How the SEC Can Waste Its Resources More Efficiently

I've written a number of times about how the SEC has thrown its scarce resources down a black hole by pursuing the phony "naked shorting" issue, which is usually nothing more than a diversion for poor-performing CEOs such as its chief propagandist, Overstock.com CEO Patrick Byrne.

Well, today the SEC Office of Inspector General has a report on the subject, describing how the SEC can more efficiently waste its scarce resources running to ground crackpot NSS complaints.

The OIG report, which can be found here, does not produce much in the way of evidence that there is any actual naked shorting going on, only that it's been talked about a lot, even though it is before the SEC because of what the enforcement division calls a "small but vocal cadre of advocates" (bureaucratese for "nutcases").

The OIG found that the SEC has carried out very few enforcement actions that even tangentially involved naked shorting. And here's a clue as to why: of the 1.38 million email complaints the SEC received over a recent 17-month period, 5,000--a whopping 0.36% of the total--involved naked shorting, despite the organized email-writing campaign organized by stock market conspiracy websites.

Wow! Sounds like a really important issue if 3.6 out of every thousand complaints to the SEC involve naked shorting!

Kind of makes you wonder about the 99.64% of email complainers, genuine victims of investor ripoffs, that don't have the OIG's ear. I guess they don't have highly-paid lobbyists and astroturf organizations, with dishonest names like the "Coalition Against Market Manipulation," pushing their cause.

Still, the OIG said, attention must be paid! After all, it had received "numerous complaints" and hey, the squeaky wheel gets the wasted resources.

Accordingly, the OIG issued some fairly mild recommendations involving the processing of investor complaints involving NSS, which I'm sure will be amplified and twisted out of all proportions by the usual crackpot websites. The SEC's enforcement division. however, rejected all but one of those recommendations, in the view that tracking down the obsessions of NSS nutcases is a poor use of SEC resources.

The SEC enforcement division was right to be annoyed at the OIG's attention to this screwball issue--itself a pretty shocking waste of SEC resources--and its response warrants a full quote:

In recent months, a small but vocal cadre of advocates has emerged decrying the practice and suggesting that it has damaging market effects. But there is hardly unanimity in the investment community or the financial media on either the prevalence, or the dangers, of “naked” short selling. The Commission has repeatedly stressed the fact that the practice can provide needed market liquidity in certain circumstances. For instance, market makers sometimes engage in legitimate “naked” short selling when there is high buying demand in a security. Still others view the threat posed by “naked” short selling as wildly exaggerated, and point to instances in which allegations of abusive “naked” short selling were used to cover up other management malfeasance, like the dumping on the market of large blocks of unregistered shares. We have recently alleged such behavior in the widely-discussed CMKM Diamonds litigation. Other fraud defendants have also attempted to portray depressed stock prices as the work of clandestine short sellers.

Despite its assertions regarding the potential danger of “naked” short selling and the growing interest in the subject, the Report can cite to no bona fide studies or empirical data regarding the practice’s market impact. The Division of Trading and Markets debunks the theory that NSS creates “counterfeit” or “phantom” shares. The Report cites to the emergency orders, final rules, and interim final temporary rules addressing short selling, including “naked” short selling that the Commission issued in July, September, and October of 2008. When it issued each of these rules, the Commission noted in its releases that the purpose of the emergency actions was to address the lack of market confidence and investor fears that short selling, including legitimate short selling, could exacerbate the current financial crisis by creating downward price momentum unrelated to the fundamental financials of issuers. [emphasis added]

. . .The Division of Enforcement is called upon to police the massive U.S. securities markets with decidedly limited resources and, in order to fulfill our mission of investor protection, we must intelligently leverage those resources.

Note what I put in boldface. I'm no fan of the SEC's enforcement division, but in rejecting most of the OIG's recommendations, and thus inflaming the corporate-sponsored anti-shorting crusaders, it has shown some commendable guts.

UPDATE: CJR's Audit section has an excellent analysis of a moronic article in Bloomberg on naked shorting. I also had an online chat with Felix Salmon on the Portfolio website.

© 2009 Gary Weiss. All rights reserved.