind.
The Valukas Report on Lehman Brothers: Sarbanes/Oxley's Credibility Takes a Dive March 14, 2010
A host of hard questions lurk within all nine volumes and 2200 pages of the report by Lehman Brothers examiner Anton Valukas, released on March 11 (here <http://lehmanreport.jenner.com/>) - which finds in its executive summary (here <http://lehmanreport.jenner.com/VOLUME%201.pdf>) that the company “painted a misleading picture of its financial condition.”
One of them, directed at anyone still harboring the belief that the Sarbanes/Oxley law of 2002 has had a beneficial effect on corporate governance and financial reporting: “Ready to change your mind?”
A lengthy list of potential defendants are teed up as targets for “colorable claims,” for actionable balance sheet manipulations using accounting techniques described in internal e-mails as having no substance, but serving only the purpose of reductions in Lehman’s balance sheet.Along with the apologists among the advocates of Sarbox’s efficacy, they will be heard to argue that its aspirations did not extend to the likes of Lehman’s financial machinations - a perspective begging this further question:
How can a regulatory program of the scope of Sarbox be justified, for the cost and complexity it inflicted on public companies and their gatekeepers -- most of whom would have been legitimately law-abiding even if left entirely alone -- while failing to identify, deter and capture the truly outstanding global-scale malefactors?
More simply put, if Sarbox didn’t have an impact on Dick Fuld and Lehman, what possible good has it wrought?
I’ve been in retreat this last week, reading the final papers of my MBA students in Risk Management - a bright and engaged group writing on recent case studies in the failures of risk modeling, assessment, comprehension and regulation.
Their examples cover the three years from the collapse of the Bear Stearns real estate funds, down to Toyota’s recent spiraling loss of both quality control and reputational stature. Even ahead of the Valukas report, it’s a target-rich environment, constantly replenished by the steady supply of newly-displayed examples of human venality, folly and frailty.
Among our course goals is the search for effective regulatory tools by which to shape improved policy-making and enforcement - a particularly challenging proposition, given the manifest inability of bureaucrats and elected officials to escape their inbred limitations of vision and effectiveness.
Depending on the importance of the issues at hand, how much enforcement should be imposed, and at what cost?
Choices can be as coercive and heavy-handed as a polity will support and enforce. Taken to extremes, for example, teenage drunken driving could be eliminated: all that would be required is to raise the age of licensing to 25, and to impose automatic, non-negotiable twenty-year prison sentences on first-time violators.
Unthinkable, of course. Society is no more prepared for such draconian steps than it is to impose capital punishment on balance sheet manipulators or insider traders or even Ponzi schemers.
At the looser end of the enforcement spectrum, behavioral norms can be largely left to society’s level of tolerance for its own inconvenience. New Yorkers collectively agreed years ago, for example, that recreational marijuana was deemed to be de facto legitimate, thereby literally changing the atmosphere of Central Park. Likewise, no amount of patrolling will affect the dog-minding habits of Parisians, until they decide to alter the customs of a lifetime.
In the same way, the hindsight revelation of the Valukas report is that the inability of Sarbox to reach global-scale problems shows the futility of legislation so politically anodyne that it passed the US Senate by a vote of 96-0.
The problem is one of closing the gap, between the level of deviance that society will stand and the amount of burden that it will pay for.
That is, a program of airport security will lack credibility, if so broadly applied as to deprive ordinary citizens of their ability to carry a bottle of wine or a tube of toothpaste, but that fails to identify terrorists whose deadly threat is limited only by their inept inability to detonate their shoes or their underwear.
Sarbanes/Oxley suffers the same defect: if it could not detect and deter an “outlier” on the scale of Lehman, then what beneficial effect can its proponents claim it has accomplished, by imposing an intrusive system of box-ticking on the vast bulk of corporate registrants?
As laid out in Richard Thaler and Cass Sunstein’s 2008 book, “Nudge,” which outlines such minimally-intrusive approaches as automatic enrolment options in voter registration, organ donation and retirement savings plans, the challenge to long-term incentives - whether in personal diets or corporate financial disclosure - is the compelling immediacy of short-term rewards.
Which means it should be no surprise either that the rewards for the purveyors of subprime mortgages and exotic securities were dissociated from the risks of later implosion, or that compensation for executive leadership should be tied to measures based on the latest quarterly results.
Or, depressingly, that the time frame for political reaction to pressing public issues is no longer than the calendar for the next election.
Thanks for joining this dialog. Please share with friends and colleagues. And if not a subscriber, please sign on at the Home <http://www.jamesrpeterson.com> page.
Peter J.Chepucavage
Executive Director,CFAW
General Counsel
Plexus Consulting LLC
1620 I St. N.W.
Washington,D.C.20006
202-785-8940 ex 108
www.plexusconsulting.com
www.iasbda.com
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Pre emptive vs reactive regulation
Pre-emptive Regulation vs. Reactive Regulation of Abusive Short Selling
The recent dissents in the alternative tick test rule have in our mind raised a false premise about short sale regulation or any regulation for that matter. That premise is there must be a proven reason as opposed to a serious threat in order to regulate. In other words we must only react to risks and not pre-empt them. <http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aM_qIt_gPClY>
It must be remembered that the original tick test was not specifically aimed at abusive short selling but all short selling. It was and is well recognized by the SEC staff that some rules are pre-emptive because some violations are difficult and time consuming to pursue after the fact. Short sale manipulation is the prime example. On the pre-emptive side the net capital rule is a good example, which if applied to credit-default swaps (CDS) would have been very effective. But it’s a broker-dealer (bd) rule and the guiding premise of the 90’s was to get everything you could out of the bd and that’s where CDS’s exploded.
We note the statements of Commissioner Aguilar at the open meeting that CDS’s had to be regulated to provide a comprehensive solution to the short selling problem. Pre-emptive regulation of that product would have been helpful. But even with the clear evidence that they were a problem, the same voices against short sale pre-emptive regulation argue against reactive CDS regulation. Moreover the financial press has been totally MIA on these issues because they have been captured by free market canards that suggest that every regulation must be preceded by a disaster to justify it
When Reg. SHO was created it was hoped that the rule would substitute for the old tick test by applying vigorous enforcement /reactive regulation instead of a pre-emptive tick regulation. It did not work and the Commission had to make many adjustments. While we strongly preferred the pre-borrow or hard locate alternatives, we recognized that in a terrorist or financial crisis the alternative tick will have some value, not as much but some. We think that’s important but there is a legitimate cost/benefit debate. That debate is very different than whether its provable that short selling caused the market decline of 09. Putting aside the beliefs of the CEO’S of the major investment banks and the various work done by Matsumoto and Taibbi and Shapiro, we ask what is this proof? Is there a certain proportion of trading that must be short to prove that it drives the market? Would that trading include puts? Must it measure the entire market or can the last week of Bear Stearns suffice? Could Lehman’s demise from short sellers have created a subsequent long selling panic? See Taibbi’s analysis of Bear and Lehman.
http://www.rollingstone.com/politics/story/30481512/wall_streets_naked_swindle
The question of absolute statistical proof is best considered in the case of national defense. Did the U.S, have absolute proof of WMD’S before its invasion of Iraq? Did the commanders of Pearl Harbor escape responsibility because it had never been attacked before? The answer is obvious, when there is the potential for devastation; reasonable regulators should act pre-emptively, but should do so in the most efficient and economic manner possible.
We have witnessed a year of financial terror because regulators failed to act pre-emptively and the former employees of Bear and Lehman would appreciate the difference. So when you see this conservative canard trotted out, think about all those planes lined up at Pearl because the commanders did not have the statistical analysis on the odds of a Japanese attack. The alternative tick is not the best or most efficient solution but there will come a time it proves its worth. While we are waiting it would be useful for all the commissioners to tell us whether there were any short sale abuses in the fall of Lehman and Bear. That would be a compelling argument in the great debate and has taken too long to resolve. We do not know whether their ongoing investigations spawned this proposal so we cannot credibly determine whether there was abuse. But we can trust the three commissioners to make a good faith judgment that a potential for disaster looms.
.
Peter J.Chepucavage
Executive Director,CFAW
General Counsel
Plexus Consulting LLC
1620 I St. N.W.
Washington,D.C.20006
202-785-8940 ex 108
www.plexusconsulting.com
www.iasbda.com
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CFAW ANNUAL DINNER Dinner with Bob Pozen, Author of "Too Big To Save?"
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CFA Society of Washington, D.C. | 1620 Eye Street, NW | Suite 210 | Washington | DC | 20006 |
SEC ADOPTS ALTERNATIVE TICK RULE 3-2
PLEXUS CONSULTING
We attended the open meeting today where the commission adopted a rule that imposes an alternative tick test when a stock drops 10% from its close. The tick is then in place for the remainder of the trading day and the following day. The idea emphasized was that when that occurs it will only be longs selling because shorts must pay more. We know this is true only if there is vigorous enforcement and we hope the release will warn about counter parties agreeing to sell above the bid with a kick back to the purchaser. Experience shows that determined counter parties can agree on a price no matter what the market is doing. The release is 330 pages with 90 pages of cost/benefit anlysis.It was stated that only about 1.3% of stocks ever drop 10%. But we think lots of stocks will drop that much in a terrorist attack yet there was no discussion of that possibility. Most interesting was the dissent's emphasis on the concept of investor confidence .They suggested that there is no evidence of how short selling restrictions affect such confidence-no evidence except the 4300 letters and 5000 signature petition. We would have made the argument that without comments on a hard borrow or pre-borrow this step is the equivalent of a non alcoholic beer, all form and no substance except in a serious crisis. The investor confidence argument suggests that writing comment letters is a waste of time as the dissenting commissioners know better. The DTM director and head of risk respectfully pointed out that they might mean something. This rule will not become effective until year end . The dissent also projected significant compliance costs and that is probably the better argument given the small number of affected stocks. The following statement by two senators is a good analysis of the work done today;
FOR RELEASE: Feb. 24, 2010
CONTACT: Amy Dudley (Kaufman), 202-224-5042
Sheridan Watson (Saxon), 202-224-7777
Kaufman, Isakson Say SEC Action a “Step Forward” But Fails to Solve Naked Short Selling Concerns
Delaware, Georgia Senators dismayed SEC never sought comments on “hard locate” requirement
WASHINGTON, D.C. - Senators Ted Kaufman (D-DE) and Johnny Isakson (R-GA) released the following statement after the Securities and Exchange Commission voted 3-2 Wednesday to require short sellers - if a company’s shares fall 10 percent in one day - to exceed the prevailing “bid” for the remainder of the trading day and the following day in short sales of that security.
“We are encouraged that three of the Commissioners finally took some action to protect investors from manipulative short selling. This circuit-breaker/bid test rule is a step forward. But in our view it will be of limited use, helping only in the worst-case scenarios that could occur during a terrorist attack or financial crisis. The uptick rule worked for 70 years as a systemic check on predatory bear raids; this approach will not provide investors with the same protections as an ‘always-on’ bid test. “Moreover, the real problem is that the SEC does not have an enforceable rule to punish those who undertake market manipulation through abusive naked short selling and rumor-mongering. To this point, the SEC has not yet brought a single enforcement case in the 2008 naked short selling incidents that helped take down Bear Stearns and Lehman Brothers. Today’s new rule does not address that glaring problem. “We are also dismayed that the Commission has never sought comments on a ‘hard locate’ requirement for short sellers, even after eight senators pointedly made this suggestion last July and seven senators have co-sponsored a bill calling for this. The Commission still failed to seek comments even after the SEC acknowledged in a September roundtable that the naked short selling rule did indeed pose enforcement difficulties. What would have been the downside to proposing a firm requirement that before stocks can be sold short, the short-seller must have a legally enforceable right - and obligation - to deliver the stock at the time of settlement? Just by proposing that type of rule, the Commission would have been in a position today to adopt a pre-trade hard-locate requirement, or a circuit-breaker approach combined with a hard-locate requirement, instead of a bid test, for example. “Unfortunately, in our view, the partial action taken by the Commission today will not provide investors with the same protections as the uptick rule, nor does it address the enforcement issues surrounding the current naked short selling rule.”BACKGROUND: - On March 16, Sens. Kaufman, Isakson and Jon Tester (D-MT) introduced a bill (S.605) that calls for the following: “Not later than 60 days after the date of enactment of this Act, the Commission shall issue regulations prohibiting any person from selling securities short, unless that person demonstrates, at the time of the sale, that such person possesses, at the time of the sale, a demonstrable, legally enforceable right to deliver the securities at the required delivery date.” Co-sponsors: Sens. Robert Bennett (R-UT), Saxby Chambliss (R-GA), Orrin Hatch (R-UT), Arlen Specter (D-PA).- In a June 24 letter to SEC Chair Mary Schapiro, Sens. Kaufman, Isakson, Jon Tester (D-MT) and Rep. Carolyn Maloney (D-NY) wrote, “Focusing on the uptick rule alone, however, puts too narrow a frame on the problems associated with naked short selling. The problem at its root may be that the current rules against naked short selling are both inadequate and impossible to enforce.”
- In a July 22 letter to Schapiro, Sens. Kaufman and Isakson and five other senators suggested a pilot program as proposed by the Depository Trust & Clearing Corporation (DTCC) to prohibit short sales that do not first acquire a “hard locate.” Sens. Kaufman, Isakson, Carl Levin (D-MI), Jon Tester (D-MT), Sherrod Brown (D-OH), Orrin Hatch (R-UT) and Robert Menendez (D-NJ) wrote: “This centralized ‘hard locate’ system seems to offer a viable way to eliminate ‘over selling’ of stock inventories, in that there would no longer be multiple locates on the same shares of a security. … The DTCC proposal could standardize requirements across the industry, can be configured in a way that will not disrupt markets, would streamline locate documentation requirements, and can be overseen directly by the SEC to ensure regulatory compliance.” Sen. Arlen Specter (D-PA) later wrote to say he concurred in that letter.###
Peter J.Chepucavage
Executive Director,CFAW
General Counsel
Plexus Consulting LLC
1620 I St. N.W.
Washington,D.C.20006
202-785-8940 ex 108
www.plexusconsulting.com
www.iasbda.com
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The useless U-5
We encourage the reading of this excellent analysis of the U-5 which in our view is a relic of the past.We have always believed the following;
- It should never be used for performance related issues.
- It should never be public until a regulator has made a finding of violation.
- It should never reduce complicated employment issues to a word or phrase.
- The employer should provide the facts to the regulator without making any judgments and the employee should respond to those facts. The regulator should make the judgment.
Regulatory Notice 09-69-Payments to Unregistered Persons
From: Peter Chepucavage
Sent: Monday, February 01, 2010 8:12 AM
To: This e-mail address is being protected from spam bots, you need JavaScript enabled to view it
Subject: Regulatory Notice 09-69-Payments to Unregistered Persons
The International Association of Small Broker-Dealers and Advisers www.iasbda.com submits the following comment on one general aspect of this proposal.For the last 30 years the SEC and FINRA have been dealing with the general question of finders. See ABA report on this subject included below.Each year at the SEC'S Small Business forum it is one of the chief recommendations to help small business.This year's draft recommendation is as follows;
1. Promote the Commission's twin missions of enhancing small business capital formation and protecting investors. These objectives can be met by bringing more unregulated or ineffectively-regulated activity into an appropriate regulatory environment that emphasizes disclosure and education in the area of private placement broker involvement. Action may be accelerated by the appointment of an advisory committee or designation of a working group involving the staff of the Office of Chief Counsel of the Division of Trading and Markets and the Division' of Corporation Finance's Small Business Office.
2. The Commission should adopt rules as recommended by the American Bar Association in its Report and Recommendations of the Task Force on Private Placement Broker-Dealers, dated June 20, 2005. Background: This recommendation appeared in the 2006 Final Report of the Advisory Committee on Smaller Public Companies, and was recommended by the SEC Government-Business Forum Final Reports issued in 2006, 2007 and 2008.The report is included below
3. Allow "private placement brokers" to raise capital through private placements of issuers' securities offered solely to "accredited investors" in amounts per issuer of up to 10% of the investor's net worth (excluding his or her primary residence), with full written disclosure of the broker's compensation and any relationship that would require disclosure under Item 404 of Regulation S-K, in aggregate amounts of up to $20 million per issuer. Background: This recommendation is specifically highlighted from those found in the ABA Report and Recommendations of the Task Force on Private Placement Broker-Dealers, dated June 20, 2005.
Despite this long history of debate,this rule filing regarding unregisterd finders is going forward without any substantive recognition of the complexity of this issue and can only be confusing to large numbers of business intermediaries currently acting as finders both for members and issuers.We recommend that in forwarding the rule to the commission Finra ask that the commission clarify its position including the numerous no-action letters issued over the last 30 years.If the commission did so in seeking comments on FINRA'S rule, it would help the investment community understand the current status of the issue and may inform the commission as to how widespread a problem exists.The current economic emphasis on small business job creation demands that this issue be taken seriously at this time.We believe the ABA report is a good starting point but there may be other creative ways to clarify this issue including allowing the states to deal with it in regards to small offerings.FINRA would do a great service by engaing this issue at this time
http://www.finra.org/web/groups/industry/@ip/@reg/@notice/documents/notices/p120480.pdf
ABA Report and Recommendations
of theTask Force on
Private Placement
Broker-dealers
http://www.praxiis.com/files/SjoquistJune22005ABATaskForceReport.doc
Peter J.Chepucavage
Executive Director,CFAW
General Counsel
Plexus Consulting LLC
1620 I St. N.W.
Washington,D.C.20006
202-785-8940 ex 108
www.plexusconsulting.com
www.iasbda.com
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FINRA Regulatory Notice 10-03 Proposed Rule 4330(a)
This proposed rule 4330(a),http://www.finra.org/web/groups/industry/@ip/@reg/@notice/documents/notices/p120691.pdf requires firms to obtain a written authorization from customers before their margin securities may be loaned out. However after years of debate about short selling and stock loan practices surely the disclosure could and should cover the most opaque parts of this transaction. These include the fact that only the broker -dealer will make money on this transaction and that the securities most likely will be used for short selling. Thus the customer who pays margin interest receives no compensation and his own securities are used to short his own stock. While this has been common practice for many years it can easily be included in the required disclosure. While legitimate debate about short selling continues there is no debate that retail customers receive little benefit when their securities are used and are not likely to understand they are conspiring against their own position.We suggest therefore that the broker explain the rebate he receives and the fact that the resulting short sale may be against their own interest and perhaps that other more powerful customers may indeed participate in these stock loan profits.
The following more colorfully describes the arguably inherent unfairness of this limited disclosure and suggests an appropriate disclosure at the end. We can substitute Dendreon as the real world example of the hypothetical Acme Pharmaceutical.While the language here may be exaggerated its message is not.;
WALL STREET VERSUS MAIN STREET AND THE USE OF MARGIN ACCOUNTS by Dr. Jim Decosta
Let’s assume “Buyer Bob B.” has $10,000 to invest and he wants to buy shares of Acme Pharmaceutical which has a new cancer cure. Bob is an immunologist and very familiar with the efficacy of Acme’s new breakthrough drug. Bob places an order for $10,000 worth of Acme and his broker informs him that he could actually buy $20,000 worth of Acme if he would just open up a margin account. Bob may not be able to afford to lose $20,000 half of which is borrowed but knowing of the potential for the new drug he takes the bait and opens up a margin a/c and buys $20,000 worth of Acme. Bob can afford to buy “X” amount of Acme but he ends up buying “2X” worth but it was his choice. After all, to an immunologist like Bob Acme’s chances for an FDA approval is a no-brainer.
Bob’s brokerage firm’s clearing firm earns a fee for the “banking” business it provided to Bob and the full “2X” amount of shares serves as the collateral for that $10,000 loan. Bob’s brokerage firm incurs veritably no risk for default on this loan with 200% collateral because they can easily sell these shares out from underneath Bob should the price drop. Let’s assume that the shares that Bob bought were short sold from a short seller. This “2X” amount of shares were originally bought by an investor across town named "Buyer Bob A." They too were bought in a margin a/c; that’s why they were available for lending to the short seller.
After processing Bob B.’s $20,000 purchase order his broker now becomes the “legal owner” of that particular parcel of 2X amount of shares unknowingly “co-beneficially owned” by Bob A. and Bob B. Being the new “legal owner” of that 2X parcel of Acme shares Bob B.’s broker has all of the right in the world to rent them to yet another short seller who then sells them to yet another Bob, “Buyer Bob C.” There are now 3 “co-beneficial owners” of that one parcel of impossible to identify shares. The most recent purchaser is referred to as the “legal owner” and all previous purchasers of that same parcel of shares are referred to as “security entitlement holders”. This parcel of shares is impossible to identify because of the NSCC’s insistence on holding “street name” shares in an “anonymously pooled” format and because of the circa 1970 “dematerialization” of tough to counterfeit paper-certificated shares into easy to counterfeit electronic book entry shares.
All “security entitlement holders” are allowed by UCC Article 8 to sell that which they purchased at any time they so choose. After a year or so let’s assume that through the magic of theoretically “legal” short selling there are now 11 “co-beneficial owners” and one “legal owner” of that one impossible to identify parcel of Acme shares. Keep in mind that this is just one of many, many “daisy chains” of bogus Acme "shares" possible.
Picture Acme Pharmaceutical as a small tree attempting to grow into a big Pharmaceutical company via the introduction of their new breakthrough cancer cure. Every single time a short sale of Acme shares occurred a readily sellable unregistered share price depressing “security entitlement” was essentially “issued”. Due to their being treated as being readily sellable they add to the “supply” or “float” of Acme shares which must be treated as being readily sellable. Each “borrow” associated with each short sale damaged Acme’s share price similar to an ax chopping away at the young “Acme tree’s” trunk.
As Acme’s share price dropped from all of this wonderful “liquidity” being injected by these 12 different short sellers the 12 purchasers of the very same parcel of Acme shares through their margin accounts started to get margin calls. Since they already bought 2 times as much Acme as they could afford they were not able to meet these margin calls with cash. Therefore their brokers had to sell some of their Acme shares to meet these margin calls. This put yet further pressure on Acme’s share price which resulted in yet more margin calls which in turn put yet further pressure on Acme’s share price ad infinitum. Acme's share price is now into what is referred to as a self-sustaining "death spiral".
A self-propelling negative feedback loop has been established and Acme’s share price went to zero as they lost any ability to raise money to advance any further through the lengthy and expensive FDA approval process. Acme had become an “easy prey” due to the nature of the business they were in, the nature of margin accounts and the DTCC’s refusal to bring transparency to shares being held in “street name”. Perhaps none of those 12 investors would have invested in Acme shares if they had visibility of the immense number of share price depressing "security entitlements" poisoning the share structure of Acme.
During all of this “liquidity injecting” short selling the Wall Street “securities intermediaries” made an absolute fortune. The margin a/c hosts were making banking fees right and left, the lending agents were making lending fees, the prime brokers were going to town, the executing brokers were going to town and the short selling hedge fund manager and his investors absolutely cleaned up while raking in all of the money the 12 investors lost. In fact, 12 different brokerage firms were earning rental fees while renting out the very same parcel of impossible to identify shares in 12 different directions simultaneously.
In slow motion what just happened here. An investor unaware of how margin accounts and short selling “DTCC style” operates got talked into buying twice the amount of Acme shares that he could afford; shame on him. His margin a/c “host” took the shares purchased, both the “X” amount of shares that the investor could afford and the “X” amount of shares that he couldn’t afford and rented both parcels to a short seller whose goal it was to bankrupt Acme. In order to effect that goal the short seller needs shares to borrow and the brokerage firms earning commissions from the sale and banking income from the loan were more than happy to earn rental income from those trying to bankrupt the invested in company. One might ask what happened to the ’34 Exchange Act’s forbidding of conflicts of interest between brokerage firms and their commission paying clients.
This loan to short sellers started a “daisy chain” involving an inherent “counterfeiting/replicating” phenomenon associated with how our DTCC-administered clearance and settlement system is “rigged” in favor of the Wall Street “securities intermediaries” that own it over the Main Street investors in the Acme’s of the world. It wouldn't’t take two seconds to put an identifier onto parcels of shares to block this “counterfeiting/replicating” process but those Wall Street insiders in favor of the corrupt status quo claim that it would be too expensive, it would decrease “market efficiency”, the technology is not there yet, pricing efficiency would be lost, etc.
At the end of the day we have witnessed a very predictable “transfer of wealth” from Main Street to Wall Street because the NSCC insists on holding “street name” securities in an “anonymously pooled” format enabling this “counterfeiting/replicating” phenomenon to occur and be abused. Even though these are theoretically “borrows” occurring in short sales the key to this fraud is to craftily transfer “legal ownership” to the new purchasers of these “borrowed” shares. Why? Because nobody can stop the new “legal owner” of shares to rent them out to anybody he so chooses. But shouldn't’t the previous purchaser of the borrowed shares be identified and told that he lost his “legal ownership” and therefore can no longer sell that which he purchased? That’s the trick; you can’t identify the original purchaser of those shares when shares are held in an “anonymously pooled” format and if you can’t identify him you can’t inform him that he lost his ability to sell that which he purchased. Besides, not being able to sell that which one purchased wouldn’t go over too well with him anyways and nobody would opt to use margin accounts. All of that extra banking and rental income would be lost. Thus you can see the need to characterize what is clearly a “sale” as a “borrow”.
The key to this totally corrupt concept of holding shares in an “anonymously pooled” format is firstly the inability to keep the original purchaser of a specific parcel of shares from reselling that which he purchased after his shares were loaned out from underneath him and secondly you can’t prove that 12 investors bought and now “co-beneficially own” the very same parcel of shares and thirdly you can’t prove that 12 brokerage firms are earning rental proceeds from the simultaneous renting out of the very same parcel of shares in 12 different directions. Pretty slick, huh?
The victims of these thefts on Main Street refer to this phenomenon as the “counterfeiting of securities” that needs to be done away with. Technically what is being “counterfeited” is not a “share” of a corporation as there are a fixed amount of those “outstanding” at any given time and this number doesn’t get altered during abusive short selling. What are being “counterfeited” are the “units” on Wall Street that contribute to the “supply” of that which must be treated as being readily sellable. These “units” include legitimate registered shares and the unregistered “security entitlements” issued during each otherwise legal “pre-borrow”, each and every NSCC SBP “borrow” and each failure to deliver that is yet to be bought-in.
Abusive Wall Street insiders will argue that there is no such thing as “phantom shares” being created during short selling as the number of “shares outstanding” does not increase. What they (not so mysteriously) forget to mention is that the number of “shares outstanding” is not the only component of the “supply” variable that interacts with the “demand” variable to determine share prices. The other component is the number of “security entitlements” that are issued. I think that you in Congress can appreciate the reason why the DTCC management needs to make these intentional misrepresentations i.e. the aforementioned “iceberg” that nobody except for U.S. "long" investors and U.S. corporations are in a hurry to address.
The beneficiaries of these thefts inhabiting Wall Street refer to this blatant “counterfeiting” process as the “injection of liquidity” and the enhancement of “market and pricing efficiencies” which they lobby aggressively to maintain as the status quo. Although mere “security entitlements” are not technically “shares” of a corporation they are indeed “securities” as any “evidence of indebtedness” qualifies as a “security”. Thus the “counterfeiting” of securities phraseology is quite accurate but technically perhaps “the abusive inducing of the issuance of readily sellable share price depressing “security entitlements” with the intent to defraud the purchasers of nonexistent shares for one’s own financial gain” would be more accurate.
Theoretically “anonymous pooling” is used to enhance “market efficiency” and “streamline” the clearance and settlement process. In the case of abusive short selling, however, what is really being “streamlined” is the flow of investor funds into the wallets of abusive short sellers and those that act as “securities intermediaries” in the short selling process. At the recent SEC “roundtable” we saw the Wall Street insiders aggressively lobby to maintain the corrupt “status quo” and all of the standard malarkey about the theoretical benefits of short selling were cited.
In the example cited above the Main Streeters using margin accounts lost not only that which they could afford to lose but twice that amount and those extra shares they purchased “on credit” actually provided the leverage to augment, via the triggering of unable to meet margin calls, the already inherent “counterfeiting/replicating” phenomenon associated with otherwise legal short selling. Margin accounts clearly need a “black box warning” that unsophisticated investors can read and understand. Encouraging U.S. “long” investors to “double down” on their investments only to use the shares bought on credit as leverage against the entire amount of the “double down” is a very dirty trick especially when all of the “securities intermediaries” on Wall Street are heavily financially incentivized to assist in the defrauding process.
Didn’t we just witness the exact same modus operandi in the housing industry wherein Main Streeters were encouraged by Wall Street “banksters” to “leverage up” and get in over their heads so that the “banksters” could make tons of money in loan processing fees, commissions, banking income, rental income, etc. Doesn’t that seem like a bit of a dirty trick to facilitate the “doubling down” by client’s owed a fiduciary duty of care only to take that double amount of shares that were purchased to facilitate the destruction of the investment made all while raking in income that was otherwise unattainable if the client did not double down?
Can you see in the above example how the more an investor knew about the company he was investing in the more he would be tempted to buy on margin which paradoxically made it more probable that those that knew absolutely nothing about this new medical breakthrough would end up predictably siphoning his investment funds into their wallet? Abusive short sellers refer to this as the enhanced “market efficiency” they wouldn’t want any new regulations to do away with.
Should margin accounts have a “black box warning” similar to this? Warning: There is a significant chance that the shares you are purchasing partially on credit will act as a “seed” to propagate the formation of an unlimited amount of readily sellable share price depressing “security entitlements” that can be used to loan to short sellers to aid them in their attempts to bring down the corporation you chose not only to invest in but to actually double down on your investment bet.
The shares you purchased plus all of their “offspring” will be used to predictably manipulate the share price of the "invested in company" downwards. This may likely result in you receiving “margin calls” which if you cannot answer with cash will result in a portion of your shares and those of other margin a/c holders to be forcefully sold which will exacerbate this downward movement in share prices which may lead to yet more margin calls.
This is due to how shares held in “street name” are currently held in an impossible to identify “anonymously pooled” format that provides enough opacity to allow abusive DTCC “participants” and their hedge fund “guests” to systematically use the shares you purchased in your margin a/c to augment your own brokerage firm’s well-compensated efforts to route your investment funds into their wallets aided by an inherent “counterfeiting/replicating” phenomenon naturally present in any system using “anonymous pooling”. The brokerage firm you paid a commission to and are paying banking fees and interest to will be handsomely rewarded via banking fees, commissions, rental income, enhanced order flow from the hedge funds they are aiding and abetting, etc. for their efforts rendered on behalf of the financial interests of those trying to bankrupt your invested in corporation.
Peter J.Chepucavage
Executive Director,CFAW
General Counsel
Plexus Consulting LLC
1620 I St. N.W.
Washington,D.C.20006
202-785-8940 ex 108
www.plexusconsulting.com
www.iasbda.com
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