What Investors Should Know And Do To Make Sure The Short Interest In Arena's Stock Is Playing By The Rules.
Joseph is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
1. Arena (NASDAQ: ARNA) short-sellers using illegal short and distort-
As of November 15, 2012, Arena short interest is 61,748,793 shares. This is the highest it has ever been. How much of the short interest is illegal naked shorting? We believe its substantial. It is no secret Arena investors know illegal naked short selling and stock manipulation are being used to manipulate Arena's stock to some extent. There have been many complaints to the SEC Complaint#HO::~00198038~::HO. Many Arena investors continue to complain to the SEC to take action. Bloomberg's Special Report documented this kind of illegal activity in the past. We decided to investigate Arena's consistent appearance on the Fail-To-Deliver list for the past week and on several occasions over the last year. Fail-To-Deliver is naked short selling which amounts to selling stock you don't own, don't borrow and make no attempt to do so. Unless the short seller has actually borrowed a real share from the account of a long investor, the short sale creates counterfeit stock. While naked short selling occurs, the extent to which it occurs is in dispute. We want to let the broker-dealers know that we are watching their behavior with Arena shares and they are violating the law when they allow persistent Fails-To-Deliver. This should deter some of this naked short selling activity. We hope that by making them follow the law, the cost of being short will be properly reflected in the market place. The manipulators appear to be protecting a healthy short squeeze from ensuing.
We also know these improper Wall Street practices have been around for many decades to create artificial price movements having nothing to do with a fundamental underlying basis. Wall Street shenanigans fleece billions of dollars from investors as reported by Bloomberg's report and investigation into the 2008 financial crisis. The motive is always money, and the participants are the short hedge funds, market makers, individuals, and prime brokers who make substantial profits while fleecing the small American investor. Congress and the SEC need to strictly enforce Reg SHO, Rule 10b-21, Rule 203(b)(3)(iii) of Regulation SHO, increase the penalty for violations, and increase regulation for this illegal activity. According to the SEC, these rules were adopted to signal zero tolerance for abusive naked short selling, but in practice little to nothing has been done to enforce these rules since, at the broker and market maker level. We learned from the 2008 financial crisis and past stock market history that the financial system would work better if the short-sellers are properly regulated and penalties are enforced. The Economist reported lawyers inadvertently released emails from brokerage employees which shed light on some hidden short selling secrets. Brokerages like Goldman Sachs (NYSE: GS), UBS Securities LLC (NYSE: UBS), Citigroup (NYSE: C), Bank of America Corp (NYSE: BAC) have been sued for allegations involving improper short sales in the past. In July 2007, Piper Jaffray (NYSE: PJC) was fined $150,000 by the New York Stock Exchange. The Motley Fool investment website observes that 'when a stock appears on the RegSHO list, it is a red flag waving, stating something is wrong here!." In April 2010, Goldman Sachs paid $450,00 to settle SEC's allegations that it failed to deliver approximately 86 short sells between early December 2008 and mid-January 2009, and that it had failed to institute adequate controls to prevent the failures.
In 2008, the SEC issued a temporary emergency order, banning short selling of financial firms, in an effort to save some of the very same brokerages that facilitate illegal naked short sales today. Here is the full list of securities reported that were affected by the SEC temporary order: BNP Paribas Securities, Bank of America (NYSE: BAC), Barclays (NYSE: BCS), Citigroup (NYSE: C), Credit Suisse Group (NYSE: CS), Daiwa Securities Group, Deutsche Bank Group (NYSE: DB), Allianz (NYSE: AZ), Goldman Sachs Group, Schwab (NYSE: SCHW), E-Trade (NASDAQ: ETFC), Royal Bank ADS (NYSE: RBS), HSBC Holdings (NYSE: HBC) JPMorgan Chase (NYSE: JPM), Lehman Brothers, Merrill Lynch, Mizuho Financial Group (NYSE: MFG), Wells Fargo (NYSE: WFC), Morgan Stanley (NYSE: MS), UBS (NYSE: UBS), Freddie Mac and Fannie Mae.
This begs the question, who will help ordinary investors and equities to curb illegal naked short activity from these financial giants, we taxpayers saved in 2008 from destroying each other and wrecking our economy?
2. Why is it important for the investing public to know what is going on?
Don't sell your Arena shares to this manipulation! A good analogy, when the football team is going to use an illegal play in the game, you want to know the play to avoid losing as a result. Illegal short selling and the tactics used affect the investing public. It really doesn't matter whether you invest directly or indirectly in the stock market. We are affected by this illegal activity as Americans.
Regulation SHO became effective on January 3, 2005 to curb illegal naked short selling. Rule 10b-21 was enacted to reduce manipulative schemes involving naked short selling. 2007 Regulation SHO Final Amendments 72 FR at 45544 - states that "among other things, Regulation SHO imposes a close-out requirement to address failures to deliver stock on trade settlement date and to target potentially abusive 'naked' short selling in certain equity securities." We know from documented past lawsuits the SEC found massive illegal naked short selling existed. See Sandell Asset Management Corp., Securities Act Release No. 8857; See also Goldman Sachs Execution and Clearing LLP., Exchange Act Release No. 55465; U.S. v. Naftalin, 441 U.S. 768 (1979)(discussing a market manipulation scheme in which brokers suffered substantial losses when they had to purchase securities to replace securities they had borrowed to make delivery on short sale orders received from an individual investor who had falsely represented to the brokers that he owned the securities being sold. See also Rhino Advisors, Inc. and Thomas Badian, Lit Rel. No. 18003 (feb. 27, 2003); See also SEC v. Rhino Advisors, Inc., and Thomas Badian, Civ. Action No. 03 civ 1310 (RO)(S.D.N.Y.)(feb. 26, 2003)(settled case in which the SEC alleged that the defendants profited from engaging in massive 'naked' short selling that flooded the market with the company's stock, and depressed its price); See also S.E.C. v. Gardiner, 48 S.E.C. Docket 811, No. 91 Civ 2091 (S.D.N.Y. 1991)(alleged manipulation by sales representative by directing or inducing customers to sell stock short in order to depress its price); U.S. v. Russo, 74 F.3d 1383, 1392 (2d Cir. 1996)(short sales were sufficiently connected to the manipulation scheme as to constitute a violation of Exchange Act Section 10(b) and Rule 10b-5).
According to the DTCC, under the current Stock Borrow Program, the NSCC only borrows shares from the lending member if the member actually has the shares on deposit in its account at the DTCC and voluntarily offers them to NSCC. If the member doesn't have the shares, it can't lend them. Once a loan is made, the lent shares are deducted from the lender's DTC account and credited to the DTC account of the member to whom the shares are delivered. DTCC First Deputy General Counsel Larry Thompson stated:
"There can be any number of reasons for a 'fail-to-deliver,' many of them the result of investor actions. An investor can get a physical certificate to his broker too late for settlement. An investor might not have signed the certificate, or signed in the wrong place. There may have been human error, in that the wrong stock (or CUSIP) was sold, so the delivery can't be made. Last year, 1.7 million physical certificates were lost, and sometimes that isn't discovered until after an investor puts in an order to sell the security. There are literally dozens of reasons for a "fail to deliver," and most of them are legal. Reg SHO also allows market makers to legally "naked short" shares in the course of their market making responsibilities, and those obviously result in fails. We can't do anything about them but what we are doing: that is, report all fails of more than 10,000 shares in any issue to the marketplaces and the SEC for their action."
We learned from our investigation and the lawsuits filed that the market participants quickly adapt to circumvent the law. The evidence suggests the system fails to curb illegal shorting activity by hedge funds, individuals, brokers and market makers who are able to hide, misrepresent the reasons behind the short positions, and attempt to use significant loopholes, until they are caught.
3. What can investors, the SEC, and Congress do about Arena's consistent Fails-To-Deliver:
Call, email or fax this article to your broker to enforce Reg SHO, Rule 10b-21, and Rule 203(b)(3)(iii) of Regulation SHO on all Arena short interest.
Fails-to-Deliver are, in essence, counterfeit shares because naked shorting (selling shares you don't own) creates an imbalance in the market as the sell side is artificially increased with naked short shares. Typically, a stock market investor or trader has three days (T+3) to cover. According to SEC rules, if the broker-dealer has not located a share to borrow, they are supposed to take cash in the short account and purchase a share in the open market. This is called a "buy-in," and it is supposed to maintain the total number of shares in the market place equal to the number of shares the company has issued. Mr. Thompson explained the process:
"The markets check to see if the amount of fails to deliver is more than 1/2 of 1% of the total outstanding shares in that security. If it is, then it goes on a "Threshold List." If it is then on the Threshold List for 13 consecutive settlement days, restrictions on short selling then apply.The "close-out" requirement forces a participant of a registered clearing agency to close out any "fail to deliver" position in a threshold security that has remained for 13 consecutive settlement days by purchasing securities of like kind and quantity. If the participant does not take action to close out the open fail to deliver position, the participant is prohibited from making further short sales in that security without first borrowing or arranging to borrow the security. Even market makers arenot exempt from this requirement."
The total lack of enforcement and regulation is apparent by Mr. Thompson's admission that the DTCC is powerless:
"Naked short selling, or short selling, is a trading activity. We don't have any power or legal authority to regulate or stop short selling, naked or otherwise. We also have no power to force member firms to close out or resolve fails to deliver. That power is reserved for the SEC and the markets, be it the NYSE, Nasdaq, Amex, or any of the other markets. The fact is, we don't even see whether a sale is short or not. That's something only the markets see. NSCC just gets "buys" and "sells," and it's our job to try and clear and settle those trades."
The problem is clearly in the loopholes, enforcement, regulation, and penalty side of the equation. Your broker dealer is responsible for enforcing Reg SHO, Rule 10b-21, and Rule 203(b)(3)(iii) of Regulation SHO. Demand it!
4. We need transparency in the Identity of Shorts Creating Counterfeit Shares:
We can limit the amount of counterfeiting by demanding that they enforce the law at the broker-dealer and market-maker level. The identity of the shorts is not known. Further, regulation needs to be adopted because current rules obscure their true identity by allowing them to hide behind the prime brokers and/or hiding behind layers of offshore domiciled shell corporations. The magnitude of the counterfeiting is locked within the prime brokers and market makers who basically use the loopholes to protect themselves and their customers.
There are three mechanisms for the creation of counterfeit shares:
If a short seller cannot borrow a share and deliver that share to the person who purchased the (short) share within the three days allowed for settlement of the trade, it becomes a fail-to-deliver and hence a counterfeit share; however the share is transacted by the exchanges and the DTC as if it were real. Since forced buy-ins rarely occur, the other consequences of having a fail-to-deliver are inconsequential, so it is frequently ignored. Enough fails-to-deliver in a given stock will get that stock on the SHO list, (the SEC's list of stocks that have excessive fails-to-deliver), which should (but rarely does) see increased enforcement. Penalties amount to a slap on the wrist, so large fails-to-deliver positions continue to exist for months and years. Regulation SHO, implemented in January 2005 by the SEC, was supposed to end wholesale fails-to-deliver. We need to stop the financial industry from exploiting these loopholes:
- Stock sales are either a long sale or a short sale. A broker can mis-mark the trading ticket by checking the long box when it is actually a short sale. Thereby the short never shows up in the system. The position usually gets reconciled when the short covers.
- Settlement of stock transactions is supposed to occur within three days. If it doesn't settle in three days a naked short should become a fail-to-deliver. SEC routinely and automatically grants a number of extensions before the naked short gets reported as a fail-to-deliver by giving brokers an opportunity and discretion to create a lie for the reason why the short shares have not been delivered or covered. Short hedge funds and broker dealers have multiple entities, many offshore, so they sell large naked short positions from entity to entity. Broker-dealer can create a phony 'easy to borrow list.' They can 'roll' their position broker-to-broker, or hedge-fund to hedge-fund, in block trades that never appear on an exchange. Each movement can reset the time clock for the naked position becoming a fail-to-deliver resulting in quickly getting a company off of the SHO threshold list.
- The prime brokers can do a buy-in of a naked short position. Typically, they tell the short hedge fund when the buy-in will take place. For example, they may say at 3:30 EST on Friday, then hedge fund naked shorts into their own buy-in or has a another hedge or controlled entity do it, and then rolls its position, hence circumventing Reg SHO.
- Large broker dealers typically operate internationally, and can play the shell game with regulators who come in to check compliance by taking large naked positions out of the country and returning them at a later date.
- Broker-dealers make enormous profits by charging large fees for the "borrowed" shares. Shares loaned to a short are supposed to remain with the short until he covers his position by purchasing real shares. Broker-dealers do one-day lends, which enables the short to identify to the SEC the account that shares were borrowed from. As soon as the report is sent in, the shares are returned to the broker-dealer to be loaned to the next short. A daily loan can allow eight to ten shorts to borrow the same shares, resetting the SHO-fail-to-deliver clock each time, which makes all of these counterfeit stocks look like legitimate shares. The broker-dealers have an incentive to do this activity because they charge each short for lent stock.
- Margin account buyers inadvertently aid the shorts. If a short-seller sells a naked short he has three days to deliver a borrowed share. If the naked stock is purchased in a margin account, it is immediately put into the stock lend cycle and, for a fee, is available as a borrowed share to the short who counterfeited it in the first place. This margin process is perpetually fluid with multiple parties, but it serves to create more counterfeit shares and is an example of how a counterfeit share can grow due to the existence of margin account activity rules.
- Margin account agreements give the broker-dealers the right to lend those shares without notifying the account owner. Shares held in cash accounts, IRA accounts and any restricted account is not supposed to be loaned. Broker dealers have been known to change cash accounts to margin accounts without telling the owner the real motive behind the move, or take shares from IRA accounts, take shares from cash accounts and lend restricted shares.
2. Ex-clearing. This is the second tier of counterfeiting that occurs at the broker dealer level. Most of the problems here are in the magic of accounting. Strict auditing rules to audit this activity for compliance should help. The financial Accounting Standards Board issued statement No. 161, to enhance disclosure of derivatives and hedging, but does little to address naked short selling.The brokers sometimes disguise naked shorts that are fails-to-deliver as disclosed shorts. Broker-dealers essentially accounting for them as borrowed shares when they are not. This also makes naked shorts "invisible" to the system so they don't become fails-to-deliver, which is the only thing the SEC tracks.
This is just a sample of loopholes used under the guise of the discretion given brokers by the SEC. The SEC only tracks the Fails-To-Deliver and the counterfeit shares that exist at this ex-clearing tier can be ten or twenty times the number of fails-to-deliver.
3. Market-makers. The third tier of counterfeiting occurs at the market-maker level. Market makers are exempt from the pre-borrow requirement. The SEC rules related to the market maker are not well defined. The "Bona Fide Market Making" requirement is rarely tracked or checked by the SEC. The SEC adopted guidance that militates against finding "bona fide market making," including (i) activities that are related to speculative selling strategies or investment purposes of the broker-dealer and that are disproportionate to the usual market making patterns or practices of the broker-dealer in that security; (ii) continually posting at or near the best offer, but not also posting at or near the best bid and a market maker continually executing short sales away from its posted quotes. The SEC has stated that bona-fide market making activity does not include activity that is related to speculative selling strategies or investment purposes of the broker-dealer. Likewise, where a market maker posts continually at or near the best offer, but does not also post at or near the best bid, the market maker's activities would not generally qualify as bona-fide market making. See 2004 Regulation SHO Adopting Release, 69 FR at 48015. Moreover, a market maker that continually executes short sales away from its posted quotes would generally not be considered to be engagng in bona-fide market making. For purposes of qualifying for the locate exception in Regulation SHO, a market maker must also be a market maker in the security being sold, and must be engaged in bona-fide market making in that security at the time of the short sale. See Rule 203(b)(1) and (b)(2)(iii). In addition, the SEC has clearly stated if a market maker sells stock (short) together with a synthetic short position (e.g., a conversion) to a client and the client then sells the stock (long) retaining the synthetic short position, the effect would be as if the market maker had 'rented' its exemption to the client - such a transaction or other transactions that have the same effect will not be considered bona-fide market making activity. This activtity appears to be taking place if you watch the tape closely. We have not been able to find a single instance of SEC investigation or enforcement action. Arena's stock would be a good start. The market maker controls the market for the stock through manipulation, instead of simply allowing the equity to move according to natural free market forces. An often-cited classic example of this involved Global Links Corporation. How did wholesale counterfeiting of shares decimate a company's stock price? Global Links is a company that provided computer services to the real estate industry. By early 2005, their stock price had dropped to a fraction of a cent. At that point, an investor, Robert Simpson, purchased 100% of Global Links stock (1,158,064) issued and outstanding shares. He immediately took delivery of his shares and filed the appropriate forms with the SEC, and disclosed he owned all of the company's stock. His total investment was $5,205. The share price was $.00434. The day after he acquired all of the company's shares the volume on the over-the-counter market was 37 million shares. The following day he saw 22 million shares change hands. Simpson did not trade a single share. This clearly means there were invisible shares created out of thin air through naked short selling by a broker or market maker.
If the SEC does not act, ordinary private investors can file lawsuits against those who violate RegSHO, Rule 10b-21, 10b-5 and other Anti-fraud Federal Securities laws. See Superintendent of Insurance v. Bankers, 404 U.S. 6, 13, n.9(1971); Ernst & Ernst, 425 at 196 (citing prior cases).
5. Arena short attack play book:
Don't give up your shares to artificial manipulation. We know that abusive short selling is not random acts of some renegade hedge funds, brokers, individuals, or market makers, but rather a concerted or coordinated effort with a business plan that is carried out by a consortium of one or more of these players. Arena has a healthy balance sheet - zero debt and $165,000,000 in cash. It will be cash flow break-even in the fourth quarter 2012 or first quarter 2013. Shorts are concerned about their growing losses here.
Recognize these tactics, which shorts have used to try to drive Arena's stock price down. We have noticed the play book because it's very similar from attack to attack, and the participating prime brokers and lead shorts are fairly consistent. The SEC should subpoena records and seek enforcement during this period of time. All these tactics will look familiar, standing out as bright badges of fraud, because Arena's stock endured these typically used tactics:
a. Flooding the offer side of the board. Ultimately the price of a stock is found at the balance point where supply (offer) and demand (Bid) for the shares find equilibrium. This equation happens every day for every stock traded. On days when more people want to buy than want to sell, the price goes up. Conversely, when shares offered for sale exceed the demand, the price goes down. The market makers and shorts manipulate the laws of supply and demand by flooding the offer side with counterfeit shares. This can be done with a single hedge fund transacting from two different accounts or two hedge funds working together.
b. Media assault. In order to profit, the shorts must ultimately purchase real shares at a price much cheaper than what they shorted at. These real shares come from the investing public who usually panics and sells into the manipulation. Panic is induced with assistance from the financial media. The shorts have "friendly" reporters with the Dow Jones News Agency, the Wall Street Journal, Barrons, the New York Times, Gannett Publications (USA Today and the Arizona Republic), CNBC and others. Jim Cramer speaks about his role as a commentator on his investment entertainment show.
Noteworthy, on The Daily Show with Jon Stewart, we heard Jim Cramer, in a video-taped interview describe the shorts illegal game. Jim Cramer gives entertaining investment advice but his law license was suspended by the State of New York. Hedge funds short, Jim Cramer and TheStreet.com (NASDAQ: TST) have made repeated efforts to disparage Arena. The Street.com is now participating in these shenanigans by issuing a weekly bogus sell rating on Arena.
c. Analyst Reports. Some alleged independent analysts were actually paid by the shorts to write slanted negative rating reports. The reports, which are usually represented as being independent, were actually written by the shorts and disseminated to coincide with a short attack. All are designed to panic small investors into selling their stock into the manipulation for the shorts to cover cheaply.
d. Pulling margin from long customers. This past summer brokers reduced margins on Arena stock. The clearinghouses and broker-dealers who finance margin accounts will suddenly pull all long margin availability, citing "risk" as a reason for the abrupt change in lending policy. This causes a flood of margin selling, which further drives the stock price down and gets the shorts the cheap long shares that they need to cover.
e. Paid bashers. The shorts will hire paid bashers who "invade" the message boards of the company. The bashers disguise themselves as legitimate investors and try to persuade or panic small investors into selling into the manipulation.
This does not cover every dirty little trick that the shorts use when they are manipulating the stock. But, it clearly undermines the free market system and investor confidence in it.
6. What to Do?
Call, email or fax your broker to enforce Reg SHO, Rule 10b-21, and Rule 203(b)(3) of Regulation SHO. Do not sell your shares. Don't listen to noise by paid bashers. Don't set stop losses. Call your broker and make sure your Arena shares are not in a margin account where the broker can loan out your shares without getting your permission. Do not allow your shares to be loaned out. If you can place your Arena shares in a cash account, you would be best protected from broker dealers illegally using your shares to create counterfeit stock. Lastly, contact your local Congressman and Senator at the federal and state level to help them understand this fraud. We want legislation passed and enforced to stop this activity and force the players in this activity to be transparent in their short selling activities. Let's level the playing field. Arena has several strong short-term and long-term catalysts coming:
1. DEA schedule IV announcement any day now;
2. $65,000,000 milestone payment;
3. December, 2012, EMA preliminary assessment of Belviq's EU application;
4. First quarter, 2013, Belviq U.S. sales and marketing;
5. EU Belviq approval first half 2013;
6. Continued institution and fund ownership growth;
7. EU Partnership;
8. Additional Rest of World Partnerships;
9. Quarterly sales results; and
10. EU Launch;
11. Approval in Switzerland, Canada, Mexico, Brazil and Korea
12. Belviq-Phentermine combination drug
13. Belviq for treating addiction (such as smoking cessation support)
14. Belviq-Metformin combination drug (Diabetes is a huge market by itself)
15. Advancing APD811 towards phase IIb (PAH treatment)
16. Starting clinical trials with at-least one more promising NCE
17. Potential Buy-out by Big Pharmaceutical before Belviq becomes a success.
18. Short squeeze coming soon.
I reiterate my buy rating on Arena stock all the way up to $20/share based upon the fundamentals. Now is an excellent time to add to your stock positions before the momentum of the company's fundamentals takes off like a rocket.
Disclosure: I am long ARNA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.While I am a licensed lawyer this article is not to be construed as legal or financial advice. The ideas herein are solely presented for informative and/or entertainment purposes. The stock market is inherently risky, and each individual investor must make his/her own decisions based on his/her research and risk tolerance. Before investing, always do your own due diligence and/or speak with a licensed financial advisor.