Thursday, April 14, 2005

The Mystery of the 38 Diamonds, Part III

And now, The Mystery of the 38 Diamonds itself.

This case involves yet another “skunk-works project"—that fanciful term given by Overstock CEO Patrick Byrne to initiatives which other, less promotional companies, might simply call "R&D."

(Google calls them nothing at all—one day, without so much as a press release, a new and usually highly slick function will appear on Google search. You could say Google takes the Warren Buffett approach to new ventures: less talk, more rock.)

Given Overstock's spotty history with such "skunk-works projects"—including the fizzled “Project Rocket” and the less-than-earthshaking “Project Ocean” —a cynic might refer to them not as "skunk-works projects" so much as "Hail-Mary passes."

In any event, the “skunk-works” project in this mystery is the company’s “Build Your Own Ring” function within the jewelry site of, announced with fanfare in January:

“We have opened our own Build Your Own Ring site. Something like Blue Nile. But it is where you can think of the diamond industry, up to $1,000 is really controlled by Zales and Wal-Mart and mall jewelers and Blue Nile operates average order size is about $5,500. We intend to dominate in the $1,000 to $5,000 range. Fantastic pricing."

It sounded good, it sounded exciting—in fact, it sounded like all “skunk-works” projects from Overstock have sounded, at first. (Recall early reports of the “mCommerce” shop-by-mobile phone phenomenon: “We decided that there would be an opportunity to lead the field..."; or the online auction business: “It’s…far faster growth than eBay saw in their first 15 days….”)

The key, of course, is the follow-through, and here the reality—as with “Project Rocket” and “Project Ocean”—does not appear to be cooperating with the ample vision of Dr. Byrne.

For starters, the diamonds offered on the “Build Your Own Ring” site at Overstock do not squarely fit the $1,000 to $5,000 price range Overstock intends “to dominate” with “fantastic pricing.”

Of the approximately 2,800 diamonds available at launch, 582 or so were priced at $5,000 and higher while another 490 or so were priced below $1,000. So roughly a third of the diamonds were offered at price-points outside "the range."

Some of them way outside the range.

There were 14 diamonds offered at $25,000 a piece and up; 50 at $20,000 a piece and up; and more than 120 at $15,000 and up.

In fact, over $3 million of the total value of diamonds offered on the “Build Your Own Ring” were offered at $10,000 a piece and higher, while the total value of all diamonds offered at $5,000 a piece and higher was more than $5 million.

Granted, this $5 million should be put perspective. After all, if one-third of the diamonds were priced outside the $1,000 to $5,000 price range, then two-thirds were priced within the range. And these numbered approximately 1,750 diamonds.

Stated value of 1,750 diamonds "in the range"? Roughly $2.7 million.

So, having put it in perspective, we discover that the “Build Your Own Ring” site offered over $8 million in stated value of diamonds: $5 million worth at $5,000 a piece and higher; and less than $3 million within the $1,000 to $5,000 range Overstock intends “to dominate” with “fantastic pricing.”

Now, about that $8 million worth of diamonds.

After announcing the new site, and the price range he intends “to dominate,” Byrne went on to speak about what appeared to be the source of the diamonds being offered on “Build Your Own Ring”:

"We did a $7 million deal on diamonds that was the steal of a lifetime. Just fantastic pricing in there."

(How Overstock came to getting "the steal of a lifetime" on loose diamonds is another mystery, and not the subject of the Mystery of the 38 Diamonds. I take Byrne at his word that he somehow purchased $7 million worth of diamonds at an unusually attractive price, despite the fact that the diamond supply chain is tightly controlled, and not at all an inefficient market.)

Assuming an Overstock-type markup of 15% on those $7 million worth of diamonds, they would appear to be the same diamonds being offered for sale at the time of the launch.

So, how is "Build Your Own Ring" actually doing? Well, once again, it would appear, based on a careful monitoring of daily sales on “Build Your Own Ring” starting in late March, that reality indeed bites.

One diamond was sold March 29—price range $1,000 to $2,5000—and another on April 2, same price range. Then again on April 4, same price range.

Pretty slow.

But on or about April 7, something interesting happened: 38 diamonds vanished from the available inventory. I say “vanished” because it is impossible for an outsider to determine whether the 38 diamonds were sold, or otherwise removed from available stock. Either way, there were 38 fewer diamonds spread across various price points.

Furthermore, if the missing 38 were indeed sold, it is likewise impossible to determine whether they were sold one at a time to 38 different people—unlikely given that the previous single-day sales record tracked since March 24 had been a whopping one—or sold in a batch to a single buyer.

It is, however, possible to identify the price ranges from which the “missing 38” vanished: one was a $25,000+ stone; four were in the $17,500 to $25,000 range; four in the $10,000 to $12,500 range; six in the $5,000 to $7,500 range; and 23 in the $1,000 to $5,000 range.

Total value of the 38 diamonds newly missing: approximately $220,000.

It would be quite a coup for Overstock if the sudden vanishing of those 38 diamonds represented a sudden upsurge in ring-building on its “Build Your Own Ring” site. Going from the occasional one-a-day to 38 is exactly the kind of “tsunami” CEO Byrne once predicted for “Project Ocean.”

But just as suddenly as the 38 diamonds flew out the door one way or another, Overstock customers suddenly resumed building their own rings at a more measured pace—one more on April 8, in the $1,000 to $2,500 range. And none since.

Which makes the Mystery of the 38 Diamonds even more of a mystery than if those 38 were the start of something big.

Like previous Overstock mis-adventures—from The Enigma of the Sputtering Rocket to The Vanishing Naked Shorts and its sister case, The Stranger on the Conference CallThe Mystery of the 38 Diamonds will, no doubt, be followed by other adventures in the casebook of Patrick Byrne and

It is also likely that certain of these new adventures will begin with a "Project" allowed to ferment in shrouds of mystery, its fanciful code-word hinting of grand aspirations ("Project China," perhaps, or "Project Google-Killer," maybe), designed to tantalize Wall Street analysts and perhaps result in the "super-sizing" of the P/E ratio.

And they may even, one day, prove more successful than "Rocket" or "Ocean" or "Build Your Own Ring."

In the meantime, we watch and wait for an explanation to The Mystery of the 38 Diamonds.

Perhaps you, reader, were the one who bought those 38 diamonds—all $220,000 worth. We'd love to hear about it.

Jeff Matthews
I Am Not Making This Up


The Unknown Broker said...

I'll take a guess at what happened Jeff. And yes, I'm making this up -- in the sense that I am speculating. But I don't believe it stretches the bounds of credulity.

1. As you noted, sales of diamonds have been slow. Darned slow. Painfully slow. At the rate of sales described Byrne and Co. are going to be sitting on those "deals of a lifetime" diamonds for quite a while.

2. Slow inventory turn is the death stroke for retailers -- particularly in a relatively low margin operation like Overstock.

3. The diamond market is not one way in direction. It trades up and it trades down - based on many factors. So not only is slow inventory non-profitable, it also exposes a diamond merchant to market risk -- and in the case of such a large inventory, considerable market risk.

4. There is a cost to inventory. Be it hard cost (financing costs) or soft (opportunity lost to use the capital more profitably), bad/sluggish inventory costs you.

5. The esteemed Dr. Byrne is not hesitant to jettison ill-chosen inventory. Witness this Byrne quote that you referenced: "I decided in early December, let's just flush everything that has been around more than a few months. ...We just marked down, promoted, did whatever we had to do to blow out the older inventory. I lost $1.5 million on that inventory to move it all."

6. Several of the missing stones were the high dollar ones. If the lower-priced diamonds weren't exactly leaping off of the shelf, it probably wasn't hard to reach the conclusion that Byrne was going to be sitting in a retirement home someday talking about the great high end diamonds he had in inventory in his most recent company, Skunkworks "R" Us (symbol STNK)

So, my guess? He found somewhere to offload some moribund inventory. Maybe he found a decent buyer, or perhaps he took the "blow it out" approach noted above and took a bit of a beating.

I don't fault a guy for trying new things, and I don't blame him if some don't work out. I also don't believe that taking an occasional whipping on some bad inventory is a terrible thing. Sometimes it's smart.

But idea after idea, project after project, one skunkworks-spawned can't-miss deal after another that fizzles and ends up in write-downs and charge-offs? That's a bit much to stomach and not the kind of company/management that inspires much confidence.

If my theory is correct, look for more diamonds to disappear, since this was just a drop in the bucket, inventory-wise. And very possibly look for charge-offs to show up in the numbers.

Just my 2 cents worth.

(It was 4 cents when I bought it. But I'm running a blow-it-out special today.)

bob obrien said...

Never before have so many words been used so often to say so little.

Jeff, you seem to have almost an unhealthy fixation on OSTK. It seems a bit odd, all the articles. I'm going to surmise that you are short and that your venom is driven by that position and the desire to see the price of the stock decline.

I have no idea what happened to the diamonds, or what didn't. Maybe they sold them? Huh. They do that, you know. Sell stuff.

There's a lot of backseat driving going on here - a lot of well intentioned (?!) experts explaining all the things Byrne is doing wrong.

And yet you don't hear much mention that OSTK is now profitable. Nope. Tut tut, we'll hear none of that. They are, you know. Now, I know you will attempt to make the whole world revolve on a quarter to quarter basis, but the fact is that on an annual basis, they are now profitable.


And it seems to be annoying the heck out of Jeff.


Enjoy that. No need to make it up.


mfairview said...

Much like Frank Perdue's (Jr) non obsession with chicken, Jeff "Frank Perdue" Matthew's non obsession with OSTK is a laugher.

What's next on the horizon Frank? Perhaps it'll be a dissertation about that "C", Byrne got in his English class while attending Stanford?

Jeff Matthews said...

You two still have nothing in your hand...only now that OSTK is off the SHO list you can't bluff with the Naked Short Conspiracy card.

Keep up the amateur play, and next stop'll be the Loser's Lounge for both of you.

mfairview said...
This comment has been removed by a blog administrator.
mfairview said...

Quick!!!! Jeff. There's someone on EBAY selling a Jesus Rocking chair:

Hurry and write a slamming expose on EBAY before the NY Times gets to it. Thank me later! Oh wait, you're probably not short EBAY...

mfairview said...

Yup, looks like Jeff is short OSTK. Now who was it that said he's probably under some contractual agreement not to disclose his position? Gotta love the "ace financial columnist Herb Greenberg" line... You guys are so incestuous, it makes Deliverance look like a Disney film...


From another blog on the net...

Paranoia, The Destroyer
2/02/05 10:00 AM EST
Bearish OSTK

When companies spend time bashing shorts, it's usually worth wondering what they're worried about.
As Hamlet's mother, Queen Gertrude, might have said, "The Doctor doth protest too much, methinks."

It's been a busy earnings season and I've only just now heard out the entire replay of the Overstock (OSTK) earnings call from last week. (Overstock's CEO, Dr. Patrick Byrne is something of both a control freak and an erudite, so he likes to take a long time, and use big words, to answer simple questions. Hence, the conference calls contain a great deal of what my teenage daughter would term "overshare." And not particularly relevant "oversharing" at that.) In any event, Overstock's call is one for the ages, and I urge all to listen to a replay or read the transcript, to the bitter end. And it is quite a bitter end. Doctor Byrne, whose lot in life is that he is the son of a famously A+ insurance executive, Jack Byrne (one of Warren Buffett's faves), does not spend as much time as usual hectoring the short-sellers who seem to get under his skin (despite the fact that his stock has tripled in the last year), although he does get in the usual zings about ace financial columnist Herb Greenberg and other journalists whose main fault appears to be that they do not believe the Overstock story. Instead, a caller named Bob O'Brien hijacks the Q&A, with Dr. Bryne politely listening, and describes a massive conspiracy against Overstock and other small companies by short-sellers led, in this case by David Rocker of Rocker Partners. "I know this probably sounds a lot like the X-Files," Mr. O'Brien says, before launching into an X-Filian conspiracy theory that concludes that these companies "have been gang raped by mountain men... " [i.e. Rocker]. Well, I worked at Rocker Partners from 1989 to early 1994 before starting my own long/short fund, and I know the amount of research he and Marc Cohodes have done on frauds such as Lernout & Hauspie. I also know Herb Greenberg and some of the terrific work he has done on frauds like Media Vision. And it is my experience that any time a CEO spends as much time as Doctor Byrne attacking short-sellers, rather than simply running a really good business ... then it is usually -- not always, but usually -- the short-sellers who are on the right track, not company-defending "X-Files" type conspiracy theorists such as Bob O'Brien. As a result of the Overstock conference call, I am moving OSTK to the front of the line in potential short sale candidates I am monitoring, and have bought puts in case things unravel more quickly than I suspect at the moment. As Ray Davies of the Kinks sang a long time ago, "Paranoia is a great destroyer." In fact, it's a trait I like to see in potential short candidates. And there was paranoia galore on that Overstock call. OSTK puts

Jeff Matthews said...

Hmmm. The point being, what exactly?

That CEO Patrick Byrne let a paranoid know-nothing on his conference call, pretended not to know the paranoid know-nothing, and let this paranoid know-nothing hijack the call with paranoid ravings about about an SHO short list that, subsequently, proved 100% wrong when OSTK went off the SHO short list, as anybody would have expected if they had read this blog with an open mind?

Is that the problem? That you two have been dead wrong about the Naked Short Conspiracy against Overstock?

Or is the problem that the man whose word you take at face value is the same CEO who misled his investors on a conference call--not something the regulators like to see--by pretending not to know the paranoid know-nothing on the conference call when in fact they each had spoken and were indeed quite known to one another, months before?

Is that the problem?

Oh, wait--I see now. Your problem is that people who disagree with your assessment of Patrick Byrne happen to know one another.

Okay, I get it.

As far as I can tell, however, the only difference here is that I acknowledged it and publicly disclosed the fact that we know each other right up front--as you kindly showed by reprinting my Street Insight post.

Unlike Patrick Byrne, who did not acknowledge or publicly disclose it at the time. And not for nothing, but he's the one who runs a public company.

Since you and the paranoid know-nothing were completely wrong about the SHO thing being as issue with OSTK, you might ask yourself if you're right about Patrick Byrne.

Jeff Matthews
I Am Not Making This Up

bob obrien said...

Let me see if I can help out here, make some peace and clear the air.

1) Dr. Byrne and I hardly "knew" one another before the call. That is not true. To this day he does not know my real name.

2) A handful of Canadian companies and OSTK all dropped off the list last Monday, without experiencing any surge in volume or price. The odds of all of them doing so the same day, and all but OSTK being from Canada, are astronomical. The likely explanation is that one of the big houses that held those fails figured out a way to move them ex-clearing, taking the fails in-house, so to speak.

3) It's amusing to me that since I arrived on the scene the DTCC and the SEC are tripping over themselves to assure the public that their refusal to divulge any information and to have all the past fails grandfathered is innocent. The more they say, the more obvious it is that the system is rotten. Witness the latest from the SEC's website, replete with such gems as admitting there is a large fails problem, and that the reason they grandfathered was to avoid creating damage to the lawbreakers, and that further the reason they don't publish the level of the fails is to avoid inconveniencing the lawbreakers by revealing their illegal trading strategies (read systematic use of fraud to damage companies.)

With defenses like that, I hardly have to work at it. They are their own worst enemies if they lack the basic self-awareness to understand the damage that statements like that do to their credibility. Check out my deconstruction of it at the news page.

I couldn't make it up.


mfairview said...

Jeff you're sounding pretty defensive. I'll give you credit for blogging where there's interactivity unlike your other "ace" friend Herb. Talk about drive-by journalism (and I use the term "journalism" very loosely with his work).

You guys are patsies (though in your case you have money on the table) with the articles you write-- which is "my point" as you so bluntly asked. Your last several articles on OSTK really have been quite truly pathetic:

1) What happened to the 38 diamonds (three articles alone on this one)? -- hm, perhaps they sold them?

2) Why isn't Byrnes charging retail for WorldStock items? Is he ripping off artisans? -- hm, perhaps they wouldn't sell as well at retail?

3) Why do they allow people to post dumb auction items? -- hm, this one is really too stupid to even postulate, even a sarcastic answer, on.

Blog after blog of inane no nothing comments that does nothing but blind bash the company. You're short, Rocker's short, and I wouldn't be surprised if Herbert was short on OSTK. You guys all know each other, and quite intimately I might add, and you continue to write imbecelic articles on the company. Something smells rotten in Auckland.

Re: Naked Shorting. We can definitely step back into this one if you want though I haven't said much on it for weeks now. It looks like, where something didn't exist or at best a "non-issue" before, is suddenly coming to a head. Good luck on all that and let's hope your name doesn't end up on the short list of perps. But let me know if you want to reopen this can of worms since there's a lot more data to be interpretted and a lot more coming it seems.

bob obrien said...


Why, that's shocking. Do you mean to tell me that the guy that is the biggest individual investor in the horribly failing TSCM, and yet who only met its founder once in the grocery store, which rag did with unerring and unfailing vigor trash whatever said same investor/short (until such time as it became the laughing stock of the industry and an obvious propaganda machine), has set up a network of blogging quislings to replace his mouthpiece "news" rag?

Why, that's just shockingly unexpected. You must be paranoid, or delusional, or whatever else Jeff calls people that understand that he is in fact just making things up.

Where do you get notions like that? I mean, it is pure coincidence that the network of negative commentators who are known associates of this group regularly bash his targets for hard hitting reasons like they dislike the color of the CEO's shirts or the fact that some CEO's don't respond to unrequited love letters promptly enough.

How dare you.

Why, you make it sound as though there could be an organized, racketeering-like coordinated effort among collusive, conspiring entities to manipulate the price of targeted stocks via smear campaigns, class action suits, blog bashes, message board clogging, naked short selling, related party trading, misappropriation, libel, etc.

That's crazy talk. That would never happen on the ugly side of Wall Street.

AGain - How dare you. You should be ashamed of yourself. I think the Elgindy and Rhino cases more than amply demonstrate that hedge funds and especially short biased ones that use the communications channels to denigrate their targets are actually fluffy soft furry creatures that help children across chocolate rivers in candy-land, and not the raptor-like, venomous, parasitic predators you would imagine.

You have it all wrong.

I'm glad I could step in and help clear things up.

And remember, if you are a company that has lost more than 50% of its market cap due to illegal naked shorting, do not, under any circumstances, fight back or atttempt an sort of meaningful countermeasures. That is bad. Bad bad bad.

Thank you for your time.

mfairview said...

Since you brough it up Jeff.. Here's a nice FAQ from the SEC on the non-existent Naked Shorting... These are the people that are assigned to protect you folks.

F. Grandfathering Under Regulation SHO

The requirement to close-out fail to deliver positions in threshold securities that remain for 13 consecutive settlement days does not apply to positions that were established prior to the security becoming a threshold security. This is known as "grandfathering." For example, open fail positions in securities that existed prior to the effective date of Regulation SHO on January 3, 2005 are not required to be closed out under Regulation SHO.

The grandfathering provisions of Regulation SHO were adopted because the Commission was concerned about creating volatility where there were large pre-existing open positions. The Commission will continue to monitor whether grandfathered open fail positions are being cleaned up under existing delivery and settlement guidelines or whether further action is warranted.

********* Oh BOO HOO!

It is important to note that the "grandfathering" clause of the Regulation does not affect the Commission's ability to prosecute violations of law that may involve such securities or violations that may have occurred before the adoption of Regulation SHO or that occurred before the security became a threshold security.

7. Does grandfathering permit illegal activity to go unaddressed?

Regulation SHO does not require close-outs of "grandfathered" fails. As noted above, "grandfathered" status applies where the fail position was established prior to the security becoming a threshold security. However, any new fails in a security on the threshold list are subject to the mandatory close-out provisions.

Any grandfathered position that resulted from illegal activity, such as manipulation, continues to be fully subject to redress by the Commission.34 The Commission will continue to monitor whether grandfathered open fail positions are being cleaned up under existing delivery and settlement guidelines or whether further action is warranted.

********* Wouldn't it scare them more if they just snuck up on the Naked Shorter and said BOO!

11. Can I obtain fails information?

Currently, threshold lists include the name and ticker symbol of securities that meet the threshold level on a particular settlement date. Some investors have requested that the SROs provide more detailed information for each threshold security, including the total number of fails, the total short interest position, the name of the broker-dealer firm responsible for the fails, and the names of the customers of responsible brokers and dealers responsible for the short sales. The fails statistics of individual firms and customers is proprietary information and may reflect firms' trading strategies. The release of this information could be used to engage in unlawful upward manipulation of the price of the securities in order to "squeeze" the firms improperly.

******* So it's OK to illegally short something to death but we certainly don't want to cause a "squeeze" because of it.

Jeff Matthews said...

"X-Files" is going out on a limb claiming he and Byrne didn't know each other before the January call.

On 2/15/05, Byrne himself wrote: "Obrien called me for the first time shortly after the October conference call. He talked about all of this..."

You guys knew each other--you, "X-Files" and Byrne, when Byrne pretended not to know you on the call.

You're going out on a very very slender branch there, "X-Files."

You better be careful not to make it up.

bob obrien said...

So, if I contact you and tell you that you are full of it, would it be fair to say that I know you?

Have you ever wondered aloud how many people might contact a visible, accessible CEO in any given day, much less any given month?

Does it strain your ability to cogitate to consider that the good doctor was not so transfixed by my every notion and syllable as to ad me to his rolodex and invite me over for dinner?

I suppose if one inhabits a world where everyone lies, one expects to find liars in every one he meets.

Nice place you got here.

Jeff Matthews said...

"X-Files" told him about the German listings, you told him about the press--in short, you told Patrick Byrne everything he pretended not to know on the January 28th call.

Only you told him before the call, and you and Byrne orchestrated your little rant on the call itself, with Byrne prodding you along.

Am I right?

Come on, be honest here. Don't say "the name is not familiar." You can't make it up on this site, even if you can on a conference call.

bob obrien said...

Actually Jeff, to change the subject for a second, let's talk about how your attempts to make up facts about naked short selling have been going. Trying to color me as a kook, and the whole thing as a tempest in a teacup. I know it's your gig, but still, there's no finesse to the effort, and frankly it's a bit embarrassing, not up to snuff, if you know what I mean.

Did you see the Robert Shapiro letter to Mr. Thompson at the DTCC? Where he basically says that your take on the topic is a big fat pack of lies? No?

Here it is, for your perusal. Perhaps you can then write a rebuttal, given how well informed and smart you clearly are on the topic. Or as I suspect, you will either delete this or ignore it. Because it blows your entire line of hokum out of the water, bigtime. And leaves you looking like an idiot, who, well, for lack of a better term, is just making this up.

Let's see how you do with the former Clinton Undersecretary of Commerce - this I can't wait to see.

April 13, 2005

Jill M. Considine
Chairman and Chief Executive Officer
The Depository Trust & Clearing Corporation
55 Water Street
New York, New York 10041-0099

cc: Stuart Z. Goldstein, Managing Director, Corporate Communications
Larry Thompson, Managing Director and Deputy General Counsel

Dear Ms. Considine:

I am Robert J. Shapiro, chairman of Sonecon LLC, a private economic advisory firm in Washington, D.C. I served as U.S. Under Secretary of Commerce for Economic Affairs from 1998 to 2001, Vice President and co-founder of the Progressive Policy Institute from 1989 to 1998, and principal economic advisor to Governor William J. Clinton in the 1991-1992 presidential campaign. I hold a Ph.D. from Harvard University and have been a Fellow of the National Bureau of Economic Research, Harvard University, and the Brookings Institution. I currently provide economic analysis to the law firms of O’Quinn, Laminack and Pirtle, Christian, Smith and Jewell, and Heard, Robins, Cloud, Lubel and Greenwood, on issues associated with naked short sales, including matters raised in an interview published by @DTCC with DTCC deputy general counsel Larry Thompson. Certain comments by Mr. Thompson in that interview were inaccurate or misleading, and I request that you allow me to correct the record by publishing this response.

Mr. Thompson begins by asserting that “the extent to which [naked short selling] occurs is in dispute.” While this statement may be narrowly correct, objective academic analysis has established that naked short selling has been a widespread practice and one which, when allowed to persist, can pose a threat to the integrity of equity markets. A recent study by Dr. Leslie Boni, then a visiting financial economist at the SEC, analyzed NSCC data and found that on three random days, an average of more than 700 listed stocks had failures-to-deliver of 60 million-to-120 million shares sold short – naked shorts – that had persisted for at least two months. In addition, over 800 unlisted stocks on any day had fails of 120 million-to-180 million shares sold short that also had persisted for at least two months. The total number of naked shorts, including those that had persisted for less than two months, was presumably considerably greater.

Regarding the extent of naked shorts, Mr. Thompson has provided closely-related additional information: “fails to deliver and receive amount to about $6 billion daily…including both new fails and aged fails.” Mr. Thompson minimizes this total by comparing it to “just under $400 billion in trades (emphasis added) processed daily by NSCC, or about 1.5% of the dollar volume.” By most people’s standards, a problem involving hundreds of millions of shares valued at $6 billion every day is a very large problem. Moreover, the $6 billion total substantially underestimates the actual value of all failed-to-deliver trades measured when the trades actually occurred. Most of the $6 billion total represents uncovered or naked short sales, many of which have gone undelivered for weeks or months with their market price being marked-to-market every day. As a stock’s price falls, the market price of naked shorts in that stock also declines, reducing the total value of the outstanding failures-to-deliver cited by Mr. Thompson.

In other respects, Mr. Thompson’s comparison to the “$400 billion in trades processed daily by NSCC” seems disingenuous and misleading, because that $400 billion total covers not only U.S. equity trades which can involve most of the failures-to-deliver at issue, but many other transactions also processed by the NSCC. The value of all equity transactions on U.S. markets in 2004, for example, averaged $82.3 billion/day. If Mr. Thompson is correct that the daily value of fails-to-deliver averages $6 billion, that total is equivalent to 7.2 percent of average daily equity trades or nearly five times the 1.5 percent level suggested by Mr. Thompson. Furthermore, the DTCC reports on its website that on a peak day, “through its Continuous Net Settlement (CNS) system, NSCC eliminated the need to settle 96 percent of total obligations.” Assuming that CNS nets out the same proportion of trades on other days, $384 billion of the $400 billion in daily trades cited by Mr. Thompson are netted out, leaving only $16 billion in daily trades that require the actual delivery of securities. The $6 billion of fails-to-deliver securities existing on any day are equivalent to 37.5 percent of the average daily trades that require the delivery of securities, or 25 times the 1.5 percent level cited by Mr. Thompson.

Mr. Thompson tries to explain the large numbers of shares that go undelivered – in most cases arising from naked short sales -- by citing problems with paper certificates, inevitable human error, and the legitimate operations of market makers. This also seems misleading or disingenuous. Regarding problems with paper certificates, the DTCC estimates that 97 percent of all stock certificates are now kept in electronic form. Nor can human error or legitimate market-making operations explain the high levels of failures-to-deliver that persist for months – on any day, an average of 180 million-to-300 million shares have gone undelivered for two months or longer – as documented by Dr. Boni’s analysis of NSCC data.

Mr. Thompson also disparages the attorneys who represent companies that have been damaged or destroyed by massive naked short sales, and their shareholders, by claiming falsely that the cases in this matter have almost all been dismissed or withdrawn. The legal firms that I advise -- O’Quinn, Petrie and Laminack; Christian, Smith and Jewell; and Heard, Robins, Cloud, Lubel and Greenwood – have not lost any motions against the DTCC or its affiliates and currently have one case against the DTCC pending in Nevada and another case against the DTCC pending in Arkansas. In addition, on February 24, 2005, these attorneys were granted an order by the New York Supreme Court ordering the DTCC to produce trading records involving two companies they represent, including records from the Stock Borrow program, which may establish whether large-scale naked short sales were used to manipulate and drive down the stock price of those two companies.

Mr. Thompson also asserts that the plaintiffs suing the DTCC for damages associated with the handling of naked short sales rely on “theories [that] are not an accurate reflection of how the capital market system actually works.” This assertion is inaccurate. There is no dispute about how the capital markets work -- nor any doubt that naked short sales have been used to manipulate and drive down the price of stocks, as seen in numerous death-spiral financing cases. The issue here is the DTCC’s role in allowing or facilitating such stock manipulation through its treatment of extended naked short sales.

In explaining the DTCC’s role in these matters, Mr. Thompson rejects the claim that the NSCC’s Stock Borrow program allows the same shares to be lent over and over again, potentially creating more shares than actually exist or “phantom” shares. By Mr. Thompson’s own account, shares borrowed by the NSCC to settle naked short sales are deducted from the lending member’s DTC account and credited to the DTC account of the member to whom the shares have been sold. Therefore, those same shares become available to be re-borrowed to settle another naked short sale and, if that happens, to be re-borrowed again and again to settle a succession of naked short sales. Throughout this process, the actual short sellers may continue to fail-to-deliver the shares to cover their shorts and, as Dr. Boni’s analysis of NSCC data found, the underlying failure can age for months or even years. The process which Mr. Thompson describes is one in which shares can be borrowed and lent over and over again, introducing more shares into the market than are legally registered and issued. If any ambiguity remains, Mr. Thompson can clarify it by responding to the following query: Once a share that has been borrowed through the NSCC Stock Borrow program is delivered to the purchaser, is that share restricted in any way so it cannot be lent again?

It is important to note that the Stock Borrow program is used when continuous net settlement cannot locate the shares to settle. As a consequence, Stock Borrow is usually called into play when there are relatively few shares available for borrowing. These are propitious conditions for market manipulation: Unscrupulous short sellers undertake large-scale naked short sales involving stocks for which few shares are available for trading and lending, relying on the Stock Borrow program to borrow the limited available shares, again and again, at sufficient levels to drive down the market price of the shares.
Mr. Thompson notes that of approximately $6 billion in outstanding failures-to-deliver existing on any day, “the Stock Borrow program is able to resolve about $1.1 billion … or about 20% [18 percent] of the total fail obligation.” In this statement, Mr. Thompson raises very serious questions about the integrity and operations of the NSCC and DTCC, which he can clarify by responding to the following queries: If the Stock Borrow program “resolves” only 18 percent of total fails, what is the disposition of the remaining 82 percent of outstanding fails? When failures-to-deliver occur that are not resolved through Stock Borrow, does the NSCC credit the undelivered shares to the member representing the buyer, creating genuine “phantom shares”? Finally, how many shares do the borrowing brokers, clearing firms and other participants in the Stock Borrow program owe the NSCC on a typical day, and what is their total value?

In a related matter, Mr. Thompson tries to distance the DTCC from charges that shares held in restricted accounts – for example, cash accounts, retirement accounts and many institutional accounts – are improperly lent through the Stock Borrow program by claiming that responsibility for segregating restricted shares from lendable shares falls to the “broker and bank members” of the DTCC, while responsibility for monitoring or regulating their performance in this matter falls to the stock exchanges and the SEC. As a trust company, the DTCC cannot hold that it has no role, duty or responsibility to ensure the probity of its operations. Mr. Thompson could address this issue by responding to the following queries: What procedures does the NSCC have to ensure that shares held in members’ accounts for possible loan through the NSCC Stock Borrow program are unencumbered by regulatory or legal restrictions from being pledged or assigned and eligible to be borrowed? On any given day, how many participants in the Stock Borrow program have lent shares that exceed their lendable shares, in what numbers and of what value?

Mr. Thompson also tries to distance the DTCC as far as possible from the naked short selling that generates most of the extended failures-to-deliver: “We don’t have any power or legal authority to regulate or stop short selling, naked or otherwise. We also have no power to force member firms to close out or resolve fails to deliver … we don’t even see whether a sale is short or not.”

In fact, the DTCC chooses to not distinguish short sales from long sales, chooses to not regulate or stop extended naked short sales, and chooses to not force member firms to resolve protracted naked short sales.

First, Regulation SHO requires that all transactions be clearly marked short or long. If the DTCC and NSCC do not know whether sales are short or long as Mr. Thompson contends, they choose to not know. Second, the NSCC has a clear responsibility and adequate means to stop naked short sales of extended duration, with no legal barrier that would prevent them from so doing. As a trust company with an acknowledged duty to provide investors certainty in the settlement and clearance of equity transactions, the DTCC chose to carry out that duty by assuming the role of counterparty to both sides of every equity transaction, through the operations of the NSCC’s CNS system and the Stock Borrow program. By allowing short sellers to fail-to-deliver shares for months or even years, the NSCC clearly fails to provide certainty in settlement to the buyers, sellers and issuers of securities. Since it is widely known that extended naked short sales have been used to manipulate stock prices in cases of death-spiral financing, and the NSCC created the Stock Borrow program to address failures-to-deliver that prominently include naked short sales, the NSCC and DTCC share a responsibility with the SEC and the stock exchanges to protect investors by resolving extended fails.

Third, the DTCC and NSCC have the clear capacity to force member firms to resolve the extended failures-to-deliver of their customers by purchasing shares on the open market and deducting the cost from the member’s account. A 2003 study by Dr. Richard Evans and others provides evidence that forced buy-ins by any party occur very rarely. They found that a major options market maker who failed to deliver all or a portion of shares sold in 69,063 transactions in 1998-1999 was bought-in only 86 times or barely one-tenth of 1 percent of the fails. Mr. Thompson can clarify investors’ understanding of their operations by responding to the following query: What proportion of shares that are persistent fails-to-deliver, of one month or longer, are ever bought in?

Mr. Thompson acknowledges that the DTCC and NSCC know precisely how many failures-to-deliver exist for each stock and the precise duration of each of these fails. Yet, the DTCC refuses to disclose this information even to the issuer of the stock in question, which Mr. Thompson justifies by citing “NSCC rules” prohibiting such a release of data based on “the obvious reason that the trading data we receive could be used to manipulate the market, as well as reveal trading patterns of individual firms.”

This response is both disingenuous and revealing. We know now, for the first time, that the DTCC has full knowledge of the extent of protracted, large-scale naked short sales in all particular cases. We also know now that the DTCC has had this information for at least a decade, since Mr. Thompson also notes that “fails, as a percentage of total trading, hasn’t changed in the last 10 years.” Yet, based on the DTCC’s own rules, it allowed these abuses to persist and fester. The DTCC and NSCC can change their rules at any time. Moreover, in this case, those rules are unjustified. Data documenting outstanding short sales in each stock are currently issued publicly, so further data on how many of those short sales are naked would not reveal additional information about the trading patterns of individual firms or in any way empower manipulators. In fact, the DTCC could substantially disarm manipulators by both publicly reporting naked short sales in each issue and pledging to force buy-ins of all naked short sales that persist for more than a limited period.

Surely, if large-scale, extended naked short sales have effectively created “phantom” shares, companies have a responsibility to their shareholders and the right to secure this information from the organization which manages the settlement of short sales. At a minimum, the DTCC should respond to requests by issuers for data on extended failures-to-deliver in their own stocks, both in the past and currently, so they can take steps to resist stock manipulators or bring them to account for past manipulation.

Mr. Thompson also claims that the DTCC did not create or manage the Stock Borrow program to serve its own financial interest, insisting that the service generates less than $2 million a year in direct fees to the DTCC and that all DTCC services are priced on a “not for profit” basis that seeks to match revenues with expenses. Without further information, these responses beg the question of whose private financial interest has been served by the Stock Borrow program, especially as the DTCC is owned by the stock markets, clearinghouses, brokerage and banking institutions that use its services. Mr. Thompson and the DTCC can clarify this serious matter by responding to the following queries: Do DTCC participant/owners receive interest or other payments through or from the Stock Borrow program for lending the shares of their customers and, if so, how much have they received for these activities over the last 10 years? Further, do DTCC participant/owners receive any dividend, interest or other payments or distributions from the DTCC or its subsidiaries?

I appreciate the opportunity to address the important issues raised by Mr. Thompson, and I look forward to your response to this request to publish these comments.


Robert J. Shapiro

KensingtonPartners said...

I wish everybody would refer to Byrne as Dr. Byrne. He has a doctorate degree in case you didn't know!

Jeff Matthews said...

You're absolutely correct: "Doctor" Byrne it will be from now on.

My apologies. It's just that I know of no other CEO of any public company who seems to need people to remember he got a PhD from Stanford, but so be it.

Also, I notice "Bob O'Brien" keeps posting here, despite the fact that his posts appear to have disappeared from Yahoo message boards.

[He used the alias "DirtyDeeds" on Yahoo, while he uses "Bob O'Brien" here and on his own blog, as well as on company conference calls.]

Apparently, the folks at Yahoo did not appreciate "Bob O'Brien" putting personal information about other people on message boards, particularly information about wives and children.

That's right: not content to argue with facts, since he has none, "Bob O'Brien" resorted to the lowest of the low tactics--bringing wives and children into the picture.

Which makes him as low as they come--as I have suspected all along, given the near-total lack of any factual basis for his "Naked Short" crusade when it comes to the actual workings behind heavily shorted stocks such as

The Yahoo folks figured that out--and you have to be pretty low to get deleted from Yahoo.

Makes you wonder why "Doctor" Byrne paid any attention to the low-living "Bob O'Brien"...and what that says about "Doctor" Byrne's own bearing on reality.