“Phantom” stock shares lead to civil suit

By Wayne Jett
Pasadena Star-News
June 16, 2006

Two class action lawsuits filed by hedge funds in Manhattan federal court indicate major problems in U.S. stock markets. The hedge funds blame big brokerage firms for failing to deliver shares of stock "sold short" by the hedge funds. The problem: buyers who paid for shares didn't get the stock, but don't know it.

The hedge funds - Electronic Trading Group LLC and Quark Fund LLC - say they were swindled by their "prime brokers," including Merrill Lynch, Banc of America Securities, Goldman Sachs, Lehman Brothers, Citigroup, Bear Stearns and Morgan Stanley. ETG and Quark allege their prime brokers conspired to charge very high fees for securities lending services and to fail-to- deliver (FTD) shares required by law for "short sale" purposes.

In separate suits, ETG and Quark allege the conspiracy also defrauded other hedge funds in the same way over a period of years. They ask the court to certify a class of all such hedge funds so all may recover damages.

The prime brokers may implicate the hedge funds in the FTDs. But filing of the suits is unlikely unless many shares sold remain undelivered.

If that is true, many buyers have paid for shares they never received from short-selling hedge funds. Some of these buyers have resold the shares to others, not knowing they had no shares to deliver. Hedge funds have billions in assets and are active traders. The number of "phantom" shares may be very large.

How this could occur in the heavily regulated U. S. securities markets is unclear. SEC regulations require shares to be delivered within three days after trade (T+3), when funds are paid (cleared) and shares delivered (settled). Most clearing and settling is done through Depository Trust & Clearing Corp. (DTCC), a private firm organized and controlled by the securities industry.

SEC regulations permit shares to be "sold short" only if the seller has access to borrow shares and does so after the sale, meeting the T+3 deadline. The hedge fund suits allege that DTCC clears funds to short sellers without actual delivery of shares, and that the prime brokers have exploited this flaw in procedures to create many FTDs.

Evidence shows T+3 often is not met. Regulations allow the seller to be "bought in" by the receiving brokers if delivery is not made within ten days after the trade. But the hedge fund plaintiffs say brokers seldom do this when large hedge fund clients are involved.

DTCC has been asked how many FTDs are occurring, but refuses to disclose FTD data, either for particular companies or for the general market, citing concerns for possible trading volatility.

Despite its professed fears of trading volatility if FTD data is known by the public, DTCC says FTDs are minor matters. But DTCC frequently uses discretion to transfer pending FTDs to private brokerages involved for resolution "ex-clearing" among them. The number of FTDs in ex-clearing is unknown to the public.

Issuers of shares affected by FTDs have complained to DTCC regarding its failure to enforce the "buy in" rule to cover FTDs ten days after the trade. DTCC states it has no authority to "buy in" brokers or their delinquent clients.

The SEC has received related complaints for years, but public enforcement actions have been minimal. The SEC adopted Regulation SHO effective Jan. 1, 2005, requiring brokerages to report FTDs in certain stock trades after that date. When the total FTDs in a stock reach a "threshold" level, the stock is named on a Reg SHO list.

The Reg SHO list names several hundred firms, most of them small, but provokes no public enforcement actions by the SEC. FTDs existing prior to 2005 were left unresolved by Reg SHO, and their present status is unknown.

Last year, SEC chairman William Donaldson was asked about FTDs, or "naked short selling," by Sen. Robert F. Bennett of Utah during Senate hearings. Donaldson asked to discuss the subject in closed session, which is out of character with information transparency sought in U.S. financial markets.

Christopher Cox became SEC chairman in 2005. In 2006, the agency provided FTD data to a NYSE-listed firm, Novastar Financial Inc. (NFI). The data covered daily trading in NFI shares during 2004 and 2005, revealing that on certain days as much as 40 percent of NFI shares traded were FTDs. On days with high FTDs, NFI's share price fell sharply.

Small investors call this fraudulent market manipulation and ask why the SEC does little to enforce "buy in" provisions of law. Some institutional investors report extended delays or no success at all in getting delivery of large lots bought.

In Utah, the governor recently signed into law a novel requirement that brokers report every FTD affecting the shares of any company organized or headquartered in the state. The Securities Industry Association lobbied hard against the measure that imposes liability of $10,000 for each day of violation.

On June 20, the U. S. Senate Judiciary Committee convenes a hearing on "short selling activities of hedge funds and independent analysts." No witness list is yet available, but may include the hedge funds and prime brokers named in the Manhattan class actions. The Committee may also invite (or subpoena) DTCC, SEC, NASD, NYSE and SIA.

Wayne Jett is managing principal and chief economist of Classical Capital LLC, a registered investment adviser in Pasadena.

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