From: hgbjr [hgbjr@ix.netcom.com]
Sent: Friday, November 21, 2003 11:55 AM
To: rule-comments@sec.gov
Subject: File No. S7-23-03 - Comment to Regulation SHO 
(also attached as a Word file)

November 21, 2003

 

Jonathan G. Katz, Secretary
Securities and Exchange Commission
450 Fifth Street, NW
Washington, DC 20549-0609

            Re:  File No. S7-23-03   -   Regulation SHO

Dear Mr. Katz, Commissioners and Staff:

    This letter is in response to the Securities and Exchange Commission's 
("SEC") request for comments on proposed Regulation SHO, which is intended to 
reform current short selling rules and regulations and, in part, to curb market 
abuses related to illegal "naked" short selling. As noted in the Background 
section of the Proposed Rule, "Congress gave the Commission broad authority 
to regulate short sales in order to stop short selling abuses" when it passed 
the Securities Exchange Act of 1934, as amended (the "Exchange Act"). 

            Initial Comments.

Initially I would note that the SEC in general does a good job in regulating 
the securities markets in the United States. It is an enormous task, and 
without doubt the SEC needs additional resources, both financial and manpower, 
to fully police the securities markets. Recently, the SEC has been repeatedly 
upstaged by the Attorney General of the State of New York, who has in fact on 
numerous occasions publicly taken the SEC to task for certain failures to 
protect the investing public. The Attorney General of the State of Massachusetts 
and other state regulatory authorities are now beginning their own investigations 
in an effort to protect their citizens, a trend that I expect to continue as more 
and more market abuses of different types are revealed and the perception that 
the federal authorities are not policing the industry continues to grow. 

History will show that the manipulation of the securities markets by "naked" 
short sellers (and those entities, both private and "quasi-public," that enable 
them) has been and is by far the largest financial fraud in history, with 
investor losses ultimately measured in trillions of dollars. A major public 
relations problem exists for the SEC because the SEC has known of these abuses 
for at least five years (see, e.g., the SEC's Concept Release No. 34-42037 
(October 20, 1999), Section #7, to "Extend the Short Sale Rule to Non-Exchange 
Listed Securities") and to date has not taken action to stop or even limit these 
abuses, instead relying upon self regulatory organizations ("SRO's") such as the 
National Association of Securities Dealers ("NASD") to police their members. At 
the time of the said Concept Release, apparently the SEC relied upon the assurances 
of the industry that there was nothing untoward occurring, and any abuses that did 
occur were minor and could be addressed by the SRO's and the industry. Obviously 
these assurances were at best self-serving and misleading.

Because no one else has taken steps to curb these abuses, state regulators and 
trial lawyers will now seek redress. This process has begun in earnest, and will 
continue until resolution is achieved. However, the SEC in proposed Regulation SHO 
has the opportunity to take the lead in correcting this problem, if the SEC will 
promulgate an effective regulation that is clear cut, with no "wiggle room" for 
those who would use loopholes and gray areas to continue their abusive activities, 
and with sufficient penalties against violators to deter wrongdoing. The industry 
(including its SRO's) has demonstrated both its unwillingness to act in good faith 
and in the best interests of the investing public, and its inability to police 
itself.

The SEC must make the rules crystal clear, and make it clear to the industry that, 
as Mr. Spitzer said recently with respect to the mutual fund industry, violations 
"will impose pain."  Regulation SHO is a good first draft. The SEC in its comments 
has demonstrated its understanding of most of the issues, and has demonstrated that 
it is aware of what needs to be done, though the SEC appears to be reluctant to 
take some necessary steps, such as (i) actually requiring all trades to timely 
settle, even if it means the failing broker has to face a "buy-in" at whatever cost 
with respect to the unsettled trade, (ii) applying the new rule to market makers 
and specialists, who are-based upon their current behavior-likely to abuse any 
exemption, and (iii) applying the "uniform bid test" to all securities markets 
(instead of only exchange listed securities), and apply this rule to market makers 
and specialists, as well. I strongly urge the SEC to take the necessary steps and 
make the necessary changes to ensure that Regulation SHO is effective to accomplish 
the SEC's stated purposes therefor, and to fulfill the Congressional mandate in the 
Exchange Act to "stop short selling abuses."

Uniform Locate Rule.

In order for the SEC to "fully address the problems of naked short selling and 
extended fails to deliver," as stated under the SEC's Proposed Amendments, it is 
a very good idea to promulgate a "uniform 'locate' rule applicable to all equity 
securities, wherever they are traded." This is an absolute necessity if the SEC 
wants to minimize the egregious practice of "naked" short selling. The SEC says 
the following:

 "Proposed Rule 203 would prohibit a broker-dealer from executing a short sale 
 order for its own account or the account of another person, unless the broker-
 dealer, or the person for whose account the short sale is executed (1) borrowed 
 the security, or entered into an arrangement for the borrowing of the security, 
 or (2) had reasonable grounds to believe that it could borrow the security so 
 that it would be capable of delivering the securities on the date delivery is due."

            I will address the problem with the second clause of Option no. (1) below. 
Option no. (2) creates unnecessary "wiggle room" for industry professionals, and 
they will in short order abuse it. Why is it necessary to give them this option? 
And who determines what "reasonable grounds" might be? What if the broker is relying 
upon its ability to "borrow" shares held-supposedly-in trust as a part of some 
"fungible bulk" held by the Depository Trust and Clearing Corporation ("DTC"), even 
though DTC has in fact already loaned out all or several times the number of shares 
it actually holds? Who is to be held responsible then for the artificially generated 
downward pressure that results? "Reasonable grounds" is not an objective standard 
and there are too many dishonest market participants who will take advantage of 
this proposed subjectivity to allow it, especially when the currently proposed 
penalties for non-compliance are so minimal.

I realize the SEC is proposing that clearing firms that process transactions 
enforce settlement, more or less, by providing for certain penalties. However 
there seems to be a glaring hole in this proposal. I elaborate on this below. 
The industry has demonstrated that its brokerage commissions and trading profits 
are more important than complying with the spirit, and in many cases the letter, 
of the current regulations.

            I agree with the idea of the SEC's proposed "delivery requirement 
targeted at securities where there is evidence of significant settlement failures."  
But, it does not make sense to allow even these extended settlement failures in 
the first place. In other words, why are settlement failures ever permitted for 
extended periods of time, whether the industry deems them "significant" or not? 
Of course there are circumstances that result in settlement of a legitimate trade 
being held up for various reasons. For those occasions there are regulations that 
currently provide reasonable extensions of time to settle. But again, why would 
the SEC permit any settlement failure to exist for any extended period of time, 
unless to give the industry 'cover' for those times when they just can not resist 
a little market manipulation? How much time is really needed to settle a trade? 
Two weeks? Three weeks?

In any other industry, a failure to timely deliver a product bargained for and 
sold-and for which consideration is received-is a breach of contract. It is in 
the securities industry as well, but the victim usually does not know about it 
and his fiduciary (the broker) is often unwilling to enforce his client's rights 
against a fellow industry player, who might return the favor later. By permitting 
"naked" short selling, and allowing the resultant settlement failures, the SEC 
is in fact allowing the creation of an artificial increase in the supply of the 
victim company's securities. The fact that this results in an artificially 
lowered price is basic economics.

            The SEC's "punishment" for a selling broker dealer that does not 
deliver a security within two days after the settlement date, is no real 
punishment at all. I quote from the Proposal:

 "If for any reason such security was not delivered within two days after the 
 settlement date, the rule would restrict the broker-dealer, including market 
 makers, from executing future short sales in such security for the person for 
 whose account the failure to deliver occurred unless the broker-dealer or the 
 person for whose account the short sale is executed borrowed the security, or 
 entered into a bona fide arrangement to borrow the security, prior to executing 
 the short sale and delivered on settlement date. This restriction would be in 
 effect for a period of 90 calendar days."

            Where is the punishment here? Where is the deterrent? Why not 
require all players to "borrow the security, or enter into a bona fide arrangement 
to borrow the security, prior to executing the short sale," and "deliver on the 
settlement date" with all violations resulting in buy-in's and forfeiture of all 
profits on the transactions, with suspension or revocation of licenses for repeat 
offenders? I think the SEC should have the courage to give the proposed Regulation 
SHO some teeth. It makes no sense to say, in effect, "If you short sellers break 
the rule by too much, we are going to make you stop breaking the rules with your 
current victim (unless, of course, you use another broker to do so) and go find 
another victim to break the rules with-and at some point we may even make you 
obey the rules-but don't worry too much, we won't take your profits away in any 
event and we most likely aren't even going to make you cover your illegal short 
sales." Again, where is the punishment here? What is the risk for the violator? 
That he will have to stop short selling against his current victim, unless he 
follows the rules next time-or until he can get another broker on the phone?  
Just keep it simple. If the trade does not settle timely, after reasonable 
extensions, force the buying broker to buy-in the unsettled shares, and charge 
it back to the selling broker, who can pass it along to the manipulator (assuming 
it was not the broker or market maker in the first place). If the buying broker 
does not force timely settlement of a trade, have the clearing firm force the 
buy-in and fine the broker the first couple of times-as well as forfeiture of 
all profits on the trade-and thereafter, force the buy-in, seize all profits 
and suspend or revoke the broker's license. This will remove the brokers' 
incentive to cheat (or to allow cheating).

            Further, and absolutely critically, unless the SEC is going to 
forbid the Depository Trust and Clearing Corporation ("DTC") from loaning out 
shares that DTC does not have to lend (but "lends" anyway, creating phantom 
shares that are subsequently used to negatively affect the market for the 
victim security), "enter[ing] into a 'bona fide' arrangement to borrow the 
security" will be a non-event for DTC's participants. 

To date there appears to be no interest at the SEC in curbing the activities 
of the ultimate enabling entity for market manipulation via "naked" short 
selling, which is DTC and its stock lending (better described as its 
counterfeiting and unregistered distribution) profit center. As long as DTC-
supposedly a fiduciary, holding securities in trust for the owners and their 
representative broker dealers-is permitted to lend the same securities to 
multiple participants at the same time, charging fees to each participant, and 
all this without the knowledge or consent of the beneficial owner of the 
securities, market manipulation will occur. The SEC should bar DTC from lending 
securities. Period. Why should DTC be allowed to lend someone else's property, 
which DTC claims to hold in trust, without that person's informed consent, to 
a broker who is going to use the shares to try to diminish the value of the 
owner's same property-short selling against the rightful owner's financial 
interests-and thereby damaging the owner!?! It is unfathomable that the SEC 
would allow this to occur, all to the exclusive profit of DTC, its subsidiaries 
and its "participants" and to the clear detriment of everyone else. At the 
very least, forbid DTC from ever lending more shares of a security than it 
actually holds, require outside accountability, and require DTC to deliver 
the proceeds of such loans to the owners of the securities, not to the rightful 
owners' so-called "fiduciaries." This scam is unconscionable and must be stopped, 
and one way or another it will be stopped once the investing public finds out 
what is happening and how they are being victimized by this so called "Trust" 
and their so called "fiduciaries." It would be nice to see the SEC take the 
lead on this.

            Again I emphasize, I see nowhere among the requirements listed in 
the "rules of the registered clearing agency that processed the transaction" 
the requirement that all non-settled trades actually be settled!  Why not, in 
addition to the penalties stated that the clearing agency is to impose on 
violators, require the violators to go into the market and purchase the 
securities they have illegally sold short, and surrender all profits from the 
trade?  Better yet, require the buying broker to inform his client of all 
settlement failures, and give the buyer the right to cancel any trade that 
does not timely settle. The fear of buy-in's and potential market losses 
therefrom will be a greater deterrent than the "penalties" suggested in the 
Proposed Rule. A NASD wrist slap obviously creates no terror for the industry, 
because today it does little if anything to deter the behavior of the violator 
or its peers; if this were not so, why would the same brokers and market 
makers get fined again and again for the same behavior?  A $10,000.00 fine 
and "censure" is not going to deter a broker or market maker that made 
$500,000.00 violating the rule for which it was "penalized." It is simply 
a cost of doing business, and a tax deductible one at that.

            In summary, if the SEC truly wants to stop naked short selling, 
then require all short sellers to borrow the target securities prior to 
selling them, require them to settle the trades timely, and force them to 
buy-in the sale if they do not timely deliver, and forfeit all profits 
therefrom. This will be easy if the SEC requires the clearing firms to 
enforce it, because they know which trades settle and which don't, and they 
have the transaction information. If the SEC leaves the currently proposed 
loopholes in place, the practice of "naked" short selling might be lessened 
among the weaker manipulators who have to leave the game, but the major 
players-especially the market makers-will continue their current practices 
unabated.

            Market Maker Exemption.

With respect to the proposed exemption from the rules for market makers and 
specialists, it is not appropriate to provide a blanket exemption to market 
makers engaged in "bona fide market making activity," unless the SEC can 
come up with a specific definition of the phrase and enforce the distinction 
between whatever "bona fide market making activity" is and the naked short-
selling-based trading strategy that many market makers currently employ on 
a daily basis on the NASDAQ Small Cap, OTC and Pink Sheets markets (often 
collusively with other market makers in the classic "bear raid" scenario). 
Again, if the SEC gives these industry players "wiggle room," many will 
abuse it, as they do today. I realize the industry professionals who daily 
profit from such activities will loudly and strongly object to not having 
their "blanket exemption." If the SEC once again gives in to their demand 
for an exemption, I would suggest the following, with rationale included.

If it is true as the SEC has stated in its comments to the Proposed Rule 
that "most specialists and market makers seek a net "flat" position in a 
security at the end of each day and often "offset" short sales with purchases 
such that they are not required to make delivery under the security settlement 
system," and further that "extended failures to deliver appear characteristic 
of an investment or trading strategy, rather than being related to market 
making... it is questionable whether a market maker carrying a short position 
in a heavily shorted security for an extended period of time is in fact 
engaged in providing liquidity for customers, or rather is engaged in a 
speculative trading strategy," then the solution is rather simple:  require 
that market makers and specialists close out all naked short positions by 
the end of the trading day, or at the latest by the end of the trading day 
following the day on which they effect the naked short sale. 

This will allow the market maker to practice its alleged "bona fide market 
making activity" while limiting its ability to "engage in a speculative 
trading strategy." This will not stop them from doing the latter, but at 
least it will limit the market manipulations to short periods of time. 
Acknowledging that they might quibble over the time limits to cover (same 
day, next day, three trading days, etc.), why would a market maker object to 
such a rule, unless its agenda is something other than bona fide market 
making? I realize the industry exerts great pressure on the SEC to see things 
"their way," but the SEC to restore its own credibility as the nation's 
securities regulator must put first the restoration of the integrity of the 
public markets and the protection of the investing public, and only then 
consider the desires of the industry. The industry will continue to make 
boatloads of money either way. 

The SEC knows that the main concern of the industry is making money for 
itself, and this is perfectly fine, that is why they are in business. But 
the SEC must be willing to take the steps necessary to protect the public 
from industry abuse.  Why take half-measures that do not achieve the SEC's 
stated goals for Regulation SHO and fulfill the SEC's Exchange Act mandate?  
If the measures prove to be overkill, then the SEC can later scale back its 
reforms to the extent it deems necessary. If the SEC is going to err, it 
needs to err on the side of protection of the investing public, not on the 
side of the industry and protecting the profits of the illegal short sellers 
and their enablers (DTC, et al.). Half-measures now will further weaken 
the SEC's credibility and will result in state regulators and private 
litigators having to step into the void to ensure the markets' integrity 
and punish those guilty of market manipulation, along with those guilty 
of aiding and abetting market manipulation. 

Short Sales Disguised as Long Sales.

            To quote in part the proposed rule: "Regulation SHO would 
extend the delivery requirements of Rule 10a-2 to all securities, 
including those traded over-the-counter. As with our proposal to apply 
borrow and delivery requirements for short sales in all equity securities, 
we believe it is equally important to apply long delivery requirements to 
securities with lower market capitalization that may be more susceptible 
to abuse."  I absolutely agree with this modification, it is necessary 
and (pardon the pun) long overdue.

            With respect to the second change proposed in Regulation SHO, 
"that a loan or failure to deliver is permitted if the seller has informed 
the broker-dealer that the seller owns the security and will deliver it to 
the broker-dealer prior to settlement of the transaction, but fails to do 
so." This is fine, and reasonable as far as it goes. But what about 
punishment for the dishonest seller? When will this trade be settled, and 
who will force settlement? Can the failure to deliver be carried forever, 
as they currently are by "naked" short sellers, so long as it is not under 
Regulation SHO deemed "significant"? I understand the notion of relieving 
an innocent or duped broker-dealer of liability for a time, but why should 
not the manipulator be punished? He should, indeed he must, if the SEC 
wishes to restore integrity to the markets. Make the criminals promptly 
buy-in the security at the market and settle the trade, whatever the cost, 
and forfeit all profits from the trade. Otherwise the SEC is allowing the 
dishonest seller to cheat the innocent buyer and allowing the markets to 
be artificially depressed as a result of the increased supply of securities 
(albeit counterfeit securities) entering the market.

In answer to the SEC's question, the delivery requirements in proposed 
Rule 203(a) are appropriate, except in addition to all other penalties 
and requirements there needs to be a provision requiring settlement of 
all trades within a reasonable time after the trade date, including those 
improperly labeled 'long sales,' and forfeiture of all profits associated 
with such trades. If nothing else, let the clearing firm keep the 
forfeited profits; that should encourage them to enforce the rules.

Uniform Bid Test

            Proposed Rule 201 of Regulation SHO, which would replace 
Rule 10a-1's tick test with a test using the consolidated best bid as the 
reference point for permissible short sales, is a very good idea. But, if 
the SEC is interested in minimizing the market manipulation that routinely 
occurs on the NASDAQ Small Cap, OTC: Bulletin Board and Pink Sheets markets, 
the SEC must extend the bid test to all U.S. securities markets and exchanges, 
and apply it to all market participants. As was intimated by a number of 
Commissioners during the October 22, 2003, open meeting, there is no good 
reason not to extend the proposed bid test to all securities markets and 
exchanges.  The only group that could possibly object to so extending it 
are those broker-dealers, market makers and other industry players that 
use the lack of a bid test to conduct daily "bear raids" on OTC and Pink 
Sheet stocks, and those who profit from such activities by their clients.  
Again I would ask, why would the SEC be satisfied with half-measures, when 
it has the opportunity to really curb these abuses? What reason is there 
not to protect investors in all U.S. securities markets? 

            The SEC says in the rule-change proposal: "We are not proposing 
at this time to extend the uniform bid test to securities not currently 
covered by a short sale price test (i.e., Nasdaq SmallCap, OTCBB, and Pink 
Sheet securities) in part because these markets have not been subject to 
the rule in the past."  Is this really enough reason not to extend the 
uniform bid test, just because these markets were not previously subject 
to it?  These markets were also not previously subject to the other rules 
and regulations the SEC is promulgating under Regulation SHO, either.  This 
argument is not sufficient justification to continue to deny protection to 
the companies whose securities trade on these markets and are regularly 
victimized by "bear raids" orchestrated by naked short selling market makers, 
brokers and offshore funds of unknown origin or purpose.

The SEC continues: "More significantly, we believe that the proposed locate 
and deliver requirements may address many of the concerns regarding abusive 
short selling in thinly-capitalized securities trading over-the-counter. In 
particular, these proposals should significantly discourage efforts to 
deliberately depress the price of these securities by removing the leverage 
abusive short sellers enjoy through short selling without incurring the costs 
of borrowing and delivering."  The phrases "may address" and "should 
significantly discourage" do not give one much comfort when dealing with 
known, demonstrated illegal manipulative activity on the part of the 
perpetrators. It does not sound as though the SEC truly believes the proposed 
locate and deliver requirements will be sufficient, either. There is no 
logical reason to withhold the additional protection the proposed uniform bid 
test would provide from these markets, which are the most victimized by far 
of all the U.S. securities markets. It is a simple act, it will impose no 
hardship on the industry other than to make manipulation a bit more difficult, 
and it will help curb some of the abuses targeted by Regulation SHO. Extend 
this minimal protection to all companies traded on any U.S. exchange or market.

Finally, the uniform bid rule should absolutely be applied to market makers 
and specialists, as well as everyone else on every exchange and market. If 
these market professionals are only engaging in "bona fide market making 
activity," then what reason is there for allowing them an exemption? Do they 
have to be able to drive prices down to do their jobs? To do what their trading 
competitors can not and thereby further increase their own profits? Again, the 
SEC should focus on protecting the investing public, not on helping the industry 
further increase its profits to the direct detriment of that same investing 
public. I respect everyone's right to make as much money as possible, but if 
government is to have any function at all it should be to ensure a level playing 
field for all the players, not just industry insiders.

Conclusion

            Again I would like to commend the SEC for acknowledging the problems 
associated with "naked" short selling and settlement failures in the U.S. 
securities markets, and for putting forth a proposal to "curb these abuses."  
I strongly urge the SEC to fulfill its Exchange Act mandate and "stop short 
selling abuses" wherever they occur, by (i) requiring trades to timely settle, 
with forced buy-in's for failures to timely settle, whatever the cost and with 
additional real pecuniary and restrictive punishments for violators, (ii) applying 
the new rule to market makers and specialists, who are-based upon their current 
behavior-likely to abuse any exemption, and (iii) applying the "uniform bid test" 
to all securities markets (instead of only exchange listed securities), and 
specifically applying this rule to market makers and specialists, as well as 
everyone else.

            The Proposed Rule and comments thereto indicate the SEC recognizes 
many of the problems. The SEC has the opportunity to do the right thing and put 
an end to these abusive and destructive practices. Please do it now, so that it 
won't have to be done again later after still more companies have been destroyed 
and still more investor wealth has been stolen by the market manipulators and 
their enabling industry partners. 

            Sincerely,

            H. Glenn Bagwell, Jr.
            Attorney at Law