Rot on Wall Street.
Bernard L. Madoff the ex-chairman of the NASDAQ stock exchange, was once one of the most important market makers on Wall Street.
As NADDAQ chairman Madoff was the principal author of the SEC rule that exempted market makers (i.e. Madoff) from various regulations governing short sales.
A short sale is a sale of stock that the party does not actually own. Theoretically the seller will borrow the stock from someone while paying them a premium and sell the stock and then repurchase the stock and return it later. For ordinary mortals this has whole scenario has to play out (clear) within 3 days.
But Madoff made sure that the rules did not apply to him.
The SEC rule exempting Market Makers from rules against naked short selling is called the "Madoff Exception".
Madoff’s rule ensured that market makers (Madoff) could, among other things, engage in so-called "naked short selling." The rule allowed them to sell stock without borrowing it. It allowed them to sell stock that did not exist, and gave them 13 days to kite the check, Uh find the stock and buy it to deliver.
In other words They sell stock created out of thin air. Stock transactions between ordinary traders must be closed out within 3 business days.
But wait! The Market Maker can put off having to buy to deliver the shares to the buyer for 13 days. In many cases they continued to sell more shares than existed and covered after 13 days, or not (this is called a Fail to Deliver) to the point that a huge float of phantom shares was built up.
The market maker stood to make a lot of money if the value of each share went down, and by dumping huge numbers of phantom shares on the market the Market Maker could almost assure this.
There is an extraordinary level of double talk and ignorance about how financial markets work that has allowed frauds like Bernie Madoff to thrive because no one listened when people called bullshit. We are going to have to get savvy on how they work and how to make them work FOR us instead of us becoming victims of them.
Naked Short Selling is just one way Wall Street has compromised the ability of companies to do business in this country by diluting the value of a companies stock to the point that it could be taken over at less than asset value.
The SEC issued new rules to curb this practice in 2005, but short floats established before that time were "grandfathered in".
See the Waffle Language at the SEC rules page:
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.
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.
V. Answers to Frequently-Asked Questions from Investors
- Is all naked short selling abusive or illegal?
When considering naked short selling, it is important to know which activity is the focus of discussion.
* Selling stock short without having located stock for delivery at settlement. This activity would violate Regulation SHO, except for short sales by market
makers engaged in bona fide market making. Market makers do not have to locate stock before selling short, because they need to be able to provide liquidity. However, market makers are not excepted from Regulation SHO's close-out and pre-borrow requirements.
* Selling stock short and failing to deliver shares at the time of settlement. This activity doesn't necessarily violate any rules. There are legitimate reasons why a seller may fail to deliver on the scheduled settlement date.
* Selling stock short and failing to deliver shares at the time of settlement with the purpose of driving down the security's price. This manipulative activity, in general, would violate various securities laws, including Rule 10b-5 under the Exchange Act. Regulation SHO does not address this issue.
But then in the 3rd paragraph of item 4.
It's Okay to break the rule if you are a broker dealer.
Because the Commission recognized that there are many reasons why broker-dealers may fail to deliver securities on settlement date, it designed and adopted Rule 15c6-1 to prohibit broker-dealers from contracting to settle transactions later than T+3. However, failure to deliver securities on T+3 does not violate the rule.
http://www.sec.gov/...
Yes it was good to be Madoff.