From: Mark Feldberg [hukkah546@hotmail.com]
Sent: Monday, January 05, 2004 4:31 PM
To: rule-comments@sec.gov
Subject: File No. S7-23-03

First, I’d like to make a general comment of appreciation.  The authors of 
this proposed Regulation have spent a lot of time thinking about this issue. 
  The proposal was a literate, well-informed, and well-considered piece of 
writing.  The authors are clearly versed in the academic literature (e.g., 
Thaler) as well as the current news (e.g., the Carol Remond and Gretchen 
Morgenson articles). Irrespective of whatever regulation results, the 
authors deserve a lot of credit.

Having said that, I do have some comments on one part of the proposed 
Regulation.
It is certainly theoretically possible that a fine, legitimate company could 
be adversely and permanently affected by a relentless campaign of naked 
shorting and failed deliveries, though I am unaware of a single example of 
this.  The example in the proposed Regulation, Sedona, was victimized not by 
naked shorting but by fraud on the part of Rhino Advisors (at least as the 
press reported it.  I have no direct knowledge of the Sedona situation).  
Rhino had allegedly pledged not to short the stock but ignored that pledge.  
The solution to that problem is not to go after naked shorting, or all 
convertible debentures, or all financing companies named after large 
mammals.  The solution is to go after scurrilous financing entities.  After 
all, if Rhino had gotten an affirmative borrow on all of its shares, would 
that have made their actions legitimate?  Not in my book.  It would still 
have been fraud.  And I would favor strong penalties against this kind of 
behavior.

The financiers of “death spiral” or toxic convertibles have an economic 
interest in pummeling the shares of their borrowers, irrespective of the 
performance of those companies.  By contrast, a normal short-seller can 
profit only if his low opinion of the value of a company’s shares is borne 
out over time.  If he’s wrong, he’s going to lose.  In the real world, 
fails-to-deliver can last for a few weeks, but eventually, if the stock is 
over-shorted, there are going to be buy-ins.  And, in the real world those 
buy-ins are almost always at a 10-20% premium to the market for Bulletin 
Board issues.  One can’t make money suffering those kinds of losses every 
few weeks.  So, in the real world naked short-selling occurs during 
temporary rises of a stock, not as part of a long-term effort to devalue the 
stock by incessant selling.  And in the real world the stock is covered 
during the subsequent decline in price.  I find remarkable the frequent 
belief that short-sellers are imperviously shorting and “diluting” 
Bulletin-Board issues ad infinitum, since this opinion does not take into 
account the real-world costs of continuous buy-ins.  Maybe somewhere there’s 
a case of a legitimate, non-toxic convertible issue which was unfairly the 
subject of a campaign of short-selling abuse and where somehow the 
short-selling actually went on for many months.  But there are not a lot of 
such examples.

In contrast to this rare event, there is a very common occurrence: the 
continuous stream of pump-and-dump schemes run by promoters whose sole 
interest is self-enrichment.   This game is pretty straightforward.  One 
purchases a Bulletin Board shell and folds into it a new-fangled “product”.  
The whole idea is to keep the float as small as possible initially and to 
run this tight float up as high as possible.  The company offers free stock 
to an IR firm which promotes it via press releases relying on Safe Harbor 
immunity, Internet message boards, small boiler-room brokerages, or e-mail 
“investment advisory services”.  Since the stock is a low-priced Bulletin 
Board, it is non-marginable almost everywhere.  Thus, it is almost 
impossible to borrow.  This is exactly what the promoters want, since the 
whole idea is to jack the stock up as high and fast as possible, and 
short-selling would only get in the way.  This is a heady period where, like 
all Ponzi schemes, everybody who’s in is making money since the stock keeps 
going up.  But then, once the stock is up high enough, the insiders sell 
their shares.  A variant is that the company at this point sells some stock 
too, so it has some cash in the bank to keep going for a while.  When the 
company or its insiders run low on money, the process is repeated.  Thus, 
the pattern is 1) a steep rise, 2) dumping of shares, and 3) a descent back 
to or below the initial price (with a possible repeat of the process every 
couple of years).  When done by skilled practitioners, there is nothing 
illegal here, since all the filings are in order, and all the press releases 
have suitable disclaimers.  That doesn’t mean that the process serves any 
kind of legitimate investment purpose: there is no earnest attempt to 
develop a product or service which ultimately makes a profit.  There is only 
a single effort or periodic campaign on the part of insiders and promoters 
to make money at the expense of the public.

Short-sellers (who are usually naked short-sellers since the stocks are 
nearly impossible to borrow) are the natural enemy—or at least competitor—of 
these promoters.  These short-sellers are selling at the same time as the 
promoters, and thus this results in a lower return for the promoters.  
Short-sellers also have a tendency to expose the flaws of these “companies” 
to the public and to regulatory agencies.  It is not surprising that the 
promoters of these companies would want to stop the practice of 
short-selling.  It is also not surprising that the promoters would try to 
shroud themselves with the cloak of legitimacy, pretending to be earnest 
development-stage companies, unfairly targeted by unscrupulous 
short-sellers.

The only group with an economic incentive to keep stock promotion in line is 
short-sellers.  Without them I have no doubt that the stock-promotion 
business would quickly quadruple in size.  And the large scale of this 
questionable activity would devalue the legitimate equity markets.

Equity markets exist to give successful and legitimately 
aspiring-to-be-successful companies access to capital from the public.   
They do not exist to give unscrupulous promoters a free ride—though that is 
undoubtedly a side effect.   Nor do they exist to give gamblers, posing as 
investors, an opportunity to ply their avocation in a venue outside of Las 
Vegas—though that is also undoubtedly a side effect.  While it would 
probably be impossible to try and wipe out all promotion on the part of 
companies or all gambling on the part of investors, why would we want to 
encourage these activities?  In my opinion, eliminating naked short-selling 
would do just that by getting rid of the only impediment to the most 
egregious of these activities.

I appreciate the willingness of the Market Regulation Division of the 
Commission to solicit and carefully consider the opinions of concerned 
citizens.  But I would encourage the Market Regulation Division to solicit 
opinions from one other source: your counterparts in Enforcement.  Ask them 
about some of the most vociferous companies in this campaign against naked 
short-selling.  And, most importantly, ask them if they feel that, if this 
rule were passed, whether their workload would stay the same.  I would be 
quite surprised if they didn’t feel that without the impediment of 
short-sellers there wouldn’t be far more Bulletin Board and Pink Sheet 
abuses in the future.

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