Reuters reports that Richard Choo-Beng Lee will testify that he “engaged in illegal insider trading while working at Steven Cohen’s SAC Capital, a Connecticut-based hedge fund.”

I’m predicting that much will be made of this development, and rightly so.

As you encounter conversations on this topic in the days to come, it is a good opportunity to point out that Deep Capture published irrefutable evidence of insider trading at short selling hedge funds SAC Capital, Kynikos Associates and Third Point Partners almost one year ago.

Read about it here: “Hedge funds reading tomorrow’s headlines today“

You can hardly blame Fat Squirrel Trading Group (FSTG) and Rhino Trading, LLC.

After all, it was 2007, and illegal short selling was almost the norm. The SEC, in passing a toothless Regulation SHO, had demonstrated that it didn’t care much. With just a few exceptions, America’s financial press had made it clear that the shorts were to be believed and their targets attacked or ignored.

And, in the midst of what history would eventually show to be the high-water mark of the greatest bull market of all time, how could a self-respecting short seller possibly be expected to do business in any other way?

What FSTG and Rhino couldn’t have known is that four factors were working against them:

1- In December of 2007, the SEC would appoint a true inspector general, in the form of David Kotz, and that Kotz would hear the cries of untold thousands of shareholders certain that the SEC had ignored their untold thousands of complaints of illegal naked shorting of companies in which they had invested untold millions of dollars, and that before too long, Kotz would issue a scathing report confirming as much, and…

2- In September of 2008, naked short selling would provide the spark that lit the fuse that ignited the greatest financial collapse of all time, and…

3-  In January of 2009, Joe Biden would leave the Senate for the Vice President’s mansion and Ted Kaufman, Biden’s successor, would make a major issue out of demanding the SEC start enforcing long-ignored prohibitions on illegal naked short selling, and, perhaps most unjustly…

4- By November of 2009, FSTG and Rhino would remain small and inconsequential firms (FSTG is headquartered at the end of a dirt road 90 miles from NYC), not at all the kinds of major players with deep payrolls into which SEC staffers hope the revolving door will eventually thrust them.

Rhino Trading Founder Damon Rein (on right)

Except for the “small and inconsequential” part, how could FSTG and Rhino Trading have possibly known that these factors would conspire to hold them to account in 2009 for their participation in an illegal and manipulative trading strategy that was de rigueur in 2007?

But it happened.

In fact, it happened yesterday.

Yes, the SEC has opened the second (or possibly third, depending on how you count an abortive 2005 case against the unrelated hedge fund Rhino Advisors) administrative proceeding alleging illegal naked short selling in its storied history. And we should be very happy about that. I know I am!

But I’m also bothered by the above alluded-to fact that Rhino Trading and FSTG are really just insignificant patsies, cast, like a pair of white-robed virgins, into a fiery volcano to appease the angry gods in Congress intent on forcing the SEC to do what it would really rather not (it’s job).

In the complaint, FSTG and Rhino are accused of illegally shorting such long-time threshold listees as USANA, iMergent, Medis Technologies, and NovaStar: all companies that experienced extreme levels of naked shorting for much longer periods of time than those described in the SEC’s action, and on a level unattainable by a firm headquartered at the end of a dirt road 90 miles from NYC.

In fact, certain very reliable sources confirm that a major hedge fund – one which has received much more than its fair share of coverage on this site – was coordinating media and message board attacks on one of these targeted companies during precisely the same period.

And yet the wrist slap (in the form of a $45,000 fine and firm instructions not to naked short any more) goes to the guys set up in a converted barn with dial-up internet access.

Brilliant.

The SEC was a bit tougher on Rhino Traders. The company and principals Damon Rein and Steven Peter will pay several hundred thousand dollars between them, in addition to promising to mend their naked short ways. They will also consider themselves officially censured.

Take that!

SB 605 is a bill on Capitol Hill

Something of great importance in our effort to finally end illegal naked short selling took place recently.

Senator Ted Kaufman of Delaware, together with three colleagues, distributed a letter to the remaining 96 members of the Senate formally requesting co-sponsors for SB 605: A bill to require the Securities and Exchange Commission to reinstate the uptick rule and effectively regulate abusive short selling activities.

You can find a copy of the letter and the bill itself here.

This is a very good sign that this most vital bill has momentum. However, this is always a very tenuous time for any bit of nascent legislation. That’s why I encourage all supporters of true market reform to contact their US senators (remember you each have two!), encouraging them to co-sponsor Senate Bill 605.

Every additional co-sponsor’s name added to the bill reduces the likelihood that backroom shenanigans — something at which our adversaries are experts — will kill our best opportunity for true reform yet, while still in its cradle.

Please reach out to your senators today. Click here to find his or her contact information.

I’m usually a real optimist. Sometimes to a fault, according to my more balanced wife. But when it comes to financial market reform, I’ve devolved into a deeply cynical pessimist.

Too many stinging disappointments, I suppose.

Too many instances of people behaving badly, to be certain.

But as they say, there’s some value in expecting the worst…you’ll never be disappointed.

And so it was with today’s second and concluding session of the SEC’s roundtable on securities lending and short selling: I expected the absolute worst, but in the end was pleasantly surprised to find that it wasn’t quite as bad as I feared.

That’s not the same as proclaiming it a good thing, because it was not. Indeed, I stick by yesterday’s characterization of the event as farce with a pre-determined outcome.

Having said that, I was deeply impressed by two surprises I clearly had not anticipated. And I’ll get to those in a moment.

But first, an overview.

There were two panels. The first examined proposed pre-borrow and hard locate requirements — keys to closing two of the most dangerous remaining loopholes in the US stock settlement system. The second panel examined proposals requiring enhanced disclosure of short selling data — a good idea but ultimately one that would be much less necessary were the proposals discussed in the first panel enacted.

I’ll start with the second panel, which surprised me by coming down overwhelmingly in favor of more transparency in short selling.

Georgetown University Professor James Angel pointed out that greater disclosure would essentially be doing legitimate short sellers a favor, by vindicating them in cases when they are incorrectly accused of manipulation in response to stocks dropping in value.

David Carruthers, of short selling analytics firm Data Explorers, supported greater transparency in short selling where the goal was to “prevent market abuse and prevent the development of a false market, or to prevent situations where market participants take advantage of a vulnerable company.”

Richard Gates, founder of short selling hedge fund TFS Capital, denied that shorting exacerbated the onset of the current financial crisis, but went on to concede that there should be greater disclosure parity on the short and long sides of market activity.

Michael Gitlin of investment manager T. Rowe Price echoed the position of Professor Angel in saying real time reporting of short versus long sales would result in the “demystification of short selling,” adding, “The ongoing debate of what caused an individual security to decline would largely disappear with this added level of transparency.”

As the lone issuer represented on the panel, Jesse Greene, Vice President of Financial Management at IBM, was enthusiastically in favor of a general overhaul of the SEC’s short selling regulatory framework, including public disclosure of short positions, in order to “improve market stability and restore investor confidence.”

Joseph Mecane, Executive VP at NYSE, noted that market fragmentation has made it more difficult to detect manipulation, requiring regulators have access to more short selling data in order to better conduct market surveillance.

In other words, the second panel was a slam dunk in the right direction.

The first and ultimately more meaningful panel, on the other hand, was the Yin to the second panel’s Yang.

Appropriately enough, Managing Director of the Equities Division at Goldman Sachs William Conley kicked things off, lamenting that “both the pre-borrow and hard locate requirement would require significant infrastructure builds on the part of the industry as well as its participants.”

By “infrastructure builds”, Conley is referring to the development of new software able to track down real shares for short sellers to borrow. He seems to have forgotten three things:

1. When there’s money to be made, Goldman Sachs has a rare talent for developing extremely complicated software. Could it be that Conley never met former co-worker Sergey Aleynikov?
2. LocateStock.com, then a bootstrapping startup, developed software that accomplishes precisely the same task Conley regards as so burdensome, on a shoestring budget.
3. If Goldman Sachs has enough cash on hand to spend nearly $12-billion in employee bonuses this year, it can probably set a couple hundred thousand aside to write some crumby software.

As I predicted yesterday, much of the balance of Conley’s mic time was spent echoing the anti-reform talking points currently being circulated on Capitol Hill by his employer’s army of lobbyists — in some cases, verbatim.

William Hodash, Managing Director at DTCC, took us on a trip to his organization’s mindset circa 2005 by pointing out that fails to deliver are not necessarily evidence of naked short selling. With one foot remaining firmly in 2005, another in 2009 and a third in a pile of his own illogic, Hodash then said that the reduction in fails observed before and after the SEC’s implementation of Rule 204 “may be relevant to the discussion of whether naked short selling remains a problem.”

No, you didn’t miss anything. That’s what he said, with all remaining panelists basically pleading some variation of the on his and Conley’s approaches.

With one very prominent exception: Dennis Nixon, Chairman of International BancShares Corporation (IBC).

Looking at the program, I had assumed that IBC’s role on the panel was that of a broker or other market intermediary. Well I was very wrong. IBC was there in the role of an issuer targeted by naked short sellers, and Nixon very poignantly expressed the anguish of someone in his position, after a 45-day long bear raid removed $1.2-billion in IBC shareholder value.

“And I think it was all attributed to this predator-type short selling that goes on in this market today that’s uncontrolled. It’s unbelievable,” Nixon said.

That was the first surprise.

The second surprise came from an even less likely source:Commissioner Elisse Walter.

Mostly silent throughout the previous day’s panels, today Walter made it clear that she’s not buying the excuses offered by industry representatives insisting this problem is too much for them to tackle.

“I’m sort of surprised that the industry hasn’t come up with a solution, particularly as this controversy has continued to swirl and does not go away,” Walter said, adding that by failing to address the issue, the industry is essentially passing the cost of non-compliance on to the SEC’s own Division of Enforcement.

I think she’d make a stronger case had the Enforcement Division brought more than two cases against naked short sellers in its entire history, but that’s a topic for another post.

The bottom line is, this panel was undeniably stacked against any additional meaningful steps to limit illegal naked short selling, but the contributions of Dennis Nixon and Elisse Walter were as welcomed as they were unanticipated.

The entire affair could have been much better, but also could have been much worse.

Deep Capture goes to Washington.

(Washington, DC) The SEC’s roundtable on securities lending and short selling got started today, and Deep Capture was there.

What follows is my assessment, based on my observations thus far.

In the simplest terms, I’d say the situation at the SEC is one of extreme disconnection. This is an agency that has completely lost track of its founding mission.

The day consisted of four panels, all dedicated to examining different aspects of securities lending. The panelists included one academic, one public employees’ pension fund manager, the CEO of FINRA, and 20 representatives of hedge funds and brokerages or companies that provide services to hedge funds and brokerages.

Not a single representative or advocate of retail investors had a voice on any panel, and the substance of the panelists’ comments was consistent with the thinking that obviously called them all together: the discussion never got beyond reforms to benefit the institutions that get rich from lending out the shares entrusted to them by the rest of us.

Nor did retail investors get any more than a passing reference in any other context. The industry was there to talk about the needs of industry. Period.

The result was eight hours of possibly the least interesting discussion I’ve voluntarily endured. In fact, it more resembled two dozen high school book reports on a handful of facets of a single industry, as the same thing was said over and over in the lest interesting way possible.

For eight hours.

Meanwhile, the subject that really matters: illegal naked short selling, is scheduled for just three hours tomorrow (including a break!), with panelists hailing from four hedge funds, Goldman Sachs, DTCC, the Security Traders Association, NASDAQ, NYSE, one academic, and one fish-out-of-water from IBM.

Is there any question how those panels are going to come down on the issue?

This entire exercise, I’m nearly prepared to declare, is little more than a farce.

Lest I leave you with the impression that everything was devoid of meaning, allow me to recount one of those moments of cosmic synchronicity that make days like today all worthwhile.

It happened during the fourth panel. Specifically, during the opening remarks given by Leslie Nelson (yes, a male, but sadly no, not the guy from The Naked Gun movies), Managing Director of Global Securities Lending at Goldman Sachs.

Just as Mr. Leslie Nelson was beginning to talk, about 15 of you emailed me a link to Matt Taibbi’s recent post where he announced that naked shorting will be a major component of his upcoming piece in Rolling Stone.

Included in that post was a link to a pamphlet apparently being circulated broadly on Capitol Hill by Goldman Sachs lobbyists, intent on preserving the status quo with regard to loopholes permitting illegal naked short selling. Trusting my audio recorder not to miss anything, I decided to tune Mr. Nelson out slightly to read the words of his notorious employer.

In the Goldman pamphlet, the first sub-point of bullet point one reads:
“Rule 204 of Regulation SHO has been effective at reducing fails in the marketplace.”

At precisely the same time read that line, I heard Nelson read the following from his prepared statement (prefatory to what — consistent with the rest of the day’s panel — had nothing to do with delivery failures):
“Rule 204 has been undeniably effective at bringing US equities fails to levels that are truly de minimis.”

See…I read and heard those lines at precisely the same moment.

It was as though the Goldman Sachs government relations team had briefly hijacked my eyes and ears.

It’s also indicative of how very seriously Goldman is taking this challenge to what is likely one of that company’s most plumb sources of revenue.

Finally, I’d say it’s predictive of the message what we can expect to hear repeated over and over again as the issue makes its was earnestly through Congress and flaccidly through the SEC.

You know, I do not drink, but if I did, I’d suggest everybody take a shot whenever they hear that phrase repeated during the three short hours (including a break) of the roundtable’s second and final day. That might just make the thing tolerable.

I need some input on the book I’m writing (more information on that here).

I’m looking for the best, most colorful examples of post-1934 short-side stock manipulations.

As I see it, stock manipulation comes in three general flavors…

1. Trade-based: on the short side, this is the essence of abusive, illegal short selling, is the general focus of this blog, and not something I need more examples of. Instead, please consider the following two types.
2. Action-based: where the manipulator, usually (but not always) from within the company, takes steps to literally affect the real or perceived value of the company for the purpose of benefiting an existing stock position. There are myriad examples of this sort of thing happening prior to Securities Exchange Act of 1934, but not nearly as many since, and most of those are long-side. If you know of any great examples of short-side, action-based stock manipulation, pleases add them as a comment below.
3. Information based: where the manipulator intentionally disseminates incorrect information about a company’s prospects for the purpose of benefiting a stock position. Much of DeepCapture.com is dedicated to exposing examples of this sort of abuse, primarily on the short side. This was also technically outlawed in 1934, but as I suspect we’ve all seen, happens on a grand scale nonetheless.  But if you know of any particularly interesting or outrageous examples not yet discussed here, please add them as a comment below.

Please limit your suggestions to cases that went to trial or otherwise experienced some level of fact-finding or other official response.

As always, if you’d rather add your insights privately, my email is jbagley@deepcapture.com.

It’s recently come to our attention that too many of you are not taking full advantage of the Deep Capture Twitter feed. If not, then you are likely among the many who do not get to see video clips like this one, in which Patrick Byrne discusses executive compensation and recent activity by the SEC on Fox Business Network’s Neil Cavuto show.

In addition to using Twitter to alert our followers to new posts on deepcapture.com, we use Twitter to spread the word about subjects, happenings, breaking news stories, and occasionally links to posts on other blogs that are likely of interest to you, but which may not warrant full posts on this site. This includes advance notice of Patrick Byrne’s many network TV news show appearances, as well as links to the video of those interviews as soon as they’re available.

You can follow our Twitter feed in one of two ways:

Old fashioned way: Come to deepcapture.com and look for updates in the column to the right (just below the fold) under the title “Deep Capture on Twitter”.

Web 2.0-compliant way: Get a free Twitter account and follow us there. This also gives you the option of having our “tweets” delivered to you via email or even your phone via SMS. Don’t worry…unlike some, we not manic tweeters. Between one and three relevant updates per day is about our limit. Any more than that and you can assume the sky is falling.

Additionally, I invite those of you who find the kind of content that is suitable for our Twitter feed to let me know, either via email, or (preferably) via direct message on Twitter itself. If that last part doesn’t make sense, just get an account and it should be fairly obvious.

I originally published this video on the first anniversary of the destruction of Bear Stearns, though its lessons seem even more timely today, the first anniversary of the destruction of Lehman Brothers.

And so, as you bump into some of the many discussions currently underway touching upon the cause of Lehman’s demise and the global financial meltdown that followed, kindly refer folks to this video. When the shorts protest that it’s a “conspiracy theory,” you might agree that it is indeed a conspiracy, but a conspiracy fact, not theory.

When they continue to protest, ask them to get specific.

And then sit back and enjoy the silence.

Hedge Funds and the Global Economic Meltdown

Recently, I revealed a few details of a security flaw I had discovered on the Yahoo! message boards, which made it possible to determine a user’s IP address and username. This would have been nothing more than a curiosity but for the fact that, as we’ve documented many times on DeepCapture.com, stock message boards are among the preferred venues for short selling hedge funds seeking to spread disinformation about targeted companies and — often — opponents of short-side stock manipulation.

As I wrote, a few months ago, I used this security flaw to determine an IP address frequently used by Gary Weiss, who, prior to being repeatedly outted by yours truly, was among the most active, anonymous spreaders of such disinformation on stock  message boards, blogs, and Wikipedia. With this information, I was able to prove that Weiss was again engaging in pro-naked short selling sockpuppetry, this time on political blog DailyKos.com (a claim DailyKos.com later verified).

Cade Metz, a reporter for the prominent British tech publication The Register, took note of the above-referenced security flaw, and wrote a very in-depth piece on it and the part it’s played in Weiss’s latest trip-up, in addition to examining the way this fight has so starkly turned in our favor as of late.

Take a look at Cade’s piece and, if you like it, be sure to Digg it here.

We’ve long maintained here at Deep Capture that Charlie Gasparino is possibly the most insightful figure at CNBC.

Today, Mr. Gasparino underscored that status while on air with Joe Grano, former CEO at UBS Financial Services and an early predictor of the current financial crisis. Grano’s interview was set to coincide with the upcoming first anniversary of the bankruptcy of Lehman Brothers — commonly recognized as the event that sparked the meltdown — and attempted to answer the question, “what have we learned?”

Along the way, the following exchange took place:

(starting at 00:55)

Co-Host: …doesn’t that eliminate a lot of the need for all this call for legislation?

Grano: A good part of it. And as long as you limit to a degree some of the leverage. I don’t believe in naked shorts, I don’t believe in naked credit default swaps when there’s really not a counterparty there because all you’re doing is levering into the sky. We don’t need that and it has nothing to do with our…

Gasparino: Patrick Byrne was right, all along…the Overstock guy…that everybody made fun of and then every Wall Street CEO mimics him right now.

Grano: In length of speculative excess there’s no question.

For taking a position that is undoubtedly very unpopular at CNBC, the Deep Capture team salutes Charlie Gasparino.

By the way, the interview in its entirety is very interesting, and can be seen here.