The U.S. Securities & Exchange Commission sued a New York lawyer on Monday for allegedly writing bogus opinion letters to help stock promoters improperly procure unrestricted stock certificates in three unregistered “penny” stock offerings.The lawsuit, filed in U.S. District Court in Manhattan on Monday, alleges that Stephen Czarnik, a partner at Cohen and Czarnik LLP, assisted three stock promoters in the abuse of a rule that allows accredited investors to acquire unrestricted shares from transfer agents in unregistered securities offerings that don’t exceed $1 million.
The SEC said Czarnik continues to serve as a “one-man ‘opinion-mill’ for unregistered penny stock offerings.” The regulator said Czarnik has authored at least 111 opinion letters for unregistered stock offerings, involving the transfer of more than 2.5 billion shares to penny stock promoters by 43 issuers.
Disclosure: No positions in any stocks mentioned and no relation to anyone mentioned. I have a terms of use.
sued Summit Advisory Partners, LLC and its managing partner, Robert Feeback, for directing and providing essential services in a scheme to “pump and dump” the stock of various penny stock companies in Texas. According to the complaint, the actions of Feeback and Summit allowed three stock promoters – Ryan Reynolds, Jason Wynn and Carlton Fleming – to purchase millions of shares of stock for pennies per share, hype the companies through promotional mailers and other advertising, and illicitly sell their shares to the public for millions of dollars in profits. The Commission alleges that because the shares were not registered, public investors were deprived of full and fair disclosures necessary to make an informed decision to purchase the stock.
The pump and dumps mentioned in the complaint are “My Vintage Baby, Inc., Alchemy Creative, Inc. and Beverage Creations, Inc.” I suggest reading the SEC’s full legal complaint (pdf). The best part of the complain is the SEC’s description of how the pump & dump allegedly worked:
In each of the MVBY, Alchemy, and BCI offerings, the Promoters applied the same basic “pump and dump” formula. The Promoters (a) organized a reverse merger of the company into a public shell, (b) purchased large blocks of common stock at pennies a share from the Issuer in a purported Rule 504 offering (in an effort to evade registration requirements and obtain a large percentage of the company’s stock without investing much of their own cash), (c) created initial trading volume for the stock by selling some of their shares to a tightly controlled group of friends, family, and affiliated brokers, (d) touted the company to the public through spam, television advertising, and mass mailers, and then (e) dumped their shares on the investing public without registration at prices grossly inflated by their promotion activity.
Furthermore, the SEC complain alleges that
The Promoters also touted the Issuers through a penny stock promotion website, www.thestockpic.com, then run by Ryan Reynolds’s sister. In addition, the Promoters helped create a flurry of press releases for each Issuer to release during the first few weeks of public trading.
The pump & dumps worked and the stock prices of all three stocks pumped soared:
BCI’s stock price more than doubled, from an intraday low of $.55 per share on January 30 to its February 21 close at $1.25 per share. Likewise, in the first five weeks of trading, Alchemy’s stock price soared almost 75%, from an intraday low of $1.90 per share on December 5, 2007 to an intraday high of $3.32 per share on January 11, 2008. My Vintage Baby’s stock price experienced even greater gains over its first five weeks of trading, rising from an intraday low of $.40 per share to an intraday high of $2.88 per share.
The scheme was also allegedly highly profitable:
“Fueled by the pump, the Promoters sold their purported 504 shares to the investing public for a total profit of over $20 million.
Disclosure: No positions in any stocks mentioned and no relation to anyone mentioned. I have a terms of use.
When writing about stock fraud and other illegal activities it is important to keep in mind that people’s reputations can be destroyed. Much of the time this is right and just punishment for wrongdoers who have violated the laws and harmed others. However, I am cognizant of the undue harm to a person’s reputation that can come to someone who is charged with a crime by the SEC or others when those charges are later dropped. I have in the past cut a section of an article in response to a request from someone who was named in a securities enforcement action but later dropped from that action. But just as I believe that I should not contribute to the undue sullying of the reputations of those who do not deserve it, I believe that those who violate the laws deserve to have their reputations destroyed.
So when I received an email from Nicholas Czuczko asking me to take down this past blog post about his loss in court to the SEC, my inclination was to not comply. Simply put, my reporting of the SEC’s litigation release on the matter was fair and accurate. Furthermore, a search of SEC litigation releases since that time did not reveal any additional information related to the case. So I am certain that my blog post did not libel Czuczko.
For those of you who are not familiar with the case, here is a quote from the SEC’s litigation release, highlighting the judgment of the US District Court for the Central District of California:
The Commission filed its complaint on August 1, 2006. On December 5, 2007, the court entered judgment enjoining Czuczko from future violations of the antifraud provisions of the federal securities laws (Section 17(a) of the Securities Act of 1933, Section 10(b) of the Securities Exchange Act of 1934, and Rule 10b-5 thereunder), as well as from future violations of the ownership disclosure provisions of the federal securities laws (Section 16(a) of the Securities Exchange Act and Rule 16a-3 thereunder). In addition, the court ordered Czuczko to disgorge $1,552,463 in ill-gotten gains plus $121,105.64 in prejudgment interest, imposed a $100,000 civil monetary penalty, and barred him from participating in penny stock offerings and from serving as an officer or director of a publicly traded company.
I suggest that interested readers also read the SEC’s original complaint (pdf) in the case and the press release announcing the SEC’s civil lawsuit against Czuczko. I have also found and uploaded the court’s final ruling in the case (pdf).
Below is the email I received from Czuczko through the contact form on this blog. Surprisingly enough, he did not accuse me of libel in asking me to remove the blog post. Instead, he cited copyright and trademark infringement.
To whom this will concern:
As a media organization, I’m sure you value your trademarks and copyrighted
material. Be advised I am requesting removal (as soon as possible) of
copyrighted and trademarked material under U.S. Law that I own from your site.
The webpage is:
Since there are no backlinks to the page, the material seems to have no
editorial value to your website.
I have documented that your website has been publishing this content without
permission since 2007.
Although this request is meant to be a friendly request, I am advising you that
I will file a Digital Millennium Copyright Act (DMCA) take-down notice, and all
other necessary steps to have this content removed from your website, if not
done in a timely manner. Thank you ahead of time and your timely removal of my
copyrighted and trademarked material from your website.
Sincerely,
Nicholas A. Czuczko
Upon reading the above letter I was flabbergasted; nothing in my blog post could be construed as violating copyright or trademark. My post was text and except for a brief quote from the SEC litigation release (for which Czuczko most certainly does not own the copyright), it was all in my own words. Needless to say, I will not be removing my original blog post.
——
Let me conclude by pointing out that in some cases, issuing a DMCA takedown notice can itself violate the law. I do not know if that would be the case here if Czuczko were to issue a DMCA takedown notice, but anyone who has considered issuing a DMCA takedown notice should consider whether this might apply to them. I suggest that the interested reader see the decision in Online Policy Group v. Diebold, Inc., 337 F.Supp.2d 1195 (N.D. Cal. 2004). Below the court cited the relevant section of the law:
17 U.S.C. ß 512(f) provides as follows:
Misrepresentations.–Any person who knowingly
materially misrepresents under this section–
(1) that material or activity is infringing, or
(2) that material or activity was removed or
disabled by mistake or misidentification,
shall be liable for any damages, including costs and
attorneys’ fees, incurred by the alleged infringer, by
any copyright owner or copyright owner’s
authorized licensee, or by a service provider, who
is injured by such misrepresentation, as the result
of the service provider relying upon such
misrepresentation in removing or disabling access
to the material or activity claimed to be infringing,
or in replacing the removed material or ceasing to
disable access to it.
The court stated (in a decision in favor of the plaintiffs, who had sued Diebold for using a DMCA takedown notice against them), “Thus, any person who sends a cease and desist letter with knowledge that claims of infringement are false may be liable for damages.”
Disclosure: No positions in any stocks mentioned and no relation to anyone mentioned. I have a terms of use.
The SEC just published a litigation release today, announcing a large settlement with Investools, a company that runs investment workshops. The release makes for some juicy reading. The SEC’s complaint is available online.
Investools agreed to a civil injunction and to pay a $3 million civil penalty. Drew and Miller agreed, respectively, to pay civil penalties of $380,000 and $130,000, and to be enjoined from violating the antifraud provisions of the federal securities laws. Drew and Miller additionally agreed to be enjoined, for five years, from receiving compensation for their participation in, among other related activities, the sale of classes, workshops, or seminars given to actual or prospective securities investors concerning securities trading. In settling the matter, Investools, Drew and Miller neither admitted nor denied the allegations in the Commission’s complaint.
Perhaps the funniest part is that while the Investools salesmen claimed they were great traders, they were allegedly poor traders who lost money.
The Commission’s complaint alleges that from 2004 to approximately June 2007 at Investools how-to-trade-securities workshops former Investools employees Drew and Miller misleadingly portrayed themselves as expert investors who made their living trading securities. They did so to mislead investors into believing that they too would make extraordinary profits trading securities if they purchased expensive Investools instructional courses and other products and followed Investools’ securities trading strategies. The complaint further alleges that in reality, neither Drew nor Miller made the trading profits they claimed. For example, in 2005 and 2006, while Drew was portraying himself as a successful investor, he had hundreds of thousands of dollars in net trading losses. In 2006 and 2007, while Miller was portraying himself as a successful investor, he had tens of thousands of dollars in net trading losses.
The SEC also states in the release that the investigation of Investools is ongoing.
Investools Ad
What is the moral of the story? Don’t trust anyone. If someone says they are a good trader and have a good trading system, ask for verification. If their results are audited, check out the auditor.
Disclosure: I have no positions and I have no connection to anyone involved. I have a disclosure policy.
The SEC has a habit of belatedly suing those that Andrew Left of Citron Research has criticized. This time the company is Home Solutions of America, a company that I have writtenabouta few times. I have written about Left many times before. Definitely make sure to see my “Can you trust the StockLemon” series, Part 1,Part 2,Part 3, Part 4.
The SEC alleges that Home Solutions of America, Inc. recorded millions of dollars in bogus revenue and issued a series of materially false press releases boasting robust financial results following Katrina and other weather-related disasters, thus inflating the company’s stock price. The stock price later plummeted after large insider stock sales, the filing of private securities lawsuits alleging fraud, and the company’s public announcement that it would restate its financial statements. Home Solutions then-CEO Frank Fradella, who is among seven individuals charged by the SEC in the scheme, dumped approximately $6.8 million worth of stock into the inflated market.
The SEC further alleges that Marshall engaged in a separate revenue-inflation scheme at Fireline, booking more than $9 million of fake construction revenue from undisclosed, related-party contracts with entities that Marshall controlled. In fact, at the time Fireline caused Home Solutions to record the revenue, very little work had been performed on the projects and most remained bare-dirt lots.
Unlike most SEC complaints, just about every executive at HSOA was named, and four of the lesser executives have already consented to the SEC’s findings, without acknowledging guilt of course
Four others charged today by the SEC simultaneously agreed to settle on the following terms, without admitting or denying the allegations in the complaint.
Former Home Solutions CFO and COO Rick O’Brien agreed to pay a $130,000 penalty.
Former Fireline controller Stephen Gingrich agreed to pay a $25,000 penalty and to an administrative order barring him from practicing before the Commission as an accountant for at least three years.
Former Fireline COO Thomas Davis agreed to pay a $25,000 penalty and to pay disgorgement and interest of $32,850.
In addition, O’Brien, Gingrich and Davis each consented to final judgments permanently enjoining them from violating Sections 17(a)(2) and (3) of the Securities Act and from aiding and abetting violations of Sections 13(a) and 13(b)(2)(A) of the Exchange Act and Rules 12b-20, 13a-1, and 13a-13 thereunder.
Finally, Jeff Craft, a business partner of Marshall, consented to a final judgment permanently enjoining him from violating Rule 13b2-2 under the Exchange Act.
So it turns out that once again the short seller was right, the executives were (allegedly) crooked, and the SEC was slow.
Disclosure: I have no positions and I have no connection to anyone involved besides reading Left’s blog.
A lot can be said about short sellers. One undeniable fact is that short sellers are the sellers of last resort. When everyone else wants to buy, the only ones who wish to sell are often short sellers. In fact, while many fear the depredations of short sellers manipulating the market with bear raids (of which there is little evidence), short sellers are the ones who protect the market from pump & dump schemes and bull raids (a bull raid being a concerted promotion of a stock when the promoter is not being compensated and has no position in the stock; certain stock pumpers will engage in these from time to time to enhance their credibility). It is worth noting that pump & dump schemes are common in OTC and Pinksheets stocks that usually trade for less than a dime per share, but there are almost none in higher-priced listed stocks. The reason for this is that margin rules and difficulties borrowing shares to short prevent short sellers from being the sellers of last resort for penny stocks. For listed securities they are more easily able to sell. It is the fear of short sellers that causes most stock pumpers to avoid stocks trading for over $1 per share on exchanges like the NYSE and Nasdaq.
Sometimes pumpers get a little cocky or a short seller gets lucky and a pump & dump runs headlong into the brick wall that is a motivated and well-funded short seller. Whatever the reason, this short seller was able to find plenty of shares to borrow of last Thursday’s pump of Alanco Technologies (ALAN). This pump (or in this case a bull raid, as the pumper reported having received no money to promote the company) came from stock tout Stockpreacher (about which I have written previously). Stockpreacher released its ‘report’ on the company just as the market opened and ALAN jumped 100% from an opening price of $0.49 to over $1.00 in less than a minute (this was no doubt caused by Stockpreacher’s idiot subscribers buying with market orders). The stock touched a high of $1.30 but very few shares traded hands above $1.05.
ALAN Daily Stock Chart (pump and dump day highlighted; click to enlarge)
Seeing that the stock was up an insane amount for no reason other than a bull raid and that there were shares available to short, I quickly started selling large blocks of shares. I knew that the only reason the stock was up was a bull raid and I knew from past experience that previous Stockpreacher bull raids dropped quickly from their highs. I quickly exhausted all 12,550 shares of ALAN available to short at my main brokerage, Interactive Brokers (see a screen shot of my trades there). I then moved on to another brokerage account that had shares available and sold short another 34,500 shares. I had an average short price of $1.01. My fusillade of short sales (I sold over 2% of that day’s volume in the span of a couple minutes) helped to keep the stock from hitting more outrageous highs than the already outrageous $1.30 it briefly hit. How do I know? Stockpreacher’s bull raid on BOSC from the previous week (for which no shares were available to short at any of my four brokerages) had driven the stock price from $0.60 to an intra-day high of $5.80.
ALAN Intraday Stock Chart (click image to enlarge)
About an hour and fifteen minutes after I first sold short, I covered my short position at prices between $0.60 and $0.65. I netted $17,322 for a few minutes’ work and I got the satisfaction of helping to counter the manipulation of a notorious stock tout. It was indeed a good day.
How You Can Profit from Pump & Dumps
Some fellow stock traders were impressed with my courage in short selling a stock that was up 100% on manipulation without even waiting for the buying pressure to ease up. My response was simple: manipulation has its limits. I am now nearly an expert on manipulation and hype, having learned from Tim Sykes how to short sell manipulated stocks. I knew from observing the previous Stockpreacher bull raids that the stocks always dropped quickly from their intraday highs. There are no easier trades than short selling a stock that has been manipulated 100% higher when you know the manipulation is going to cease (Stockpreacher does not keep pumping the stocks it selects for bull raids after the initial day). That being said, it is scary to quickly take a large short position in a volatile stock. To do so requires both understanding hype and manipulation and confidence in being right. Unfortunately, until the last couple weeks (during which I have made several great trades), my confidence has been poor (like my trading) this year.
As I have mentioned repeatedly in my articles on becoming a stock trader (Part 1, Part 2) and in my Introduction to Evidence-Based Investing, the bane of any trader (or investor) is emotion. Fear and greed are both anathema to successful trading; a trader should be confident but not overconfident. Trading involves implementation of a specific plan; emotion will distract from the plan and lead to poor decisions. I have struggled with my trading this year, suffering from a large draw-down in my secret super-awesome trading strategy, suffering from meager profits in my pennystocking trading strategy (Tim Sykes’ strategy), and even messing up my arbitrage trades.
As a result of the above troubles, my account dipped into negative territory and I was feeling horrible. While I gained 5.13% in January and gained 5.32% in February, I lost 3.81% in March and lost 9.90% in April. I resolved to dial down my risk a bit and focus on fixing my trading errors. I revised my super-secret trading strategy (which had been responsible for 80% of my profits and losses) in a way that only slightly reduces returns while greatly reducing risk. For my pennystocking trades, I focused on getting my confidence back. The best way to do that is to focus on the easiest trades. So, knowing how easy it would be to profit from short selling a Stockpreacher pump, I followed each one and did not let my fears keep me from taking a huge short position in ALAN. It helped that I follow Tim Sykes and he kept reiterating the ease of profiting from stocks up on hype alone. That strategy seems to be working as I am now up 12.14% so far this month (and May is only half-over!).
Now I have my confidence back and will look to improve my performance in more difficult trades. Of course, there is no reason for me to abandon the easiest trades! If possible, I will gladly sell short 100,000 shares of the next Stockpreacher pump!
Chart of my cumulative profit trading Tim Sykes’ strategy
Disclosure: No Positions. I am an affilliate of Tim Sykes as well as a customer, having purchased multiple of his DVDs (I recommend Pennystocking Part Deux; it is by far the best) and being a Lifetime TimAlerts member. I have a disclosure policy.
The SEC Enforcement Division just published a press release about a ’successful’ enforcement action in regards to stock manipulation of former penny stock Exotics.com (a pornography purveyor). The sad thing is that the press release once again highlights not the SEC Enforcement Division’s success but rather its complete and total failure. The gist of the release is that one of the alleged involved stock manipulators made $156,870.92 in illicit profits and his punishment is promising to never be a bad boy again and paying only $20,000 in fines (having few assets because he already spent his ill-gotten gains).
I don’t know how other people think, but if I were to make $156,870.92 in a penny stock manipulation scheme and then be fined only $20,000 by the SEC because I had already spent all the money, I would not feel very punished. In fact, I would not be dissuaded at all from participating in future stock manipulation. If I were a con man who had not previously engaged in stock manipulation and I saw this information, I would drop whatever I was doing and get into stock fraud because even if a perpetrator is caught their punishment is light and they usually end up better off than they were before the fraud.
A note to the SEC Enforcement division: for a punishment to deter offenders, they must actually be punished; in other words, they must be made worse off than before they committed the crime. How about fining them for three times the amount they stole and then hounding them for payment for the rest of their lives? Giving prison sentences would also be nice.
In the wake of the stock market rout of 2008, the SEC is considering reinstating the uptick rule [pdf] or some variation thereof and the SEC has asked for comments from market participants (see the submitted comments). Having researched the question thoroughly (as a short seller it behooves me to be prepared for any such changes), I found that while there has been some good research on the effects of the uptick rule, there is little information in the press and most of the bloggers and journalists who have written about the uptick rule have given biased or incomplete accounts of what the uptick rule is and how it has affected markets. This post is an attempt to correct the misinformation. In addition to reading this article, I encourage you to download and read the original research that I cite in forming your own opinion on the uptick rule.
A History of Stock Market Manipulation
While bear raids are legend on Wall Street, there is much less evidence of bearish stock price manipulation than there is of bullish manipulation, even back in the wild days before there was much stock market regulation. So while tens millions of dollars of illicit profits are made each year in pump and dump schemes there have only been a couple of ’short and distort’ schemes prosecuted in the last couple decades (in fact, of the two cases of which I am aware, Anthony Elgindy’s case involved no distortion; his crime was conspiring with FBI agents to gain information on companies actually being investigated by the FBI). For some information on stock market manipulation back in the early 1900s I suggest reading Edwin Lefevre’s Reminiscences of a Stock Operator.
Allen’s article Stock price manipulation [pdf] also has a few interesting tales, including the story of how members of the City Council of New York conspired to manipulate the stock price of the Harlem Rail company but were outsmarted by Cornelius Vanderbilt. While there is little evidence of manipulation on the part of short sellers, there is plenty of evidence of manipulation by longs to squeeze short sellers. A recent example is how Porsche cornered the stock of Volkswagen in October 2008 without anyone knowing, causing a huge short squeeze (which could not have happened in the United States due to the requirement that large stockholders disclose trades in 13d or 13f filings; for background on past stock corners see this NY Times article from 1989 and the follow-up article).
A Brief History of the Uptick Rule
In response to the stock market crash in late October 1929, the US Senate formed the Pecora Commission, which revealed many problems with banks and led directly to the Glass-Steagall act and the Securities acts of 1933 (which required that securities be registered) and 1934 (which formed the SEC to regulate stock exchanges). Short sellers were often blamed in the media and by politicians for the stock market crash. In response to this, the NYSE collected data on short interest, which was only at 0.15% of outstanding shares on November 12, 1929, compared to 2.3% on September 13, 2002 (Jones, Shorting restrictions, liquidity, and returns [pdf]). Opponents of short selling continued to call for measures to restrict the practice or ban it outright. To prevent politicians from completely banning short selling, the NYSE ruled on October 6, 1931 that short selling on a downtick was ‘demoralizing’, thus banning the practice as demoralizing trades were already prohibited.
Interest in restricting short selling continued among politicians and on April 1, 1932, a new rule went into effect that required written authorization for brokers to borrow customers’ stock to lend to short sellers. While this caused a temporary short squeeze, Wall Street has adapted, and now most brokerages’ margin account documents grant the brokerage the right to borrow all securities held in the account without payment of interest (a broker cannot borrow stock from a cash account). Starting on February 8, 1938 short selling was restricted even further when the SEC ruled that short sells could take place only on a strict uptick (at a higher price than the previous transaction); this applied to all exchange-listed stocks, including the regional stock exchanges. This greatly restricted short selling; because it was so restrictive the SEC amended the rule to allow short selling on upticks or zero-plus ticks (this rule went into effect on March 20, 1939); the uptick rule was not changed after this point until Reg SHO came along in the early 2000s.
Before addressing recent research on the effects of the uptick rule, we must take a detour to the Nasdaq (formerly an acronym, NASDAQ), which was not a stock exchange prior to August 1, 2006. It was simply the National Association of Securities Dealers Automated Quotation system for OTC securities (SEC OEA, Economic Analysis of Short Sale Price Restrictions [pdf]). Nasdaq stocks were thus not subject to the uptick rule. In 1994, the NASD introduced a bid test for Nasdaq National Market stocks (not the smaller companies listed on the Nasdaq SmallCap Market), which required short sales of Nasdaq stocks to be above the best bid if the bid is lower than the previous best bid. This is less restrictive than the uptick rule. Furthermore, the bid test was never instituted by certain popular ECNs, including Inet and Arca; this made it easy for short sellers to avoid the bid test (Diether, Lee, & Werner, It’s SHO Time! [pdf]). So if short sellers who have primarily traded Nasdaq stocks think the uptick rule will not affect them because they had no problems in the past, they are wrong; the SEC has indicated that whatever rule it promulgates will apply to Nasdaq as well as NYSE and Amex stocks and to all the ECNs.
Non-Experimental Research on the Uptick Rule
The uptick rule prevents short sellers from hitting the bid most of the time and requires them to use limit orders above the best bid. This causes short sellers to achieve better prices than they would absent the uptick rule (because their limit orders are on average executed above the midpoint of bid and offer), but conversely many short sale orders are never filled and those that do fill take more time to fill than they would absent the uptick rule (Alexander & Peterson, Short Selling on the NYSE and the Effects of the Uptick Rule [pdf]). In fact, the uptick rule was found to delay or prevent the execution of over 90% of short sale orders on the NYSE.
The lack of a bid test for NasdaqSC stocks while NasdaqNM stocks had a bid test allowed Ferri, Christophe, and Angel (A short look at bear raids Testing the bid test [pdf]) to examine the effects of the bid test on the tech bust of 2000-2001. They found that there was less short selling in the NasdaqSC stocks than in the NasdaqNM stocks and that highly-shorted NasdaqSC stocks did not suffer a greater frequency of stock price crashes than similar NasdaqNM stocks. These conclusions are not very useful in the uptick/upbid rule debate, considering the weakness of the bid test and the ease with which it could be avoided. One intriguing finding from the study is that in every instance (out of thirteen) where a Nasdaq stock fell by over 10% in one day and over 20% of the sales that day were short sales, bad news such as a poor earnings report (and not rumors or a bear raid) explained the stock price decline.
In the debate over the uptick rule, it is important to remember that tick size affects the restrictiveness of any uptick or upbid rule. After tick sizes were reduced from 1/8 dollar to 1/16 dollar in 1997, short sales became easier and executions faster (Alexander & Peterson, Implications of a reduction in tick size on short-sell order execution [pdf]). With decimalization in early 2001 the uptick and upbid rules became even less effective.
Reg SHO & The Great Experiment
Reg SHO (short for Regulation on Short Selling or Regulation Short; those SEC folks are creative!), besides changing the rules regarding naked short selling (which is beyond the purview of this article) established an experiment wherein from May 2, 2005 to August 5, 2007 one-third of all the stocks in the Russell 3000 index were exempted from the uptick and upbid rules. Detailed tick-level data (with short sales identified by the exchanges) was collected on all the stocks, with the 2000 stocks for which the bid or tick test was not removed serving as controls for the pilot group of stocks that had the rules lifted. The SEC Office of Economic Analysis analyzed the data and made it available to other economists as well. The outside economists and the SEC used varying methodologies to analyze the data; due to the number of different analyses conducted I will not describe them in detail, referring the interested reader instead to the SEC OEA report [pdf] for a good discussion of all the analyses. I provide only summaries of the results below.
The researchers were interested in the effect of the uptick/upbid tests on liquidity, volatility, the prevalence of ‘bear raids’, stock returns, and short interest. Generally speaking, different researchers reached similar conclusions. All researchers found that differences between uptick-test and non-uptick-test stocks were greater than between bid-test and non-bid-test stocks; for that reason when I will discuss only the uptick test stocks below.
Multiple studies found that short-term (5-minute level) volatility increased significantly in pilot stocks, as would be expected, because short sellers could demand liquidity rather than supplying it. This increased the likelihood of small downward moves as short sellers hit the bid, exhausting all the orders at the best bid, then filling at the new lower best bid; conversely, upward volatility increased because large buyers were more likely to exhaust the best offer and drive the price higher without short sellers’ limit orders there. In fact, control stocks, because short sellers were forced to offer liquidity, had 10% greater liquidity on the offer than on the bid; this imbalance was corrected once the uptick rule was removed and test stocks thus had more balanced bid/offer liquidity (Diether, Lee, & Werner, It’s SHO Time! [pdf]). Longer-term volatility (at the 30-minute level or longer) did not increase in pilot stocks.
As to stock returns, the SEC study found no significant difference in returns over the first 6 months of the Reg SHO study. A more recent study of the same data by Harmon and Bar-Yam of the New England Complex Systems Institute or NECSI (Technical Report on SEC Uptick Repeal Pilot [pdf]) came to a different conclusion using different statistical methods. They found that pilot stocks–both Nasdaq and NYSE stocks– fell significantly relative to control stocks. I disagree with many of the methods they used, inlcuding fitting to a normal distribution and trimming outliers (with long-term stock returns having very fat tails–Mandlebrot has argued they are best described by the Cauchy distribution rather than a normal distribution–both those methods are inappropriate).* The more important problem with their finding is that pilot Nasdaq stocks fell by 2.09% relative to control stocks, while pilot NYSE stocks fell by 2.38% relative to control stocks. As I described above, the Nasdaq bid test was generally ineffective and it could easily be avoided by sending orders to ECNs. Therefore, similarly negative adjusted returns for both NYSE and Nasdaq stocks seems likely to be a spurious finding. Furthermore, even if this finding were robust, it could indicate either that stocks in general were overvalued due to the uptick/upbid rules or that they became undervalued when the uptick/upbid rules were removed. I must wonder why the NECSI researchers did not compute the stock return data for the rest of the Reg SHO pilot period, instead sticking to the data from the first 6 months that was used by the SEC.
As to bear raids, different researchers searched for them in different ways. Some used variance and semi-variance. These measures capture normal volatility more so than extreme events like bear raids. Alexander and Peterson ((How) do price tests affect short selling [pdf]) also compare the daily price change (known to stock traders as the average daily range or ADR; this is the day’s high minus the day’s low) of pilot and control stocks, finding no differences. They also looked at price runs following a short sale, a much more powerful method of identifying bear raids. There was no tendency for there to be runs of more than two short sales executing at lower prices in pilot stocks relative to control stocks, on either the NYSE or the Nasdaq.
The SEC study found no increase in short interest or put option open interest in pilot stocks. While there were more short sales in pilot stocks, the increase in short sales was explained by a decreasing size in short sales. Because short sellers did not have to worry about the uptick rule preventing them from selling quickly, they were more likely to split up larger orders to disguise their true size (just as large buyers do).
Conclusions & Caveats
The conclusion of all the economists whom I have cited above or listed in my bibliography below, as well as the SEC’s Office of Economic Analysis, is that the uptick rule does not fulfill its goal of preventing bear raids while allowing short sellers to sell into rising markets. Rather, there remains little evidence of bear raids, while the uptick rule restricts short selling even when a stock is rising. I recommend reading the transcript of the SEC’s roundtable discussion on the results [pdf] to see the opinions of the relevant people.
There are a couple caveats to the Reg SHO pilot study. It took place as stock markets were generally rising and volatility was low. If bear raids do exist, it is likely that they would be more prevalent during bear markets when confidence is low and investors are more easily scared. None of the above studies can address whether bear raids have taken place over the last year.
Recommendations
I am of course against reinstating the uptick rule. It is a poor rule that restricts all short selling (even though speculative short selling is a less common use of short selling than are arbitrage, hedging, and market neutral strategies) and if the SEC really wishes to prevent bear raids, it would make more sense to use some sort of individual stock circuit breaker, such as the one proposed by the major US stock exchanges that would institute a bid test only after a stock has fallen by a certain percentage, such as 10%. Such a rule would allow most short selling while restricting it when a stock is falling precipitously. Furthermore, a circuit breaker that automatically halts trading in a stock for 30 minutes following a huge drop or spike (say 20%) would be a good addition to the rule proposed by the stock exchanges.
Disclosure: I am a full-time stock trader who primarily sells short.
*I should also mention that combining the NYSE and Nasdaq stock data (one of the other methods used by the NECSI researchers) is also innappropriate, given the facts I outlined above after the asterisk (I apologize for making the reader jump around). The one method the researchers used that was legitimate was using non-market-adjusted data. In general, I have to say that I was unimpressed with the NECSI report. It is obvious that the authors are not social scientists and are thus unfamiliar with certain difficulties inherent in social science research. Their other main analysis compared the number of large stock drops in 2000 and 2001 to those in 2007 and 2008. It is not appropriate to compare stock returns during a mild recession and the bursting of a bubble in a small subset of stocks and a period during which most large financial companies require government support to stay afloat and GDP in many countries decreases at rates not seen since the Great Depression as every single stock sector got pummeled.
I would congratulate Stockpreacher.com on the skill with which they have in consecutive weeks sent Candela Corp (CLZR: $0.00 0.00%, market cap: $N/A) up 100% and on April 20, NetSol Technologies (NTWK: $0.92 -0.03%, market cap: $32.6M) up 60% (from $0.45 to a high of $0.72). However, their pump of NetSol attracted so much interest that it crashed their website. On the day it was pumped over 5 million shares were traded versus an average of 400,000 shares per day in the prior week. I can only guess that 1 million more shares would have been traded if StockPreacher’s website had not crashed.
Of course, like most pumped stocks, NetSol and Candela both fell after the pump and I profited from short selling both of them (I also profited from buying NetSol into the pump). Tim Sykes also has a post on this pump and how he (and I) profited from trading it. Do you want to learn how I have made $2577.30 in 2009 and $50,801.90 since last June by following Tim Sykes’ trading system? Buy some of Tim’s stuff (like his Pennystocking Part 2 DVD set … but skip Part 1) and find out.
For those who must know, I bought NTWK at $0.47 (because their website was down and my email was slow I found out which stock they were pumping from a post in the InvestorsUnderground Chatroom, which is a great place for day-traders), sold at $0.61, went short at $0.65, covered at $0.58, went short again at $0.64 (all on 4/20) and covered at $0.57 on 4/21. I made over $1500 in under 24 hours with no more than $4300 at risk at any time. Not bad, eh?
Disclosure: No positions in any stock mentioned. I am an affiliate of InvestorsUnderground and Tim Sykes and will make a commission if you buy junk using my links. I am a subscriber to InvestorsUnderground. I am a TimAlert lifetime member and have purchased Sykes Pennystocking 1 & 2 and received TimRaw as part of a TimSeminar I attended. I have a disclosure policy that loves to profit from idiots who put faith in stock touts.
Some of you may remember Hydrogen Hybrid Technologies (OTC BB: HYHY.ob). It was a spam stock from last summer, perhaps the most recent successful pump and dump. The SEC just halted the stock, trading at 3 cents. During its pump & dump days, this stock reached $2.50.
Update later on the same day: The SEC just put out a release alleging that the majority owner of HYHY and other penny stocks made $20 million from illegal market manipulation. Impressive take.
