The Washington Times
Commentary by Jonathan E. Johnson III
November 21, 2007
In the late 1800s, American financier Daniel Drew refined the art of selling counterfeit shares. Drew's biographer wrote, "There is no limit to the amount of blank shares a printing press can turn out. White paper is cheap... printer's ink is also cheap." Today, it is possible to counterfeit shares electronically and it happens with such frightening regularity and impunity that Drew would be proud.
In modern stock markets, stock ownership has been separated from stock certificates through a process known as "dematerialization." As a result, when investors buy or sell stock, they are actually trading "security entitlements" not actual stock certificates.
The Securities and Exchange Commission's Division of Market Regulation Director Erik Sirri explains: "The beneficial owner's [i.e., the investor's] ownership cannot be tracked to a specific share... [T]hey own a bundle of rights defined by federal and state law and by their contract with the broker. ... That's news to a lot of people." News indeed.
Brokers in U.S. equity markets receive commissions when buyers pay for shares, not when sellers deliver those shares. Thus, incentives to deliver share are so weakened that some brokers and large institutional customers (e.g., hedge funds) regularly use loopholes to avoid delivering shares at all. The result is a "failure-to-deliver" (FTD).
FTDs can be caused in several ways, but they commonly result from short sales in which the seller does not borrow or even locate the stock he sells (the infamous "naked" short sales). Regardless of how an FTD occurs, for each share not delivered the system creates a "phantom" entitlement the market treats as a real share. These "phantom shares" are supposed to be temporary in duration and few in number. Loopholes, however, are exploited on such a scale, and phantom shares are so persistent, they are corrupting the U.S. equity markets in three ways.
(1) Phantom shares warp corporate governance by inflating the number of voting shares. Bob Drummond (Bloomberg Markets) reported in April 2006, "The results of high-stakes company decisions may hinge on the invisible influence of millions of votes [i.e., phantom shares] that shouldn't be counted." In an analysis of 341 corporate votes in 2005 by the Securities Transfer Association, there was evidence of overvoting in all 341 cases.
(2) Phantom shares distort share prices by flooding the market with excess supply. In July 2006, SEC Chairman Christopher Cox said "abusive naked short sales ... can be used as a tool to drive down a company's stock price to the detriment of all of its investors." The creation and sale of phantom shares has become a common means to manipulate share prices in U.S. equity markets.
(3) Phantom shares create systemic risk. According to the Depository Trust and Clearing Corp. (DTCC), on any given day "fails to deliver and receive amount to about $6 billion daily ... or about 1½ percent of the dollar volume." Bradley Abelow, a former DTCC director, says FTDs within the settlement system "occur as a matter of course with great regularity," and calls them "endemic." The stock market has turned into a game of "musical chairs" where claims of ownership exceed shares issued. What happens when the music stops?
In a weak attempt to curb abusive naked short selling and reduce outstanding FTDs, the SEC implemented Regulation SHO in January 2005. Regulation SHO requires the stock exchanges to publish daily a list of "threshold securities" companies that through no fault of their own have FTDs in excess of 0.5 percent of their outstanding shares. More than 6,000 companies have appeared on these Threshold Lists many for hundreds of consecutive trading days. For these companies, Regulation SHO does not work.
Freedom of Information Act (FOIA) data received from the SEC reveal that FTDs have been as high as 10 percent of the average daily trading volume on the New York Stock Exchange and Nasdaq. FOIA data also reveal that, for many companies, FTDs are a significant portion of their total shares outstanding in at least one case more than 45 percent.
Economists, the U.S. Chamber of Commerce, members of Congress, public companies, and hundreds of informed investors have urged the SEC to adopt a G.O.L.D. standard: G, eliminate Regulation SHO's Grandfather clause; O, eliminate Regulation SHO's Options market maker exception; L, require short-sellers to Locate and borrow shares before selling them; and D, require the exchanges to Disclose fully and promptly the aggregate FTDs for every Threshold List company.
To its credit, the SEC is working to fix two significant loopholes in Regulation SHO by eliminating the grandfather clause (final phase-in on Dec. 3, 2007) and by proposing to eliminate the options market maker exception (proposed, but not yet adopted).
However, these half-measures will not stop the creation of phantom shares. Will the SEC finish the job? That remains to be seen. According to a recent Senate Judiciary Committee report, the SEC is riddled with conflicts of interest that prevent it from properly policing brokers who are guilty of securities crimes. If the SEC does not act to protect investors, it falls to Congress to adopt the G.O.L.D. standard and bring an end to market distortion caused by phantom shares.
Jonathan E. Johnson III is senior vice president of corporate affairs and legal at Overstock.com Inc., a Nasdaq-listed firm on the Regulation SHO Threshold List for 642 consecutive trading days and counting.
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