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Patrick M. Byrne, Ph.D.

Chairman and CEO of Overstock.com

"The Dark Side of the Looking Glass: The Corruption of Our Capital Markets"

Transcription of Audio Interview, March 31, 2007


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JIM: In the past few weeks, several high profile Wall Street firms have been fined by the SEC. One firm was fined for failure to maintain a wall between its research department and its sell-side brokers; another firm was fined for allowing one of its clients to make illegal naked-short sales. Corruptions and scandals are resurfacing again. Is this the tip of an iceberg, or just a series of isolated instances?

Joining me on the program this week is Patrick Byrne, he’s Chairman and CEO of Overstock.com, and also the author of the Dark Side of the Looking Glass: The Corruption of Our Capital Markets.

Patrick, just to set the stage for our listeners, I thought we might begin with how shares are settled and transacted on Wall Street. Let’s say that, for example, I own 100 shares of IBM, and today I want to sell those 100 shares to you. Why don’t you take our listeners through how this transaction plays out.

PATRICK BYRNE: Sure. And thank you Jim for having me on your show. Well, at the highest level of abstraction what’s happening is if I’m buying those shares from you, I of course have to deliver you cash, and you have to deliver me the stock. And the stock you have to deliver doesn’t have to be in paper form � a lot of stock has been dematerialized, it’s just electrons. It’s just like when I pay you money for the stock it’s not actual cash, other electrons are moving around the system. Well, that is all called settlement. The exchange of stock for money is settlement. Now, in reality, rarely are we going to operate by your going to find me, and making this deal on a street corner. How it works is you have your broker and I have my broker, and we’re each calling. I’m calling my broker and saying I’m willing to buy it at this price; and you’re calling your broker � well, you are a broker-dealer so you would be offering it at that price.

And the brokers are meeting in the market place. And now the brokers themselves are connected in a hub-and-spoke system around a central clearing and settlement organization. And it’s kind of the backroom of Wall Street. It’s called the DTCC. It’s kind of a mysterious corporation. It stands for the Depository Trust and Clearing Corporation. And what that is it’s the hub; all the brokers are the spokes. And then, as these transactions occur, my money is sent from my broker � to really simplify it � through the central hub and out to your broker; and your stock is sent from your broker through the central hub and out to my broker. That, at least in an abstract level, is how the system originally works. Now, there’s all kinds of loopholes and sidebars to that, but that’s the basic idea. [3:22]

JIM: Now, let’s assume that, for example, I’m selling these 100 shares for IBM for one of my clients, and my client has the certificates, but they can’t get to their safety-deposit box. So three days later settlement is supposed to take place, and we don’t have the shares. Explain what that means and what happens then.

PATRICK: Well, in a variety of places in the system this can occur, but let’s just say for now it’s occurring at that central hub, the DTCC. What is created is basically like a marker for those shares. It’s just like in a casino when you owe them some money you have a marker � they have your marker. An IOU is created and it’s called an FTD or a Failure to Deliver. And it’s just an IOU that is created � your broker [owes] to the DTCC that many shares. Now, me out on the receiving end, I don’t know my shares never came through the system unless I call my broker and ask. And generally, I’ve discovered they’re not even honest about that. You really have to demand proof, and then you discover that, “oh, your shares never actually came through the system.� And all I’ve got in my account is effectively is an IOU from you. And in fact, it’s really a string of IOUs: you’ve now got an IOU to your broker; your broker has one to the DTCC. But basically an IOU is created. The term they use for that IOU is an FTD (Failure to Deliver), and it’s important to remember it’s an IOU for stock, not for money. [4:59]

JIM: Let’s take this to another level. Now, let’s say I’m Harry Hedgefund, and I think the stock market is going down. So let’s take IBM stock. I think technology stocks are vulnerable so what I’m going to do is I’m going to short IBM’s stock, and I’m going to go out and short 100 shares of stock. Now explain the different parties involved and what happens under this transaction.

PATRICK: Well, if you’re Harry Hedgefund and you’re going to short IBM, what you want to do � wherever it’s trading � is you want to go out and you want to borrow 100 shares now; and to do that you have to get something called a locate. Your broker dealer locates some of that stock to borrow; he loans it to you; and now you sell into the market. And your idea is you’re going to sell it out into the market and after a month, six months, or a year when it has dropped, you’ll go out into the market and buy it at a cheaper price and effectively, give it back to the person you borrowed the stock from; and you’ve captured the difference. You’ve captured how much the stock has declined. So you’re betting against the company. [6:09]

JIM: Well, let’s say IBM is trading at $94 today, so I think IBM is going to $80 a share. So I call a broker, I borrow the 100 shares of IBM and I sell it to you, Patrick, for $94. This is perfectly legal.

PATRICK: Oh yes. It’s actually good. It adds information to the marketplace. You have an opinion � you had to pay a cost to borrow that stock and it adds information that is your point of view into the market place. And so it’s actually quite valuable.

JIM: Ok. So let’s say IBM goes down to $80. Now, I sold it to you for $94. So now what I would have to do is go back into the market to buy 100 shares of IBM at $80, and then I would have to give those shares to the broker that I borrowed them from, and the transaction is made whole.

PATRICK: That is correct. And you would have captured the decline of $14 a share; and on the 100 shares you would have made $1400. So in the first trade, when you first borrowed them and then sold them for 94, you would have collected $9400. And now, to buy them back, if it’s at $80, it only takes $8000. So after you do all this work you’re left with a $1400 gain. Now, you’ll have had some commissions and maybe had to pay a fee to rent the stock that you borrowed, so it won’t be pure profit � but that’s the basic economics. [7:33]

JIM: Now, we do know because of the high volume of shares that are traded everyday where several billion shares are traded there’s going to be some mess ups. Just even two or three weeks ago, when the markets were down almost 500 points, there were settlement problems because the system got jammed. So these kinds of things occur. And failure to deliver � that happens, it’s just part of the market.

Now let’s suppose, we’re going back to Harry Hedgefund. And Harry Hedgefund has got a hedge fund it’s in the Bahamas or someplace � Panama. And he decides that look, there are a lot of stocks out there that are not as liquid � especially in biotech, new start-up companies, and especially in the mining business � so I don’t want to borrow the shares. I’m thinking of a way to scam the system. And explain for our listeners what a naked short sale is; what it involves, and how people are able to get away with this.

PATRICK: Okay. And I would also add to that list of companies � in general, companies that are difficult for the market to understand, or companies about which it is possible to create some misdirection or confusion. So often, finance companies are likely targets. Typically you can’t do this to a large cap, or mid cap, but if you have a smaller-cap financial company � and by its nature a financial company always has to make estimates and things, you can always call into question that; or a biotech company, call in to question its progress on drugs and such.

So, how do they do it? What they do is they have a friendly broker to whom they say, “Okay, I’d like to sell 10,000 shares of stock in this company, XYZ, and don’t worry I have a locate on it. I have already borrowed it.� And now technically, all they need to have is a good faith belief that they found a place where they will be able to borrow that stock in 3 days. So I believe there’s a lot of nudging and winking going on, and the broker-dealer might say, “Okay, great. We’ll sell it for you.� I think also what really happens � and hedge funds are starting to point fingers at the brokers � is the hedge fund calls the broker and says, “I want to short a million shares of this company.� And the broker-dealer says, “I can’t find you a million shares to borrow.� And the hedge fund says, “Look, you find me a million shares or I’ll start doing business with a broker-dealer who can.� And the prime broker looks at that, you know, $5 million a month in trading commissions he gets out of that hedge fund or whatever it is, and he looks real hard and again he suddenly “finds� the shares that the guy wants to borrow, and then shorts them into the market. So of course, those don’t deliver in a few days.

By the way, maybe that prime broker has a million shares in the box � so to speak, it has a million shares in its inventory that it could loan out � but it’s got four different hedge funds who all want to borrow a million shares to short. And so they over locate � they tell each one, “yes, yes, we’ve got you that million shares you needed.� So maybe they’ll loan it out three, or four, or who knows how many times over. So, Harry Hedgefund does that. The prime broker who, again, is nudging and winking, he sells and he creates FTDs. Now, there are some theories that the FTDs that some of these are occurring out at the prime brokers. There all kinds of more technical things to get into about netting positions and stuff, but basically somewhere in the system when you do that, there has to be the creation of an IOU. Now, the IOUs have all these different kinds of names. One is FTD but there are other names, and it seems as if some folks are playing some semantic tricks to try to avoid disclosing where these are.

So, now, there are a failure to deliver for however many shares are created in the system. Your question: how do they get away with it? Well, it’s hard to say who has the dirty hands in that case. Is it the hedge fund? The hedge fund is going to throw up its hands and say, “hey, I didn’t do anything wrong, my broker-dealer said they had a million shares for me; that they had located me a million shares.� Well, yeah, and the prime broker is going to say, “but this guy said if we don’t find that form he’s going to take his business elsewhere.� I can tell you that when prime brokers go to hedge funds to sell their services, they may as well just have two slides. I’ve come from the financial world and I don’t want to say where I’ve seen this but they basically have one thing to sell on. The first slide should be the name of the prime broker, and the second slide should be their stock-loan business. It’s the only thing that they have to differentiate themselves at this point. And it’s what they sell when they go to hedge funds and try to win business. It’s what they sell on which is their ability to locate stock for you. “We’ll be able to find you stock.� Where �find’ may very well mean we’re taking the same stock and loaning it to five different people. [12:46]

JIM: And could it be also, Patrick, that brokerage firms aren’t allowed to loan out shares unless they’re in like a margin account. But let’s suppose that the very stock that these hedge funds want to short just happens to be owned in the long account. Could they be saying to themselves, “Well, we really don’t have these shares to loan as much as we do in a margin account, but we do have some of these shares held in the long account held by some of our customers.�

PATRICK: It could be that. And then they say, if they’re ever caught doing it: “Oh, we made a little clerical error;� or “we forgot that was in a long account and not a margin account. We shouldn’t have loaned it.� And then they pay a little fine, a de minimis fine, and they go on about their day. And they all pretty much know at this point that a) they’ll rarely, rarely get caught and b) if they do, there’s just a tiny fine to pay. And it was just an innocent error they say. [13:39]

JIM: So what you have here, also, from the brokerage firm, not only are they getting commission revenues but let’s say in reality they only have one million shares that they can loan out to Harry Hedgefund. The problem is they’ve got four hedge funds that want to borrow the shares, so in reality, they are loaning out 4 million shares when only one million shares exist. But from a brokerage point of view they’re making commissions on 4 million shares � so it’s a great business.

PATRICK: They’re making not only the trading commissions, but they’re making the negative rebate. They’re charging that hedge fund some interest rate for this stock that they borrowed, that in this case they’d be charging it to four different guys, four different hedge funds. In fact, there’s really some evidence that this is the last great business on Wall Street. You know, the transactional business�what is Goldman charging its clients? A half-cent a share in trading? I mean, that business is gone. The last I went through the numbers for Goldman � and they’re public and everything � and basically two-thirds of their profit is from its proprietary trading. It is a hedge fund � it’s a hedge fund with the name of bank on the door. Then one-third of the profits come from being an investment banking house. And of the third that comes from being an investment banking house, of course there’s some from M&A activity and IPOs and such, but it looks like primarily the prime brokerage business. Well, prime brokerage is just a fancy name for the stock loan business. I mean, prime brokerage is trading shares at half-a-cent commission, or whatever they charge now, and stock loan repo. So it’s the last really good business on Wall Street as an investment bank. And it’s especially good if you can sell the same thing, or rent the same thing, three or four times over. [15:34]

JIM: So, in reality here, you can have a situation � and like you said, for an IBM or a General Electric, it’s pretty hard to do that, but some of these smaller stocks (biotechnology, mining, companies in the technology area that may be difficult for them to understand)�Now, this has gotten the attention of quite a few people, and I wonder if you might take us through the DTCC which is the Depository Trust and Clearing Corporation that supposedly holds these shares in trust for all these firms. They had a reaction to this, and there have been a number of other individuals who have looked into it, and I wonder if you might take us through that story.

PATRICK: Sure. And I’d like to just comment for a moment on what you said with an IBM and such. There are two reasons why this stuff doesn’t work on an IBM or a Microsoft. One is it’s just hard to create doubt about a company like that. And secondly, it’s just the nature of the market that there are oceans of capital out there looking for any misprice. And if you tried to naked short Microsoft down, there’s trillions of dollars of capital that is going to step in and capture any misprice. But if you’re talking about a small cap company � certainly a micro-cap and small cap (it seems like they are working their way up the food chain) � that’s not true. There are not oceans of capital out there looking for opportunities in those areas. And it is possible with those kinds of companies to say this is a company doing drug research, and it’s not going to get approval. Basically, Jim Cramer laid it out a couple of months ago on TV that you call up � I forgot what names he used but basically some client journalists � and you plant stories with them and get them to publish it. And you can create a story about a company and that supports this kind of stuff. And when you do destroy it you can always say, well it was the fact that their drug wasn’t going to work; or that there was an SEC [U.S. Securities and Exchange Commission] investigation; or a bunch of lawsuits � and it wasn’t the naked shorting. [17:43]

JIM: I’m just thinking there’s another thing that we should cover with our clients. Okay. We talked about what takes place between, let’s say, I wanted to sell 100 shares of IBM to you today. Now, we have this settlement. Let’s talk about outside the DTCC system. Let’s say that Morgan has 100,000 shares of IBM that they owe Goldman Sachs, and Goldman Sachs on their side has 96,000 shares of IBM that they owe Morgan. So the net difference between the two is roughly only about four thousand shares. Explain the settlement between broker-dealers that takes place out side the DTCC system.

PATRICK: Well, first of all, there’s something [called] the CNS � the continuous net settlement system. It isn’t as though 100,000 shares move into the DTCC from one side and 96,000 from the other. In fact the two positions get netted out against each other, and so then it just says, okay, one side owes 4,000 shares. And so it gets netted out against each other. And they say, by the way, that 96% of the trades � they’ve acknowledged (they probably wish they hadn’t acknowledged this and we’ll come back to it) but the DTCC has said that the continuous net settlement system takes care of 96% of the trades, which is scary because they’ve also come out and said this is a $6 billion problem. Well, if it’s a $6 billion problem after you’ve used CNS to net out everything, then it really might be a much bigger problem.

There’s one thing that happens which is Morgan and Goldman might say if an FTD has been lingering on the books for a long time, is say let’s take it outside the DTCC � and that’s called ex-clearing. And it’s external to the DTCC. Then it becomes a private contract between Morgan and Goldman. And my understanding is that it is then viewed as a private contract � it’s basically outside the jurisdiction of the DTCC and SEC. It has taken on the nature of a private contract between two parties and it’s not clear if there is any oversight of that. That’s probably the Wild West. It’s not clear that there is any oversight of what is going on there, and how much is getting built up and so forth.

In addition, it turns out that some of this doesn’t even make it into the clearing and settlement system to begin with because if Goldman has one guy who is selling and another guy who is buying, and the guy who’s selling is failing to deliver, you know, could it be that they’re netting right out at Goldman � keeping the IOUs right out at Goldman and they never even show up into the deep levels of the system. In the continuous net settlement system there’s a stock borrow program which is another source of support of stock-to-loan, and on and on. Anyway, it looks like there are three or four or five different levels where stocks can be netted against each other, and where settlement takes place where IOUs can accumulate. Now, I can tell you that people from within the system tell me that’s absolutely what is going on. Officially, the DTCC will just not discuss any of this stuff. They won’t discuss it. But it could be that the numbers that are known are actually scary enough as they are but they could be a tiny fraction of the full amount of this scattered throughout the system. [21:21]

JIM: With the Freedom of Information Act (FOIA), a lot of this information, which the press doesn’t write about it, and which is not disclosed to the public, people now have access to this information. And tell us about some of the inquiries that were made with the DTCC, and also some of the problems that have been occurring at the SEC.

PATRICK: Whoa, big question. Well, first of all it was impossible to get any of this kind of information on failures from the SEC, the DTCC � anybody. But rumors were building up over four or five years that there was a lot more of this going on than anyone was owning up to. And there was actually an SEC economist named Leslie Boni who wrote about it, had an opportunity to study it, said that it is going on, it’s massive. And in particular, it’s deliberate because she studied the statistical distribution of the failures, and if it really was just inadvertent human error then you would have imagined them to be spread like peanut butter across a sandwich; but in fact it shows up as a statistical distribution which shows that it’s very conscious, and that’s because it’s very focused in certain areas.

Well, what the FOIA (Freedom of Information Act) request started coming out, really I think just about a year ago, and started getting responses after a fair bit of pushing � maybe a year and a half ago. And what it turns out is that there is clearly more of this than anyone was owning up to. A few years ago they were basically saying this is a rare event, it never happens, this is all a tempest in a teapot. Well, what comes out is that on any given day there is 500 million to 750 million shares of companies that have gone undelivered. And again, that’s only counting the shares in that hub, and it’s only counting those shares after these things have gone through all these levels of netting and stock borrowing and so forth. So the actual number of IOUs in the system may be much greater than that. So the DTCC was not crazy about releasing the data.

I actually feel for the SEC. I think there are many good people there who are trying to do a good job. I think that they may be between a rock and a hard place. It’s interesting � and I hate to get all patriotic on you for a moment � but our country was founded on this idea that power concentrated in a few hands and shielded from public observation was just intrinsically pernicious. It’s a bad idea. Well, buried underneath, the world economy is driven by the US economy. The US economy � the engine of that is the financial markets; and at the center of the financial markets there is this fuel pump so to speak, the DTCC. And it’s a big black box. It trades $1.4 quadrillion of trades; it trades something like 40 times the total world � or 30 times the total world � domestic product. I mean the entire economy of the world trades through there and it’s a corporation � it’s a privately held corporation that’s owned by the broker-dealers that use it.

And there has been some real question about who regulates that. I understand that it wasn’t even clear until recently that the SEC does. Now, there’s a type of organization called an SRO � a self-regulatory organization (like the New York Stock Exchange or the NASD, or the NASDAQ). Everybody thought that the DTCC was regulated by the SEC, except they have taken the position, I understand � and I’m not a lawyer but this is my reading of things � that certainly when state regulators have tried to approach the DTCC and get information out of this black box, the DTCC says, “no, no, no, you have no authority over me. I’m Federally regulated.� But I’ve also heard it said that when the Federal government has tried to look into the DTCC their attitude is, “you really don’t regulate us.� It’s the equivalent of I live in Utah. It’s as if a bunch of doctors here in Utah formed a buying group � a company that would be a buying consortium owned by [the doctors]. And then the AMA tried to show up and look at that company, and that company said, “whoa, whoa, whoa, you don’t regulate us. This company is not a doctor. You, the AMA, you regulate the doctors but you don’t regulate this corporation that they all own together.� And so apparently they’ve taken that position. And so there’s a huge black box that is Federally regulated except on the days it doesn’t want to be. Nobody really understands what’s going on inside of it; and going through it is 30 to 40 times the entire world GDP. That’s a recipe for a disaster. That’s a huge concentrated power shielded from public observation. It’s a very bad idea. [26:18]

JIM: Now, I know that people have requested information in terms of how big this FTD, or failure to deliver, is. And the DTCC responded in almost a self-done interview. I believe the gentleman’s name was Larry Thompson, where he said, “hey, look, we trade $400 billion a day. Only $6 billion a day is really FTDs, or failures to deliver.� And some people questioned [this]. In fact, I think a Harvard professor questioned whether this was really indeed the truth that was being told to the public.

PATRICK: Well, Larry Thompson, who is the Deputy General Counsel did this self-interview where his press guy asked him questions and he dictated the answers and got it online and posted it. Just when you read the interview you see how carefully crafted the wording is. It really looks all squirmy. It looks like they’re trying to hide something to me. Anyway, there is an economist named Robert Shapiro � and I know Dr. Shapiro. He’s a Harvard-trained economist, he’s Undersecretary of Commerce for economics under Bill Clinton; he was on the National Council of Economic Advisors; and a very serious and heavyweight guy. And full disclosure � he works as a consultant for a group of lawyers who are representing me. I’ve gotten to know him and he tells an interesting story about how he had unraveled one little area of some shenanigans on Wall Street called toxic converts that you may have done stories on. And it turns out, toxic converts, or toxic financings, death-spiral converts � they are linked to this naked shorting stuff. So he was asked to look into it, and he said at first he did, and figured you know he would take the money and look into it, and just report honestly on what he had found. And then he gradually went down the rabbit hole, as I would put it. He got into a bit of a public debate with the DTCC where he answered Larry. He wrote a letter to them and they refused to answer it, and refused to publish it so he just published it online. And basically it takes all the wormy answers of Larry Thompson and says, okay, if this is true can you tell us this, and can you tell us that, and can you tell us the other thing. And the DTCC won’t respond. But he very carefully dissects it and shows that the DTCC response sure looks like it’s understating the real problem � maybe by an enormous magnitude. [28:59]

JIM: Yeah, let’s walk through that because Larry Thompson, the attorney for the DTCC, basically said, look, this is only 1 �%. Shapiro when he looked into it said, wait a minute, the 400 billion that you say are trading each day, the 6 billion that is in default, yeah on the surface that looks like 1 �%. But what we’re talking about here is stock transactions; and stock transactions are only about $82 billion a day, so this failure to deliver the securities of 6 billion represents 7 �%. And we’re not even talking about what goes on outside the DTCC. So take us through that.

PATRICK: Okay. I’ll use this metaphor. Somebody went to a bank with a million dollars in the vault, and they robbed it and they left $10,000 behind. And then somebody showed up and said, “oh, this bank robbery � you see it’s just a $10,000 problem.� You’d say, “Wait, you’ve missed the whole point, telling us how much is there as a residual isn’t the issue.� And so one of the effects of massive, concerted naked-shorting is to drive a company’s stock price down, and after they have been driven down, the amount of these IOUs add up to 6 billion. Well, that’s their compressed number. It doesn’t cost 6 billion to clean up a 6 billion FTD problem because you have issues like short squeezes and stuff; it can cost many times that to clean it up. So that’s the number after it’s all been compressed down. That’s one issue.

It’s also the number after a lot of companies have been destroyed by it. You know, Shapiro says publicly that’s in the hundreds. And so it’s after those aren’t in the ballgame anymore. And in addition, as you say, it’s after there’s been the IOUs that have basically been addressed by the stock-borrow program within the DTCC, have been netted through the continuous net settlement system, have been taken out through ex-clearing or have had pre-netting out at the brokers � after you take all those things out and compress the rest, it’s just down to 6 billion. Well, that means how big is the real problem. You know, in God’s eye, who sort of knows where everything is, how much money does it really take to clear it up? Well, the real number then isn’t 6 billion � it’s some multiple of 6 billion. Now, I have people telling me � and I don’t know what to believe � but I have people telling me that the real number is 15 to 20 times that. I have other sober people telling me it’s sort of 5 to 10 times that. The truth is not only don’t I know, I don’t think there is any one place where this is known.

Remember, the DTCC, and quite frankly the SEC, just a few years ago, was trying to assure the public that, “no, there’s nothing to this, it’s a tempest in a teapot.� Now, the DTCC is kind of hiding under the covers and saying: “Well, we don’t really know what goes on out at the pre-netting at the brokers, and in the ex-clearing, and that’s not our responsibility. We don’t really know,� and words, words, words. The SEC has gone from saying this is a tempest in a teapot � and there’s a commissioner who I won’t mention by name but who is basically maligning anybody who would bring attention to this � to saying (and they actually say this on their website) that we can’t disclose how big this is, and we actually have to grandfather (forgive) the IOUs that are in the system because otherwise it would create excessive market volatility. So on one side of their mouths � and I do try to be respectful about government employees, and I don’t mean to offend anybody, but it feels out of one side their mouth � they’ve been saying, “hey, drive on by. Don’t look. No problem here.� And out of the other side they started to say, “Well, actually, it’s such a big problem that we have to grandfather it, and we can’t even disclose exactly how big it is because that’ll disrupt the market place.� So you understand why there’s a contradiction in those positions? [33:12]

JIM: Sure. On the one hand, they say no worry. But on the other hand, they’re saying this is so big we’ve got to grandfather it. Now, that brings up an interesting question because since 1934, with the passage of the SEC and all the securities acts, illegal short selling is illegal. It’s a crime. So how can a regulatory authority such as the SEC take a law passed by Congress and say, “oh, by the way, we’re grandfathering all the criminals� Explain that one to me, Patrick.

PATRICK: Good of you to pick up on that. The reason I asked does that seem contradictory to you is because I admit as you end up, as you get into this, going down such a rabbit hole it’s hard to tell how it looks to an outsider. But this is another kind of rabbit-hole proposition. There are in fact criminal provisions in the 1934 Security Act � so this is a crime. And it isn’t just the naked shorting. Let’s think of it even more broadly. Let’s say some grandmother is buying stock through her broker and what she’s really getting are these IOUs. You have to ask yourself: what are those IOUs; what is their nature, their metaphysical nature? Are they securities, or are they not securities? Well, if they’re not securities then it is pretty clear a fraud has been committed. Grandmother thought she was buying something, and was told she was buying something and she didn’t get it � it looks like fraud. So they’re not going to be able to say these aren’t securities. And in fact, the 1934 Securities Act has a very careful definition of what a security is; and it looks pretty clear that those things, whatever they are, count � they meet the definition of a security.

Now, you have to ask are those registered securities, or not? Well, they don’t look registered to me � in fact, they’re not registered, they can’t be registered. The company didn’t register them. So what that means is somebody � the hedge fund, the broker � has now been involved in selling an unregistered security. And I believe that’s been illegal since 1934. You can’t sell unregistered securities. So whether it comes from naked shorting � the naked shorting may turn out to be just a small part of it. There’s actually fail to deliver long sales, and there’s unsettled offshore trades � all of these other different ways these IOUs come into existence. And arguably, what the SEC says (what I assume they’re going to say), there is a savings clause in the 1934 Act. By the way, the words are something like: the United States Congress finds that it’s in the interests of the United States to provide for prompt and accurate settlement of trades. There is a clause that says that the SEC can waive this only when it’s in the interests of the general public. Well, so you certainly get the intent of all that, would be the Congress is saying we’re going to have prompt clearing and settlement of trades, and they are quite strict about it. And there’s only just a little loophole that says the SEC can waive this, but only what’s in the interests of everybody. So that empowered them, arguably, one would think on a case by case, or a remote basis, to waive the settlement to allow for an IOU to be formed and these kinds of things. But it’s become a loophole through which these guys are driving train loads.

And it’s certainly not in the interests of the general investors; [it’s] in the interests of a couple of dozen hedge funds in the Caribbean and New York. So I don’t know how it’s all going to play out in court; and it’s going to take a long time because everybody is trying to slow down this process and [inaudible]. But you’ve hit the nail on the head. The way law and regulation is supposed to work Congress writes in big letters what the rules are, and the regulators are supposed to operate within those rules and fill them in in more detail. A regulator doesn’t have the authority, generally, to break the law, or to empower other people to break the law � and that’s not what regulators do. So, yeah, it’s all a very strange situation. [37:20]

JIM: But, you know, in essence, what these guys are doing and as the Thompson versus Shapiro study shows, this could represent as much as almost 37% of sales that take place. Now, everybody knows that legitimate short sales have been going on � there’s nothing wrong there. But Patrick, in essence, when they make a naked-short sale, what these guys are doing � if we were to boil down their scheme � they are counterfeiting stock; and we know that counterfeiting is illegal. But isn’t this really a counterfeiting scheme?

PATRICK: Yes. It’s exactly the same as counterfeiting. It has exactly the same effect as counterfeiting. It basically is counterfeiting. It really is � it’s electronic counterfeiting. Counterfeiting a company’s stock in terms of paper certificates, that’s illegal, just as it would be with United States money. It happens to be a different kind of crime. Does that mean that counterfeiting a company’s shares electronically is also a crime? One would think so. So this is exactly the same as if we had some hedge funds that had been empowered, so to speak, by the SEC to set up printing presses and just crank out stacks and stacks and stacks of stock certificates in companies that they really didn’t have anything to do with; and flood the market with them. If they were empowered to do that it would be a very rational thing for them to pick a select group of companies, that once you did this to them, create some other explanation why their stock collapsed. Again, it could be financial or tech companies. And then it would be useful to have a couple of friendly journalists that were compliant � for whatever reasons made them compliant; but you could do what Jim Cramer described and what has finally hit the news in the last few weeks � that would come in very handy too. If you had those printing presses up in Ria [phonetic], New York and were printing off paper shares, well, I would argue that you have it just right: this is counterfeiting. And the same thing happened � they don’t do it with printing actual shares � how they do it is by having a broker in Canada or the Bahamas that they can call and say, “Hey, Louie, I need a locate on 500,000 Krispy Kreme. I know you’re good for it,� � or something. That’s precisely the same thing economically. [40:08]

JIM: If you were to bring this up and talk to anybody, the party line is given. And why don’t we talk about that because I can remember (I think this was about a year ago) there was a stock that was written up in Barron’s � it was an interview of this fund manager. And he’s talking about these stocks, he’s given information that discredits these companies, but the guy is short the stock. So, in essence, you’ve got the press doing you work for you.

PATRICK: Yes. Before Watergate, the Washington Press corps had really been quite captured. And when Woodward and Bernstein wrote, they were writing stuff that other people knew � maybe not the details of. But the Press corps had become the poker playing buddies of Lyndon Johnson, and certainly with Kennedy � I doubt anyone was with Nixon. But in general, there’s a very chummy relationship. That happens and it’s not good journalism. There are good business journalists. But the New York financial press is very, very chummy with the people that they report on. Just like I used to have a friend who was an NBA player, and I really discovered that sports-writers were not adversarial journalists, and they did as much ignoring perhaps as they should have reported. Maybe in the world nothing too dramatic hinges on that. But the financial markets � that’s Grandma’s savings. And there are some financial journalists who have gotten awfully chummy with the people with whom they should have a proper, properly-distanced relationship. But it’s pretty clear that there’s a remarkable coincidence of positions taken by certain journalists and certain hedge funds. And it would be very handy to have one of these. And I’m not even saying that they are on the payroll � although there are rumors of that kind of thing. People can be paid in a lot more ways than with money. [42:24]

JIM: Soft dollars, sort of?

PATRICK: Well, there’s soft dollars, but that’s more within the broker-dealer world. But you can pay journalists with access, you can pay them with information; you can play poker with them and purposefully lose a lot. I mean there are different ways to pay them with cash and in non-cash. You can pay them with prestige and access. So there are different ways they might be compensated. [42:47]

JIM: I want to bring this to give our listeners sort of an example, and I wonder if you would tell the story of Sedona stock; and then how this all came to play in a company that went under that everybody’s familiar with which is Refco.

PATRICK: Well, Sedona is a Pennsylvania software manufacturer � they make a CRM (customer relationship management) product. Basically, a customer-service software system for small and mid-sized companies � actually it’s more than just customer service. And it’s a nice product. In fact, I’ve looked at it for purchase for myself for a company I’m involved in, which is incidental. It’s actually a nice product.

They were shorted and naked shorted by a crew � the Badian brothers who were some Austrian fellows, and they were acting on behalf of a hedge fund in Panama with a Swiss or Dutch parent. Anyway. So it’s a lot of offshore money. The broker-dealers at Refco were caught on tape saying, or taking instructions: “We want you to short this mercilessly. We want you to carpet bomb it. We want you to kill it.� Maybe not in those exact words, but words equally bad. But they were told to short it mercilessly, and things like that. And they did � Refco kept giving locates to this company which kept the hedge fund to the Badian brothers, and just kept shorting it. And this has all just come out because not only did the tapes end up with a Manhattan prosecutor who bought charges against Refco and the hedge funds involved � but then it moved into an SEC matter. And in fact, the SEC � I feel like actually like not such a nice guy for how much I’ve busted on government employees; I feel bad about that because I admire guys who go to work for the public � but the SEC basically gave them a de minimis fine of a million bucks, and cleared them to go public. Refco went public in August of 05; and then, two months later it went Chernobyl. It went Chernobyl and it destroyed. And the Badian brothers � one of them I think has been brought to justice or may be in a civil suit filed against him. Anyway, it turns out Refco was at the heart of some of this. But there are a lot of other people doing just what Refco did. It’s pretty clear. [45:26]

JIM: But there’s a toxic waste that’s out there on Refco, and that’s this half a billion dollars of what is believed to be naked short positions that are just kind of floating out there.

PATRICK: Well, nobody really knows. That’s certainly strongly suspected that there is something like that. Left behind, there’s an aspect to its bankruptcy which is very unusual and that is there is this liability. Michael Garcia who is the US attorney in New York has described it publicly as something that floats, it’s marked to market every night, but they wouldn’t say what it was. The government wouldn’t say what it was, and in the bankruptcy proceedings some very strange steps were taken. Normally, a bankruptcy proceeding would be open to the public � the courtroom was sealed, records were sealed on the argument that some information was going to come out that the lawyer making the argument said that this could hurt the general public. Well, all of that would be consistent. It doesn’t prove that it was a big naked-short position, but all of that is consistent that there is just a whole bunch of this toxic naked-short positions left behind from the Refco bankruptcy. Nobody knows that for a fact, and nobody will say. [46:46]

JIM: But isn’t it unusual, Patrick, that something like this would be sealed from the public. Normally these bankruptcy proceeding are open. This is closed. Why are they closing this?

PATRICK: Well, again, the reasons are they are not disclosed. I think Matthew Goldstein from The Street wrote � if I’m not mistaken �an article about this that your listeners could Google. Again, it’s circumstantial, and I don’t pretend to have all the facts. This all just smells really bad. I mean, when you try to explain this to outsiders, they basically say, “whoa, whoa, stop. Let’s go back to that thing why some people get to sell something they never deliver.� I mean we’re eleven steps down the chain talking about what exactly is left under Refco, and who knows what, and nobody really knows. But let’s get back to why are there people selling billions, or tens of billions, or who knows what, of something that doesn’t deliver. So in that PowerPoint you mentioned, I pieced together the evidence and I know the direction it looks like it’s pointing to me, but I don’t mean to say I’ve got absolute knowledge of this � it just smells very bad. [47:57]

JIM: Well, you know, this is something that I see, the very same thing that you’re talking about. I suspect, and have seen and others have commented, is going on in the mining industry and especially in the junior mining industry where you’ll see these guys go into chat rooms, they’ll start planting rumors, bashing companies, and then all of a sudden you’ll see these short sales. Patrick, if you had a stock and you suspected this is going on, I mean, what do you do about it, and how do you find out about it. Or do you just remain unsuspecting.

PATRICK: I’m afraid to say it’s pretty much hopeless if you report it. It just goes in the nutcase file. The SEC won’t do anything. I actually think what’s happened is this: the other side of this scam is something called pump-and-dump. And pump-and-dump is a way you could take small stocks and manipulate them so that the stocks go up and till the general public rushes in and carries it from you, and at that point you naked short into it, and you make a bunch of money until the thing turns around and craters, and you’ve made a bunch of money. And I think that that probably went on � well, I know that that went on for decades, or at least in the 90s � until, my guess is, what happened is the SEC decided to turn an institutional blind-eye when people come in to complain about naked shorting. My guess is they decided that we can’t police all of these little pump and dump schemes, and so we’ll turn a blind eye; and the people who engage in the naked shorting will act as sort of a natural predator and regulator in that market. Well, that’s essentially vigilantism.

And what’s happened is, just like if you had a sheriff in some town who sort of gave a nudge and a wink to some vigilantes to keep a neighborhood, which was maybe a tough neighborhood, to establish order, then eventually those thugs become the mafia; they become a group that’s not just keeping order but they’re mugging store keepers or demanding protection money and such. So I think that that’s why we got to where we are.

Now, the question is � and there are two competing theories. One is the SEC is, just in general, not really up to taking on Wall Street in a major way, but they can take on small players, but they can’t take on dozens of big powerful hedge funds and broker-dealers. That’s one theory. The other theory is that because the exploration they just gave that they sort of turned a blind-eye to it for too long, and meanwhile, the vigilantes realized after a while they could work their way up the food chain and get into companies with more market capitalization, and hence make more money out of it; that the problem got so big, so fast, that it’s now too late for them to do anything. They realized that they have to grandfather the crime because it’ll create excessive market volatility. It will crater the market if they try to clean it up � [that’s] what they say on their website, I’m not making it up. But they’re saying, “we had to grandfather this�yeah, yeah, it’s a small problem but don’t worry about it but we had to grandfather it because we were afraid it would create too much volatility if we didn’t.� I don’t know, but it’s just a very � it’s guesswork � but the thing that annoys me we’re not debating the properties of subatomic particles beyond the range of modern instruments. Everything we’re debating is a knowable fact, and there is in fact someone, somewhere, who knows it; and nobody is answering questions. I really fear for my country because if that second explanation is correct, then Houston we have a problem. [51:58]

JIM: Let me just take this a step further, Patrick, because if the theory is they’re afraid of Wall Street and taking them on, and they’re not going to do anything or look into it � look at the problem that we are now starting to see unfold in the subprime lending market. Only now is Congress looking into government authorities and saying, “Why did you allow these kind of credit practices to take place?� Because I just read an article today where the unemployment rate, the vacancy factors in business in the Irvine area of California where almost half the subprimes are located, it’s like we’re in a great depression now.

PATRICK: Absolutely.

JIM: So if we’re seeing this unfold now, and it turns toxic as we’re seeing with subprime, what about this bigger problem because I don’t see � there’s just too much big money here. When you can counterfeit shares and sell something and take money out of thin air, which is in essence what they are doing; on the other side, you have the broker-dealers who are now getting 4 or 5 times the transaction revenues on this � I don’t see that being cleaned up. In fact, two weeks ago, one of them was just fined for naked-short selling. What happens, Patrick? I mean, you can’t do this forever. Eventually, this whole thing goes up in smoke, and if it does, it’ll take down the financial system.

PATRICK: I hate to say, Jim, but that’s�two and a half years ago�the truth of this stuff is that there has been rumors of this stuff floating around for years. And I ignored it � I’m a value guy, I trust the market to take care of pricing and so on. And I’m afraid to say that was a handicap for me because when people started getting in touch with me and sending me letters I was actually very dismissive for three or four or five months until finally I talked to one guy. He laid this out in about an hour, and I said, “yeah, yeah, right buddy.� And as I was hanging up, I’ll never forget, he made five specific predictions. And he said, “I know you don’t believe me so I’m just going to tell what’s going to happen over the near future.� And maybe five specific predictions � and every one of them came true over the next eight weeks. I won’t even go into what the predictions were but they were things he could not have had any control over and they were really far out things. And when somebody does something like that you have to start paying attention.

And then I started like really studying it and I studied it for a couple of months, and realized, holy cow, we could be looking � I mean, I don’t want to be dramatic � but this could be not just a $6 billion problem, but it could be a $16 billion problem which the country could handle just fine; it could be a $60 billion problem which would hurt our banking system; or it could be that hundreds of billions, if not more, have been drained out of our financial system. And that fuel pump is going to vapor lock. If you’ve ever run out of fuel in your car, and then you fuel it up later and you try to start it, and sometimes it doesn’t, that’s a vapor lock. And it could be we’re going to have a vapor lock in our system because that money is not in the system anymore. People can sue and regulate all they want. If it is that dramatic a number that money has been drained out, and it’s been turned into private yachts, and country homes in the Hampden’s, and who knows what, but it’s not in the system anymore. And that would also be consistent with why the government seems to be acting more to protect the system than to be actually clearing up this mess.

And I actually feel for them because if it�I think Chris Cox, I was familiar with him before he went to the SEC, they say in Congress he’s like the smartest guy in Congress, and yet I think he inherited a very tough position that he probably didn’t understand what he got into. And maybe nobody really understood it. And I don’t know � really the doomsday scenario that we’re talking about � I don’t know what to say the SEC should do because it is something that’s going to create a bit of volatility in the markets if it gets exposed. But there’s always this goal people talk about of maintaining the confidence in the market. But that itself isn’t the real goal. The goal should be to have a market in which people are right to have confidence. And sometimes I think that our government may have gotten confused on that point. They are against anything that shapes the investor confidence and integrity of the market place. Well, the real way against that being shaken is to fix these problems. I think the dynamics of it are going to turn out to have been quite a bit like the S&L crisis in the late 80s. There were people out there for four or five years showing how these incentives lined up; Charlie Munger wrote a beautiful letter resigning from the board of I think it was an S&L and he laid it out perfectly. And this looks like a bit of a repeat. In fact, there was a government regulator � I forget his name at the moment � in the 80s, who was going and saying years before the crisis: “We have a problem here. And we have this perverse set of incentives that are creating a deeper and deeper pothole that somebody is going to have to fill in some day.� And he was branded a lunatic and they ignored him and so forth. And there’s also the political question of what politician wants to be the guy whose shift that comes to light on. And I wasn’t speaking of Chris Cox � but who wants that? If you have a choice between trying to fix it and possibly exposing a huge scandal, or moving it along for the next guy, well, you can see why some people take the easy course. I think that you’ve to remember though that the SEC is not monolithic; there are good people in it � in fact, I’m sure there are good people who aren’t on my side, I think there are good people who are not on my side but are on the side of trying to see that this gets fixed; and there are some folks who I don’t think could care less. [58:35]

JIM: Let me give you a hypothetical. I see this kind of activity you’re talking about taking place in the junior mining industry all the time. What would happen theoretically, let’s say there was a big naked short position in a company, and let’s say that company gets taken over. When you get shares that you’re going to have to deliver for the new company, do the FTDs just get carried over into the new stock? Wouldn’t that expose it?

PATRICK: I don’t think so. I know that there’s been all kinds of � and I hear about this in the mining industry and especially in the smaller cap have talked about all kinds of Rube Goldberg kinds of contraptions which have exposed this. Let’s have a company that issues, does this or does that, I don’t know, that does these [devices] which would trade this class of stock for this class of stock that will expose it. I think that one of the things that will happen is the SEC comes after you and says you are trying to manipulate your stock, which is siding with the bad guys. People have written me all kinds of letters about why I don’t do this thing, and it all sounds kind of Rube Goldberg to me. In particular, I really have tried to divorce this issue from my own company. In fact, I don’t even want to mention the name. You’ll notice in that Dark Side, yeah, I happen to be in this because people got in touch with me because I run a company, but this isn’t about my company. This is about my country. We have a massive problem building up here. I don’t know if any of those systems that people talk about small-cap companies: “Well, we’re going to pay a dividend and buy it back,� and whatever � it all sounds a little cockamamie to me. I think none of them are going to work because if they started to work somebody would come in and say, “No, we’re not going to let you get away with that.� [1:00:32]

JIM: So, basically, you’re saying this system continues until some day it just implodes.

PATRICK: Until it gets exposed. It started to get exposed. I mentioned to you before we began taping that Bloomberg did an amazing documentary, it just came out a week ago. It’s 25 minutes long, it’s called Phantom Shares. I’m not sure if it is up on their website; people can find it where people find videos. It’s shocking � it’s as if Bloomberg came out with a documentary that says Martians walk among us. I mean, I’ve shown it to some people who just don’t know anything, they’re just trying to get the general public’s reaction, and it’s as if somebody had done a documentary which says Martians walk among us. It’s a very sober, fact-based documentary. And to be honest, the documentary is just concerning that $6 billion number; it doesn’t even go into the possibility that that may be the tip of an iceberg, and nobody knows how deep the iceberg goes. [1:01:36]

JIM: Well, Patrick, I want to thank you for coming on the Financial Sense Newshour and we’re going to take your presentation and put it up on our website, along with the Bloomberg story, as well as the interview with James Cramer where he was talking about this very same type of thing. I mean, it’s remarkable � though sometimes good things happen � because your slide presentation, which we’ll post, has come out; Bloomberg does its story on phantom shares; and then the interview with Cramer. Now, how coincidental all 3 of these have come out within a short period of time. So maybe there is justice.

PATRICK: Maybe. Mine actually came out 15 months ago, and it has slowly built an audience. I think it has built up to 400,000 viewers. But if your folks come from your site and see it� But it does seem to be, two years ago, all these financial journalists started saying Byrne’s gone nuts because I came out and said there is this naked-shorting problem that nobody knows how big it is. And secondly, there seems to be an unhealthy collusive relationship between some journalists and some hedge funds. And I went from golden boy to whipping boy for saying these two things. Well, now, in the space of one week Bloomberg has come out and said exactly what I’m saying on the first one; and Jimmy Cramer himself came out and confirmed the second one. So it has been an odd week for me. It’s been an odd week. [1:03:05]

JIM: Well, thank goodness there are people like you out there doing things like this. Patrick Byrne, I want to thank you for joining us on the Financial Sense Newshour. You are a great citizen and patriot for doing this.

PATRICK: Thank you very much, Jim

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