Kaufman, on Senate Floor, Calls on SEC Enforcement Division to Address Naked Short Selling
October 21, 2009
Mr. President, I rise today to applaud the SEC’s Enforcement Division for recently bringing two actions for insider trading against Wall Street actors. While our judicial system must run its course, I’m nonetheless pleased that investigators and prosecutors are working together to target Wall Street wrongdoing.
In white collar crime, securities fraud and insider trading, enforcement is critical to deterrence; in turn, deterrence is critical to maintaining the integrity of our capital markets.
The importance of these cases extends beyond deterring and punishing criminal conduct. By identifying, prosecuting and punishing alleged criminals on Wall Street, we are restoring the public’s faith in our financial markets and the rule of law.
But while the Enforcement Division is sending a strong signal about insider trading, it still has not brought any enforcement actions against naked short sellers, despite the fact that naked short selling is widely acknowledged by many on Wall Street to have helped manipulate downward the prices of Lehman Brothers and Bear Stearns in their final days -- and their resulting failures served as a catalyst for the ensuing financial crisis that affected millions of Americans.
Mr. President, I’m pleased that the SEC has flashed a red-light in front of insider trading. But until it brings a case or makes the naked short selling that took place last year an investigative priority, the Commission is leaving a green-light in front of naked short sellers. And when you’ve got a red-light on one road and a green light on another road, everyone knows where the cars are going to go.
This concern is not mine alone. In the words of Dow Jones Market Watch, in a recent article entitled “SEC Loses Taste for Short Selling Fight," and I quote: “More than a year after short-sellers allegedly sucked the broader market lower by concentrating negative bets in troubled financial firms, the nation's securities regulators appear to be backing off curbing the practice.”
And in a piece on the naked short selling debate, Forbes magazine noted, “We have become a nation that ponders everything without resolution.”
This is critical, Mr. President, because the SEC’s current rule against naked short selling — a quote "reasonable belief" unquote that the underlying stock will be available if it is needed — is widely viewed as unenforceable.
The market has recently been showing promise and moving upward. But if it goes south, and it will again, the bear raiders who destroyed our economy a year ago and made millions in the process will strike again.
If you know you can sell five thousand umbrellas on a rainy day in New York, you are going to be out on the street with five thousand umbrellas the next time it rains. The next time one of our TARP banks or other financial institutions looks vulnerable, naked short sellers will seize the opportunity to profit again – this time costing the taxpayers directly. And the SEC will have no ability to stop them or punish them after the fact.
Given what is at stake, why have we not had action? Frankly, it’s a story emblematic of the problems on Wall Street.
The story starts in July of 2007 when the SEC decided to remove the uptick rule — which forces short sellers to wait until a stock 'ticks' up at least once before being allowed to sell —without putting anything effective in its place.
Now, when I was at Wharton back in the mid-1960s, the uptick rule was an article of faith. But a couple of years ago, the 70-year-old uptick rule became just another casualty of deregulation, an impediment to market liquidity, they said.
A little over a year later, two of the nation’s biggest banks, Bear Stearns and Lehman Brothers, had collapsed. Lehman’s failure alone, with $613 billion in debt, was far and away the largest bankruptcy in U.S. history.
Mr. President, both banks were victims of their own risky behavior and their own poor judgment. Their thinking was clouded by an aura of invincibility — willingly taking highly-leveraged positions in what turned out to be toxic assets.
But while Bear and Lehman certainly are responsible for their actions, naked short selling played a crucial role in accelerating their fate.
Now I want to make an important distinction: short selling is a well-established market practice. It can enhance market efficiency and price discovery.
I myself have sold stocks short, on many occasions. But, I always had to borrow the stocks first before I could sell them into the market.
Naked short selling is another matter altogether. It occurs when someone sells a stock they do not own and have not borrowed. Naked short selling creates two risks to the marketplace: the seller might not be able to deliver the necessary shares on the delivery date and bad actors can manipulate stocks downward, repeatedly selling something they don't own.
Naked shorting – without first borrowing or obtaining a so-called hard locate of the shares -- essentially increases the number of shares in the market, which tends to lower the value of the stock.
It’s just like if I made three copies of my car’s title and then sold the title to three different people. By the time I sold my third title, it would likely be impossible to deliver the car to the third buyer, and its value would also have declined.
When Bear and Lehman started to crumble, many believe manipulative, naked short sellers, using a series of large and frequent short sales known as "bear raids," helped drive both firms into the ground.
Bear Stearns stock dropped from $57 to $3 in three days.
When Lehman collapsed, an astonishing 32.8 million shares in the company had been sold short and not delivered on time.
The SEC has proven incapable of both preventing market manipulation from happening and punishing those who are responsible for it. Mr. President, we cannot allow this to continue.
Since March, a bipartisan group of Senators and I have been calling on the Commission to reinstate some form of the uptick rule and put a rule in place that the SEC’s Enforcement Division could use to stop naked short sellers dead in their tracks.
At a recent SEC Roundtable, major problems with the current regulatory structure were exposed. Even the panelists heavily stacked in favor of industry admitted that compliance with the locate requirement is widely ignored. And Commissioner Elisse Walter acknowledged, prosecuting naked short sellers on the reasonable belief standard is a “very difficult case to bring.”
Because the “reasonable belief” standard is unenforceable, abusive short sellers are essentially free to engage in criminal activities without fear of facing criminal prosecution.
Mr. President, the SEC's silence speaks volumes; they have given no indication there will ever be action. Nothing -- from the SEC's strategic plan to various speeches by SEC executives -- acknowledges that this is a priority. The SEC has taken action on insider trading; it should devote the same intensity of purpose to stopping abusive naked short selling.
I suspect the problem is that our financial institutions, which can now trade stocks with previously unimaginable speed and frequency, simply are unwilling to support any regulation that will slow down their profit-maximizing programs. High-frequency traders balk at the suggestion they wait in line and get their ticket punched – by first obtaining a “hard locate” of the stock -- before selling short.
If that is the case, then we are letting technological developments on Wall Street dictate our regulatory and enforcement destiny, rather than vice versa. That philosophy is simply unacceptable.
Clearly, the cost of inaction in this area is too great to ignore. Accordingly, I urge my colleagues to join Senators Isakson, Tester, Specter, Chambliss and me as cosponsors of S. 605, which requires the SEC to move quickly to address naked short selling by reinstating the substance of the prior uptick rule and requiring traders to obtain a contractual hard locate before selling short.
We need to send a strong message to the SEC that the United States Congress will not tolerate inaction on this critical issue.
kaufman.senate.gov |
