SEC Economists Debunk 'Fails to Deliver' Baloney

A devastating study, released today, knocks out the underpinnings of anti-naked-short selling hysteria -- the myth that "failure to deliver" securities is evidence of evil traders seeking to run down the price of worthy stocks.

This myth has been advanced by executives of red-ink machines-- such as Overstock.com CEO Patrick Byrne in a press release today -- in an effort to divert attention from their own incompetence. Members of Congress, some state legislatures, a smattering of state regulators and some in the media have lapped up this baloney. The SEC itself has spent far too much time and energy on this subject.

The terms "failure to deliver" and "naked short selling" are used interchangeably by anti-naked-shorting crackpots, in their effort to divert regulatory attention from real issues. A "fail" simply means that the shares required to settle the transaction have not been transferred from one brokerage to another. That can happen for a host of reasons. Whether a transaction has "failed" or not has no effect whatsoever on buyers or sellers of shares.

This highly technical aspect of the securities business has been turned into a conspiracy theory, and promoted on the Internet by CEOs of small companies and shills ranging from illiterate psychos to the U.S. Chamber of Commerce. It was recently the subject of a stunningly moronic segment on Bloomberg TV.

The SEC economists' study -- not conducted officially for the commission, but distributed to the media today by the SEC -- "documents the use of short selling in IPO’s and provides evidence of the relation between short-selling and failures to deliver." It was posted today on the Social Science Research Network. The full text can be downloaded from the SSRN site.

"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 failures to deliver are uncorrelated with short selling [emphasis added] and for many IPOs, the level of failures to deliver exceed the level of short selling," the economists say in their abstract of the study.

"Uncorrelated" means "they ain't got nothing to do with each other." Remember that whenever you read a polemic on "fails to deliver" by one of the advocates of this cause. It's really amazing how much regulatory attention has been devoted to this nonissue.

I'll quote here from an SEC summary of the study:

The study finds that short selling is prevalent in IPOs and on average, more than 7% of the shares offered are sold short on the first day that the IPO trades. The study also documents that failures to deliver are common in IPOs. Failures to deliver in IPOs amount to more than 4% of shares offered, on average, and 36% of IPOs qualify for the Regulation SHO threshold list on the first day possible. In a number of cases, failures to deliver significantly exceed the amount of short selling.

However, the study finds no evidence that the magnitude of failures to deliver is correlated with amount of short selling in IPOs. Moreover, the factors associated with the amount of short selling in IPOs are not the same as the factors associated with the level of failures to deliver. The results of the study suggest that short sellers are more active in IPOs with price increases on the first day of trading. In contrast, failures to deliver are more prevalent in offers that either have no price change or a decline in value on the first trading day.

Additional empirical tests on failures to deliver indicate that IPOs in which the underwriter is more likely to be engaging in price support tend to have higher failures to deliver. This result, coupled with the observation that many IPOs have greater failures to deliver than short sales, suggests that failures to deliver may not be a good measure of naked short selling.

The study makes clear that its findings are not just restricted to IPOs:

The results presented in this paper also inform a public debate surrounding the role of short selling and fails to deliver in price formation. We find no evidence that short selling is related to either fails to deliver or to the inclusion of an IPO on the threshold list. More specifically, we present clear evidence questioning the use of fails to deliver to measure naked short selling, even outside the context of an IPO.

A recent study by Canadian regulators had similarly debunked the "fails to deliver" hysteria.

None of this, of course, will put a stop to the Baloney Brigade, which is fueled by the money and PR machinery of Byrne and the penny stock crowd, and the volunteer efforts of retired medical equipment salesmen and off-duty dentists. But hopefully the SEC will stop pandering to anti-shorting crackpots long enough to behave rationally on this issue. For a change.

However, I do expect that the authors of the study will be a target of the usual threats, intimidation and smears that come from contradicting the anti-naked-shorting crackpots.

© 2007 Gary Weiss. All rights reserved.

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