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The Hazards of Analogies

It sounds harmless enough when you are borrowing your neighbor™s
lawn mower with his “generous permission.” But when short sellers
sell stock they don™t own, they don™t actually get the permission of the
real owners; and selling your neighbor™s lawn mower won™t affect
lawn mower prices at Sears. In the stock market, by contrast, prices
fluctuate from moment to moment according to the number of shares
for sale. When millions of shares are “sold” without ever leaving the
possession of their real owners, these “virtual” sales can force down
the price, even when there has been no change in the underlying asset
to justify the drop. Indeed, this can and often does happen when the
news about the stock is good, because speculators want to take down
the price so they can buy in cheaply. The price is not responding to
“free market forces.” It is responding to speculators with the collusive
battering power to overwhelm the market with sell orders -- orders
that are actually phony, because the “sellers” don™t own the stock.
Like fractional reserve lending, in which the same “reserves” are lent
many times over, short selling has been called a fraud, one that dam-
ages the real shareholders and the company. Analyst David Knight
explains it like this:
Short selling is a form of counterfeiting.iii When a company is
founded, a certain number of shares are created. The entire
value of that company is represented by that fixed number of
shares. When an investor buys some of those shares and leaves
them registered in his broker™s street name, his broker makes
those same shares available for someone else to sell short. Once
sold short, there are two investors owning the same shares of stock.
The price of stock shares are set by market forces, i.e., supply
and demand. When there is a fixed supply of something, the
price adjusts until demand is met. But when supply is not fixed,
as when something is counterfeited, supply will exceed demand
and the price will fall. Price will continue to fall as long as supply
continues to expand beyond demand. Furthermore, price decline
is not a linear function of supply expansion. At some point, if
supply continues to expand beyond demand, the “bottom will
fall out of the market,” and prices will plunge.2

Counterfeit: to make a copy of, usually with the intent to defraud; to carry on

a deception.

Chapter 19 - Bear Raids and Short Sales

The lending of shares by a broker who holds them in trust for his
customers is comparable to the goldsmiths™ lending of gold held in
trust for his depositors. The broker™s customers may have agreed to
lend out their shares in the fine print of their brokerage contracts, but
they are probably not aware of it. They could avoid having their shares
lent out by taking physical possession of the stock; but if they leave the
stock with the broker (as nearly everyone does), it is in “street name”
and can be lent out and “sold” without the real owners™ knowledge,
although they still believe in the company and have no intention of
flooding the market with their shares.
An April 2006 article in Bloomberg Markets highlighted another
serious problem with short selling. The short seller is actually allowed to
vote the shares at shareholder meetings. To avoid having to reveal what
is going on, stock brokers send proxies to the “real” owners as well;
but that means there are duplicate proxies floating around. Just as
bankers get away with lending the same money over and over because
they know most people won™t come to collect the cash, brokers know
that many shareholders won™t go to the trouble of voting their shares;
and when too many proxies do come in for a particular vote, the totals
are just reduced proportionately to “fit.” But that means the real votes
of real stock owners may be thrown out. Hedge funds are suspected
of engaging in short selling just to vote on particular issues in which
they are interested, such as hostile corporate takeovers. Since many
shareholders don™t send in their proxies, interested short sellers can
swing the vote in a direction that is not in the best interests of those
with a real stake in the corporation.3
Some of the damage caused by short selling was blunted by the
Securities Act of 1933, which imposed an “uptick” rule and forbade
“naked” short selling. The uptick rule required a stock™s price to be
higher than its previous sale price before a short sale could be made,
preventing a cascade of short sales when stocks were going down.
But hedge funds managed to avoid the rule by trading offshore, where
they were unregulated. (See Chapter 20.) And in July 2007, the uptick
rule was repealed.4 “Naked” short selling is the practice of selling
stocks short without either owning or borrowing them. Like many of
the regulations put in place during Roosevelt™s New Deal, that rule
too has been seriously eroded . . . .

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The Nefarious, Ubiquitous Naked Short Sale

According to a November 2005 article in Time Magazine:
[N]aked short selling is illegal, barring certain exceptions for brokers
trying to maintain an orderly market. In naked short selling, you
execute the sale without borrowing the stock. The SEC noted in
a report last year the “pervasiveness” of the practice. When not
caught, this kind of selling has no limits and allows a seller to drive
down a stock.5
A May 2004 Dow Jones report confirmed that naked short selling
is “a manipulative practice that can drive a company™s stock price
sharply lower.”6 The exception that has turned the rule into a sham is
a July 2005 SEC ruling allowing the practice by “market makers.” A
market maker is a bank or brokerage that stands ready to buy and sell
a particular stock on a continuous basis at a publicly quoted price.
The catch is that market makers are the brokers who actually do most of
the buying and selling of stock today. Ninety-five percent of short sales
are now done by broker-dealers and market makers.7 Market making
is one of the lucrative pursuits of those ten giant U.S. banks called
“money center banks,” which currently hold almost half the country™s
total banking assets. (More on this in Chapter 34.)
A story run on FinancialWire in March 2005 underscored the per-
vasiveness and perniciousness of naked short selling. A man named
Robert Simpson purchased all of the outstanding stock of a small com-
pany called Global Links Corporation, totaling a little over one million
shares. He put all of this stock in his sock drawer, then watched as 60
million of the company™s shares traded hands over the next two days.
Every outstanding share changed hands nearly 60 times in those two days,
although they were safely tucked away in his sock drawer. The incident
substantiated allegations that a staggering number of “phantom” shares
are being traded around by brokers in naked short sales. Short sellers
are expected to “cover” by buying back the stock and returning it to
the pool, but Simpson™s 60 million shares were obviously never bought
back, since they were not available for purchase; and the same thing
is believed to be going on throughout the market.8
The role of market makers is supposedly to provide liquidity in the
markets, match buyers with sellers, and ensure that there will always
be someone to supply stock to buyers or to take stock off sellers™ hands.
The exception allowing them to engage in naked short selling is justi-
fied as being necessary to allow buyers and sellers to execute their
Chapter 19 - Bear Raids and Short Sales

orders without having to wait for real counterparties to show up. But
if you want potatoes or shoes and your local store runs out, you have
to wait for delivery. Why is stock investment different?
It has been argued that a highly liquid stock market is essential to
ensure corporate funding and growth. That might be a good argu-
ment if the money actually went to the company, but that is not where
it goes. The issuing company gets the money only when the stock is
sold at an initial public offering (IPO). The stock exchange is a second-
ary market “ investors buying from other stockholders, hoping they
can sell the stock for more than they paid for it. Basically, it is gam-
bling. Corporations have an easier time raising money through new
IPOs if the buyers know they can turn around and sell their stock
quickly; but in today™s computerized global markets, real buyers should
show up quickly enough without letting brokers sell stock they don™t
actually have to sell.
Short selling is sometimes justified as being necessary to keep a
brake on the “irrational exuberance” that might otherwise drive
popular stocks into dangerous “bubbles.” But if that were a necessary
feature of functioning markets, short selling would also be rampant in
the markets for cars, television sets and computers, which it obviously
isn™t. The reason it isn™t is that these goods can™t be “hypothecated” or
duplicated on a computer screen the way stock shares can. Like
fractional reserve lending, short selling is made possible because the
brokers are not dealing with physical things but are simply moving
numbers around on a computer monitor. Any alleged advantages to
a company from the liquidity afforded by short selling are offset by
the serious harm this sleight of hand can do to companies targeted for
take-down in bear raids.

The Stockgate Scandal

The destruction that naked short selling can do was exposed in a
July 2004 Investors Business Daily articled called “Stockgate,” which
detailed a growing scandal involving market makers and their clearing
agency the Depository Trust Company (DTC). The DTC is responsible
for holding securities and for arranging for the receipt, delivery, and
monetary settlement of securities transactions. The DTC is an arm of
the Depository Trust and Clearing Corporation (DTCC), a private
conglomerate owned collectively by broker-dealers and banks. The
lawsuits called “Stockgate” alleged a coordinated effort by hedge

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funds, broker-deals and market makers to strip small and medium-
sized public companies of their value. In comments before the
Securities and Exchange Commission, C. Austin Burrell, a litigation
consultant for the plaintiffs, maintained that “illegal Naked Short
Selling has stripped hundreds of billions, if not trillions, of dollars from
American investors.” Over the six-year period before 2004, he said,
the practice resulted in over 7,000 public companies being “shorted
out of existence.” Burrell maintained that as much as $1 trillion to $3
trillion may have been lost to naked short selling, and that more than
1,200 hedge fund and offshore accounts have been involved in the
The DTC™s role is supposed to be to bring efficiency to the securities
industry by retaining custody of some 2 million securities issues,
effectively “dematerializing” most of them so that they exist only as
electronic files rather than as countless pieces of paper. Once
“dematerialized,” the shares can be “re-hypothecated,” something the
Stockgate plaintiffs say is just a fancy term for “counterfeiting.” They
allege that the DTCC has an enormous pecuniary interest in the short
selling scheme, because it gets a fee each time a journal entry is made
in the “Stock Borrow Program.” According to the court filings, almost
one billion dollars annually are received by the DTCC for its Stock
Borrow Program, in which the DTCC lends out many multiples of the
actual certificates outstanding in a stock. Worse, the SEC itself
reportedly has a stake in the deal, since it receives a transaction fee for
each transaction facilitated by these loans of non-existent certificates.
The SEC was instituted during the Great Depression specifically to
prevent this sort of corrupt practice. The Investors Business Daily
article observed:
The largely unregulated DTC has become something of a defacto
Czar presiding over the entire U.S. markets system . . . . And, as
the SEC™s July 28 ruling indicates, its monopoly over the electronic
trading system appears even to be protected. The Depository
Trust and Clearing Corp.™s two preferred shareholders are the
New York Stock Exchange and the NASD, a regulatory agency
that also owns the NASDAQ (NDAQ) and the embattled
American Stock Exchange! . . . In an era when corporate
governance is the primary interest for the SEC and state
regulators, the DTCC is hardly a role model. Its 21 directors
represent a virtual litany of conflict . . . . The scandal has embroiled
hundreds of companies and dozens of brokers and marketmakers, in a

Chapter 19 - Bear Raids and Short Sales

web of international intrigue, manipulative short-selling and cross-
border actions and denials.
A web of international intrigue and coordinated manipulation --
the image recalls the “spider webbing” described by Hans Schicht.
The Stockgate plaintiffs expect to show that the “hypothecation” or
counterfeiting of unregistered shares is a specific violation of the
Securities Act of 1933 barring the “Sale of Unregistered Securities.”
Restrictions on short selling were put into the Securities Acts of 1933
and 1934, according to Burrell, because of first-hand evidence that
the “sheer scale of the crashes [after 1929] was a direct result of intentional
manipulation of U.S. markets through abusive short selling.” He maintains:
There are numerous cases of a single share being lent ten or
many more times, giving rise to the complaint that the DTCC
has been electronically counterfeiting just as was done via printed
certificates before the Crash. . . . Shares could be electronically
created/counterfeited/kited without a registration statement
being filed, and without the underlying company having any
knowledge such shares are being sold or even in existence.9
In a website devoted to the Stockgate scandal called “The Faulking
Truth,” Mark Faulk wrote in April 2006 that the lawsuits and repeated
calls for investigation and reform have made little headway and have
been denied media attention. The SEC has imposed only minor
penalties for infractions, which are perceived by the defendants as
being merely a cost of doing business.10 Like with antitrust regulation
in the Gilded Age, the fox has evidently gotten inside the SEC hen
house. The big money cartels the agency was designed to control are
now pulling its strings.
Patrick Byrne is president of a company called Overstock.com,
which has been an apparent target of naked short selling. In a reveal-
ing presentation called “The Darkside of the Looking Glass: The Cor-
ruption of Our Capital Markets,” he says the SEC has the data on
how much naked short selling is going on, but it refuses to reveal the
numbers, the players or the plays. Why? The information can hardly
be called a matter of national security. The SEC calls it “proprietary
information” that would reveal the short sellers™ trading strategies if
exposed. Byrne translates this to mean that if the thieves were found
out, they could not keep stealing. Why are the regulators protecting
them? He offers two theories: either they are looking forward to being
thieves themselves when they go back into private practice, or they

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are afraid that if they blow the whistle, the whole economy will come
crashing down, along with the banks that are arranging the deals.11

Financial Weapons of Mass Destruction?


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