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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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