By Christopher Twarowski
Washington Post Staff Writer
Monday, August 18, 2008
When the Securities and Exchange Commission issued an emergency order last month protecting the stocks of the country's largest financial institutions against a form of short selling, three businessmen saw an opportunity.
Harvey Pitt, SEC chairman from 2001 to 2003 and chief executive of District-based global consulting firm Kalorama Partners, teamed up with John Tabacco, chief executive of LocateStock.com, and Tom Ronk, the chief executive of Buyins.net, to launch RegSHO.com.
The D.C. company operates a Web-based, real-time electronic stock lending and location service that provides tools to help sellers and brokerage firms comply with SEC rules governing naked short selling -- the practice the agency sought to prevent -- and regular short sales of stocks. The Web site matches traders with available stocks that can be borrowed for short sales and offers immediate data on the short-sell market. It is named after the SEC's order regulating such trades, Regulation SHO.
The emergency order required short sellers to borrow shares before initiating a short sale in the stocks of 19 major companies, including Morgan Stanley, Goldman Sachs and Merrill Lynch, along with mortgage giants Fannie Mae and Freddie Mac. Issued July 15, the order expired Aug. 12, with SEC officials saying they were moving toward introducing a permanent rule that could cover the entire market.
In regular short selling, which is legal and adds liquidity to the market, a short seller borrows securities from a brokerage firm, then sells them, betting that the stock will decline in value. The seller buys the stock back at a later time and returns it to the lender, pocketing a profit if the stock price declined.
In naked short selling, the seller never borrows the shares but continues with the transaction as if he had. This results in fake, or phantom shares, critics say. Since the seller is not constrained by the number of available shares, he can sell an unlimited number of securities that may not even exist. Naked short selling, in large volumes, can depress a company's stock, by creating sustained downward pressure, and ultimately destroy it, driving down the price until the stock is worthless, critics say.
"It is a very serious problem, and it has led to a whole host of additional problems in the marketplace," Pitt said. "It's definitely a vehicle that has and can be used by those who effectively want to push the price of the stock down and do it rapidly."
The SEC order provoked debate. Smaller banks sought coverage and complained that they had become victims of the practice, while hedge fund and investment groups wanted the order rescinded, citing increased costs to complete regular short sales.
Richard H. Baker, president and chief executive of the Managed Funds Association, an advocacy group for hedge funds and futures funds, said member firms had been reporting an increase of more than 200 percent in operational costs associated with short trades in the protected companies.
Longtime critics of naked short selling weren't happy either, saying the order protected the firms and clearinghouses conducting the trades.
The prospect that the SEC might expand the order has spurred more dismay among hedge funds and other short sellers. "An extension to every stock is going to begin to make trading in all securities more cumbersome and more expensive," said James S. Chanos, chairman of Coalition of Private Investment Companies and president of hedge fund Kynikos Associates.
But RegSHO.com's executives say their company can help reduce costs because transactions are done electronically and traders never have to take the time to pick up the phone.
Besides helping match borrowers and lenders with stock, RegSHO.com alerts subscribers to compliance problems. It also offers solutions, with guidance and consultation from Pitt via the site. Clients pay a monthly fee of $995 for standard access to the site and an additional per-share fee for stock locates.
Access to RegSHO.com includes access to LocateStock.com, a real-time lending-borrow marketplace specializing in hard-to-borrow stocks, and Buyins.net, which specializes in identifying demand for borrowed stocks and features a historical database of more than 2.1 billion short sale transactions. The three founders said that membership in the sites has increased by at least 30 to 40 percent since the SEC's announcement of its order.
"We've been telling people for the last couple years that they're not doing things correctly," Tabacco said. "But until somebody slams their fingers with a ruler, kids will play."
Other companies that offer similar services, to varying degrees, include ShortSqueeze.com, Stock-Borrow.com, ICAP and Quadriserv.
Regulation SHO requires short sellers to locate or have reasonable belief that they can locate stock prior to effecting a short sale. It requires a seller or broker to deliver shares to a buyer to settle the transaction within three days from the trade date. Naked short selling can result in what's called failures to deliver, or FTDs. FTDs represent trades where only half the transaction of a sale was completed. The trade went through, but the seller never delivered the shares to the buyer.
RegSHO.com uses data from SEC-mandated "threshold security lists" and National Securities Clearing Corporation, a centralized clearing and settlement house for all U.S. trades, to create their own "Naked Short Lists." The lists identify available stocks to short and those needing "imminent" buys for compliance.
In 2005, the SEC required the publishing of the daily threshold lists, which include companies that have a high degree of FTDs.
Brokers are mandated 13 days to resolve any FTDs after landing on the lists. Despite this, some companies have been there for hundreds of days, with millions of failed shares.
The incomplete trades could represent lucrative business for RegSHO.com, because they will eventually have to be resolved under the rules of Regulation SHO.
The FTD problem represents a decent chunk of change. Josh Galper, managing principal of Vodia Group, said an analysis revealed $9 billion of FTDs in 2007. Susanne Trimbath, chief executive and chief economist of California-based STP Advisory Services, calculated that FTDs in the U.S. equity market cost investors $2 million daily in lost earnings last year.