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Are Regulators Liable for their Securities Violations? - January 24, 2005

David Patch


In reviewing the daily Securities and Exchange Commissions news digest I frequently read of Brokers or Corporate Officers being cited for alleged schemes to deceive.  The cases brought forward by the SEC will cite violations of Section 17(a) of the 1933 Securities Act and Section 10(b); Rule 10b-5 of the 1934 Securities Act in the complaints.  In each the allegations pertain to the presentation of materially false or misleading information used as a mechanism to manipulate a stock price.


For those wondering, Rule 10b-5 of the 1934 Act says it shall be unlawful “to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading.”  Sections 17(a) and 109b) simply get into the acts of obtaining money through misleading information and interstate commerce violation.   So under this rule, how is it accepted when the Securities Regulators may present materially false and misleading information to the public affecting stock pricings and to some degree receive money, by way of trade volume transactions, in the violation?


When the SEC released their sweeping reforms pertaining to short selling they did so by stating that these reforms would address the abuses incurred by excessive “naked short selling”.  They publicly cited the potential abuses caused by excesses in naked shorting and presented how this reform would address such abuses.  Privately they informed Congress as well that Regulation SHO would resolve the now more public issue. 


The SEC released to the public Regulation SHO on June 23, 2004 and provided the industry six months to prepare their systems for this sweeping reform package.  January 3, 2005 being the introductory date for full compliance.


For those who were fortunate enough to listen in on a Bear Stearns conference call on December 13, 2004 we were enlightened to hear that the SEC and regulators may have actually taken SHO seriously.  The General Council for Bear Stearns initiated the call by identifying that SHO came about over years of concerns and private conversations with regulators about the industry practice of not following established laws.  The call eventually discussed the “threshold security list”, the list of settlement abused companies, and Richard Bernstein, managing director of operations highlighted that regulators had been providing a “would be list” for over a month that contained over 1000 potentially abused companies.  Mr. Bernstein broke down the list by the number of companies representing specific trading markets or quoting service.


Although the question of the confidentiality of the list concerns me; did the Regulators have the right to present non-public information to Bear Stearns, the fact that the list was of this size showed the magnitude of the issue and the acknowledgement by the regulators.  The list also provided insight that the abuses could slow down if not cease altogether when the list of 1000 would be made public and as regulators started to enforce laws they had ignored for so many years past.


But then something happened on the way to print.  The list of 1000 companies never made it to the public.  A phantom editor dissected it on the way to the press.


On January 7, 2005 the NASDAQ presented it’s first “threshold security list” and on it was a sum total of 379 NASDAQ NMS, small-cap, OTCBB and Pink Sheet Securities.  This compared to a reported 900+ that Bear Stearns identified would make the list from these category stocks.  What happened to the 500+ that are missing?


What happened was, on January 14, 2005 the list was merely trimmed again and yet another 250 or so companies were removed bringing the list down to a paltry 111 companies.  Many of those removed had not even traded since they were added initially.


In all, nearly 750 OTCBB and Pink Sheet Companies were trimmed from the list between December 13, 2004 and January 14, 2005.  During this same window of trading the number of NASDAQ NMS, small-cap, AMEX, and NYSE securities remained nearly identical with more additions than subtractions.  In the OTCBB and Pink Sheet quoting service of relative illiquid securities the Industry was able to wipe out 750 Issuer settlement problems.  The Industry failed to resolve nearly any of the 250 highly liquid NASDAQ, NYSE, and AMEX securities listed during this same timeline.


This anomaly leads to a direct question.  Is the list an accurate depiction of abused companies or has the NASD published a document that is an untrue statement of material fact that can be used to manipulate and deceive investors?  Did the NASD violate Rule 10b-5 of the 1934 Securities Act while also violating the public disclosure rules of Regulation SHO?  Or, was the data presented by the NSCC doctored to manipulate the publication results?


While these are harsh accusations, consider this.


Bear Stearns has claimed their list came from the regulators.  Those are the same regulators who are now required to make the list public.  In the list of 1000 that was disseminated in December to Bear Stearns are the very names of NASDAQ listed securities that the NASD published on January 7.  So how could the 100 NASDAQ securities be correct and the 800 OTCBB and Pink Sheets be totally inaccurate when the same organization was conducting both calculations?  The data is calculated by the NASD after receiving fail data from the NSCC’s Continuous Net Settlement System.


Furthermore, in a PIPE’s report dated January 15, 2005 Jeffrey Meyerson of Crown Financial was quoted regarding the published lists “I don’t think they got everything done in time” going further stating “I wouldn’t be surprised if we see it really different a month from now”.  Crown Financial is a Market Maker on the NASDAQ exchange utilizing the naked shorting exemptions permitted in their bona-fide market making activities.  Crown Financial would also be one better equipped to know how accurately securities are trading and settling as they themselves carry fails and execute the orders that may not settle.


If the NASD had not “got everything done in time” they should have published that material fact as a disclaimer to the list.  The disclaimer would have protected investors looking for the list as a material fact regarding the abuse they have suffered.  But then, if they did not get it done in time, what was the list they provided to Bear Stearns and how come they could not comply after being provided six months to do so?


To go further into the possible inaccuracy of the published list is a report by visiting economics professor Leslie Boni working for the SEC.  Prof. Boni was hired by the SEC under a one-year term to look specifically at the implications of Regulation SHO and the underlying causes to the settlement failures.  In her working document titled “Strategic Delivery Failures in the US Equity Markets” the professor provides us with three separate trading snapshots of the settlement failures of Wall Street as reported by the NSCC.  Her analysis is broken up between the primary markets of the NYSE, AMEX, and NASDAQ and the quoting services of the OTCBB and Pink Sheets.


The Professors report, like the Bear Stearns list, directed the primary level of fails at the OTCBB and Pink Sheet Companies.  Her data, while providing for various interpretations, implies that of 1790 OTCBB and Pink Sheet Companies with fails greater than 5 business days the mean percentage of total fails is 1.56% of the issuers outstanding shares, or 3X the allowable threshold levels that would get you listed.  The report also cites that the mean time of fail is 56 days, which is 53 days greater than the required settlement period of 3 days.  Certainly more than 10 companies would be eligible for the Reg. SHO threshold list if 1790 had a mean of 1.56% of their outstanding in a fail status for an average of 56 days.  To read the entire report, go to:


If all the data trends show a prevalence of fails pertaining to the OTCBB and Pink Sheets, how is it the NASD publishes a list in which practically none of the OTCBB and Pink Sheets is being identified?


What does it matter?


Without being on the list those companies abused by settlement failures will not see the enforcement of mandatory closeout of failed trades.  Without being on the list violations can continue to take place and the overselling of securities that drive a stake into the hearts of long investors continues.  Investors lose and those abusing the system win.  Ultimately, without being properly disclosed on the list the list becomes a public disclosure of materially false and misleading information now used as a conduit to manipulation.  The list disseminated by the individual SRO regulators.


The Bear Stearns list is documented.  Many who were eligible on December 13, 2004 but have since missed the official list have seen the steady declines in the stock values one would expect based on prior abuse activities.   Short sellers and market abusers have been given a reprieve from mandatory closeouts and can fully short without delivery as they have always done previously.   With the SEC’s “grandfather clause” in Reg. SHO the SEC will only further protect these potentially abusive trades from the closeout provisions intended to stop the abuse simply because the closeout provision only applies to fails that take place “once on the list”.  How responsible is the NASD in this activity?


To date the NASD has refused comment on the publication of the list citing its accuracy as best they know it.  Most investors and media calling the NASD about the logical inaccuracies in the list are put into a daisy chain of forwarded calls ultimately giving up before their questions get answered.  One person I was able to speak to in the NASD’s Market Operations department agreed that something looked odd but would not comment any further.  Another spokesman from Market Operations stated that it was the SEC that had requested removal of the 250+ companies on January 14th claiming the NASD was improperly following eligibility requirements in their calculations.  No official notice was being formulated.


In calls to the SEC, spokesman John Heine would only say that the SEC does not publish the list and to direct all calls pertaining to NASDAQ lists to the NASD.  While Mr. Heine is correct the SEC does not publish the list, they are responsible for enforcement of SEC Rule 10b-5 and Regulation SHO disclosure provisions.  Even if the violators in this case are the Self Regulatory Operations like the NASD or the NSCC.


This issue will not be going away any time soon no matter how hard those in Washington try to bury it.  The continued allowances for Wall Street to become a printing press of counterfeit shares will soon destroy our economy if we never address it properly. 



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