PDF Summary:Naked, Short and Greedy, by Susanne Trimbath

Companies and investors confront a peculiar challenge where more shares circulate in the market than those officially issued—these "phantom shares" arise from failures in the US stock clearing and settlement systems. In Naked, Short and Greedy, Susanne Trimbath investigates how phantom shares distort stock prices and undermine corporate governance by enabling manipulative "naked short selling."

This book examines the regulatory shortcomings surrounding unsettled trades and short selling. It contemplates how ineffective oversight jeopardizes economic stability and investor confidence. Trimbath probes the underlying conflicts as brokers exploit loopholes and resist reform efforts that threaten the status quo.

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Companies' diminished ability to access capital markets.

Short selling, along with stock lending and unsettled trades, creates phantom shares that impede the ability of entrepreneurs to initiate, operate, and expand their enterprises in America. The author elucidates that an oversupply of shares in the market can lead to a reduction in the worth of individual shares, thereby complicating the process for companies to secure funding from public and private sources.

Engaging in short selling can distort the valuation of stocks and disrupt the seamless execution of trade settlements, thereby impeding companies' capacity to raise funds.

Trimbath, along with many others, believes that the influence of short sellers, especially those who do not settle their positions, is substantial enough to lower stock prices by the sheer number of their transactions and by swaying the behavior of other market players. She argues that the impact of short selling on stock prices often goes unnoticed because transactions are not always clearly marked as short sales in the records, and without a regulatory requirement to resolve naked short sales, the number of unrecorded shares can increase significantly more than the total number of available shares.

Companies of modest and intermediate size are particularly vulnerable to these predatory tactics.

The author acknowledges that the impact of phantom shares is not limited to small or medium-sized businesses. However, Trimbath underscores that the resilience of larger companies to stock price volatility is due to the substantial capital needed to generate a sufficient volume of non-existent shares that would significantly alter market equilibrium.

Harmful to the economic well-being of individual investors.

Trimbath argues that the system causes multiple forms of harm to investors. Due to the frequent occurrence of unsettled trades within the system, investors frequently fail to acquire the stocks they have bought. Shareholders who provide their stocks for short selling purposes forfeit their voting privileges and receive no financial benefits from the broker's use of these securities.

Investors may end up compensating for stocks that they never actually receive due to shortcomings in the settlement process.

Susanne Trimbath is notably concerned about the system's tendency to function in a way that harms the interests of individual investors. The author, Susanne Trimbath, contends that the system's design inherently facilitated fraudulent actions against investors, even in the absence of involvement in activities associated with naked short selling. Brokers who sell shares to other brokers and fail to deliver them at the scheduled settlement time are not subjected to the expenses associated with obtaining shares for short selling or the obligations related to tracking and disclosing positions that are not backed by actual shares. The system allows them to circumvent the obligation of providing shares at the time of settlement.

Shareholders lose their right to receive dividend payments and their voting power when their shares are allocated without their knowledge.

Trimbath explains that investors forfeit their voting privileges and are not entitled to a portion of the revenue generated by the broker through the share lending process when their shares are utilized to facilitate a naked short sale. The writer clarifies that even if an investor is against the lending of their stocks, these transactions can still happen because of poor record-keeping practices in the operational departments of brokerage companies. When you lend out your shares, you retain what is known as a phantom share until the loan is repaid, because the borrower receives the actual shares, including the rights to vote and receive dividends. Upon opening a standard US brokerage account, investors consent to a provision allowing brokers the authority to loan out their securities without any requirement to notify the account holders. After the Jobs and Growth Tax Relief Reconciliation Act of 2003 was enacted, the IRS started to levy a heavier tax on dividends for investors who collateralize their shares for short selling transactions. Many individual investors do not realize that their shares are being lent out, leading to them facing a higher tax rate on "payments in lieu" of dividends, which they receive without understanding that these are taxed more heavily than actual dividends that qualify for certain tax treatments.

Investors discovered that their capital was tied up during the period they were expecting the shares they had purchased to be delivered.

Trimbath highlights that numerous individual investors do not realize their trades are completed using borrowed shares and that unresolved settlement failures exist, despite their brokerage statements indicating they own the purchased shares. When settlement does not occur, investors find their cash balances reduced, yet their securities accounts show an equivalent increase in share entries. The failure of the selling broker to provide the necessary shares for settlement causes the buying broker to be unable to obtain the shares, which in turn creates "phantom shares" in the investor's portfolio. Investors were under the impression that the stocks they believed to be in their possession were safely handled by their investment advisor. The writer clarifies that financial advantages accrue to brokerage firms when they utilize the funds of investors in the phase where transactions are being settled.

Other Perspectives

• The financial incentive for Wall Street brokers and banks to maintain the status quo regarding nonexistent shares is not necessarily due to malicious intent; it could be a byproduct of complex financial systems and regulations that require careful reform.
• Short selling is a legitimate investment strategy that can provide market liquidity and price discovery, and not all short selling leads to the creation of phantom shares.
• The impact of short selling on stock valuations can be overstated; other factors such as company performance, economic conditions, and investor sentiment play significant roles in stock prices.
• Larger companies can also be affected by the creation of phantom shares, and their resilience may not solely be due to the capital required to generate a significant volume of non-existent shares.
• The settlement system is designed to manage risk and ensure the orderly transfer of securities; unsettled trades do not always result in harm to investors or companies.
• Investors who lend out their shares for short selling purposes do so voluntarily and are typically compensated through lending fees, which can be a source of additional income.
• Brokers are subject to regulations and audits, and while there may be instances of failure to deliver, these are not necessarily indicative of systemic fraud or exploitation.
• The tax treatment of "payments in lieu" of dividends is a complex issue that involves tax policy and regulation, not just brokerage practices.
• Investors have a responsibility to understand the terms of their brokerage accounts, including the potential for their shares to be lent out.
• The creation of phantom shares due to settlement failures is monitored by regulatory bodies, and measures are in place to address and mitigate these issues.
• The use of investor funds during the settlement period is a standard practice in the industry and is regulated to protect investor interests.

Initiatives to address the prevalent problem of nonexistent stock shares and enhance the integrity of the financial infrastructure through legal and regulatory reforms.

Despite numerous complaints from stakeholders and companies impacted by share dilution, the SEC has largely failed to effectively oversee the activities resulting in the emergence of non-existent shares. Trimbath attributes the problem to the American financial markets' reliance on self-governance, which allows Wall Street intermediaries and financial institutions to create rules that facilitate the selling of shares they do not own, the continuous re-lending of the same borrowed stocks, and the resulting failure to deliver the shares when it's time to settle the transactions.

Regulatory attempts to address the challenges associated with naked short selling and the frequent instances of trades that fail to settle.

Trimbath argues that the measures implemented by the SEC to prevent the creation of phantom stock shares have largely been unsuccessful in reaching their intended objective. Trimbath believes that if the duty to deliver securities for transaction completion is not rigorously enforced, the anticipated outcomes of regulation will consistently fall short.

In response to the challenges posed by naked short selling and the failure to meet delivery commitments, the SEC implemented Regulation SHO and other regulatory measures.

The author concentrates on the regulations governing short selling, stock borrowing and lending, and the occasions when transactions involving equity securities fail to conclude as expected. Trimbath offers an in-depth analysis of the "Regulation SHO" guidelines, informed by her comprehensive interactions with the regulatory body responsible for securities and exchanges. Under Reg SHO, brokers had to label transactions indicating whether the seller possessed the shares and promised to deliver them for settlement, known as "long," or otherwise as "short," and they had to take action regarding any undelivered shares within a period of 13 days. She explains that the Securities and Exchange Commission believed a timeframe of 13 days would suffice for brokers to obtain the required stocks to complete short sales or repurchase shares when trades failed to settle properly, for example, due to inconsistencies in account records or mistakes on certificates.

The ineffectiveness of the framework resulted in a failure to tackle the fundamental problems.

Trimbath observes that the SEC, as the authority supervising securities transactions, took measures to rectify the shortcomings in the effectiveness of Reg SHO. The regulatory body overseeing securities, known as the SEC, established regulations that ended the allowance for trades, executed prior to the establishment of these rules, to remain unsettled, and they also reduced the number of specific exemptions related to market-making activities in stock options. In August 2008, the SEC rapidly introduced a rule prohibiting the practice of short selling in the financial sector, recognizing the existing shortcomings in the financial markets. However, she argues that without the Commission and the SROs enforcing the completion of transactions and possessing significant enforcement authority, the updates will be just as ineffective as the original Regulation SHO.

Companies and investors initiated legal proceedings.

Trimbath argues that allegations of market manipulation are often brought forward by companies and investors in American courts, but seldom do these claims succeed. She references lawsuits alleging that companies such as Overstock were damaged by malevolent activities, specifically the selling of shares they did not possess and the failure to finalize the settlements of stock transactions. Corporations often struggled to prevail in lawsuits as the criteria established by federal courts generally favored those being sued.

Legal proceedings have been commenced by corporations and investors to address the challenges associated with market tampering and the presence of non-existent stock shares.

Trimbath explains that companies often resort to legal action in an effort to recoup monetary damages when the value of their stocks suffers due to practices involving the selling of borrowed shares. Financial entities and brokerages often resolve their disputes in New York's federal courts, where the outcomes are more likely to favor the financial sector over individual investors or companies. Many lawsuits are settled prior to reaching the stage of a trial.

The complexity of pursuing legal action is often compounded by the influence of powers specific to the sector and challenges related to jurisdictional matters.

Trimbath acknowledges that if a company or investor intends to seek redress for grievances against broker-dealers or entities in charge of self-regulating Wall Street, they are required to do so in a federal court located in New York City. She believes that political influences swayed the choice of location, giving preference to proponents of the nation's financial industry situated in the government's seat. She underscores the fact that the main entity tasked with clearing and settling trades in the United States is under the control of broker-dealers, which enables them to understand their lack of immediate delivery requirements for shares at the time of settlement.

Practical Tips

• You can enhance your investment decisions by researching the settlement practices of stocks you're interested in. Before buying shares, look into whether the company has a history of failed share deliveries or has been involved in legal actions related to share lending practices. This information can often be found in financial news articles, investor forums, or by reviewing the company's legal filings, which are usually accessible through their investor relations website.
• Develop a habit of checking the short sale volume data for stocks you own or plan to invest in. This data is publicly available through the Financial Industry Regulatory Authority (FINRA) and can give you insights into the level of short selling activity. A high volume of short selling might indicate potential issues with share delivery and settlement that could affect the stock's performance.
• Consider using alternative trading platforms or brokers that offer greater transparency in their stock lending and settlement processes. Some platforms provide information on how they handle short sales and stock borrowing, which can give you a better understanding of the risks involved. By choosing a platform that aligns with your values on these issues, you can indirectly support better practices in the industry.

The unresolved matter's wider consequences, along with the resistance to reform from political and institutional bodies, stem from the shares that remain unrecorded.

The writer argues that the continuous presence of non-existent shares is due to the US capital markets being self-regulated, allowing banks and brokers to create rules that shield them from being held responsible for their deeds. She argues that two main elements contribute to the insufficient supervision: the failure of US regulatory agencies to keep pace with the self-regulated rules and procedures of the banking and securities sector, and the hesitance of the US Congress to take action, thereby allowing those who pose a risk to oversee the protection of the at-risk parties.

Conflicts arise due to the goals and power of regulatory bodies.

Susanne Trimbath believes that the SEC neglects the problems related to naked short selling and settlement failures, even though individuals from within the industry, whose firms are frequently involved in these transactions, assert that they have the matters in hand. She contends that the considerable influence wielded by lobbyists from financial institutions and brokerage firms on the creation and enforcement of market regulations is due to the revolving door of personnel transitioning from regulatory agencies and legislative roles to Wall Street, and vice versa.

Organizations that self-regulate typically consist of members who are reluctant to adopt new practices.

The financial sector's inclination towards self-governance, which became prominent in the 1980s, was heavily influenced by the period's trend towards deregulation and the Reagan administration's policies. Throughout the 1990s, cases of economic malfeasance were rampant, yet Congress seldom intervened with legislative measures. The Sarbanes-Oxley Act, instituted in 2002, was the initial legislative action taken in the wake of the Enron debacle, during which the energy company deceived its shareholders. The legislation, rather than tackling the fundamental problems inherent in the self-regulatory framework, simply expanded the requirements for reporting and other accounting procedures, even though the entity in charge of overseeing the accounting professions had demonstrated little initiative in protecting investors. Trimbath argues that significant reform cannot occur without a transition in governance, moving away from individuals who have failed to ensure the delivery of shares and who presently hold positions of authority over the board that supervises the clearing and settlement operations.

Wall Street entities, leveraging their political influence, obstruct the enactment of substantial regulatory measures.

Trimbath argues that the absence of legislative intervention allowed the influencers from banking and brokerage sectors to establish a framework that permitted the offenders to set their own rules. She underscores the involvement of specific lawmakers associated with the practice of short selling, as documented in Congressional records. Trimbath posits that the interests of numerous individual investors are frequently overshadowed by the preferences of corporations and industries that finance their political campaigns, as senators and other political figures have a stake in maintaining the status quo.

The wider repercussions and economic ramifications

Trimbath warns that the global financial system is inherently at risk due to the prevalent tolerance of unsettled securities transactions. She clarifies the complex scenario in which a shortage of liquid assets and financial securities exists, preventing the settlement of all outstanding transactions and the fulfillment of unsettled stock loans. She elucidates that the securely designated resources are inadequate to guarantee full restitution to all stakeholders involved. What concerns me most about potential solutions is the doubt regarding their efficacy.

The stability of the worldwide financial infrastructure could be undermined by unsettled trades and the presence of phantom shares.

Susanne Trimbath believes that the escalating quantity of non-existent shares could soon reach a critical threshold, which may trigger a banking crisis. The emergence of panic resembles a bank run, triggered by the sudden realization that the shares in circulation and up for borrowing are, essentially, nonexistent. The repercussions will resonate throughout global financial networks because of the widespread ownership of shares in American corporations and the variety of bonds issued by the US, encompassing government treasuries and obligations from organizations like Fannie Mae and Freddie Mac. Trimbath uses a metaphor to demonstrate how the financial well-being of the United States has a profound influence on the global economy, suggesting that even small disturbances in the US financial system can have major worldwide repercussions.

Confidence in American financial markets has waned, resulting in challenges for raising funds and creating obstacles for new business ventures.

Susanne Trimbath contends that the systems used for processing and completing transactions within the United States' banking and brokerage sectors have eroded investor confidence, created obstacles for entrepreneurs seeking funding, and as a result, have impeded the growth of the American economy. Should this trend continue, she argues, investors will redirect their funds to global markets; US entrepreneurs will be compelled to explore different avenues for obtaining funding, and the critical liquidity of the market will disappear. She underscores the increasing skepticism surrounding the notion that every novel idea can attract investment by issuing shares to the general populace.

Other Perspectives

• Self-regulation can foster innovation and efficiency in the markets by allowing industry experts to tailor rules to complex financial environments.
• Regulatory agencies may be constrained by limited resources and bureaucratic processes, which can impede their ability to adapt quickly to evolving market practices.
• The SEC and other regulatory bodies often have to balance the interests of various stakeholders, which can make it appear as though they are neglecting certain issues when they are actually pursuing a broader regulatory strategy.
• The trend towards self-regulation in the 1980s also coincided with a period of significant financial innovation and growth, suggesting that deregulation can have positive economic effects.
• The Sarbanes-Oxley Act did introduce significant reforms that increased corporate accountability and enhanced the accuracy of financial reporting, which may have helped to prevent some forms of economic malfeasance.
• Political influence is a complex phenomenon, and while some Wall Street entities may have significant influence, this does not necessarily mean that all regulatory measures are obstructed or that all such influence is detrimental to the public interest.
• The global financial system is resilient and has mechanisms in place to manage risks associated with unsettled trades, including central counterparty clearinghouses that mitigate the risk of default.
• The presence of non-existent shares, while a concern, may be mitigated by market mechanisms and investor due diligence, and does not necessarily indicate an imminent banking crisis.
• Investor confidence in American financial markets may fluctuate, but the U.S. markets remain among the largest and most liquid in the world, attracting significant domestic and international investment.
• Challenges in raising funds and creating obstacles for new business ventures can also be attributed to broader economic conditions and not solely to the state of the financial markets or regulatory environment.