The Enforcement Apparatus for the securities industry is the classic foxes guarding the hen house. Regulatory agencies are a closed loop with no transparency and, therefore, very little outside oversight, be it from Congress, the public, lawyers for investors or the media. The lines between the regulators and those being regulated are blurred or nonexistent. The opportunity for conflicts of interest exist at almost all levels, so it is no surprise that enforcement actions rarely happen, and when they do, they are not very meaningful, criminally or economically.
The SEC is the top federal agency charged with enforcing the rules within the industry. They promulgate new rules, hold public hearings, and, in the final analysis, may have the appearance of advancing rules that will stop counterfeiting and other stock manipulations. But, by the time the industry waters the rules down and adds loopholes and exemptions, the reform intended is emasculated. Reg SHO, which was enacted to solve the problem of naked short (counterfeiting) abuse, is so fraught with loopholes, meaningless enforcement and safe havens for counterfeiting, that the law itself is a fraud perpetrated upon the American public, who believe their investments are being protected. The securities industry has little apparent difficulty staying one step ahead of the SEC.
Flooding the offer side of the board with counterfeit shares, thereby altering the price point at which the demand curve intersects the supply curve, is the most fundamental principal of economics, and an obvious and overt manipulation of the price of a stock. Short attack days regularly see over 90% of the sells being short and counterfeit shares, causing the price to plummet or on good news days, soaking up the demand thus keeping the stock price from going up.
The SEC almost never prosecutes shorts for “price manipulation.” Instead, on the rare occasions when they do investigate, they look at trades on a microscopic level. For example: Were short sales tickets mismarked as long sales? Was there short selling on down ticks? etc. If there is a finding it is for a minor infraction and the fine is minor as well. Almost all of the broker dealers have been fined for mismarking tickets, virtually none for manipulation with short sales. One case we know of resulted in a million-dollar fine, which was gladly paid. The broker reportedly made $50 million on the manipulation. This process of microscopic rules enforcement and loophole compliance while ignoring the larger price manipulation question permeates the securities enforcement apparatus from top to bottom.
It is ironic that microscopic rules enforcement is the guideline when prosecuting short manipulations, yet when the manipulation involves long shares, the enforcement looks at the overall scheme vs. the individual trades. If one examines a classic pump and dump scheme in a mirror, you see a short down ladder. If one replaces long shares with short shares, pump with crash and dump with cover, the manipulations are the same with the same outcome: the fleecing of the public. Per the SEC, pump and dumps are illegal and occasionally prosecuted. Short down ladders are deemed legal so long as the trades fall into a loophole, and are rarely prosecuted.
Investigations of complaints alleging stock manipulation are handled in complete secrecy, so the victim rarely knows what the outcome was or if it was even investigated. After an investigation is closed, in theory, the documents should be available under the Freedom of Information Act. The SEC routinely obfuscates these requests, citing proprietary trading strategies and other reasons for not providing the requested information. The lack of disclosure regarding investigations of the securities industry keeps the public and media spotlight off them. The industry cites this as evidence that there really isn't a problem with counterfeiting and stock manipulation.
Another way of deflecting the spotlight of public disclosure is for the SEC to investigate companies. Corporate malfeasance is certainly within the scope of responsibility of the SEC, and it is commendable when corporate officers who pillage tens of millions from the shareholders are prosecuted. But what about the short hedge funds and the broker dealers who pillage billions from the shareholders of victim companies? For every Kozlowski or Scrushy prosecuted, there are doubtlessly scores — maybe hundreds — of securities industry frauds involving exponentially larger sums of money that are not even investigated.
An emerging company that we know of was subject to massive counterfeiting and stock manipulation. On a daily basis, 50 to 90% of the sells were short and the stock had been crashed three times in a year. Detailed complaints were filed with the SEC and the SROs by the company and shareholders; they cited DTC share movements, known holdings and identified the suspected shorts. The company's reward for protecting the interest of their shareholders was an inquiry into the company for alleged insider information violations. Eventually, the SEC left with no findings because there never was any insider information. The investigation of the shorts and the stock manipulation was white-washed and the manipulation continues.
The reason for the apparent immunity the securities industry enjoys is that many upper level SEC staffers ultimately sign on with the securities industry in jobs that often have seven-figure compensation packages. In the recent past, every year saw about 1/6 of the lawyers with the SEC jump ship and sign on with Wall Street for considerably more money. The reluctance to prosecute a potential future employer is understandable. For more information see the segment about Frivolous Investigations and Richard Sauer, a former SEC administrator who went to work for David Rocker and other shorts.
The five-person Board of Governors that oversees the staff of the SEC are political appointees. The securities industry is one of the largest political contributors in the country, and they have been successful in insuring that their interests are well represented at the Board of Governors level, where the values and mission of the SEC are set. Christopher Cox, the current head of the SEC, while from the Congress, clearly is a close friend of the industry. As a congressman, he was actively involved in the passage of some of the most anti-small investor legislation. Since his chairmanship, he has grudgingly made rule changes that were allegedly designed to curb stock counterfeiting, but, in fact, the new rules are so fraught with loopholes and blind eye enforcement that little has changed except the hiding places for counterfeit shares.
The next line of enforcement is the Self Regulating Organizations or SRO's. What we are really talking about is the exchanges, i.e. the NYSE, NASDAQ, ARCA, etc. They are supposed to monitor trading to protect against illegal activities. Their enforcement focus is also on the microscopic level. Consequently they don't view trading days where, in the face of good news or no news, 90% of the sells are naked or disclosed short, as a manipulation. Rather they look at whether naked shorts fit into one of the many loop holes, i.e. market maker exemption, specialist exemption, options trader exemption, etc. They also do little investigation to determine if locates (of borrowed shares) are valid; trading tickets are mismarked; shares are fails-to-deliver; etc. Should infractions be found, they are treated as minor transgressions, and the larger issue of whether the shorts are collusively attempting to manipulate the stock is never meaningfully examined and prosecuted.
The reasons for the SRO's lack of enthusiasm in protecting small investors is the same as the SEC's. Upper management of the SRO's, who are extremely well compensated, are from the industry or friends of the industry. It is the large Wall Street firms who provide the revenue necessary to pay the exorbitant salaries. The ARCA exchange was owned by Goldman and others prior to its acquisition by the NYSE Group. It is probably not an accident that the ARCA is among the most lax in their enforcement and allegedly contributes almost three-quarters of the NYSE Group's bottom line.
The last line of enforcement is the broker dealers, who are supposed to make sure their customers follow the rules. Unfortunately, it is the broker dealers who provide the majority of counterfeit shares for the shorts, be it their hedge fund customers or their own proprietary trading desk. This activity purportedly generates $8 to 10 billion annually for the broker dealers, so it is probably safe to say that enforcement will be on the underside of zealous.
The enforcement apparatus, top to bottom, operates in secrecy, with little outside oversight; is systemically fraught with conflict; and has insignificant punitive consequences. Consequently, and not surprisingly, there is little meaningful enforcement of the securities industry.