Accidentally Released – and Incredibly Embarrassing – Documents Show How Goldman et al. Engaged in ‘Naked Short Selling’

By Matt Taibbi / Posted by Wendy Becerra

Wendy: I couldn’t pick my jaw off the floor for a few minutes on this one. Thank you, God for smiling down on us. That’s one heck of a banana peel.

It doesn’t happen often, but sometimes God smiles on us. Last week, he smiled  on investigative reporters everywhere, when the lawyers for Goldman, Sachs  slipped on one whopper of a legal banana peel, inadvertently delivering some of  the bank’s darker secrets into the hands of the public.

The lawyers for Goldman and Bank of America/Merrill Lynch have been involved  in a legal battle for some time – primarily with the retail giant,  but also with Rolling Stone, the Economist, Bloomberg, and the New York Times. The banks have been fighting us to keep sealed certain  documents that surfaced in the discovery process of an ultimately unsuccessful  lawsuit filed by Overstock against the banks.

Last week, in response to an motion to unseal certain  documents, the banks’ lawyers, apparently accidentally, filed an unredacted  version of Overstock’s motion as an exhibit in their declaration of opposition  to that motion. In doing so, they inadvertently entered into the public record a  sort of greatest-hits selection of the very material they’ve been fighting for  years to keep sealed.

I contacted Morgan Lewis, the firm that represents Goldman in this matter,  earlier today, but they haven’t commented as of yet. I wonder if the poor lawyer  who FUBARred this thing has already had his organs harvested; his panic is  almost palpable in the air. It is both terrible and hilarious to contemplate.  The bank has spent a fortune in legal fees trying to keep this material out of  the public eye, and here one of their own lawyers goes and dumps it out on the  street.

The lawsuit between Overstock and the banks concerned a phenomenon called  naked short-selling, a kind of high-finance counterfeiting that, especially  prior to the introduction of new regulations in 2008, short-sellers could use to  artificially depress the value of the stocks they’ve bet against. The subject of  naked short-selling is a) highly technical, and b) very controversial on Wall  Street, with many pundits in the financial press for years treating the  phenomenon as the stuff  of myths and conspiracy theories.

Now, however, through the magic of this unredacted document, the public will  be able to see for itself what the banks’ attitudes are not just toward the “mythical” practice of naked short selling (hint: they volubly confess to the  activity, in writing), but toward regulations and laws in general.

“Fuck the compliance area – procedures, schmecedures,” chirps Peter Melz,  former president of Merrill Lynch Professional Clearing Corp. (a.k.a. Merrill  Pro), when a subordinate worries about the company failing to comply with the  rules governing short sales.

We also find out here how Wall Street professionals manipulated public  opinion by buying off and/or intimidating experts in their respective fields. In  one email made public in this document, a lobbyist for SIFMA, the Securities  Industry and Financial Markets Association, tells a Goldman executive how to  engage an expert who otherwise would go work for “our more powerful enemies,” i.e. would work with Overstock on the company’s lawsuit.

“He should be someone we can work with, especially if he sees that  cooperation results in resources, both data and funding,” the lobbyist writes, “while resistance results in isolation.”

There are even more troubling passages, some of which should raise a few  eyebrows, in light of former Goldman executive Greg Smith’s recent public  resignation, in which he complained that the firm routinely screwed its own  clients and denigrated them (by calling them “Muppets,” among other  things).

Here, the plaintiff’s motion refers  to an “exhibit 96,” which refers to “an  email from [Goldman executive]  John Masterson that sends nonpublic data  concerning customer short  positions in Overstock and four other hard-to-borrow  stocks to Maverick  Capital, a large hedge fund that sells stocks short.”

Was Goldman really disclosing “nonpublic data concerning customer  short  positions” to its big hedge fund clients? That would be  something its smaller, “Muppet” customers would probably want to hear  about.

When I contacted Goldman and asked if it was true that Masterson had shared  nonpublic customer information with a big hedge fund client, their spokesperson  Michael Duvally offered this explanation:

Among other services  it  provides, Securities Lending at Goldman provides market color  information  to clients  regarding various activity in the securities lending marketplace on  a  security specific or sector specific basis.  In accordance with the   group’s guidelines concerning the provision of market color, Mr.   Masterson provided a client with certain aggregate information  regarding short  balances in certain securities.  The information did  not contain  reference to any particular clients’ short positions.

You can draw your own conclusions from that answer, but it’s safe to say we’d  like to hear more about these practices.

Anyway, the document is full of other interesting disclosures. Among the more  compelling is the specter of executives from numerous companies admitting openly  to engaging in naked short selling, a practice that, again, was often dismissed  as mythical or unimportant.

A quick primer on what naked short selling is. First of all, short  selling, which is a completely legal and often beneficial activity, is when  an investor bets that the value of a stock will decline. You do this by first  borrowing and then selling the stock at its current price, then returning the  stock to your original lender after the price has gone down. You then earn a  profit on the difference between the original price and the new, lower  price.

What matters here is the technical issue of how you borrow the stock.  Typically, if you’re a hedge fund and you want to short a company, you go to  some big-shot investment bank like Goldman or Morgan Stanley and place the  order. They then go out into the world, find the shares of the stock you want to  short, borrow them for you, then physically settle the trade later.

But sometimes it’s not easy to find those shares to borrow. Sometimes the  shares are controlled by investors who might have no interest in lending them  out. Sometimes there’s such scarcity of borrowable shares that banks/brokers  like Goldman have to pay a fee just to borrow the stock.

These hard-to-borrow stocks, stocks that cost money to borrow, are called negative rebate stocks. In some cases, these negative rebate stocks cost so much just to borrow that a short-seller would need to see a  real price drop of 35 percent in the stock just to break even. So how do you  short a stock when you can’t find shares to borrow? Well, one solution is, you  don’t even bother to borrow them. And then, when the trade is done, you don’t  bother to deliver them. You just do the trade anyway without physically locating  the stock.

Thus in this document we have another former Merrill Pro president, Thomas  Tranfaglia, saying in a 2005 email: “We are NOT borrowing negatives… I have made  that clear from the beginning. Why would we want to borrow them? We want to fail  them.”

Trafaglia, in other words, didn’t want to bother paying the high cost of  borrowing “negative rebate” stocks. Instead, he preferred to just sell stock he  didn’t actually possess. That is what is meant by, “We want to fail them.” Trafaglia was talking about creating “fails” or “failed trades,” which is what  happens when you don’t actually locate and borrow the stock within the time the  law allows for trades to be settled.

If this sounds complicated, just focus on this: naked short selling, in  essence, is selling stock you do not have. If you don’t have to actually locate  and borrow stock before you short it, you’re creating an artificial supply of  stock shares.

In this case, that resulted in absurdities like the following disclosure in  this document, in which a Goldman executive admits in a 2006 email that just a  little bit too much trading in Overstock was going on: “Two months ago 107% of  the floating was short!”

In other words, 107% of all Overstock shares available for trade were short – a physical impossibility, unless someone was somehow creating artificial supply  in the stock.

Goldman clearly knew there was a discrepancy between what it was telling  regulators, and what it was actually doing. “We have to be careful not to link  locates to fails [because] we have told the regulators we can’t,” one executive  is quoted as saying, in the document.

One of the companies Goldman used to facilitate these trades was called SBA  Trading, whose chief, Scott Arenstein, was fined  $3.6 million in 2007 by the former American Stock Exchange for naked short  selling.

The process of how banks circumvented federal clearing regulations is highly  technical and incredibly difficult to follow. These companies were using obscure  loopholes in regulations that allowed them to short companies by trading in  shadows, or echoes, of real shares in their stock. They manipulated rules to  avoid having to disclose these “failed” trades to regulators.

The import of this is that it made it cheaper and easier to bet down the  value of a stock, while simultaneously devaluing the same stock by adding fake  supply. This makes it easier to make money by destroying value, and is another  example of how the over-financialization of the economy makes real, job-creating  growth more difficult.

In any case, this document all by itself shows numerous executives from  companies like Goldman Sachs Execution and Clearing (GSEC) and Merrill Pro  talking about a conscious strategy of “failing” trades – in other words, not  bothering to locate, borrow, and deliver stock within the time alotted for legal  settlement. For instance, in one email, GSEC tells a client, Wolverine Trading, “We will let you fail.”

More damning is an email from a Goldman, Sachs hedge fund client, who  remarked that when wanting to “short an impossible name and fully expecting not  to receive it” he would then be “shocked to learn that [Goldman’s  representative] could get it for us.”

Meaning: when an experienced hedge funder wanted to trade a very hard-to-find  stock, he was continually surprised to find that Goldman, magically, could  locate the stock. Obviously, it is not hard to locate a stock if you’re just  saying you located it, without really doing it.

As a hilarious side-note: when I contacted Goldman about this story, they  couldn’t resist using their usual P.R. playbook. In this case, Goldman hastened  to point out that Overstock lost this lawsuit (it was dismissed because of a  jurisdictional issue), and then had this to say about Overstock:

Overstock pursued the  lawsuit as part of its longstanding self-described “Jihad” designed to   distract attention from its own failure to meet its projected growth and   profitability goals and the resulting sharp drop in its stock price  during the  2005-2006  period.

Good old Goldman — they can’t answer any criticism without describing their  critics as losers, conspiracy theorists, or, most frequently, both.  Incidentally, Overstock rebounded from the  2005-2006 short attack to  become a profitable company again, during the same period when Goldman was  needing hundreds of billions of dollars in emergency Fed lending and federal  bailouts to stave off extinction.

Anyway, this galactic screwup by usually-slick banker lawyers gives us a rare  peek into the internal mindset of these companies, and their attitude toward  regulations, the markets, even their own clients. The fact that they wanted to  keep all of this information sealed is not surprising, since it’s incredibly  embarrassing stuff, if you understand the context.

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