Post by jannikki on Apr 26, 2007 17:39:23 GMT -4
SEC's OEA Study Short Changes Public - April 25, 2007
David Patch
You really have to wonder what talent pool the SEC searches when they seek out their economists.
For the second time in barely a year the SEC's Office of Economic Analysis (OEA) has submitted a study or analysis in which the conclusions drawn directly mislead the public relative to market risks and market controls. The two questionable studies took on the common issue of short selling and Regulation SHO and each presented opinions that were either directly misleading, inaccurate, or both.
The latest study to be published, Short Selling and Failures to Deliver in Initial Public Offerings by Amy Edwards and Kathleen Hanley of the SEC's OEA investigates short selling, naked shorting, and underwriting roles in an IPO. The study has the standard disclaimer attached that identifies that the opinions of the authors are not that of the Commission or Commission staff despite the cover page identifying the SEC's Office of Economic Analysis as the sponsor of the report.
The conclusions drawn by the authors are of great concern as it is becoming more and more evident that the SEC is in constant fear that investors will find out the truth about where naked shorting takes place and how it impacts our public markets. Instead of being forthright in efforts to resolve the issues, the SEC outright manipulates the dissemination of information in order to cattle the public to the conclusions wanted.
Before I take a stab at debunking the report you must understand that short term fails to deliver in an IPO are insignificant relative to the overall issue of persistent fails to deliver and market manipulation. This study in fact evaluates a mere 295 IPO's since 2005 yet prior SEC data gathered identified that on average more than 2600 companies have fails to deliver in excess of 10,000 shares with more than 200 listed daily with fails exceeding 0.5% of their issued and outstanding shares. Since Regulation SHO has been incorporated, more than 4000 public companies have been on the list at one time or another
Anyway...
The study by Edwards and Hanley concludes "Despite finding that settlement failures ("failures to deliver") occur regularly in IPOs, our results do not support the conjecture that naked short selling is to blame. In fact, we show that the level of failures to deliver are uncorrelated with amount of short selling and for many IPOs, failures to deliver exceed the level of short selling." Instead citing that "failures to deliver may be related to factors associated with underwriter activities to support the offer price."
The OEA study frequently referred to the 2000 research of Aggarwal to address the underwriter theories of overallocation as the cause to the settlement failures during an IPO. Aggarwal had studied 103 IPO's back in the late 1990's and had used the proprietary trading information of the underwriters to study the use of the "green shoe" clause in an underwriting agreement. The green shoe clause provides an underwriter the option to overallocate shares above the offering levels in order to provide pricing support in the aftermarket trading in the IPO.
If pricing support is not required, stock maintains IPO pricing levels; the company will issue the overallocation shares to the underwriter at the strike price to cover the fails created by the overallocation. If pricing support is required of the underwriter however, pricing support defined as the need to create demand in the open market to maintain the market, the number of shares the underwriter had to purchase to maintain pricing support will reduce the level of shares to be issued by the company to cover the outstanding unsupported shares.
But here is a part of the Aggarwal study that Edwards and Hanley failed to disclose in their study; the part that directly contradicts their conclusions if only in the semantics of terminology.
"Underwriters initially sell shares in excess of the original amount offered, thereby taking a short position prior to the offering. This short position can be covered by exercising the overallotment option and/or by short covering in the aftermarket. Almost all IPOs have an overallotment option whereby the underwriter can sell additional shares up to 15 percent of the offer size, exercisable for 30 calendar days after the offering. In offerings where weak demand is anticipated, underwriters frequently take a naked short position by allocating more than 115 percent of the stated size of the offering. We refer to this form of price support as aftermarket short covering."
Edwards and Hanley directly stayed away from calling this overallotment a short position, and specifically a naked short, although that is exactly what it is. Any effort to dismiss it in a slight of hand is irresponsible. "It depends on the definition of 'is' is"!
To conclude that the fails to deliver were not due to shorts, and in some cases naked shorts, is misleading as these fails to delievr that take place are exactly attributed to an underwriter shorting ahead of the IPO as part of the IPO process. It is the IPO underwriting version of market making.
Also missed by Edwards and Hanley is that last portion of Aggarwals comments, that regarding underwriters overallocating beyond the "green shoe" limit of 115% allocation. Those additional allocations being naked shorts as they are shorts not covered in the underwriting agreement.
Under IPO contract, the underwriter is allowed to overallocate such that the underwriter will then go into the open market and purchase shares as price support at or just below IPO pricing levels. Due to the initial response in a week demand market, early sell-off may drive prices down and the underwriter is offered the option to over sell the IPO [short the IPO] and cover the short in the open market by providing price support where demand is thin. The agreement however is that all overallocated shares will be closed out within 30 days after the IPO.
Since this overallotment is common, the real study would involve investigating how well this agreed upon "short" and "naked short" process works and whether preferred clients are active in the process.
The global concern of many is that naked shorting or abusive shorting can have a detrimental impact on those companies who are aggressively targeted. Not all companies are targets. Interested parties have never implied that legal naked shorting [market making], within controlled limits is all negative. The focus is really on those localized areas where damage takes place due to a systemic breakdown and illegal naked shorting has co-mingled in the market with the legal trades.
Consider the underwriting responsibilities during the Vonage debacle last year. Vonage went public with 31 million shares at 17.00/share. The green shoe overallotment would thus be 4.5 Million shares before executing any additional naked shorts ahead of the IPO.
By the end of the first day of trading the stock had already lost 13% of the market cap closing at $14.85 and, according to records obtained under FOIA, the level of fails associated with the days trading had exceeded 5.6 million shares.
To determine the economic impacts, the authors of this report should have identified outliers such as Vonage and dug deeper to understand whether the process has flaws where isolated abuses can take place. Did the underwriter who overallocated shares in Vonage provide the pricing support they were required to or did they take advantage of a collapsing market and cover the overallocation for significant profits? Are all overallocations covered within the mandatory 30 calendar days or do they extend beyond that timeframe and go without enforcement, the persistent settlement failure being the issue.
In a phone call with Edwards she implied that outliers such as Vonage may exist but that the study did not go to that level of detail. There will always be islated examples where the system did not work.
By the data Edwards and Hanley did present it appears that the FTD's do in fact extend beyond 30 trade days (6 calendar weeks) and thus underwriting overallocations and naked shorting can have pricing impacts on the security and should have been part of the study.
Not all hedge funds and member firms were involved in market timing, not all business operations are involved in accounting fraud yet when it came time to decide on laws it was not teh norm that was inspected it was the anomoly to understand how it happened and how to prevent it in heh future. Studies don't need to be conducted to validate the known; studies are to be conducted to understand the anomalies.
To mask this study as an effort to look into shorting and naked shorting in a public market and then not scrub down to the details of specific areas where abuses appear likely is irresponsible. It takes hard work to study this issue and the SEC OEA failed to dediate the resource to the effort. The public received the cliff notes but to the wrong book.
The response from this study only fueled the fire over shorting abuses in our public markets. The SEC staff has repeatedly denied shorting abuses existed only to recently admit that isolated groups of investors are being victimized by the abuse. The reporting of this study resulted in the media, already a disbeliever in this problem, submitting such headlines to the public as the ones listed below that only add a false sense of trust in the system.
SEC Finds No 'Naked Short'-IPO Issue - April 24 WSJ
SEC Economists Reject Claims On 'Naked' Short Sales - April 23 Dow Newswire
It headlines weren't, two economic analysts rejected claims it was the SEC rejects these claims. These headlines and this argument fueled the public's investing sounding boards - the message boards where it only escalated. The battle lines turned ugly over this debate again with this poorly drafted study being the catalyst.
The SEC economists only rejected claims of possible shorting abuses because these authors went to the SEC website and looked up the SEC definition of a naked short and took away half the story. The SEC defines naked shorting several ways depending on what point they are trying to make and the authors chose the one suiting their argument dismissing all other definitions.
When discussing persistent fails in the market the SEC will rationalize them as legitimate naked shorts taking place as bona-fide market making activities (such as what we have here). Other times the SEC will refer to the trade where an investor does not attempt to locate and does not attempt to borrow in order to meet trade settlement. This study chose to look at the latter and ignore the former definition casting a broad response to limited and select criteria.
It may be sematics but tell that to those the SEC takes enforcement action against for similar public disclosure misrepresentations.
One final issue I have here:
When an IPO goes bad, like a Vonage, and the initial investors take out a class action lawsuit against the company, who is responsible for those investors who purchased the overallocated shares? Since these are the allotment of shares that do not exist, should the company hold the legal liability of any damages the court finds or should the underwriter?
By my calculations, since the underwriter did not maintain the Vonage pricing support under the agreement, and assuming the underwriter issued the 15% overallotment of shares without any additional naked shorting, the underwriter cleared an additional $10 Million if we assumed they covered the overallotment at an average of $14.75/share and 4.5 Million shares. My personal guess is they cleared even more than that.
Wouldn't these be the studies that yield the best decisions on future rule changes? SarBox didn't come about after looking at how GE and IBM kept their records. No, the SEC looked at how the Enron's screwed up theirs. So why has the SEC once again published a broad brushed and meaningless study riddled with errors and misleading commentary regarding the issue of isolated shorting abuses?
Today market makers are fighting the SEC on the timely closeout of their exempted market making naked shorts, market makers being identified as contributors to the persistent fail in the system. This study dismisses these fails as being naked short related dismissing any concept that the members themselves can be part of the abusive process.
Once again the SEC has cheated the public of an honest and thorough analysis. The second one in a year on this particular subject matter.
For more on this issue please visit the Host site at www.investigatethesec.com (posted with permission)
Copyright 2007
David Patch
You really have to wonder what talent pool the SEC searches when they seek out their economists.
For the second time in barely a year the SEC's Office of Economic Analysis (OEA) has submitted a study or analysis in which the conclusions drawn directly mislead the public relative to market risks and market controls. The two questionable studies took on the common issue of short selling and Regulation SHO and each presented opinions that were either directly misleading, inaccurate, or both.
The latest study to be published, Short Selling and Failures to Deliver in Initial Public Offerings by Amy Edwards and Kathleen Hanley of the SEC's OEA investigates short selling, naked shorting, and underwriting roles in an IPO. The study has the standard disclaimer attached that identifies that the opinions of the authors are not that of the Commission or Commission staff despite the cover page identifying the SEC's Office of Economic Analysis as the sponsor of the report.
The conclusions drawn by the authors are of great concern as it is becoming more and more evident that the SEC is in constant fear that investors will find out the truth about where naked shorting takes place and how it impacts our public markets. Instead of being forthright in efforts to resolve the issues, the SEC outright manipulates the dissemination of information in order to cattle the public to the conclusions wanted.
Before I take a stab at debunking the report you must understand that short term fails to deliver in an IPO are insignificant relative to the overall issue of persistent fails to deliver and market manipulation. This study in fact evaluates a mere 295 IPO's since 2005 yet prior SEC data gathered identified that on average more than 2600 companies have fails to deliver in excess of 10,000 shares with more than 200 listed daily with fails exceeding 0.5% of their issued and outstanding shares. Since Regulation SHO has been incorporated, more than 4000 public companies have been on the list at one time or another
Anyway...
The study by Edwards and Hanley concludes "Despite finding that settlement failures ("failures to deliver") occur regularly in IPOs, our results do not support the conjecture that naked short selling is to blame. In fact, we show that the level of failures to deliver are uncorrelated with amount of short selling and for many IPOs, failures to deliver exceed the level of short selling." Instead citing that "failures to deliver may be related to factors associated with underwriter activities to support the offer price."
The OEA study frequently referred to the 2000 research of Aggarwal to address the underwriter theories of overallocation as the cause to the settlement failures during an IPO. Aggarwal had studied 103 IPO's back in the late 1990's and had used the proprietary trading information of the underwriters to study the use of the "green shoe" clause in an underwriting agreement. The green shoe clause provides an underwriter the option to overallocate shares above the offering levels in order to provide pricing support in the aftermarket trading in the IPO.
If pricing support is not required, stock maintains IPO pricing levels; the company will issue the overallocation shares to the underwriter at the strike price to cover the fails created by the overallocation. If pricing support is required of the underwriter however, pricing support defined as the need to create demand in the open market to maintain the market, the number of shares the underwriter had to purchase to maintain pricing support will reduce the level of shares to be issued by the company to cover the outstanding unsupported shares.
But here is a part of the Aggarwal study that Edwards and Hanley failed to disclose in their study; the part that directly contradicts their conclusions if only in the semantics of terminology.
"Underwriters initially sell shares in excess of the original amount offered, thereby taking a short position prior to the offering. This short position can be covered by exercising the overallotment option and/or by short covering in the aftermarket. Almost all IPOs have an overallotment option whereby the underwriter can sell additional shares up to 15 percent of the offer size, exercisable for 30 calendar days after the offering. In offerings where weak demand is anticipated, underwriters frequently take a naked short position by allocating more than 115 percent of the stated size of the offering. We refer to this form of price support as aftermarket short covering."
Edwards and Hanley directly stayed away from calling this overallotment a short position, and specifically a naked short, although that is exactly what it is. Any effort to dismiss it in a slight of hand is irresponsible. "It depends on the definition of 'is' is"!
To conclude that the fails to deliver were not due to shorts, and in some cases naked shorts, is misleading as these fails to delievr that take place are exactly attributed to an underwriter shorting ahead of the IPO as part of the IPO process. It is the IPO underwriting version of market making.
Also missed by Edwards and Hanley is that last portion of Aggarwals comments, that regarding underwriters overallocating beyond the "green shoe" limit of 115% allocation. Those additional allocations being naked shorts as they are shorts not covered in the underwriting agreement.
Under IPO contract, the underwriter is allowed to overallocate such that the underwriter will then go into the open market and purchase shares as price support at or just below IPO pricing levels. Due to the initial response in a week demand market, early sell-off may drive prices down and the underwriter is offered the option to over sell the IPO [short the IPO] and cover the short in the open market by providing price support where demand is thin. The agreement however is that all overallocated shares will be closed out within 30 days after the IPO.
Since this overallotment is common, the real study would involve investigating how well this agreed upon "short" and "naked short" process works and whether preferred clients are active in the process.
The global concern of many is that naked shorting or abusive shorting can have a detrimental impact on those companies who are aggressively targeted. Not all companies are targets. Interested parties have never implied that legal naked shorting [market making], within controlled limits is all negative. The focus is really on those localized areas where damage takes place due to a systemic breakdown and illegal naked shorting has co-mingled in the market with the legal trades.
Consider the underwriting responsibilities during the Vonage debacle last year. Vonage went public with 31 million shares at 17.00/share. The green shoe overallotment would thus be 4.5 Million shares before executing any additional naked shorts ahead of the IPO.
By the end of the first day of trading the stock had already lost 13% of the market cap closing at $14.85 and, according to records obtained under FOIA, the level of fails associated with the days trading had exceeded 5.6 million shares.
To determine the economic impacts, the authors of this report should have identified outliers such as Vonage and dug deeper to understand whether the process has flaws where isolated abuses can take place. Did the underwriter who overallocated shares in Vonage provide the pricing support they were required to or did they take advantage of a collapsing market and cover the overallocation for significant profits? Are all overallocations covered within the mandatory 30 calendar days or do they extend beyond that timeframe and go without enforcement, the persistent settlement failure being the issue.
In a phone call with Edwards she implied that outliers such as Vonage may exist but that the study did not go to that level of detail. There will always be islated examples where the system did not work.
By the data Edwards and Hanley did present it appears that the FTD's do in fact extend beyond 30 trade days (6 calendar weeks) and thus underwriting overallocations and naked shorting can have pricing impacts on the security and should have been part of the study.
Not all hedge funds and member firms were involved in market timing, not all business operations are involved in accounting fraud yet when it came time to decide on laws it was not teh norm that was inspected it was the anomoly to understand how it happened and how to prevent it in heh future. Studies don't need to be conducted to validate the known; studies are to be conducted to understand the anomalies.
To mask this study as an effort to look into shorting and naked shorting in a public market and then not scrub down to the details of specific areas where abuses appear likely is irresponsible. It takes hard work to study this issue and the SEC OEA failed to dediate the resource to the effort. The public received the cliff notes but to the wrong book.
The response from this study only fueled the fire over shorting abuses in our public markets. The SEC staff has repeatedly denied shorting abuses existed only to recently admit that isolated groups of investors are being victimized by the abuse. The reporting of this study resulted in the media, already a disbeliever in this problem, submitting such headlines to the public as the ones listed below that only add a false sense of trust in the system.
SEC Finds No 'Naked Short'-IPO Issue - April 24 WSJ
SEC Economists Reject Claims On 'Naked' Short Sales - April 23 Dow Newswire
It headlines weren't, two economic analysts rejected claims it was the SEC rejects these claims. These headlines and this argument fueled the public's investing sounding boards - the message boards where it only escalated. The battle lines turned ugly over this debate again with this poorly drafted study being the catalyst.
The SEC economists only rejected claims of possible shorting abuses because these authors went to the SEC website and looked up the SEC definition of a naked short and took away half the story. The SEC defines naked shorting several ways depending on what point they are trying to make and the authors chose the one suiting their argument dismissing all other definitions.
When discussing persistent fails in the market the SEC will rationalize them as legitimate naked shorts taking place as bona-fide market making activities (such as what we have here). Other times the SEC will refer to the trade where an investor does not attempt to locate and does not attempt to borrow in order to meet trade settlement. This study chose to look at the latter and ignore the former definition casting a broad response to limited and select criteria.
It may be sematics but tell that to those the SEC takes enforcement action against for similar public disclosure misrepresentations.
One final issue I have here:
When an IPO goes bad, like a Vonage, and the initial investors take out a class action lawsuit against the company, who is responsible for those investors who purchased the overallocated shares? Since these are the allotment of shares that do not exist, should the company hold the legal liability of any damages the court finds or should the underwriter?
By my calculations, since the underwriter did not maintain the Vonage pricing support under the agreement, and assuming the underwriter issued the 15% overallotment of shares without any additional naked shorting, the underwriter cleared an additional $10 Million if we assumed they covered the overallotment at an average of $14.75/share and 4.5 Million shares. My personal guess is they cleared even more than that.
Wouldn't these be the studies that yield the best decisions on future rule changes? SarBox didn't come about after looking at how GE and IBM kept their records. No, the SEC looked at how the Enron's screwed up theirs. So why has the SEC once again published a broad brushed and meaningless study riddled with errors and misleading commentary regarding the issue of isolated shorting abuses?
Today market makers are fighting the SEC on the timely closeout of their exempted market making naked shorts, market makers being identified as contributors to the persistent fail in the system. This study dismisses these fails as being naked short related dismissing any concept that the members themselves can be part of the abusive process.
Once again the SEC has cheated the public of an honest and thorough analysis. The second one in a year on this particular subject matter.
For more on this issue please visit the Host site at www.investigatethesec.com (posted with permission)
Copyright 2007