GAO rips SEC on Naked Short Selling

Discussion in 'Wall St. News' started by flytiger, Mar 29, 2009.

  1. GAO Report Blasts SEC Short-Selling Investigation

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    By Jessica Dye

    Law360, New York (March 27, 2009) -- The U.S. Government Accountability Office issued a report Friday laying out the process for clearance in the equities market, finding that a U.S. Securities and Exchange Commission office may have missed significant activities related to manipulative naked short-selling in the nation's largest equities clearinghouses.

    The GAO report stressed the importance of oversight into the clearance and settlement process for equities markets, while saying that it did not support the SEC Office of Compliance Inspections and Examinations' 2007 report validating activities of the National Securities Clearing Corp.'s Continuous Net Settlement System/Stock Borrow Program.

    The report summarized the GAO's findings regarding its investigation of the operations of equity market clearance procedures presented to the U.S. Senate Finance Committee on Jan. 30 at the committee's request.

    The NSCC's Stock Borrow Program came under considerable scrutiny in the report and was a specific target of the OCIE's routine regulatory investigation into the NSCC's activities in 2005. The GAO audited the office's 2005 report to see whether its investigation had been sufficiently thorough.

    The Stock Borrow Program allows the NSCC to borrow stocks or fixed-income securities from voluntary participants, who offer up their own holdings to temporarily back any delivery shortfalls. The backing securities are returned when the lender who short-sold the security is able to deliver the backing equity.

    While many fails to deliver are the result of processing delays or mechanical errors and are typically resolved in a few days, they can also result from attempts to naked short-sell a security, the SEC said.

    According to the NSCC, in an average day, 99.9 percent of transactions are viable, but the 0.1 percent that fall into the FTD category resulted in an aggregate value of $7.5 billion as of Dec. 31, 2007, the GAO report said.

    Critics of the Stock Borrow Program raised concerns in 2005 that the program was allowing traders to get away with naked short-selling because the NSCC let other lenders step in and cover any failed deliveries until the trader came up with sufficient backing.

    “These critics argued that the Stock Borrow Program exacerbated naked short selling by creating and lending shares that are not actually deposited at the Depository Trust Co., thereby flooding the market with shares that do not exist,” the report said.

    The Depository Trust & Clearing Corp., which operates the NCSS and the DTC, estimated that the Stock Borrow Program usually covers about 15 percent to 20 percent of the FTD balance each settlement cycle. Unfulfilled FTDs or fails to receive are rolled over to the next settlement cycle.

    As a part of its 2005 investigation of the NSCC, the OCIE conducted test transactions on securities that were suspected of being traded as naked short-sells, as well as securities with unusually high or prolonged levels of FTDs.

    The OCIE's review did not raise any concerns about the reliability of the reports generated by the Stock Borrow Program, the report said. However, the GAO wasn't so sure about those findings.

    “We did not validate the OCIE's findings,” the GAO report said, although it did not give any specific instances in which it suspected anything had gone unnoticed.

    In fact, the OCIE had a very thorough method for examining clearinghouses such as the NCSS, which manages the clearance and settlements, risk management, central counterparty services and guarantee of completion for nearly all broker-to-broker trades that involve equities or exchange traded debt, the GAO said.

    The examination process is governed by an extensive set of guidelines prepared by the OCIE, which, for large clearinghouses such as the NCSS, is applied to its enormous trading activity once every other year. The OCIE also regularly reviews internal audits from clearing house staff and performs investigations as necessary, as well as recommending and tracking any deficiency remediation.

    According to the GAO, despite its assertion that the NCSS' short position reports were above-board, the OCIE identified deficiencies in areas such as record retention, risk management and clearing fund administration. Twelve out of 13 specific examinations reviewed by the GAO contained evidence of follow-up on recommendations, the report said.

    Lori A. Richard, director of the OCIE, issued a letter in response to the GAO's report, stating that her office took its duty to examine clearinghouses and provide effective oversight of self-regulated organizations very seriously.

    “GAO specifically reviewed OCIE's examination testing of the NSCC's continuous net settlement and stock borrow program in connection with its assessment of the SEC's actions to address short selling issues,” Richards said.

    The SEC's inspector general issued a report on March 19 saying that the agency lacked a uniform procedure for handling the estimated 5,000 e-mail complaints about naked short-selling over an 18-month period. During those 18 months, the SEC did not bring a single enforcement action, the inspector general said at the time.

    In August 2008, a three-judge panel of the U.S. Court of Appeals for the Ninth Circuit dismissed a suit alleging the DTCC had violated state law by engaging in naked short-selling through the Stock Borrow Program.

    In the ruling, a judge found that any state law suit against the program would interfere with the SEC's ability to oversee clearinghouse and equity market activity.

    --Additional reporting by Jesse Greenspan and Morgan Bettex