Forbes Failed Trades Liz Moyer 8-18-06
A simple Freedom of Information Act request has reignited debate over the influence of naked short-selling in the stock markets.
Late Thursday and all day Friday, bloggers and posters in investment Web site chat rooms were furiously debating the merits of information dug up by David Patch, a now-familiar character in the blogosphere who stands firmly in the anti-naked-short-selling camp.
On Thursday, Patch got word back from the U.S. Securities and Exchange Commission on his request for information regarding failed trade data on Global Links, a Las Vegas real estate holding company that has been the target of frenzied trading activity over the last year and a half, and whose shares now trade at just fractions of a penny.
The data says on April 18, 2005, and the next day, fails in trades of Global Links stock totaled 10 million each. This compares with roughly 4 million shares in total outstanding common stock reported by the company at the end of March 2005.
So there was well over twice as many failed trades each day as there were actual common shares issued.
How can this be? Global Links is a very tiny company, but it is one example of an intensifying debate that is going on in the markets and at the SEC about possible market manipulation.
For the last year and a half, there has been a growing chorus of folks, like Patch, who argue that naked short-sellers pose a systemic risk to the markets by creating counterfeit shares that pressure stocks of targeted companies even lower and force some companies out of business (not to mention destroying the investment savings of shareholders.)
They even contend that this activity is orchestrated, involving the collusion of hedge funds, broker dealers and in some cases journalists, all under the not-so-watchful eye of market regulators.
Their detractors--blogger and former BusinessWeek editor Gary Weiss mockingly calls them the "Baloney Brigade"--say they are distorting or misinterpreting the data. Or, at worst, they are scam artists bent on the opposite form of stock fraud--the "pump and dump."
To back up for a minute, short-selling is when the trader borrows the shares and sells them, hoping they'll fall and he can buy them back at a lower price and pocket the difference when he goes to close out his loan.
But sometimes stock is hard to borrow. Trades still take place, however, though traders never managed to borrow the shares before selling them, resulting in the shares not being delivered to the buyer. These are known as fails-to-deliver. It's also called naked short-selling. Some of it's accidental, and some of it is an intentional form of manipulation.
The SEC, concerned about possible manipulative short-selling activity, instituted Regulation SHO in January 2005. It was supposed to curb abusive trading by imposing strict close-out rules in stocks that had high degrees of failed trades within certain parameters. But Reg SHO has proved to be less than effective, as the SEC itself noted last month in proposing amendments to tighten loopholes.
Since January 2005, several companies have been on the SHO list for well over 13 days, some for hundreds of days, including Overstock.com, Netflix, Krispy Kreme, and Martha Stewart Living Omnimedia. Even the SEC admits this isn't how it's supposed to work.
"Large and persistent fails to deliver," it says in its proposed amendment to SHO, "can be indicative of manipulative naked short-selling."
The SEC's own reporting on the issue doesn't even capture the whole problem. The agency uses data from the Continuous Net Settlement system at the Depository Trust & Clearing Corp., the New York clearinghouse that acts as the financial industry's go-to place for settling securities transactions.
The DTCC says fails-to-deliver equate to about $3 billion, if you divide in half the $6 billion figure it reported at the end of 2005 (it later explained it was double-counting delivered and received shares). The company, which reports fail data to the stock exchanges but won't release the data to the public, says it has no way of knowing how many transactions settle ex-clearing, meaning outside its walls, in special arrangements from broker to broker.
"We don't know the underlying reasons for why trades fail. All we do is process the data and provide the information" to the markets, says a DTCC spokesman.
Asked for the percentage of fails (among failures the DTCC tracks) in all stock trades settled, including ex-clearing, he says, "If you don't know the size of the whole market, how can you tell what percentage you have?"
Executives at Global Links think they have more like 20 million to 30 million failed trades in their stock, which might suggest ex-clearing trades in their stock are two to three times as great as at the DTCC. "It's something that we're still researching," says Patrick Donahoo, manager of marketing services.
The whole saga started in February 2005, when Global Links, then trading at 10 cents a share, initiated a 1-for-350 reverse share split, reducing its common stock outstanding from 350 million shares to about 1.1 million and narrowing substantially the number of shares available to be borrowed. After the reverse split, a Michigan businessman named Robert Simpson filed a notice with the SEC saying he had acquired 100% of Global Links' outstanding common stock.
Donahoo says there is no evidence that Simpson ever got his shares, even though he filed papers with the SEC documenting the purchase. Attempts to reach Simpson were unsuccessful.
According to the SEC data, the fails in Global Links stock dropped to just under 10 million a day after two days and gradually tapered off, but were still a lofty 5.97 million at the end of December 2005. A month after the reverse split, the company issued another 2.9 million shares previously authorized by the board, and those shares may have alleviated some of the fails.
Shares of Global Links, which trade over the counter, rose 2.22% Friday, but were still a half-penny each. Some 270,000 shares traded. "We're still operating, and our doors are open for business," Donahoo said. "But it's definitely taken our focus off what we're doing here."
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