'Short sellers' in SEC's cross hairs as it votes new rules

The Securities and Exchange Commission today announced plans to shine more light on "short selling" of stocks and to make permanent a rule change aimed at restricting so-called naked shorting.

Still on the agency’s table are much weightier issues -- including whether to bring back the "uptick rule" as a way to curb potential short-selling abuses.

Short sellers typically borrow stock from a brokerage’s inventory and sell it, betting the price will drop. If the market price declines, the shorts can later buy stock in the market, replace the borrowed shares and pocket the difference between the sale price and the repurchase price.

Although shorting is perfectly legal as long as traders follow the rules, the shorts got blamed last year for worsening the collapse of many financial stocks. That fueled Congress’ ire and triggered the SEC to take the unprecedented step of temporarily restricting shorting in hundreds of financial issues.

Since then the agency has been under intense pressure from Congress to do more to rein in abusive shorting.

"Today's actions demonstrate the commission's determination to address short selling abuses while at the same time increasing public disclosure of short selling activities that affect our markets," SEC Chairwoman Mary Schapiro said in a statement. The full text of the agency's announcement is here.

In one new move the SEC said companies and investors would be able to see the aggregate volume of shorted shares for each individual stock each day. That would let a company know if bearish bets on its shares suddenly were rising. The New York Stock Exchange and Nasdaq currently disclose twice a month the total number of shorted shares for each listed company.

In another decision, the SEC voted to make permanent penalties it imposed last year in cases in which short sellers sell shares they haven’t yet borrowed and then are unable to promptly deliver the stock to the buyer. The penalties are imposed on the brokerages that short sellers employ for their trades.

Shorting without first borrowing the stock is known as naked shorting. For reasons related to normal market function, the practice isn’t illegal. But the SEC imposed the prompt-delivery rule last year to keep short sellers from driving down a stock’s price without any intention of actually borrowing shares for sale.

Since the rule was put in place the number of cases in which traders failed to deliver shares has tumbled 57%, the SEC said. That presumably means that many abusive short sellers were pushed out of the market (although not everyone is so convinced).

Lastly, the agency still hasn’t decided whether to bring back the "uptick rule" as a way to further limit the potential for abusive shorting.

The rule historically had been a barrier to rampant short selling by banning short sales on "downticks" in stock prices. Instead, a short seller would have to wait for a stock’s price to move up at least slightly before shorting it. The idea was to prevent a cascading effect by short sellers that could drive a stock mercilessly lower (a so-called bear raid).

The SEC got rid of the rule in 2007 after finding that it hurt liquidity in the market (by keeping some traders away) and wasn’t necessary to prevent manipulation of stocks.

But the uptick rule still has a special place in the hearts of investors who hate short sellers and want to make their trading as difficult as possible.

-- Tom Petruno

Photo: SEC Chairwoman Mary Schapiro. Credit: Jay Mallin / Bloomberg News

Moody's stock dives as Warren Buffett pares his stake

Shares of credit-rating firm Moody's Corp. are up from their lows early today but still in the red on news late Wednesday that Warren Buffett cut his holdings in the firm.

Buffett’s Berkshire Hathaway Inc. said in a federal filing that it had sold 8 million Moody’s shares this week, reducing its stake to 40 million shares.

Moody’s shares fell as low as $23.70 today and were off $1.09, or 4.1%, to $25.43 at about 11:45 a.m. PDT.

Berkshire remains Moody’s largest shareholder, with 17% of the company. But the decision to reduce the stake is another blow to the already badly tarnished images of Moody’s and the other two major ratings firms, Standard & Poor’s and Fitch Ratings.

Their track record in assigning AAA ratings to mortgage-backed bonds that later collapsed will haunt them forever, of course. The California Public Employees’ Retirement System sued Moody’s, S&P and Fitch this month, alleging they’re responsible for more than $1 billion in losses incurred by the pension fund.

Now the push is on at the federal level to punish the industry with closer Securities and Exchange Commission supervision and rules aimed at reducing the companies’ inherent conflicts of interest in the ratings game.

Still, Buffett defended Moody’s at Berkshire’s May 2 annual meeting. From Bloomberg News:

Buffett said that he still believes assigning ratings to debt "is a good business" because of the limited number of competitors.

"They made a mistake that many, many people made," Buffett told shareholders. "There was almost a total belief throughout the country that house prices certainly wouldn’t fall significantly."

Although Buffett could be edging away from Moody’s for fundamental reasons, Bloomberg notes that there may be another reason for the stock sales:

U.S. accounting rules require firms to account for holdings differently when they own more than one-fifth of a company’s shares -- a position Berkshire found itself in after Moody’s repurchased shares from other investors to reduce the total amount outstanding.

The accounting requirements may have contributed to Berkshire’s decision to reduce its stake, said Michael Quigley, a portfolio manager at Wedgewood Partners Inc. in St. Louis. Wedgewood invests about 7.8% of its $500 million of assets in Berkshire shares.

"There’s definitely that legislative threat, lawsuits are definitely on the horizon," Quigley said. "But it’s probably more them being uncomfortable owning more than 20%."

-- Tom Petruno

Photo: Warren Buffett. Credit: Paul White / Associated Press

Schwab refusing to pay off clients in 'auction-rate' issues

Instead of the carrot-and-stick approach, New York Atty. Gen. Andrew Cuomo on Monday used two sticks in his campaign to force Charles Schwab Corp. to pay off clients in those notorious auction-rate preferred securities.

For stick No. 1, Cuomo threatened Schwab with a lawsuit if the discount brokerage fails to agree to buy back the offending securities.

For stick No. 2 , Cuomo resorted to peer pressure: He announced that Schwab rival TD Ameritrade Inc. settled a similar case and will repurchase $456 million of the securities. The Securities and Exchange Commission also announced a settlement with TD Ameritrade, which won’t pay any fines as part of the deals.

So far, Schwab isn’t budging. It issued a long statement defending itself and chastising Cuomo for deciding to "try cases in the press."

Auction-rate securities, popular with many individual investors before the credit markets collapsed in 2008, were essentially long-term debt instruments masquerading as short-term securities.

They were pitched by brokers to yield-hungry small investors as safe and easily redeemable -- which they were, until demand for all such engineered securities dried up. That left investors stranded in about $330 billion of auction-rate issues, unable to sell (although still earning interest).

Cuomo, the SEC and other securities regulators have since negotiated buy-back settlements with 20 brokerages and other financial firms that were selling auction-rate preferred debt, including Goldman Sachs, Merrill Lynch and Deutsche Bank.

To compel settlements, regulators have asserted that the brokerages misrepresented the safety of the securities.

In a letter to Schwab warning of a lawsuit, Cuomo excerpted from interviews his office did with Schwab brokers as part of his probe and from audio recordings of Schwab sales pitches. One broker allegedly told a client that getting into the securities "is the tough part. Getting out of it is easy as just selling."

In its rebuttal, Schwab said that its brokers, "while trained to levels beyond industry standards, could not be expected to foresee and disclose market risks that even regulators and market experts did not foresee."

Schwab asserts that the big brokerages that created the securities should have been forced to buy them back from all investors who purchased them, including investors who bought the issues from third parties such as Schwab.

But Cuomo’s settlement with TD Ameritrade, following a settlement last year with Fidelity Investments’ brokerage unit, stands to put more pressure on Schwab. TD Ameritrade CEO Fred Tomczyk said the buyback was "the right thing to do for our clients."

A person familiar with Schwab’s exposure said its clients still own about $100 million of auction-rate securities, much less than what TD Ameritrade will repurchase.

That begs the question: Is it really worth a game of hardball with Cuomo -- and a potential fat fine -- or better to just settle up and move on?

-- Tom Petruno

Photo: Andrew Cuomo. Credit: Louis Lanzano / Associated Press

Online market for California IOUs may launch Wednesday

SecondMarket, which connects buyers and sellers of illiquid assets, says it expects to have an online trading venue operating for California IOUs beginning on Wednesday.

But the firm still isn’t sure whether prices will be transparent -- i.e., whether anyone signing onto the SecondMarket.com website will be able to see what buyers are paying sellers for their IOUs to cash them out.

Jeremy Smith, SecondMarket’s chief strategy director in New York, noted that federal rules forbid making prices of certain asset transactions public, in cases where regulators deem that the information could be considered a "solicitation" to investors for whom the assets wouldn’t be appropriate.

But by asserting last week that it has jurisdiction over trading of IOUs, the Securities and Exchange Commission ostensibly was trying to protect IOU recipients from ripoff artists. If that’s the goal, SecondMarket – and the SEC -- ought to support public price disclosure, so that anyone who wants to sell the state’s scrip can see what kind of discounts buyers are offering for the paper.

The only reason to sell at a discount to an investor, of course, is if an IOU recipient can’t find a bank or credit union to cash the thing for full value. IOU holders’ options became more limited this week as major banks stopped accepting them.

One decision SecondMarket already has made: Owners of IOUs won’t pay any fees to sell them on SecondMarket; buyers will pay a transaction fee of 1% or less.

The state has said it will redeem the IOUs for cash on Oct. 2. The paper is earning a 3.75% annualized tax-free interest rate until then.

-- Tom Petruno

Photo credit: Rich Pedroncelli / Associated Press

Looking to sell a California IOU? Read this first

If you've got a California IOU you'd like to cash today, your options are much more limited than they were last week.

Major banks including Bank of America, Wells Fargo, Chase and Union Bank no longer will take the state's scrip from customers.

However, as my colleague Tiffany Hsu wrote on Saturday, Citibank says it will accept the IOUs (from customers) through Friday. Bank of the West says it plans to allow customers to deposit the paper indefinitely. Some smaller banks, and many credit unions, also continue to redeem the IOUs from members for full cash value.

If you're tempted to try to sell an IOU to someone (say, online) to get cash before the state plans to pay off the paper on Oct. 2, you should at least know your rights. The Securities and Exchange Commission last week decided that the IOUs (officially known as registered warrants) are securities under U.S. law -- which means that someone acting as a dealer and trading the paper, as opposed to just buying and holding, is subject to federal anti-fraud statutes.

The SEC's decision means that someone trading in IOUs is supposed to comply with standards set by the Municipal Securities Rulemaking Board.

Here's what the MSRB said in a statement on Friday:

"The buying, selling and trading of California’s warrants by intermediaries are subject to all MSRB rules of conduct and fair practice," said MSRB General Counsel Ernesto Lanza. "The MSRB is particularly concerned about compliance with obligations with respect to the prices at which such intermediaries buy California warrants from citizens who may be in need of immediate cash,"  Lanza said. "Persons attempting to profit from the buying and selling of municipal securities must price those transactions based on their fair market value, and California’s IOUs are no exception."

MSRB rules require that prices for the purchase and sale of municipal securities, including the California warrants, charged by securities firms and banks must be fair and reasonable based on their best judgment of the securities’ fair market value. These intermediaries would violate this rule if they attempt to take advantage of their customers by offering to purchase warrants at deep discounts that do not reflect fair market value. Advertisements and published quotations for purchases and sales of California warrants also must meet MSRB standards.

In theory, this is supposed to protect cash-needy IOU recipients from ripoff artists. 

But "fairness" in pricing any security is a subjective thing, of course.

If just having rules that call for fair pricing was enough to make it so, no one would ever feel that they got a bum deal buying or selling a thinly traded municipal bond in the broker marketplace. And we know that isn't true.

But by all means, if you're shopping around to sell an IOU, ask potential buyers if they're registered as securities dealers; if they're aware of the MSRB standards; how they're determining that the price they're offering is "fair;" and what fees are involved.

Note that once you sell, the buyer is entitled to the 3.75% annualized tax-free interest return the state says it will pay on the IOUs at maturity.

Photo: Printing IOUs in the state controller's office. Credit: Rich Pedroncelli / Associated Press

SEC says California IOUs are 'securities' under U.S. law

As expected, the Securities and Exchange Commission late today decided that California's IOUs are "securities" under the agency’s definition.

The SEC’s move won't have any effect on the state's ability to issue the IOUs, because the agency has no jurisdiction over state governments.

Rather, the decision is aimed at limiting the potential for recipients of the IOUs to be defrauded by individuals or companies that offer to buy the scrip, which cash-strapped California is issuing to pay certain of its bills. The state says the IOUs will accrue tax-free interest at a 3.75% annualized rate and will be redeemed for cash on Oct. 2.

"As securities, the IOUs are subject to the antifraud provisions of the securities laws," the SEC said in a statement. "As a result, buyers and sellers will have certain rights and remedies for fraud, and the Commission will be able to take action against any person committing fraud in connection with the purchase or sale of an IOU."

What would constitute fraud? Say an individual decides to act as a dealer, buying IOUs from people who are stuck with them and offering to resell them to others. This individual tells a potential seller, "I have it on good authority that the state won’t repay these IOUs as promised on Oct. 2. You’d be smart to take 85 cents on the dollar right now."

Assuming the state has said nothing about delaying repayment, the would-be dealer could be charged with misrepresentation under federal securities laws.

So the SEC’s move might keep some of the sharks at bay. But there’s a reason why sharks are at the top of the food chain: They’re good at going for the kill.

"If you hold an IOU and wish to sell it prior to maturity you should consider whether you think you are getting a fair price," the SEC says. But how will you know what’s fair? That’s the problem.

Some independent electronic marketplaces, such as SecondMarket.com, have expressed interest in acting as intermediaries to bring buyers and sellers together. But there won’t be a central market for the IOUs similar to the New York Stock Exchange or Nasdaq for stocks.

And the idea of doing business with someone who has just popped up on the Internet to buy IOUs has caveat venditor written all over it.

The problem for IOU recipients who need immediate cash will become much bigger after Friday, which is the final day that major banks, including Bank of America and Wells Fargo, say they’ll redeem IOUs for customers. California credit unions may be the best alternative: Many say they'll continue to redeem IOUs in full -- if you're a member. Go here for a listing.

Californians wouldn’t have to worry about any of this if Sacramento would just pass a fiscal 2010 balanced budget. But the stalemate continues.

Too bad the SEC can’t charge the Legislature and governor with misrepresenting themselves as responsible public servants.

-- Tom Petruno

Photo: A California IOU. Credit: Rich Pedroncelli / Associated Press

SEC may put California IOUs under fraud-protection rules

The Securities and Exchange Commission soon may step into the fray over the IOUs California is issuing to pay certain debts.

The SEC could decide today that the IOUs are securities, according to a source familiar with the matter. The Municipal Securities Rulemaking Board, which regulates trading in muni bond debt, was leaning in that direction earlier this week.

A move by the SEC would be an attempt to provide some fraud protection for recipients of the IOUs. Any person or firm offering to make a market in the IOUs -- bringing buyers and sellers together -- could have to register as a broker-dealer and would be subject to federal anti-fraud rules.

Recipients of the IOUs still would be free to sell them or cash them anywhere they’d like. The SEC would be trying to ensure that some orderly markets develop for the scrip, given that major banks, including Bank of America and Wells Fargo, say they won't cash the IOUs after Friday.

The state says it intends to pay off the IOUs on Oct. 2, with interest. The IOUs are earning a 3.75% annualized interest return, which is exempt from federal and state income tax.

The Associated Press reports today that SecondMarket, which creates markets for illiquid assets, has received "decent interest" from hedge funds, municipal bond investors and distressed asset investors as potential buyers of the IOUs, according to Jeremy Smith, the New York company's chief strategy officer.

Also from AP, echoing what my colleague W.J. Hennigan reported earlier this week:

The IOUs "have the hallmarks of securities, and if they are securities, they are pretty clearly municipal securities," MSRB General Counsel Ernesto Lanza said. "To the extent that municipal securities dealers are involved in the sale and trading of the warrants, our rules would apply. We would be especially concerned about dealers' obligations to customers with respect to fair pricing."

-- Tom Petruno

Post-Madoff, SEC inspection chief for fund managers quits

The Bernie Madoff scandal may have helped claim another head at the Securities and Exchange Commission.

Lori Richards, the 49-year-old chief of the SEC’s division that inspects money managers, said Wednesday that she would resign.

Richards has lead the Office of Compliance Inspections and Examinations since it was created in 1995.

Congress earlier this year skewered Richards, former Enforcement Director Linda Thomsen and other SEC officials for failing to uncover Madoff’s $65-billion Ponzi scheme. Thomsen resigned in February.

Richards, a 24-year veteran of the SEC who worked in enforcement in the Los Angeles office in the early 1990s, told Bloomberg News that it was "completely my decision" to step down.

"I’m excited about taking on new challenges," she said, without revealing her plans. "I’ve been thinking about doing something different for some time."

U.S. lawmakers were livid that the SEC could have missed Madoff’s long-running Ponzi scheme, despite evidence it was given by a whistle-blower.

As Bloomberg notes:

"Perhaps most shocking" about the case is that Richards’ unit never conducted an inspection of the money-management side of Madoff’s business after he registered it with the SEC in September 2006, U.S. Rep. Paul Kanjorski said at a January hearing.

Kanjorski said the SEC overlooked "red flags" such as the inability of investors to duplicate Madoff’s returns and his use of "an auditor the size of a mouse" to review a fund "the size of an elephant."

Richards’ defense was that the SEC had about 400 staff members to inspect more than 11,000 money managers.

She told Congress in January that the agency had to "prioritize registrants for examination, and to assign examination staff to those advisors and funds that appear to present the greatest potential for having an adverse impact on investors."

Richards said the process was "a form of triage, to help match available staff resources to the most pressing risks."

But if the process missed Bernie Madoff, it obviously wasn’t very good at identifying "pressing risks."

-- Tom Petruno

Photo: Lori Richards. Credit: Associated Press

SEC proposes rule changes to boost money fund safety

Money market mutual funds, already paying near-zero yields, could see those payouts fall further under proposed new rules to boost the safety of the portfolios.

The Securities and Exchange Commission today proposed tightening restrictions on money funds’ investments, hoping to avoid a repeat of the sudden demise of the $60-billion Reserve Primary fund last September.

Money funds, which hold a total of $3.6-trillion in investors’ savings, would have to hold more of their assets in only the most liquid securities, so that they have ready cash to pay off investors who want out.

The most liquid assets also typically pay the least, so owning more such securities probably would put more downward pressure on fund yields. The average taxable money fund’s annualized yield now is a mere 0.13%, according to iMoneyNet Inc.

Money funds already are designed to allow investors to get in or out at will, at a constant $1-a-share asset value. But when investors deluged the Reserve Primary fund with redemption notices in September it was unable to meet all of those requests.

That triggered a run on other money funds, forcing the U.S. Treasury to step in and guarantee fund assets to stem investor panic.

SEC commissioners today proposed that funds serving individual investors would have to hold at least 5% of their assets in cash, Treasury securities or other investments that could be sold in one day. At least 15% of assets would have to be in securities that could be sold within a week.

Those percentages would be doubled for funds that serve institutional investors.

The SEC also proposed that the maximum average maturity of fund holdings be cut to 60 days from the current 90 days, which also would likely depress portfolio yields further. . . .

Mozilo knew hazardous waste when he saw it

The use of "toxic" to describe high-risk mortgages has been de rigueur for the last two years. Now it looks like Countrywide Financial Corp. founder Angelo R. Mozilo might have coined the term.

In the Securities and Exchange Commission’s civil fraud case filed today against Mozilo, the agency includes excerpts from e-mails Mozilo wrote in spring 2006 to other Countrywide executives, describing his concerns about some of the lender’s unconventional mortgages.

He uses "toxic" twice in these emails -- long before word became the mortgage-market adjective of choice on Wall Street.

In March 2006, Mozilo wrote that the lender’s program of granting subprime loans for 100% of the value of a borrower’s home was "the most dangerous product in existence and there can be nothing more toxic and therefore requires that no deviation from [underwriting] guidelines be permitted irrespective of the circumstances."

In April 2006, Mozilo wrote about those loans, "In all my years in the business I have never seen a more toxic prduct [sic]."

But when Countrywide’s risk-management department in April 2006 recommended increasing minimum credit scores for the loans, echoing Mozilo’s criticisms, the idea allegedly was opposed by David Sambol, who then headed the lender’s production units (and who also is a defendant in the SEC’s case).

Sambol "noted that such an increase would make Countrywide uncompetitive with subprime lenders such as New Century, Option One, and Argent," the SEC says.

-- Tom Petruno

Photo credit: Gerry Broome / Associated Press