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To
OTC Journal Members:
Last year I wrote two editions on
the problem of Illegal Naked Short Selling on the bulletin
board market. Is The Pendulum Swinging In the Regulatory Community?
was
the April
19th edition. The follow up, entitled The OTC Rebellion,
was published on May
18th.
If you are not familiar with the
issues surrounding the debate over illegal naked short selling in microcap
stocks, now would be a good time to click on either of those links and
familiarize yourself with the story.
Last year the SEC began to
take regulatory action in several instances where the market was manipulated
by illegal short selling. Most of the abuses occurred in one of two specific
areas: 1- where a "death spiral" financing has occurred, and a fund manager
is illegally shorting against a future convertible security to force the
price lower artificially or 2- where microcap stocks which cannot legally
be shorted are manipulated by short sellers who execute their trades through
Canadian brokerage firms. They get away with this practice because the
Canadian firms are not NASD members, and therefore not subject to the same
rules. In addition, certain flaws within the DTC (Depository Trust Company)
allow the practice to go on. In the May 18th article I wrote about 80 small
companies who had withdrawn from the DTC system to attempt to thwart the
manipulation of their stock.
As it turns out, the regulatory pendulum
is swinging towards dealing with this pervasive problem. Both the SEC and
the NASD are in the process of changing the rules to close the loopholes.
 |
The
SEC's Proposed Rule Change |
 |
The SEC has proposed a rule change
to help deal with the problem of illegal naked short selling. Proposed
Regulation SHO was available for public comment up until January 5th,
2004. The comment period has passed, and one can assume a new rule will
go into effect in the near future.
If you want to read the entire text
of the proposal, simply Click
Here, and you will be taken the the SEC's web page version of the new
rule proposal.
The SEC has the following quote in
the introduction to the new rule proposal:
| Proposed Regulation SHO would,
among other things, require short sellers in all equity securities to locate
securities to borrow before selling, and would also impose strict delivery
requirements on securities where many sellers have failed to deliver the
securities. In part, this action is designed to address the problem of
"naked" short selling.
In this excerpt, the SEC spells out
the problem:
Many issuers and investors
have complained about alleged "naked short selling," especially in thinly-capitalized
securities trading over-the-counter. Naked short selling is selling
short without borrowing the necessary securities to make delivery, thus
potentially resulting in a "fail to deliver" securities to the buyer.
Naked short selling can have
a number of negative effects on the market, particularly when the fails
to deliver persist for an extended period of time and result in a significantly
large unfulfilled delivery obligation at the clearing agency where trades
are settled.
|
The proposed rule change requires
broker dealers to take electronic delivery of shares they have purchased
within two days of settlement date. On the surface, it would seem this
rule will eliminate the massive "open fail to delivers" rampant within
the DTC system, and prevent the illegal naked short selling which comes
through Canadian broker/dealers.
I am not sure when this new rule
will go into effect, but I will try to find out.
|
The
NASD Takes Decisive Action |
|
The NASD (National Association of
Securities Dealers) has taken much swifter and more decisive action. A
surprise new rule change was announced on January 20th. It effects all
NASD broker/dealers, and has already been approved by the SEC.
New Rule 3370 goes into effect on
February 20th 2004. This new rule could become the holy grail for bulletin
board traded companies. The Rule requires NASD member firms to treat non-member
broker dealers as if they were regular customers as regards delivery of
any shares that have been sold through a US registered broker/dealer.
Up to February 20th, non NASD member
broker dealers (for the most part Canadian brokerage firms) have not been
treated as if they were regular customer. They have been awarded a special
status which allowed them to keep "open fail to delivers" on their books.
Rule 3370 forces the NASD member firms to treat the non-member broker dealers
as if they were customer, and forces them to close out their trades in
a reasonable time frame by delivering sold shares.
|
Conclusion |
|
The 90's roaring bull market, which
ended abruptly in March of 2000, led to excesses on the long side. The
hangover has continued far beyond the fraudulent practices of Enron and
MCI. It extended very deeply into the heart of the mutual fund industry.
The ensuing bear market of the 2000
to 2003 led to the same kinds of excesses on the short side. Manipulative
practices of short sellers are much less widespread and more insidious.
Market Makers will still be able
to take legal naked short positions to enhance the liquidity of the market,
but the SEC has some language to try to prevent extensive abuses by market
makers also.
The Regulators in the securities
markets are not proactive; they are reactive. A problem is identified,
and the machinery slowly starts up to deal with the problem. The wheels
turn slowly, but they eventually the system works.
These new regulations are a major
step in the right direction for the microcap market. The new regulations
will enhance the liquidity of the more thinly traded stocks, making it
easier for the companies to raise capital and maximizing their chance to
successfully implement their business plans.
I believe the OTC Bulletin Board
will evolve into a carbon copy of the NASDAQ Small Cap in the 80's and
early 90's. The listing requirements were far less stringent back then,
and many small stocks traded with a great deal of liquidity.
Charts Provided Courtesy
Of TradePortal.com |
