Stock Counterfeiting - A Primer
Location: Blogs Bob O'Brien's Sanity Check Blog
Posted by: bobo 3/10/2006 10:52 PM
(Note - at the end of this section's glossary, you will find my comments, rather than in the comments section.)
The following is my new creation for the site tonight - Stock Counterfeiting. I'm trying to capture how, precisely, all of this happens, with a glossary at the end, not alphabetically, but rather, logically organized. Check it out, and let me know where I ran off the reservation, if at all...
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Stock Counterfeiting
In the old days, stock counterfeiting was a matter of using cumbersome paper and ink, and forging signatures. Nowadays, as almost all “stock” is really electronic book-entries kept in the DTC’s ledger, it is much easier. And there are numerous ways to achieve the same stock counterfeiting effect.
The most obvious is naked short selling, or “failing to deliver”.
First, an unscrupulous seller sells some “stock. Second, he fails to deliver it.
In the 3 days between when he sells it, and when he is supposed to deliver it, the buyer’s broker will credit the buyer’s account with something called a “Securities Entitlement.” When the seller fails to deliver the shares on day three, legally, per the Uniform Commercial Code (UCC) Section 8, the “Securities Entitlement” becomes invalid, and should be removed from the buyer’s account.
But because the buyer’s broker got paid his commission already, he doesn’t want to have to “bust the trade” because of non-delivery (and return the commissions), so he will just keep that now invalid “Securities Entitlement” in the buyer’s account, representing it as real and valid.
That is one form of counterfeit stock, as the buyer thinks it is real, and yet it has none of the rights that a real stock has – voting rights, dividend rights, etc. And the brokers treat these fake, invalid “Securities Entitlements” as real, and will allow the buyer to sell them to the next chump – they sort of have to allow them to, as they've been representing them as real all along.
Because this practice is not limited to just a few bad brokers, it can be said to be an institutional, or systemic, problem. Everyone on the Wall Street side of the fence wants to treat those fake “Securities Entitlements” as real – the only ones that lose by the fake, invalid “Securities Entitlements” being in the system are investors, and the companies affected.
For Wall Street it is literally free money.
A valid “Securities Entitlement” ALWAYS has a corresponding book-entry with a corresponding paper share at the DTC’s ledger. A fake, invalid “Securities Entitlement” doesn’t – so it is falsely represented to have the rights of the real thing – exactly like a counterfeit. Hence the term counterfeit stock.
This first description is the mechanism where naked short selling, or “failing to deliver”, can create counterfeit stock.
Another method of stock counterfeiting occurs when a “failure to deliver” occurs and is cured by the NSCC’s Stock Borrow Program. In that instance, stock is lent from an anonymous, self-replenishing pool at the DTC, and is delivered to the buyer. But the shares that were lent from the DTC to the NSCC have “Securities Entitlements” up at the broker level that were backed by the now-lent shares, creating yet another way of achieving the same end-result – counterfeit stock, or rather, invalid “Securities Entitlements” represented as real to investors.
Yet another method of stock counterfeiting occurs when brokers lend shares from margin accounts, and fail to alert the margin account investors that the “Securities Entitlements” are now NOT backed by the corresponding electronic book-entry anymore, as that book-entry has been lent. Again, these are invalid, fake “Securities Entitlements” per the UCC Sec. 8, and thus counterfeit stock.
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When a naked short seller fails to borrow shares to deliver to the buyer, he fails delivery to the NSCC – the intermediary in the trade. So he has a Failure to Deliver (FTD) sitting there at the NSCC – an IOU to the NSCC for shares. The NSCC is in charge of guaranteeing delivery to the buyer, so the NSCC either dips into the SBP and borrows some shares to give to the buyer, or if there aren't enough shares at the SBP the trade moves “Ex-Clearing” – outside of the DTCC system.
“Ex-Clearing” is where the buying broker and the selling broker make a contractual agreement to handle delivery of the shares off-line, outside the system. Nobody polices these arrangements, so there is no way of knowing when, if ever, the shares are delivered – that is between the two brokers.
This results in share counterfeiting, as the buyer is represented to have received valid “Share Entitlements” when in fact they are nothing of the sort, until the book-entry shares are delivered – which may never happen.
So share counterfeiting can occur in a number of ways, but always because of the same factors – the buyer’s broker misrepresents invalid “Share Entitlements” as real to his client.
That is why “over-voting” occurs – there are more “Share Entitlements” at the brokers than there are shares to support them at the DTC, and in order to continue misrepresenting the fakes as real, they have to allow investors to vote those fakes, as though real.
Pretty simple. It is all driven by Wall Street not wanting to have to give back commissions when shares are un-delivered. So a flood of fake “Share Entitlements” – counterfeit shares – are traded in the system as real, and as long as all the brokers treat the fakes as though they are real, everyone on the industry side of the fence wins big – more trades, more commissions, more shares with which to drive down prices for the large, super-important customers of Wall Street – the hedge funds. That is what is known as creating “liquidity” by creating fake shares. It is pervasive, and the SEC and DTCC refuse to tell anyone exactly how big the problem is, or to divulge the size of the problem by company.
Everyone on Wall Street – the financial press, the brokers, the DTCC/NSCC/DTC, the research firms, the banks – all have a ton to lose by this being understood by Main Street America.
Naked Short Selling & Stock Manipulation
The reason why stock counterfeiting is used by stock manipulators is because they can profit by driving the price of a company’s stock down. Without getting into the myriad number of ways to profit, suffice it to say that there are many ways to do so, including legal short selling. The key to a manipulation is to drive the price down. Naked short selling is one effective way to do so, as the manipulator can flood the market on thinly traded stock, causing the price to decline as supply exceeds demand. Some investors will sell out of fear, some because of trading theories (if a stock drops more than X, sell first, and then ask questions later), some because of margin calls – all help the manipulator maintain downward momentum.
Some manipulators aim to drive a company out of business, by exhausting the company’s capability to raise cash by selling its equity. Others merely seek to drop the price, and then keep the price low, covering their shorts with the shares being sold at or near the bottom due to the factors listed above, or investor exhaustion, or sentiment that the stock is a dog.
All of these manipulative techniques exploit the loopholes that the system has introduced by allowing clearing and settling to be de-linked from one another. In the old days, nobody got paid commissions until the stock was delivered. Now, everyone gets paid commissions when the trade is booked (cleared), and delivery is an afterthought.
By flooding the market with sales transactions that they know will create a flood of fake “Securities Entitlements” on delivery day, the fraudsters use the system to facilitate their stock manipulations – they know that buying brokers will not bust the trade, even if they don’t deliver the shares, thus they are secure in their scheme – the system will cover for them. And it does. Buy-ins are unheard of in actual practice, thus a manipulator has no dis-incentive to using this type of manipulation technique.
Terms:
Short Selling: A legal trading technique where a seller borrows stock, and then sells it, delivering it to the buyer. The seller is hoping for a price decline before he buys it back in the market to return to the lender.
Naked Short Selling: A generally-illegal trading technique where no stock is borrowed by the seller, and no stock is delivered to the buyer.
Buy-In: Where the buyer’s broker, having failed to receive shares, “Buys-in” the shares in the open market, and debits the failed seller’s account for the funds.
Share Entitlement: A marker that represents a share held at the DTC.
Fake or Invalid Share Entitlement: A marker that falsely claims to be representing a share held at the DTC, but in reality has no underlying share to support it.
DTC: The Depository Trust Company – subsidiary of the DTCC, it acts as the share vault for paper shares, and converts them into electronic book-entries – one book-entry per one share.
Book-Entry: An electronic representation of a share.
DTCC: The Depository Trust Clearing Corporation – clears and settles virtually all trades in the US.
NSCC: National Stock Clearing Corporation – subsidiary of the DTCC, acts as the “back office” of a bank, handling debits/credits for stock trades (basically handles the money) and acts as the contra-party in all trades.
Contra-Party: Middleman who guarantees shares to a buyer, and money to the seller. Legally bound to deliver both.
Clearing, clears: Processing the buy/sell, paying the commissions.
Settling, settles: Delivering the shares.
FTD: Failure to Deliver – where a sales transaction is performed, but the seller fails to deliver the shares on T+3.
T+3: Transaction day plus 3 business days. Legally, when shares must be delivered.
SBP: Stock Borrow Program – a program at the NSCC where shares are available from the DTC, on loan, to cover temporary delivery failures.
Self-Replenishing: The SBP is operated on the honor system, and it allows member brokers to put shares into the anonymous pool of shares in the SBP, to loan to the NSCC. It is said to be self-replenishing because once a share is borrowed by the NSCC, and delivered to the buyer, the buyer’s broker is free to put that same share back into the pool, to be relent out again to someone else. In that manner, one genuine share can give birth to a daisy chain of fake "Security Entitlements" at the brokers.
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I actually took the work of Tommytoyz, and of Dr. Jim DeCosta, both of whom spent hundreds of hours researching the impact of how the counterfeit stock actually gets created., and did the work to read everything available at the DTCC site, and then discussed it with ex-SEC folks and an academician.
Tommy, especially, is on top of the violation of UCC 8 that maintaining bogus "Securities Entitlements" in customer accounts produces.
He has been instrumental in some work that NCANS has done involving that breach.
As to naked short selling, I think it is pretty clear that there is a DIFFERENT violation involved than counterfeiting, namely failing to deliver within T+3 ,and stock manipulation.
So to be clear, naked short selling, or failure to deliver, is the left side of the equation. It is the root cause of one sort of stock counterfeiting - the failure to deliver the shares. What that does is causes the system to the counterfeit stock, in the manner I described.
As to, "Where's the proof" - simple.
Over-voting. The only way that over-voting happens is when there are more "Securities Entitlements" than there are book-entries at the DTC. Only way.
Now some may argue that some stock counterfeiting is legal, i.e. that the sort arising from margin lending is legal. That is highly questionable, as the UCC is clear that a "Securities Entitlement" REQUIRES a corresponding book-entry.
Fungible bulk is another complicator, as one has to take into account ALL shares held by a broker in book-entry at the DTC, versus the number of "Securities Entitlements" in the total of their accounts. If there are more "Securities Entitlements", then the overage is counterfeit stock, or more precisely, something other than valid "Securities Entitlements."
Jim DeCosta invented the term Pseudo Borrow and Pseudo shares. I use the more precise legal term "Invalid" or "Fake Securities Entitlement." Because that is what he is referring to with the term pseudo shares - "Securities Entitlements" lacking the corresponding book entry at the DTC - and thus lacking the value of a real share (the parcel of rights that comprise a stock's value - the right to vote, right to a dividend and corresponding tax treatment, etc.).
I discuss this at length in Symphony of Greed. There are numerous separate issues, but they all boil down to: how is the fake Securities Entitlement created (which is my explanation in this Stock Counterfeiting section) - exactly how, and where, in the system; and what causes that to happen? The answer to the second is, a multitude of things cause it to happen. Naked short selling is one large cause. Broker larceny is another.
Ex-clearing is interesting, because all it achieves is to circumvent T+3 delivery via an "out-of-system" contractual agreement. The EFFECT of this contract is to result in fake "Securities Entitlements" to be generated at the RECEIVING broker. Which is also stock counterfeiting.
So here's the net net - this is a little bit of a "what kills people, guns or bullets?" issue.
Think of the naked short seller as one kind of gun. Think of fake securities entitlements as bullets.
What are the various guns?
Naked short selling is a huge one.
The SBP is one, because it enables multiple "Securities Entitlements" backed by only one share.
Margin lending is one.
Ex-clearing is sort of a silencer, not a pure gun - it requires failed delivery - the gun.
The bullets are fake, or invalid, "Securities Entitlements."
It is the creation of these, and the trading of these, that represents the stock counterfeiting issue.
One can easily refer to UCC 8 to see what constitutes a valid "Securities Entitlement" and what doesn't. UCC 8 requires that a financial asset be secured and maintained, in a one for one ratio, for the "SE" to be valid. When shares aren't delivered as expected on T+3, that results in the creation of fake "SEs".
So saying that it isn't the fault of the naked short seller is worse than specious. Of course it is - they have violated the rules requiring delivery at T+3. Further, if they are doing so to drive a price down, they are violating 10(b)5.
What they are NOT doing is printing shares. They don't have to. The system does it for them.
As to the counterfeiting statute, I don't disagree with the statutes. I guess it is unclear who would be charged with it. My gut says the NSCC and the brokers.
So pseudo borrows and pseudo shares is nothing more than other terms for "fake/invalid Securities Entitlement".
Since the SEC uses the term Securities Entitlement to define what is being used as a "marker" or IOU" when it is being used legitimately, I think that using the same, consistent terminology is critical in speaking the same language - Fake or Invalid Securities Entitlement is the "correct" term for "CEBE" (counterfeit electronic book-entry) or "pseudo share" or "counterfeit share."
Again. Genuine, valid SE has a one-for-one corresponding book-entry share at the DTC.
Fake, or invalid SE has no corresponding book-entry share at the DTC.
One is a genuine representation, or "claim on title" to a legitimate share.
The other is not a legitimate "claim on title" to anything, as no book-entry share exists on the requisite one-for-one basis upon which to lay that claim.
Clear?
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