I have filed a lawsuit against the Securities and Exchange Commission (SEC), which previously failed to respond adequately to my Freedom of Information Act (FOIA) requests seeking SEC documents related to the SEC’s various investigations (and failure to perform adequate investigations) of naked short selling crimes that undermined the stability of the American financial system.
This is the first lawsuit against the SEC ever filed by a journalist seeking information about the SEC’s failure to regulate naked short selling, one of the most serious crimes affecting the American markets. I have filed the lawsuit with help from Gary Aguirre, a former senior enforcement official with the SEC, famous for having blown the whistle on the protection that top SEC officials were providing to hedge fund Pequot Capital and Morgan Stanley CEO John Mack.
Aguirre made headlines in 2006 by reporting in Congressional testimony that he had been improperly fired by the SEC after complaining that top SEC officials had derailed an investigation into an insider trading scheme perpetrated by Pequot Capital, and that the investigation had likely been derailed because the Aguirre had also been investigating Mack in connection with the insider trading, while Aguirre’s supervisor at the SEC was preparing to take a job with Mack’s law firm.
What did not make the headlines was the fact that Aguirre reported in that same Congressional testimony that when he was improperly fired, he had been investigating not only insider trading, but also naked short selling. “The investigation was two-pronged,� Aguirre reported to Congress. One prong concerned “insider trading.� However, the second, and far more important prong, concerned “market manipulation� and, more specifically, “two suspected violations: wash sales and naked shorts.�
“My colleagues,� Aguirre reported to Congress, “believed [the naked short selling] held a greater potential to severely injure the financial markets.� Indeed, Aguirre reported to Congress that naked short selling had the potential to deliver a market crash similar to the crash of 1929, from which followed the Great Depression.
Two years later, in 2008, that prediction proved correct when naked short selling contributed to a meltdown just as severe as the great crash of 1929. At that time in 2008, the CEOs of multiple Wall Street investment banks (long among the perpetrators of naked short selling) complained that naked short selling was contributing to the death spirals in their stock prices, and the SEC responded by issuing an unprecedented “Emergency Order� that temporarily banned all short selling of stock in more than 900 companies in the financial industry.
In that Emergency Order, the SEC effectively admitted that naked short sellers were contributing to the worse financial crisis since the Great Depression, and the SEC subsequently enacted new rules that supposedly made it more difficult for traders to engage in naked short selling, but those new rules were not sufficient, and to this day, the SEC has not sanctioned even one trader for perpetrating the naked short selling that (according to the SEC) contributed to the great meltdown of 2008, and nor has the SEC released any documents concerning its supposed investigation into that naked short selling—one of the great unsolved crimes of the century.
One purpose of my lawsuit is to force the SEC to hand over documents related to its investigation, or failure to investigate, the naked short selling that contributed to the great meltdown of 2008, but that is not all. There is massive amount of other information my lawsuit seeks to extract from the SEC, and I encourage you to read the lawsuit in its entirety because it is a gory chronicle indeed of the crimes that naked short sellers have perpetrated against the markets, and an even more shocking tale of how the SEC has failed to enforce the law while actually providing cover for the perpetrators of a crime that, at the present moment, is still undermining the stability of the global financial markets.
The lawsuit is posted in its entirety below:
United States District Court
FOR THE NORTHERN District of ILLINOIS
Eastern division
MARK MITCHELL
Plaintiff,
v.
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Defendant.
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Case No. ____________________
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COMPLAINT FOR DECLARATORY AND INJUNCTIVE RELIEF
This is an action under the Freedom of Information Act (“FOIA�), 5 U.S.C. § 552, as amended, to compel Defendant United States Securities and Exchange Commission (“SEC�) to produce, provide access to, and make available certain records specified below that were requested by Plaintiff Mark Mitchell.
As specifically alleged below, Plaintiff seeks records under FOIA from the SEC relating to:
the opening of matters of inquiry (MUIs), the opening of investigations, and the filing of any enforcement proceedings by the SEC in relation to individuals or institutions who may have violated SEC Regulation SHO (“Reg SHO�) and/or engaged in the naked short selling of the stock of public companies, or
the opening of MUIs, opening of investigations, or the filing of any enforcement proceedings involving specific public companies whose stock was the subject of possible violations of Reg SHO and/or naked short selling.
JURISDICTION
This Court has jurisdiction over this action pursuant to 5 U.S.C. § 552(a)(4)(B).
PARTIES
Plaintiff is a citizen of the United States, a resident of Cook County, and a journalist.
Defendant is an agency of the United States Government and has possession and control of the records that are the subject of this action.
RELEASE OF THE RECORDS SOUGHT TO PLAINTIFF WOULD SERVE THE HIGHEST PUBLIC INTEREST
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The release and disclosure of the information sought by Plaintiff’s FOIA requests as alleged in this complaint would serve the highest public interest because Plaintiff would utilize the released information to contribute significantly to the public’s understanding of the following:
 the inherent flaws in regulations created by the SEC to stop naked short selling;
the lack of transparency in the regulatory system relating to the processing of short sale trades;
the SEC’s lax enforcement of the securities acts and related rules, including Reg SHO, against those who engage in naked short selling, and, most importantly;
how these factors combine to create a dangerously high and unacceptable level of risk to the integrity of the nation’s and the world’s capital markets.
The records should be furnished without any charge in that the information is in the public interest because it is likely to contribute significantly to the public understanding of the operations or activities of the SEC and is not primarily in the commercial interest of the requester.
Federal regulations describe how the SEC has been entrusted with powers and duties of “great social and economic significance to the American people,� the prevention of abuses that would undermine the integrity of the nation’s economic institutions. Section 200.53 of Title 17 of the United States Code of Federal Regulations spells out that trust:
Members of the Securities and Exchange Commission are entrusted by various enactments of the Congress with powers and duties of great social and economic significance to the American people. It is their task to regulate varied aspects of the American economy, within the limits prescribed by Congress, to insure that our private enterprise system serves the welfare of all citizens. Their success in this endeavor is a bulwark against possible abuses and injustice which, if left unchecked, might jeopardize the strength of our economic institutions.
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As more specifically alleged below, naked short selling by broker-dealers in their own accounts and on behalf of other market participants is exactly the type of abuse that could “jeopardize the strength of our economic institutions.� The SEC has not merely failed to stop this form of market abuse. It has created a regulatory system which conceals naked short selling, prevents the public (including investors and other victims of naked short selling) from investigating the naked short sales, rewards those who engage in it, and also rewards securities exchanges, which have a duty to enforce the law, for closing their eyes to the unlawful practices consummated through them.
As specifically alleged below, the SEC has sponsored, supervises, and presides over a regulatory system that has allowed and in fact encouraged broker-dealers and other market participants to create billions of shares of counterfeit stock in hundreds of millions of trades which collectively put the integrity of the capital markets at risk. The counterfeit stock has been and continues to be created through a practice commonly referred to as “naked short selling.� Naked short sales share no properties in common with lawful short sales, except both involve a purported sale of stock.
In a lawful short sale, the seller borrows the stock from a third party and makes real delivery of the borrowed stock to the buyer. In a naked short sale, the market participant neither owns nor has borrowed the stock, but nevertheless purports to sell genuine stock of the public company to the buyer. In substance, a market participant who engages in a naked short sale delivers counterfeit stock to the buyer.
Once the counterfeit stock is sold through a naked short sale, it continues in circulation in the securities markets much like counterfeit bank notes continue in circulation after they are introduced into the monetary system. It has the effect of increasing the supply of stock available on the market for sale, which generally has a depressing effect on the price of the genuine stock of the public company whose name the counterfeit stock bares. The naked short sales of counterfeit stock harm investors holding genuine stock, investors who receive the counterfeit stock, and the public company whose stock is diluted with counterfeit stock. The aggregate creation of counterfeit stock creates high and unacceptable risks to the integrity of the nation’s and the world’s capital markets.
Plaintiff is a reporter for DeepCapture.com, an online financial news service. He previously worked as editorial page writer for The Wall Street Journal in Europe, chief business correspondent for Time magazine’s Asia edition, and as assistant managing editor responsible for the Columbia Journalism Review’s online critique of business journalism. He holds an MBA from the Kellogg Graduate School of Management at Northwestern University.
Plaintiff gathers information from numerous sources often overlooked by the mainstream financial media, uses his editorial skills to turn this raw information into narratives regarding the financial industry, and regularly publishes that information on an internet website known as DeepCapture at no cost to the public.[1]
Deep Capture also publishes news stories by other authors whose stories meet DeepCapture’s scope of interest and editorial standards.
The website is called DeepCapture because it focuses on objectively presenting in-depth news coverage of events and actions that demonstrate that the independence of a federal agencies have been compromised by regulatory capture. Regulatory capture occurs when a regulatory agency, such as the SEC, which was created to act in the public interest, instead advances the commercial or special concerns of interest groups that dominate the industry or sector it is charged with regulating. These agencies are called “captured agencies.�
The DeepCapture website, for which Plaintiff writes, has received awards, such as Business Insider’s award for best investigative journalism and the Webby award for best business reporting. The DeepCapture website has also been discussed by mainstream news organizations, e.g., CNBC and Wired magazine.
Plaintiff has also written numerous articles on the DeepCapture website about how the SEC is not only a captured agency but is part of a larger group of institutions that have been captured by the financial industry in this country.
Plaintiff has published numerous articles on the DeepCapture website describing how financial institutions and individuals have engaged in naked short selling in the stock of public companies. These violations were rarely reported by the mainstream or financial media. To the extent that naked short selling was reported in the financial media, some mainstream news organizations, including Bloomberg News,[2] reported that naked short selling was a serious problem, but these reports were few in number, and other journalists often expressed skepticism that naked short selling was even occurring, thereby giving false comfort to the public regarding the risks naked short selling posed to the nation’s capital markets.
Plaintiff is one of the few journalists, perhaps the only one, who regularly writes about naked short selling. Plaintiff believes it is vitally important for the American public to be aware that the SEC is failing to contain market participants such as large investment banks, market-makers, and multibillion dollar hedge funds from engaging in naked short selling. It is as if the Department of the Treasury were aware of massive printing of US currency by counterfeiters and yet declined to take any action to stop them.
The following examples illustrate the depth and uniqueness of news stories published on the DeepCapture website relating to naked short selling:
In relation to the settlement between FINRA and UBS in October 2011, Plaintiff was one of two media sources that reported that FINRA had found and UBS had admitted committing “tens of millions� of violations of Reg SHO and that those violations put at risk the integrity of the capital markets.[3] In the light of FINRA’s finding and UBS’s admissions, the FINRA enforcement proceeding against UBS was unquestionably the single most significant regulatory case brought by the government or a Self-Regulating Organization (“SRO�) relating to naked short selling since Reg SHO became operative on January 1, 2004. In contrast, neither the financial nor the mainstream media reported that UBS had committed “tens of millions� of violations of Reg SHO and that the cumulative effect was to create a significant risk to the integrity of the capital markets.[4]
In a story written by another reporter, DeepCapture was one of two media sources that reported on the investigation conducted by the SEC’s Office of the Inspector General (“OIG�) which resulted in a finding by the OIG in Case No. 512 (Unauthorized Disclosure of Non-Public Information) that two SEC attorneys had passed along nonpublic information through a corrupt FBI agent to a cabal engaged in naked short selling.[5] Through the reporter’s own exhaustive research and investigation, he identified the two SEC employees and published an article in DeepCapture, Moral Hazard at the SEC, which described in detail how the two SEC investigators had communicated the nonpublic information through a corrupt FBI agent to the naked short selling cabal.[6] The financial and mainstream media did not cover the story.
As specifically alleged below, the magnitude and scope of naked short selling creates major risks to the stability of the nation’s capital markets. Equally disturbing, as alleged below, the SEC, a captured agency, is not protecting the nation’s investors or the capital markets from this form of market abuse.
Plaintiff seeks the records described in this complaint to use in articles he and other guest authors will write and publish on the DeepCapture website informing the public of the risks naked short selling poses to the integrity of the nation’s capital markets and the SEC’s complicity in creating a regulatory system that does not deter naked short selling. All of the information from the SEC is vitally needed because, as alleged below, the system created by the SEC relating to the short sale trades of public companies has little if any transparency. Plaintiff intends to make avaiable to the public all records obtained through this proceeding.
FACTUAL BACKGROUND
The regulatory history relevant to the current naked short selling of stock in public companies began in 1985 when the National Association of Securities Dealers, Inc. (“NASD�) commissioned Irving M. Pollack (“Pollack�)[7] to conduct a study of short selling (“Pollack study�). As stated in his report, Pollack concluded:  “The fail-to-deliver / fail-to-receive problem has the potential for causing serious difficulties in a lengthy bear market.�[8] Naked short sales routinely result in failures to deliver and failures to receiveunless they are concealed by the broker-dealers who execute them. Pollack’s report also noted that there was no inherent mechanism to constrain the buildup of failures to deliver and warned of the consequences: “[T]he fact that there is no automatic mechanism preventing the substantial buildup of short positions at the clearing corporation and of fails to receive in the brokerage firms carries the potential for serious problems, particularly in the event of crisis market conditions.�[9] Pollack’s warning would prove prophetic two decades later in 2008, when giant investment banks began to collapse due in part to naked short selling.
Based on the conclusions in the Pollack Study, the NASD proposed an amendment to Section 59 of the NASD Uniform Practice Code which amendment was designed to curb naked short selling. In approving the amendment, SEC Exchange Release No. 26694, issued on April 4, 1989, the SEC concluded, “the NASD is taking a reasonable approach to deal with the problems that the Pollack study revealed. While fails-to-deliver resulting from short sales may be relatively infrequent, we cannot say that the proposed mandatory buy-in rule for public customers is an unwarranted restriction on short selling.â€�[10] The same SEC release also recognized: “naked short selling potentially can present substantial manipulative concerns. … The ability of naked short sellers to employ this leverage to effect ‘bear raids’ would appear to provide support for the NASD’s decision to impose additional discipline on naked short selling.â€� For the next 14 years, the SEC limited its role in relation to naked short selling to approving rules proposed by SROs relating to containing naked short selling. The constraints incorporated into the amendment to NASD Section 59 proved inadequate to stop or contain naked short selling.
On October 28, 2003, the SEC implemented its own rules to prohibit naked short selling when it issued Exchange Act Release No. 48709 (“Release 48709�) which included a preliminary version of Reg SHO.[11]
In Release 48709, the SEC explained the negative effects of naked short selling on the securities market:
Naked short selling can have a number of negative effects on the market, particularly when the fails to deliver persist for an extended period of time and result in a significantly large unfulfilled delivery obligation at the clearing agency where trades are settled. At times, the amount of fails to deliver may be greater than the total public float. In effect the naked short seller unilaterally converts a securities contract (which should settle in three days after the trade date) into an undated futures-type contract, which the buyer might not have agreed to or that would have been priced differently. The seller’s failure to deliver securities may also adversely affect certain rights of the buyer, such as the right to vote. More significantly, naked short sellers enjoy greater leverage than if they were required to borrow securities and deliver within a reasonable time period, and they may use this additional leverage to engage in trading activities that deliberately depress the price of a security.
In Release No. 48709, the SEC also explained how the SEC believed Reg SHO “would address the problem of ‘naked’ short selling.� The SEC pointed to two principal mechanisms that were expected to contain naked short selling:
[1] Proposed Regulation SHO would, among other things, require short sellers in all equity securities to locate securities to borrow before selling, and [2] would also impose strict delivery requirements on securities where many sellers have failed to deliver the securities. In part, this action is designed to address the problem of “naked� short selling.[12]
As more particularly alleged below, the financial crisis demonstrated that neither mechanism curbed naked short selling
Reg SHO became operative on January 1, 2005. In the commentary accompanying the final rule, the SEC expressed its optimism that Reg SHO and, in particular, Rule 203 would contain naked short selling:
As adopted, Rule 203 creates a uniform Commission rule requiring broker-dealers, prior to effecting short sales in all equity securities, to “locate� securities available for borrowing, and imposes additional delivery requirements on broker-dealers for securities in which a substantial amount of failures to deliver have occurred (“threshold securities�). We believe that strong and uniform requirements in this area will reduce short selling abuses. The locate and delivery requirements will act as a restriction on so-called “naked� short selling.[13]
From the date Reg SHO became operative, January 1, 2005, until the financial crisis struck in September 2008, the SEC’s enforcement of Reg SHO was almost nonexistent. Two SEC administrative decisions made passing reference to naked short selling and Reg SHO in 2006. In both cases, SEC administrative judges were dismissive of contentions that public companies were being ravaged by naked short selling.[14]
The SEC brought two administrative decisions to enforce Reg SHO in 2007.[15]  In both cases, the alleged Reg SHO violations were limited to allegations that the respondents had falsely characterized short sales as long sales. The SEC’s minimal enforcement of Reg SHO from 2005 through 2008 implies its belief that the mere issuance of Reg SHO had convinced broker-dealers, traders, and other market participants to suspend their practice of naked short selling. Those engaged in naked short selling were unimpressed by a new regulation which the SEC chose not to enforce. The SEC’s tough talk in Reg SHO, absent its enforcement, did not deter or frighten them.
The SEC’s tepid enforcement of Reg SHO from its operative date, January 1, 2005, until the financial crisis struck in 2008 gave no clue that naked short selling was festering in the shadows, invisible to public companies afflicted by it. Few saw naked short selling as a serious risk to public companies, and virtually none saw it as a systemic risk that could threaten the capital markets. Until the 2008 financial crisis, the common perception was that naked short selling, if it existed, afflicted only a few, relatively small public companies.
One industry group, the broker-dealers, knew before the 2008 financial crisis that naked short selling was rampant and also knew the supposed constraints of Reg SHO were easily circumvented.
The Securities Industry Group (“SIA�), which represents more than 600 broker-dealers, has been particularly effective in blocking legislative and rule-making efforts to contain naked short selling. The SIA and its members successfully lobbied the SEC to draft the language in Reg SHO and other rules so that broker-dealers could conceal their lucrative naked short selling practices within loopholes the SEC incorporated into Reg SHO.
The SEC dubbed one of the loopholes the “Madoff exemption,� since it was the brainchild of Bernard Madoff (“Madoff�). Madoff was held in high esteem by the SEC in July 2004 when it issued the release accompanying the final version of Reg SHO. The “Madoff exemption� effectively allows a “bona fide� market-maker to engage in naked short selling briefly, supposedly as part of its role as a true market-maker.  The limitation (bona fide) generally requires the market participant to simultaneously place a buy order at or near the best bid and a sell order at or near the best ask. As a practical matter, it is difficult  if not impossible for public companies and market participants, with exception of the broker-dealers, to determine whether a specific short sale is a naked short sale or a trade by a “bona fide market-maker,� because the data necessary to make the determination is generally unavailable.
As a consequence of the Madoff exemption, more accurately described as the Madoff loophole, and SEC’s inability to track compliance with Reg SHO as alleged herein, the SEC has brought only one proceeding for abusing the bona fide market maker exemption, a case against an individual who was an insignificant market participant.[16] The SEC has never brought a case against a broker-dealer for abusing the bona fide market-maker exception.
The “Madoff exemption� was not the only loophole the SEC incorporated into Reg SHO at the behest of the SIA and its members. Market participants can also engage in short term naked short sales if they have “reasonable grounds to believe� they can borrow the stock before they have to deliver it to the buyer.[17] This creates an even bigger loophole in Reg SHO.
The SEC has been and continues to be incapable of determining whether short sale trades by broker-dealers and other market participants are in compliance with Reg SHO, because it has lacked the market surveillance expertise and equipment to track the volume and speed of the securities trading since Reg SHO became operational in January 1, 2005. The discrepancy between trading activity, now at approximately 5 million messages per second, and the SEC’s capacity to track that trading activity has progressively widened since Reg SHO became operative. The decision by the SEC to create Reg SHO, which purports to contain naked short selling, when the SEC knew it lacked the capacity to monitor the securities markets for violations of Reg SHO leads to the inescapable conclusion that Reg SHO was a sham to appease the public companies, investors and traders who had been harmed by naked short selling, while not offending the broker-dealers, especially the mega broker-dealers owned by Wall Street investment banks, who engaged in naked short selling since Reg SHO was in fact unenforceable.
The SIA has also vigilantly monitored the state legislatures for possible legislation which could fill the glaring gaps in Reg SHO and thereby threaten the broker-dealers’ lucrative naked short selling practice. In July 2006, the SIA learned that Utah had enacted a statute designed to stop naked short selling. The SIA immediately filed a civil action for injunctive relief to stay the enforcement of the statute. Later, the SIA led the successful charge to repeal the statute. The SIA’s actions to block the enforcement and then repeal the Utah statute is exactly the type of “protectionâ€� the SIA promises its broker-dealer members on its website with this words: “The Security Industry Association (SIA) protects and advances our members’ interests by: advocating pro-industry policies and legislation on Capitol Hill and throughout the 50 states…â€�[18]
Despite the lax enforcement of Reg SHO, the tone of the SEC’s releases relating to Reg SHO began to change in August 2007 to reflect the growing and legitimate concern by public companies and their investors about the harmful effects of naked short selling. For the first time, the SEC releases relating to Reg SHO contained this language:
[M]any issuers and investors continue to express concerns about extended fails to deliver in connection with “naked” short selling. To the extent that large and persistent fails to deliver might be indicative of manipulative “naked” short selling, which could be used as a tool to drive down a company’s stock price, fails to deliver may undermine the confidence of investors. These investors, in turn, may be reluctant to commit capital to an issuer they believe to be subject to such manipulative conduct. In addition, issuers may believe that they have suffered unwarranted reputational damage due to investors’ negative perceptions regarding large and persistent fails to deliver. Any unwarranted reputational damage caused by large and persistent fails to deliver might have an adverse impact on the security’s price.[19]
Though the SEC had begun to hear public companies and their investors complain about naked short selling and sharpened its own rhetoric about naked short selling to appease the institutions and individuals harmed by naked short selling, it still took no meaningful action to enforce Reg SHO or the antifraud provisions of the securities acts against those who were engaged in the unlawful practice.
The SEC sharply escalated its verbal war against naked short selling in July 2008 when the chief executive officers of some of the world’s largest investment banks frantically sought protection from Congress and the SEC in relation to the naked short selling which was contributing to the collapsing prices of the stock of those banks. For the first time, it was not merely stock of smaller public companies which was being ravaged by naked short selling. Instead, naked short selling was perceived as a contributing cause of the failures of the nation’s oldest and biggest investment banks: Bear Stearns,[20] Merrill Lynch,[21] and Lehman Brothers.[22] The warning by the Pollack Study two decades earlier that naked short selling “carries the potential for serious problems, particularly in the event of crisis market conditions� seemed to be coming true.[23]
The voices of the CEOs reached a crescendo in September 2008 after three international and venerable U.S. investment banks (Bear Stearns, Merrill Lynch, and Lehman Brothers) had failed, leaving Morgan Stanley and Goldman Sachs teetering on the edge of the abyss. Time magazine quoted from a memo that John Mack, Morgan Stanley’s Chief Executive Officer, had sent to employees: ‘“What’s happening out there? It’s very clear to me — we’re in the midst of a market controlled by fear and rumors, and short sellers are driving our stock down,’ fumed John Mack.â€�[24] On September 17, 2008, Barron’s reported: “[T]he Securities & Exchange Commission’s head Christopher Cox is investigating naked short selling of shares of Morgan Stanley and Goldman Sachs after receiving calls from Morgan Stanley CEO John Mac [sic] about improper short-selling that was responsible for the stock’s nearly 30% decline today.â€�[25]
The pleas of the banks’ CEOs brought instant credibility to the notion that naked short selling could destroy public companies, even huge ones if the time was ripe. But the failing banks had special credibility. Bear Stearns, Lehman Brothers and Merrill Lynch all had their own proprietary desks manned by astute traders who had the skill and technology to recognize naked short selling. Each bank also had affiliated broker-dealers whose traders made markets in thousands of public companies. No one was better equipped than the traders in the banks’ brokerage firms to recognize that the banks’ stocks were in the crosshairs of traders who were pulling the trigger on naked short sales. More than likely, these banks through their proprietary desks and affiliated brokerage firms had pulled the trigger on naked short selling aimed at other public companies in the past.
The SEC quickly recognized the credibility and urgency of Morgan Stanley’s and Goldman Sachs’s pleas for help, particularly in view of the fact that three other banks had so quickly failed. Not surprisingly, Rule 203 had failed to deter naked short selling when that deterrence was most needed, during a financial crisis, just as the Pollack Study had predicted. The SEC responded with a series of emergency regulations and amendments to Reg SHO from July 2008 through July 2009 to stop or at least contain naked short selling.
On July 15, 2008, the SEC issued an emergency order prohibiting any short sales in the stock of 19 financial institutions, including Lehman Brothers, Merrill Lynch, Morgan Stanley and Goldman Sachs). In the release accompanying this emergency order, the SEC directly linked the order to the naked short sales of Bear Stearns stock. The release begins with the following explanation for the halting of naked short sales:
False rumors can lead to a loss of confidence in our markets. Such loss of confidence can lead to panic selling, which may be further exacerbated by “naked� short selling. As a result, the prices of securities may artificially and unnecessarily decline well below the price level that would have resulted from the normal price discovery process. If significant financial institutions are involved, this chain of events can threaten disruption of our markets.
The events preceding the sale of The Bear Stearns Companies Inc. are illustrative of the market impact of rumors. During the week of March 10, 2008, rumors spread about liquidity problems at Bear Stearns, which eroded investor confidence in the firm. As Bear Stearns’ stock price fell, its counterparties became concerned, and a crisis of confidence occurred late in the week. In particular, counterparties to Bear Stearns were unwilling to make secured funding available to Bear Stearns on customary terms. In light of the potentially systemic consequences of a failure of Bear Stearns, the Federal Reserve took emergency action.[26]
In issuing another emergency order in September 17, 2008, the SEC expressed even greater alarm how naked short selling had “exacerbated� other factors in causing the widening collapse of the securities markets. The SEC issued a protective stay on short sales trades in the stock of more than 900 banks, insurance companies, and securities firms. The SEC explained the rationale for the broadened stay with these words:
The Commission continues to be concerned that there is a substantial threat of sudden and excessive fluctuations of securities prices and disruption in the functioning of the securities markets that could threaten fair and orderly markets. As evidenced by our recent publication of an emergency order under Section 12(k) of the Securities Exchange Act of 1934 (the “July Emergency Order�), we are concerned about the possible unnecessary or artificial price movements based on unfounded rumors regarding the stability of financial institutions and other issuers exacerbated by “naked� short selling. Our concerns, however, are no longer limited to just the financial institutions that were the subject of the July Emergency Order. In addition, we have become concerned that some persons may take advantage of issuers that have become temporarily weakened by current market conditions to engage in inappropriate short selling in the securities of such issuers.[27]
On October 14, 2008, as the financial crisis deepened, the SEC released an interim amended version of Reg SHO to stop naked short selling (Exchange Act Release No. 58773). The summary to the release announcing the interim rule explained its purpose as follows:
The Securities and Exchange Commission (“Commission�) is adopting an interim final temporary rule … to address abusive “naked� short selling in all equity securities by requiring that participants of a clearing agency registered with the Commission deliver securities by settlement date, or if the participants have not delivered shares by settlement date, immediately purchase or borrow securities to close out the fail to deliver position by no later than the beginning of regular trading hours on the settlement day following the day the participant incurred the fail to deliver position.[28]
In the same release (Exchange Act Release No. 58773), the SEC revised its description of how naked short selling could harm public companies. The SEC no longer described the harm caused by naked short selling as a perception held by public companies and their investors. The SEC described the harm as real. On October 14, 2008, for the first time, the SEC described how naked short selling inflicted harm on public companies as follows:
To the extent that fails to deliver might be part of manipulative “nakedâ€� short selling, which could be used as a tool to drive down a company’s stock price, such fails to deliver may undermine the confidence of investors. These investors, in turn, may be reluctant to commit capital to an issuer they believe to be subject to such manipulative conduct.[29]
On the same date, October 14, 2008, the SEC issued a separate release announcing another amendment to Reg SHO eliminating the options market-maker exception and narrowing the bona fide market-maker exception, all to contain naked short selling. The summary to the 2008 amendment explained the purpose of the amendment as follows:
The Securities and Exchange Commission (“Commissionâ€�) is adopting amendments to Regulation SHO under the Securities Exchange Act of 1934 (“Exchange Actâ€�). The amendments are intended to further reduce the number of persistent fails to deliver in certain equity securities by eliminating the options market-maker exception to the close-out requirement of Regulation SHO. As a result of the amendments, fails to deliver in threshold securities that result from hedging activities by options market-makers will no longer be excepted from Regulation SHO’s close-out requirement. The Commission is also providing guidance regarding bona fide market making activities for purposes of the market-maker exception to Regulation SHO’s locate requirement.[30]
Between July 15, 2008, and July 27, 2009, the SEC issued eight releases relating to amendments to Reg SHO and “naked� short selling, including some emergency orders, all intended to contain naked short selling.[31]
Had those who engage in naked short selling not chosen the investment banks as victims during the financial crisis in 2008, the scope of these violations would likely remain unknown, except of course to those who are committing them. Now that those banks are prospering again, there is little motivation for them to speak publicly about naked short selling. Many of the records sought by Plaintiff relate to the SEC’s aborted investigations of naked short selling of the investment banks (Bear Stearns, Lehman Brothers, Merrill Lynch, Morgan Stanley, and Goldman Sachs) whose collapse or near collapse deepened the financial crisis.
After the SEC issued the amendments to Reg SHO and emergency amendments in 2008 and 2009, the minor administrative proceedings brought by the SEC’s Division of Enforcement again gave the impression that naked short selling was more an irritant than a serious threat to public companies. The SEC brought two classes of cases to enforce Reg SHO: one alleged intentional violations against minor market participants who used options to circumvent Reg SHO,[32] and the other alleged inadvertent and narrow violations against broker-dealers affiliated with large investment banks.[33] None of these cases hinted that the violations of Reg SHO were systemic or created a risk to the stability of the capital markets. There seemed to be a disconnect at the SEC between (1) the five SEC Commissioners who had acted expeditiously to issue half a dozen rules and emergency orders to contain naked short selling during the 2008 financial crisis and (2) the SEC’s Division of Enforcement which again reverted to its tepid enforcement of Reg SHO and the non-enforcement of the antifraud provisions of the securities acts against those engaged in naked short selling.
The conflict in the courses of action between the five Commissioners and the SEC Division of Enforcement suggests the SEC believed it could deter the market participants who engaged in naked short selling, including those who had deepened the financial crisis by contributing to the collapse or near collapse of five US based international investment banks (Bear Stearns, Merrill Lynch, Lehman Brothers, Morgan Stanley, and Goldman Sachs), by strengthening the regulations prohibiting naked short selling without meaningfully enforcing those regulations, i.e., by tough words without action. In short, the numerous revisions strengthening Reg SHO and other emergency orders were the rough equivalent of the SEC repeatedly telling those engaged in naked short selling: “Don’t do that again. This time we are really serious.�
The willingness of the world’s largest brokerage firms to flout the SEC rules designed to prohibit naked short selling was established beyond doubt in the fall of 2011 when FINRA’s Department of Enforcement released its Letters of Acceptance, Waiver and Consent (“AWC�), which included FINRA’s findings and conclusions, arising out of its enforcement proceedings against two of the world’s largest brokerage firms, UBS Securities, the brokerage arm of UBS Financial Services, a financial institution with $2 trillion in assets, and Credit Suisse Securities,  the brokerage arm of Credit Suisse Financial Services, a financial institution with nearly $1 trillion in assets.
In its AWC with FINRA, UBS signed off on committing approximately 30 different classes of Reg SHO violations over the five-year period from January 2005 through December 2010. The total number of Reg SHO violations committed by UBS is an unknown, since the best FINRA could do in quantifying the number of UBS violations of Reg SHO was to place them in the “tens of millions.�[34] Likewise, FINRA could not fix a date when the UBS violations of Reg SHO had stopped.
The magnitude of these violations may be more easily grasped when viewed in terms of the dollar value of the phantom stock UBS created out of thin air through the naked short sales it executed. When UBS short sold stock it did not own, possess, had not borrowed, and had not arranged to borrow, it was in essence selling counterfeit stock. Under the conservative assumption that the average size of each trade was 100 shares and the average price was $10, the average transaction would have created $1,000 worth of counterfeit stock. Since UBS engaged in tens of millions of transactions creating counterfeit stock, it created counterfeit stock pretending to be worth tens of billions of dollars. By way of example only, if UBS created counterfeit stock in 50 million transactions, it would have created $50 billion worth of counterfeit stock.
As alleged above, UBS was not alone in committing massive violations of Reg SHO. In its AWC with FINRA, Credit Suisse admitted committing massive violations of Reg SHO during the four-and-a-half-year period from June 2005 through December 2010. In all, Credit Suisse also signed off on committing approximately 30 classes of violations directly or indirectly relating to Reg SHO. For its part, Credit Suisse entered “more than ten million short sale orders without locates.�[35] Using the same conservative assumptions as before, Credit Suisse likely effectively created at least $10 billion in counterfeit stock. Once again, the scope and volume of the violations raise serious concerns regarding the effectiveness of the regulatory system designed to stop naked short selling.
The massive Reg SHO violations by UBS and Credit Suisse did not merely create risks of harm to public companies and their investors. The scope and magnitude of these violations of Reg SHO had the potential to destabilize the system itself. In the settlement agreement, FINRA found and UBS conceded that the “duration, scope and volume of the trading [violations] created a potential for harm to the integrity of the market (emphasis added).�[36] The only aspect of the settlement more stunning than the scope of UBS’s violations—whose sale of counterfeit stock threatened the integrity of the capital markets—was the tiny fine paid by this $2 trillion company: $12 million.
FINRA’s release of the AWCs with UBS and Credit Suisse in the fall of 2011 redefined the magnitude of counterfeit stock which giant broker-dealers could create. The number of violations–in the tens of millions—the scope of the violations–approximately 30 classes—and magnitude of the harm, which put at risk the integrity of the market, point to one simple, overarching question: how did the SEC, FINRA, and the exchanges overlook the massive UBS and Credit Suisse violations of Reg SHO for at least half a decade?
The Depository Trust & Clearing Corporation (“DTCC�), which settles and closes virtually all stock sales, supposedly also monitors those trades for violations of Reg SHO and naked short selling. The same question must be asked: How did the DTCC overlook the massive violations by UBS and Credit Suisse for at least half a decade?
Supposedly, Reg SHO should have kept UBS and Credit Suisse in check. The regulation was not untested when it became operative in January 2005. It incorporated the SEC’s enforcement experience with earlier regulations designed to curb naked short selling.[37] The SEC released the preliminary version of Reg SHO on October 28, 2003.[38] It then went through a fourteen-month trial process before it became operative on January 1, 2005. Since then, it has been refined from time to time to work out the kinks.[39] It was significantly amended in October 2008 to stop the naked shorts which were destabilizing the nation’s investment banks during the financial crisis.[40] UBS and Credit Suisse were nonetheless able to engage in massive violations of Reg SHO for years after the regulation became operative, including twenty-seven months after the 2008 amendments were supposed to have cured the flaws in Reg SHO.
The UBS and Credit Suisse cases highlight another inherent and major flaw in Reg SHO: the regulation purports to prohibit trading practices which are largely invisible to law enforcement, regulators, public companies, and market participants (except those committing the violations). The lack of transparency pervades every nook and cranny in the stock trading system as a short sale passes through it. By inadvertence or design, the lights are switched off on short sales as they are electronically processed by the executing broker, the clearing broker, the exchanges, and the DTCC. The lack of transparency continues even when the SEC and FINRA release their decisions and settlements relating to naked short selling or the enforcement of Reg SHO to the public.
The FINRA AWCs with UBS and Credit Suisse illustrate how FINRA itself shut off the lights on UBS’s and Credit Suisse’s violations. Despite the tens of millions of violations of Reg SHO admitted by UBS and Credit Suisse, not a single public company was identified as a victim of those violations. Although at least 270 UBS customers participated in those violations, none was identified. Although UBS and Credit Suisse could not have committed the Reg SHO violations without the participation of its employees, FINRA brought no proceeding against any executive or employee of either company for participating in any of the tens of millions of violations. The same is true of the SEC’s releases describing its settlements with Goldman Sachs in 2007[41] and 2010,[42] and UBS in 2011.[43] The silence surrounding the SEC’s and FINRA’s enforcement of Reg SHO violations is deafening, and that silence is inexplicable in view of the potential harm those violations can cause. Again, according to the FINRA-UBS settlement, “The duration, scope and volume of the trading created a potential for harm to the integrity of the market.�[44]
A June 2009 study, Analysis of Twenty-First Century Risks in Light of the Recent Market Collapse, commissioned by the U.S. Department of Defense addressed how the lack of transparency makes it impossible to identify those responsible for the bear raids of the nation’s investment banks during the financial crisis. The report observed:
While substantial, unusual trading activity can be identified, the source of the bear raids has not been traceable to date due to serious transparency gaps for hedge funds, trading pools, sponsored access, and sovereign wealth funds. What can be demonstrated, however, is that two relatively small broker dealers emerged virtually overnight to trade “trillions of dollars worth of U.S. blue chip companies. They are the number one traders in all financial companies that collapsed or are now financially supported by the U.S. government. Trading by the firms has grown exponentially while the markets have lost trillions of dollars in value� (emphasis in the original).[45]
Naked short selling occurs in the shadows, where it is too dark to see. It is dark because the government, the SROs, and exchanges who have the duty to regulate short sales have turned off the lights where this trading occurs. The light with the highest wattage was switched off by the DTCC. The DTCC has a virtual monopoly in clearing and settling all the stock trades in the U.S., with the exception of internalized trades which broker-dealers need not report to it. The DTCC refuses to provide public companies with any useful information regarding violations of Reg SHO and naked short selling, unless it is ordered to do so by a court. As a private institution, the DTCC is not subject to FOIA. Consequently, absent a court order, every window into the DTCC is shuttered from the view of every public company. With his complaint, Plaintiff seeks records of the SEC’s five-year investigation of the DTCC for aiding and abetting violations of Reg SHO and naked short selling.
Virtually no useful information relevant to Reg SHO violations is available from the exchanges and trade reporting facilities. Only the NASDAQ exchange, where only a tiny fraction of the stock of public companies is traded, provides any meaningful information to public companies, the public or journalists. Further, since NASDAQ is the most “lit� trading center, a fact well known to those who engage in naked short selling, it is not their favorite venue. As noted in a 2012 academic study, broker-dealers and their customers prefer more user-friendly venues where the rules are ignored so price manipulation through naked short sales can flourish,[46] like the Chicago Board Options Exchange.[47] Not surprisingly, the largest number of short sales are conducted over the FINRA TRF, which has the least visibility of all of the trading centers.
As the facts demonstrate, the system itself is designed so public companies, investors and other market participants can never know whether they are being victimized by naked short selling. The words of Ferdinand Pecora (whose investigation of Wall Street after the 1929 crash led to the creation of the SEC) ring as true today as they did in 1939 when he first uttered them: “The Public was always in the dark. It could not tell whether sales were due merely to the ‘free play of supply and demand,’ or whether they were the product of manipulated activities…It all looks alike on the ticker (emphasis added).�[48]
The lack of transparency creates multiple obstacles for investors and public companies to determine whether a stock trade is an unlawful naked short sale. None of the fifteen exchanges or trade reporting facilities identifies the market participant who engaged in a short sale. Likewise, no trading center or exchange releases information relevant to whether a short sale was executed within an exemption to Rule 203.
Assuming someone harmed by a naked short sale could ascertain that the trade was a short sale, the seller had not borrowed the stock, the market-maker exemption did not apply, and the identity of the short seller, there would still be no violation of Rule 203 if the short seller believed he could borrow the stock, which is nearly impossible to verify. No regulator even purports to track whether a market participant has located stock to borrow before executing a sale.
A case filed and settled by the SEC in June 2013, In the Matter of Chicago Board Options Exchange,[49] offers insight into why the exchanges are so reluctant to provide public companies with any information relating to short sales. Simply put, the Chicago Board Options Exchange (“CBOE�) was profiting on the illegal short sales.  These are some of the relevant facts which the SEC alleged and the CBOE admitted:
Not only did [the CBOE] fail to enforce the Commission’s rules by not adequately investigating a member firm’s compliance with Regulation SHO of the Exchange Act (“Reg. SHO�), CBOE’s conduct also interfered with the Commission’s Division of Enforcement (“Enforcement Division�) staff’s Reg. SHO investigation of the same member firm. This conduct was egregious. CBOE assisted that member firm by taking the unprecedented step of providing information for, and edits to, the member firm’s Wells submission to the Commission ─ even more troubling, the information and edits provided by CBOE resulted in the member firm providing the Commission with inaccurate and misleading information. When questioned by Enforcement Division staff about the underlying matter, CBOE failed to disclose that it had assisted the member firm with its Wells submission. CBOE also failed to enforce Reg. SHO because it employed a Reg. SHO surveillance program that failed to detect a single violation, despite numerous red flags that its members engaged in violative conduct.[50]
As a SRO, the CBOE was obligated to enforce its members’ compliance with the federal securities laws and rules, including Reg SHO. In effect, the CBOE was a deputy of the SEC. However, instead of enforcing Reg SHO, the CBOE closed its eyes to hundreds of millions of dollars in naked short sales consummated by one of its members, optionsXpress (a subsidiary of Charles Schwab) and some of optionsXpress’ biggest customers in 25 public companies and then the CBOE tried to obstruct the SEC’s investigation.[51]
The SEC’s release on the CBOE’s failure to enforce Reg SHO and subsequent efforts to obstruct the SEC’s investigation pointed to the reason the CBOE was behaving in this way:
CBOE’s Regulatory Services Division is responsible for enforcing the federal securities laws and regulations and CBOE rules. Until recently, CBOE had no formal policies separating its Regulatory Services Division from its business side, which was responsible for CBOE’s income generation. In fact, until recently, CBOE’s Chief Regulatory Officer reported up to a senior business executive. As a result, the line between business and regulation became blurred.[52]
The violations the CBOE had permitted optionsXpress to commit were not merely violations of Reg SHO. In a separate case, the first of its kind, SEC Chief Administrative Law Judge Brenda Murray found that the naked short sales by the optionsXpress cabal constituted violations of the antifraud provisions of Section 17(a) of the Securities Act of 1933 and Section 10(b) of the Securities Exchange Act of 1934 and Rules 10(b)(5) and 10(b)-21.[53] The CBOE had closed its eyes to the fraudulent naked short sales by one of its members and then tried to obstruct the SEC’s investigation of the fraud.
The optionsXpress decision found the optionsXpress cabal had designed a fraudulent scheme using options to circumvent the stock delivery requirements of Reg SHO Rule 204. But broker-dealers and market participants who engage in naked short selling do not have to resort to fraud to circumvent the Rule 204 stock delivery requirements. Other terms of Rule 204 create an exception to its delivery requirements, perhaps more accurately perceived as a huge loophole. Whether exception or loophole, the effect is the same: the huge void in Rule 204 in effect converts the rule into an honor code. To understand how this exception-loophole emasculates Rule 204, some understanding of Rule 204’s moving parts may be helpful.
In essence, Rule 204 is supposed to prevent short term naked shorts from becoming long term naked shorts. To that end, it requires delivery of the stock in three days[54] for non-market-makers and six days[55] for market-makers. As alleged above, the SEC issued Rule 204 at the height of the financial crisis, after three investment banks (Bear Sterns, Merrill Lynch and Lehman Brothers) had failed and Morgan Stanley and Goldman Sachs were teetering on the edge of failure.
Regulators, broker-dealers and market participants commonly refer to the huge loophole in Rule 204 with a comforting euphemism: “internalization.� As a practical matter, it is more accurate to think of it as a de facto exception to Rule 204. It allows executing and clearing brokers to happily engage in naked short selling, so long as neither party tattles on the other. With billions to be made, tattling is extremely rare.
In the official lexicon, “internalization� occurs where broker-dealers execute client trades as agents or principals within their own trading system.[56] These internalized trades are not reported to the DTCC, and thus the DTCC will never know whether the trade resulted in a failure to deliver. The DTCC has repeatedly informed the SEC that it recognizes this exception.[57] On this point, its fourth quarter June 2006 Rule 19b-4 filing stated:
Trades executed in the normal course of business between a Member that clears for other broker/dealers, and its correspondent, or between correspondents of the Member, which correspondent(s) is not itself a Member and settles such obligations through such clearing Member (“internalized trades�) are not required to be submitted to the Corporation and shall not be considered to violate the “pre-netting� prohibition.[58]
A DTCC white paper has defined internalization in even broader terms than described in the DTCC’s Rule 19b-4 filings with the SEC. It defined the term as follows:
Internalization, for purposes of this paper, is the execution of separate correspondents’ trades by a clearing broker within its own record keeping system, and the related practice of failing to submit trade data on these â