Mr. Cox, do you have an opening statement, sir?

Mr. Cox. Just briefly, let me say that I am, in fact, delighted to be here and am pleased that you decided to hold these hearings. I did, in fact, just fly in from California. It was about 4:30 in the morning their time when I had to head in here. So I will reserve my remarks until I'm fully awake.

Mr. BARNARD. That may put you at an advantage. Thank you very much.

This morning our first panel consists of Mr. Robert A. Spira and Mr. Robert J. Flaherty. Would you all take the witness stand, please. Mr. Spira is chairman of Berkeley Securities in New York, and Mr. Robert J. Flaherty is the editor of the OTC Review.

Gentlemen, thank you very much for being here. We will first hear from Mr. Spira, who is chairman of Berkeley Securities in New York.

STATEMENT OF ROBERT A. SPIRA, CHAIRMAN, BERKELEY

SECURITIES, NEW YORK

Mr. SPIRA. Mr. Chairman, members of the committee. My presentation here is not meant as a diatribe against short sellers. Abuses exist on both sides of the fence, and have since the beginning of time. My presentation is meant as an historical overview, attempting to describe the development of OTC short selling and some potential methods of creating a level playing field.

Abuses in short selling are not restricted to either our markets or our century. Joseph de la Vega published "Confusion de Confusiones" in 1688, which described trading on the Amsterdam Stock Exchange. His work depicted for the first time how the exchange mechanism functioned. The first recorded exchange short sale is discussed within that work and is described in its introduction. I quote:

Only a few days after the original subscription had been completed, the shares of the Dutch East India Company were being traded so actively that they rose 14 or 15 percent above par; and the tendency to rise continued until, by 1607, the price had almost doubled. However, in the following year, the market value fell to 130 percent of par as a consequence of manipulations by a group of speculators, organized by one Issac Le Maire, who ultimately were concerned with the founding of a rival French company. These early stock market operators sold large blocks of shares and, in addition, sought to depress the price both by selling short and by spreading rumors that were unfavorable to the Dutch company. Consequently, on the 27th of February, 1610, the first edict was published prohibiting activities of this sort, especially the windhandel-that is, the dealing in shares that were not in the possession of the seller. The sale of shares of the company by bona fide owners for future delivery was allowed. In 1621, after the outbreak of war with Spain, a second edict against the windtrade had to be issued, and further prohibitions followed; but apparently the abuses could not be eliminated.

In the course of the 1680's, trading in stocks increased considerably, and for the first time a rather lively public discussion of the problems ensued. In 1687, an Amsterdam lawyer, Nicholaas Muys van Holy, felt himself impelled to publish a pamphlet on the evils of the wind business. He pointed out that there were professional dealers in stocks who were anxious to ferret out the secrets of the State and of the companies in order to best ordinary investors through the use of inside information. In an effort to reduce speculation, he proposed not only that all sales of stocks be registered, but that such sales be taxed. The author was of the opinion that

the Portuguese nation was playing a major part in the stock speculation, especially in the speculation on imaginary or fictitious units called "ducaton" shares. His contentions met with strenuous opposition. The magistrate of Amsterdam issued a decree on the 13th of January, 1689, which did, indeed, levy a tax upon transactions.

As we can readily see, the problems being addressed by this august group are really no different now than those of Amsterdam in the 1600's. It is frustrating to those of us in the securities industry to realize that in over 300 years civilization has been incapable of mandating procedures to create a level playing field for both buyers and sellers.

Specifically, the short selling of large blocks of stock, of over-thecounter securities, was a consequence of the 1974 Wall Street automation in the guise of continuous net settlement, along with the almost simultaneous marginability of unlisted securities. Before the 1970's, it was common for fully paid securities to be delivered to the purchaser. No large pools of hypothecatable securities existed. Thus, without a meaningful position, it was not worth the short sellers time to delve too deeply into the undisclosed affairs of publicly traded companies. It was, and is, illegal to lend fully paid-for securities in a client's account without permission. And because stock loan operations did not function as profit centers as they do today, borrowing or lending between firms was considered an unrewarding chore by most.

Unlisted short sales were enacted by means of selling for delayed delivery, a contract between the seller and executor of the transaction, ordinarily for a set period of time. In reality, other than in listed securities, borrowing or lending rarely took place.

With the advent of the Depository Trust Co., the majority of the "Street's" securities were placed in a common fund-book entry system-which is routinely used to make computerized delivery of securities and cash. The stakes had been raised. Margin had created street stock and DTC made it fungible. The borrower became king. He could not only short at will, but he was paid a handsome premium to do so, thereby covering part of his risk. Loaning stock had become a profit center. Those that first understood the ramifications of the coming of the computer age in the brokerage industry anxiously solicited customer short sales as a source of increased income.

Not only did they receive a commission for executing the transaction, but they were given a rebate by the securities lender as well. The lender delivered securities and received somewhat more than 100 percent of their value in cash. The funds were invested in short-term instruments and the profit was divided between the borrower and the lender.

These enormous profits made it worthwhile to bend the rules in various instances. By building up a portfolio of rebates, the income stream would continue as long as the stock was on loan. As brokerage firms created financial "supermarkets," it became easier for the investor to leave his securities in street name with the broker. The advent of the Securities Investor Protection Corporation, coupled with the additional insurance provided by the broker-to as much as $10 million-allowed the investor peace of mind, along with many benefits heretofore unheard of, such as daily interest,

sweeps, cash management accounts, money market accounts, along with check-writing privileges. This caused the investor to clean out his vault and assign his securities to his broker. This action created an enormous pool of previously unlendable securities. No matter where his stock physically resided, his monthly statement provided all the comfort necessary.

The broker not only lent this stock to short sellers, but they knew that if certain groups were short, unfavorable articles were likely to ensue and the stock would probably go down.

It was not the broker's obligation to inform the investor that his hypothecated stock was being used for the purpose of short selling. Their obligation was to placate their more active accounts and to earn as much money as possible for the firm. I would make it obligatory that the broker inform his client if his stock has been lent to facilitate a short sale. This would be done in a first-in/first-out scenario within the broker's computer system, not in DTC. This would prevent also the lending of nonmarginable or nonhypothecatable securities.

Under normal circumstances, the basic elements of a share of common stock are (a) the right to receive dividends, as and when declared by the subject company; (b) the right to elect a board of directors and vote on matters of importance that are to be decided by the shareholders; and (c) the right to sell or lend securities to any qualified entity.

A share qualifies the holder to participate in the fortunes of the company, whether good or bad, as long as this interest is maintained. How does a share purchased in a transaction where the counter side is a short seller delivering borrowed securities, or even selling naked, differ from any other share purchased in a regular transaction? Let's examine the characteristics of what constitutes that share.

(a) In the case of the dividend, it's guaranteed to be paid by the broker. As to the right to vote these shares, (b) William Fitzpatrick, general counsel of the Securities Industry Association, has stated that the borrowed securities receive all voting rights, as that right is an integral part of the stock itself. (c) The right to absolute negotiability is guaranteed by the brokerage firm at which the stock is residing, and must be in street name, assuring a legally tradable instrument.

Each share purchased as a result of a short sale takes on all the characteristics of a share that is purchased in a regular-way transaction. This synthetic instrument becomes indistinguishable on both the books of the depository trust company or the brokerage firm where it was purchased. In the case of securities with short positions, the result would be that the total shares of all the long holders of outstanding securities, whether in street name or physically held, would always be greater than the number of shares on the books of the issuer. While there are additional issues involved in this discussion, in essence, with each share sold short, a new share is added to the company's float, but not to the company's books. That trick is done more simply than pulling a rabbit out of a hat. While the lender has transferred his vote along with these stocks, the shares on the broker's books are indistinguishable from other shares of the same security held by other clients of the

broker. All holders are allowed to vote and the broker is confident that the laws of probability will cover his lack of proxies.

When, as always, all stockholders do not vote, the proxy of the abstainee is electronically transferred to the lender of the short shares. In actuality, we hypothecated the right not to vote from somebody whose fully paid shares might now allow this transaction.

Looking more deeply to the right of proxy transfer, if it could be done by internal hypothecation in normal instances, it cannot be accomplished at all in matters that are contested. Each proxy must be voted as the holder intended and not as the broker would prefer. If you inform the lending common shareholder that he had been disenfranchised, he would probably find that this fact was inconceivable and point out that nowhere in the hypothecation agreement is there any indication he has given up his right to vote and, by and large, if explained the stock loan transaction, his reaction would be that of utter disbelief. His feeling, on balance, would be that the purpose of giving this right to his broker was for borrowing against his margin account. The current hypothecation agreements used in the industry do not indicate in any way that this possibility of disenfranchisement exists.

It would seem more honest if we reworded the margin disclosure agreements and created for bookkeeping purposes a third class of stock, hypothecated with loss of vote. If this were done, the shares on the company's books and the shares held by investors outside of this class would equal each other and the chance of confusion in closely contested proxy contents would be avoided.

We have an uptick rule on the various exchanges, created by the 1933 and 1934 acts to prevent the bear raids that occurred in the late twenties. It is interesting that our securities regulations have only provided protection to the multibillion dollar listed conglomerates of our exchanges. Only because cash stocks were not marginable and, therefore, not lendable, were they not addressed within the same regulations. The specialist on an exchange constantly makes timely delivery of a sale so that a buy-in is a rarity. It seems inconceivable that these mature companies who have earned their listing by size and liquidity are offered protection not granted to the emerging company who may be the next Xerox or Polaroid.

Today's "gunslingers" may well have been able to destroy these companies by shorting the stocks, advising friendly publications that "developing a picture in a camera, what a ridiculous idea," or "making a copy in seconds-how silly." If a negative article had appeared just as planned financing was about to come out of registration it could well have been the death knell of these fledgling companies.

This, along with calls to suppliers and banks casting doubt, could mean the end of emerging companies. The name "undertaker”— chosen by a well-known short seller-is apt.

Short selling is necessary for our markets to function. It serves well as a ballast for excesses, but should be done on a level playing field. I would propose an uptick rule on all NASDAQ stocks. Although this process cannot be as closely monitored with multiple market markers, the advent of last sale reporting provides, for the first time, an opportunity to bring to the OTC market what the

drafters of the 1933 and 1934 acts intended. I would also propose a 5-day settlement on market makers as well as clients. I am not aware of any reason that this would impede the liquidity of the market.

When a group acting in concert, or alone, acquires 5 percent of the outstanding stock in a company, they are required to file a form 13D notifying the financial world that this is a company worth their attention. Whether their intentions are for investment or for acquisition, the investment community is promptly made aware of their holdings and the present intent of the purchaser. The rule is used to prevent surprises of any nature and is made under our rules of maximum disclosure.

I would propose a type of reverse rule 13D that would require reporting of all short sales, either individually or in concert, of over 3 percent in securities, with a capitalization of under $5 million, and 5 percent in securities with a capitalization of over $5 million.

A thirdly traded, marginable, low-capitalized company is much more vulnerable to a bear raid than its larger counterpart. The number of market makers is generally less and lacks the sophistication in public relations. Its investment banker, if indeed one exists, is usually not able to provide funds under adverse circumstances. Further, its legal department is ill-equipped for damage control.

This is the ultimate nonlevel playing field. Many of these companies will be forced into oblivion by the SEC's nonsolicitation rules going into effect January 1, 1990. Pink sheet stocks are considered an anathema and the brokers pushing them very likely common criminals. Some help should be given to salvage what is left of the largest part of our venture capital market. They should be afforded at least the same protection the designers of the 1933 and 1934 act provided listed companies.

I would further propose that the reporting of the 3 percent and 5 percent positions be made on a very timely basis. This is because shorts are geared to the belief that unfriendly articles on the company may be forthcoming. The timeframe that we are currently dealing with is days and weeks as opposed to the months required to launch and succeed in a takeover bid. Timely reporting will at least send the same message a 13D filing does-something's going on, and it may not be good news.

Other than for the normal market-making functions, it would be interesting to require the exact source of the delivery to be posted on the confirm. This would make it easier for the regulators to identify the lending of nonhypothecatable securities and to identify naked short sellers. The bunching of securities within DTC makes it impossible to tell at that level whether or not the loan is legitimate. It must be done on the books of the lender for the short seller. Naked short selling, an abusive practice, would then become more controllable.

The market maker who has short sellers as clients sits in a unique position. He is allowed to leverage his borrowing at a substantially higher percentage than his public counterparts. He has knowledge based on the historic success of certain groups of shorts and how they operate. He is receiving a rebate usually not shared with his clients on his proprietary trades.