-By Alan M. Pollack
As a securities litigator for many years, I believe that our capital markets are under attack, not by terrorists or hostile foreign countries, but by brokerage firms, their hedge fund clients and large institutional investors who engage in Naked Short Selling and Spoofing. These trading strategies are forms of market manipulation that have destroyed emerging and small cap companies, caused the loss of billions of dollars in pension, profit-sharing and savings accounts of working-class citizens, undermined the integrity and efficiency of our stock markets, and placed billions of dollars of illegal profits in the pockets of the manipulators. This article will provide a general overview of how these schemes work and the impact they have on our capital markets.
A. SHORT AND NAKED SHORT SELLING
To understand how Naked Short Selling works, it is important to first understand how short selling works. Short sellers bet against the success of a company because, they only make money when stock prices decline and lose money when prices rise. Short sellers are therefore motivated to target and expose overvalued companies that are concealing accounting irregularities, product defects and management incompetence, or are subject to industry sector price fluctuations.
The mechanics of a lawful short sale are as follows: a seller, who believes that the share price of a security will decline, locates shares or has a reasonable basis to believe that shares can be located, and thereafter borrows and sells these shares to a buyer. Typically, a brokerage firm will locate and lend these shares for a fee. If the market price of the shares declines after they are sold, the short seller will purchase in the open market, shares at the lower price, and deliver them to the lender to replace the shares that were originally borrowed and sold. The profit a short seller earns is the difference between the price it sold the borrowed shares at and the price it paid to repurchase the shares that are returned to the lender, net of borrowing costs and commissions paid to the lender broker. However, the risk to the Short Seller is that, if the share price of the security rises, rather than declines, the seller must cover the loan by buying shares at a higher price than the cost at which the shares were originally sold.
While short selling is a legal trading strategy and serves as a counterweight to companies trading at artificially inflated prices, Naked Short Selling is an unlawful trading strategy where short sellers do not locate or borrow shares and “fail to deliver” authorized shares to the buyer. In a naked short selling scheme, “phantom” or “fake” shares are sold to an unsuspecting buyer, which are recorded by the buyer’s broker as an “entitlement.” This “entitlement” is the functional equivalent in the securities industry of an “IOU,” which can remain unpaid for years. When a monthly or quarterly account statement is sent by a broker to their customer, the statement does not mention the existence of an entitlement or that a book entry was created in lieu of the actual delivery of the securities themselves.
In order to insure the payment of large fees and accommodate the naked short selling of their large institutional or hedge funds clients, brokers will intentionally mismark order tickets to falsely represent that shares can be located or offer to loan the same shares dozens of times to different clients. These practices create phantom shares that are sold but not authorized by the company and dilute the value of shares that are authorized and issued by the company. When crooked brokers want to conceal their unlawful practices from regulators, they may take shares from other customer accounts to make deliveries, thereby not creating a public Fail to Deliver, exposing their actions and being able to stay naked indefinitely. Even when dishonest brokers are caught red-handed by regulators and fined, they consider such punishment as merely the cost of doing business.
Once the phantom or fake shares are in circulation, there is nothing to stop a new round of naked shorting from occurring. Naked Short Selling schemes frequently target micro-cap companies that are traded over the counter and emerging companies that are traded on NASDAQ. These types of companies are particularly vulnerable to the downward pressure generated by unrelenting naked short selling that causes the company’s share price to decline, until filing for bankruptcy becomes inevitable. Naked short selling schemes that are perpetrated by sophisticated fraudsters, often involve negative articles about the target company being written or tweeted on the internet by anonymous writers. The intent of these misleading statements is to cause shareholders to sell their securities in order to limit their losses. As more shareholders sell, the trading profit of the short selling increases because excessive supply coupled with a diminished demand drives the price down. When a naked short selling scheme causes a company to file a petition for bankruptcy, the naked short seller has won the “jackpot” because it is not required to deliver the shares or pay taxes on the profits. The payment of taxes only accrues, when and if, their position in the stock is closed, not if the company files for bankruptcy.
To place in context the impact and magnitude of the naked short selling problem in our capital markets, it is estimated by industry experts that there are trillions of phantom shares being circulated, hundreds of emerging and small cap companies have been driven out of business by this practice and in 2020 there was an average of 7.4 billion Fail to Deliver shares- daily!
Spoofing is another predatory market manipulation practice that is used to drive share price downward. The objective of a spoofing scheme is to distort the publicly available information concerning the actual supply and demand of the targeted company’s securities. This objective is accomplished by the spoofer placing in the Limit Order Book (“LOB”) or Inter-Dealer Quotation System (“IDQS”) hundreds or thousands of “Baiting Orders” that have no legitimate financial purpose and are never intended to be executed. The purpose of these Baiting Orders is to create a false illusion or artificial perception of market interest (either negative or positive) that will generate a response from other market participants to follow either the selling or buying signal created by the Baiting Orders. This is commonly referred to as the “pile-on” effect. If the goal of the spoofing scheme is to drive the price of the targeted company’s securities downward, the spoofer will flood the market with Baiting Orders to Sell, which are intended to “trick” other market participants into selling their securities in order to minimize or avoid suffering losses in a declining market.
Shortly after the Baiting Orders are placed, the spoofer will place, sometimes within a nano or millisecond, on the opposite side of the LOB or IDQS, Executing Orders to Buy. These orders are intended to be executed at the lower price caused by the Baiting Orders to Sell. Immediately after placing the Executing Order to buy, the spoofer will cancel the Baiting Orders to Sell, which completes the spoofing cycle. If the spoofer’s goal is to drive the price of a security upward, the process is similar except that the spoofer places Baiting Orders to Buy and Executing Orders to Sell at the manipulated higher price.
Spoofing schemes to either buy or sell are used multiple times during a trading day and are repeated throughout a protracted trading period. To maximize the speed of their market access and execution of their trading strategies, spoofers typically utilize algorithmic trading programs through high-frequency trading computer systems which enable thousands of Baiting Orders to be placed and cancelled in a matter of nano or milliseconds. Like naked short selling, spoofing is used to destroy companies and cause their shareholders to lose billions of dollars in investments. Recently the SEC imposed fines and penalties on JP Morgan, which was caught spoofing in the metals market, in the amount of $920 million. However, as industry experts have observed, regulatory fines have only a de minimis deterrent effect because like fines for short selling they are also treated as the cost of doing business.
Brokerage firms are charged with the regulatory duty of serving as “gate-keepers” of our exchanges and are required to monitor and surveil the trading activities of their clients and their own traders. However, certain brokerage firms are facilitating the destruction of shareholder equity and emerging companies by turning a blind eye and deaf ear to these market manipulation schemes in order to realize billions of dollars in fees and commissions.
When Michael Douglas played Gordon Gekko in the movie “Wall Street,” he famously declared that “Greed is good.” While most people would disagree with this statement, the obsession on Wall Street with making money through unlawful market manipulation schemes is undeniable. Not every broker-dealer on Wall Street acts unlawfully. However, based on the significant increase in regulatory investigations, fines and punishments, the problem of market manipulation has become systemic in our capital markets.
When broker-dealers either intentionally orchestrate or passively ignore trades where phantom shares are created or authorized, or knowingly place orders that have no legitimate financial purpose and are not intended to be executed in orders to trick unsuspecting investors to buy or sell securities, some observers of our capital markets have called this activity—”fraud on the market.”
In future articles, we will discuss the roles the SEC and FINRA have played in investigating and prosecuting Naked Short Sellers and Spoofing, and to what extent these agencies are part of the problem.
Alan M. Pollack is a partner in the New York City law firm of Warshaw Burstein, LLP. Mr. Pollack specializes in representing individual investors and corporations who have been defrauded in market manipulation schemes. This article is not intended as legal advice. If a reader believes that they have been victimized by a market manipulation scheme, they should consult with their own attorney for advice and guidance.
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