The strategy, of course, is to avoid paying more for the shares. The paper by Leslie Boni, says that 1,790 OTC and BB stocks, representing 93.7 percent of all the issues on those two boards, suffered from fail-to-deliver shorting on three representative days from Sept. 23, 2003 to Jan. 21, 2004. Boni was a visiting financial exonomist at the SEC - the equivalent of a visiting professor - when he developed the paper, but it is not an official SEC document.
The scholarly paper is located at http://www.unm.edu/~boni/Fails_paper_Nov2004.doc. Be sure to study the tables at the end, which seem to have devastating implications. The abstract states:
Sellers of U.S equities who have not provided shares by the third day after the transaction are said to have “failed-to-deliver” shares. Using a unique dataset of the entire cross-section of U.S. equities, we document the pervasiveness of delivery failures and provide evidence consistent with the hypothesis that market makers strategically fail to deliver shares when borrowing costs are high. We also discuss the implications of these findings for short-sale constraints, short interest, liquidity, price volatility, and options listings in the context of the recently adopted Securities and Exchange Commission Regulation SHO.
When the author mentions "constraints," he is saying that short sellers and market makers who empower them do not self-regulate, which would require them to move against sellers of these so-called "naked" shares, i.e., shares that have been promised for delivery but that in fact do not exist:
Recent work by Evans, Geczy, Musto, and Reed (2003) introduces the idea of strategic failures-to-deliver, which result when short sellers choose not to deliver shares that would be expensive to borrow. Evans et al show that strategic failures by options market makers can reduce short-selling constraints for stocks that have options listed. More generally, strategic fails may extend beyond those of options market makers, thus reducing short-sale constraints for non-option stocks as well.
At this point, with hundreds of non-option stocks including ERHC having been shorted in huge volumes, expecially on the Nasdaq and OTC BB, the cost of buying real shares is so prohibitive that I fear the market makers will invest substantial sums in legal and political efforts to stop enforcement of the SEC's new Regulation SHO.
That regulation would seem to put a damper on their short sales in the future, but many have already criticized it because it permits fails-to-deliver for up to 13 days before market makers even have to stop selling the the stock short. Even then, there are escape hatches in the regulation that allow market makers to indefinitely postpone settling up for such shares. And the SEC made existing fail positions exempt from mandatory close-out provisions. Also exempt are market makers, specialists, and short positions that represent hedges by options market makers for pre-existng option positions. Non-market maker hedge funds and arbitrageurs, who were formely exempt, no longer are.
Here is a brief explanation of the new rule from the SEC:
“Rule 203(b) creates a uniform Commission rule requiring a broker-dealer, prior to affecting a short sale in any equity security, to ‘locate’ securities available for borrowing. For covered securities, Rule 203 supplants current overlapping SRO [i.e., self-regulatory organizations NYSE and NASD] rules. Specifically, the rule prohibits a broker-dealer from accepting a short sale order in any equity security from another person, or effecting a short sale order from the broker-dealer’s own account unless the broker-dealer has (1) borrowed the security, or entered into an arrangement to borrow the security, or (2) has reasonable grounds to believe that the security can be borrowed so that it can be delivered on the date delivery is due. The locate must be made and documented prior to affecting a short sale, regardless whether the seller’s short position may be closed out by purchasing securities the same day.”
The SEC may view the forced close-out of naked short positions as a problem that would destabilize the very markets it is dedicated to stabilizing, and so, even if it is a dishonest practice, has found ways within Regulation SHO to continue to permit naked short positions to remain open.
A more optimistic view would say that market makers will understand what the SEC is trying to do and will independently quit selling short positions in stocks on the threshhold securities list. They would recognize, in this view, that nothing good can come of being exposed to lawsuits and regulatory action by involving themselves in a dubious and even shady side of the market.
Reinforcing them in this position would be the major media, who have generally avoided reporting on the topic; almost everything of substance written about naked shorting comes from small, independently-owned Websites. A long-rumored Dateline program that NBC was supposed to run, for instance, has never appeared (a caveat: we have not checked with Dateline producers to determine if such a report was ever started).
In the post-September 11 world, stock market liquidity is a fundamental priority of government, and as long as our government can issues fines aganst broadcasters for what they do or don't say, show and report, they are unlikely to challenge the status quo on a subject of "national security" interest, which liquidity is. Thus, a presidential appointee at the FCC may be a lot more vigorous against a network that exposes the dark underbelly of the stock markets - those huge uncovered short positions - than against one that routinely praises the administration.
The author of the report makes some interesting predictions at the end. Here they are:
These findings suggest that post- Regulation SHO:
1 Liquidity will decrease and short-sale constraints will increase, particularly for stocks that are expensive to borrow.
2 As institutions are more likely to be lenders in the market for stock loans, stocks with little institutional ownership will likely become even less liquid. Stocks that trade on the Over-the-Counter Bulletin Board and Pink Sheets had average institutional holdings of only 1.3% of shares outstanding and are likely to be among the hardest hit.
3 Options listings will decrease for stocks that are expensive to borrow.
4 Short interest will decrease, especially for expensive-to-borrow stocks.
5 As a result of or in anticipation of mandatory close-outs, illiquid, expensive-to-borrow stocks may be more likely to experience temporary short squeezes and increased price volatility.
These predictions may provide interesting areas for future research.
For my part, I expect the market makers will back off slowly from the practice of empowering naked short positions and that there will be somewhat less price volatility in many low-cap issues such as ERHC as a result. They will also put some pressure on their customers who hold "naked short" positions to close them out. In this process, the situation would slowly but surely be resolved over several years. This is the way of the world in America in 2005, sadly, but it seems to work for us.
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