here's the entire read (part 1) courtesy of PB &
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Posted On: 01/23/2020 10:22:52 AM
here's the entire read (part 1) courtesy of PB & DC
The SEC & Me, Part I: #MeToo
November 10, 2019 24 min read
1) “Pariah for Life on Wall Street”
In 2002 Overstock went public using the Hambrecht Dutch Auction method. How did that come about?
The conventional IPO system is corrupt. I have given the full explanation numerous times in B-school talks, and will write it out here another day, but this is the basic principle: when people are in a position to allocate guaranteed profits they generally demand kick-backs, and that is true whether one is talking about Customs officials in Paraguay or white-shoe Wall Street bankers.
In late summer of 2001 one of our early board members, Gordon Macklin, an honest, straight-laced guy from Findlay, Ohio who had gone on to be the first CEO of NASD, asked me to the Bohemian Grove for a long weekend. Several times over the weekend he told me, “You gotta meet this guy Bill Hambrecht. He’s your cup of tea. He’s really Left, a limousine liberal, pals around with Nancy Pelosi and Dianne Feinstein, but you two are gonna love each other. You are both ‘up the organization’ type of guys. He’s really your cup of tea.” Gordon must have said it three times.
Gordon explained that Bill Hambrecht had come up with a way to defeat the kickback principle outlined above by using an action to make IPO allocations (thus removing the need for bankers to make IPO allocations, and hence, their opportunity to demand kickbacks).
By Christmas Eve 2001 we were working with Hambrecht on organizing an IPO for Spring 2002.
During 2001 numerous banks (e.g., Goldman, Lehman, CSFB, and half-a-dozen second and third tier banks) had been sniffing around (e.g., visiting us in Utah, having me come speak at their conferences) in anticipation of running our IPO. As things got rolling with Hambrecht, we let them all know the train was leaving the station, and Hambrecht would be involved. Goldman let us know immediately that they were not interested, but all the others expressed interest in participating. However, they all raised the same three objections:
The deal was too small (≈ $25 million), whereas even though the IPO market was dead that year, they claimed they had recently raised their minimums to ≈ $50 – $60 million;
The fees Hambrecht was willing to share (≈ 3%?) were too small, whereas they all demanded 7% (precisely 7%, no “≈” about it);
They would not “go to the right” of Hambrecht. The lead banker in an IPO puts its name in the upper left of the cover of the prospectus, and the space goes to any of the (then five) bulge bracket bank involved. Then the names step down and to the right in order of posh: second tier banks, third tier banks, etc. If two banks from the same tier are involved in an IPO, they squabble between themselves, but a bulge bracket (for example) does not “go the right” of a second-tier bank.
Throughout the months of run-up to the IPO road show, we tried to get the non-Hambrecht banks to join in, and even though the IPO market was dead-as-disco, no bank would budge on their demands.
Our firm’s Wilson Sonsini lawyer was part of these discussions, and he advised me, “Patrick, you’re smoking crack if you go public with Hambrecht when you could go public with Lehman or CSFB.”
Simply to satisfy my own curiosity (and only after receiving Bill Hambrecht’s permission), a few days before the finalization of the deal, I caved on all three points.
I called each of the other banks who had expressed an interest, and told them we change the deal to meet their needs. We would raise the deal to $60 million, we would raise the fees to 7%, and Hambrecht would go to the right of all the other banks. Just one thing (I added): “Hambrecht’s Dutch Auction does the allocation.”
Every single bank said, “No.” That was odd, as I had caved on all the of the points that had ostensibly separated us.
Finally one banker said aloud what I had just proven to myself: “Patrick, we will not be involved in any deal with Hambrecht.”
Another team of bankers flew to Utah, and delivered the same message, adding, “If we worked with Hambrecht there would be repercussions for us in other syndicates.”
An SVP of a well-known bank (and himself a good guy) flew out to Utah to meet myself and Jason Lindsey (then CFO of Overstock), to say, “Patrick, if you go through with this you will be a pariah for life on Wall Street”.
I thought about the short story I read in junior high school, something about a guy showing up at a party with a Black friend, and being told, “You can come into the party, but you’re friend cannot.” And I decided, “Screw it, we’ll do it alone with Hambrecht.” And we did.
Technically, the last night of the roadshow, Cantor Fitzgerald put their name on the deal as well.
We welcomed their doing so, as their firm had largely been wiped out by 9/11).
When the IPO was over, I sent a dozen roses to the SEC examiner who had been on our issue. I never heard back so I don’t know if she got them. Yet odd as it may sound now, I grew up in the Holy Church of Capital Markets, and I revered the SEC and its mission. I was raised to see a capital market as a web of millions of promises that people make to each other, and the SEC as the organization that makes those millions of promises be kept in good faith.
2) Salting the Wound
In early 2004 Google revved up to do their IPO, and as part of their “Don’t Be Evil” ethic they decided to be the second Dutch Auction IPO.
They came under intense pressure from Wall Street to back down, but while Wall Street walked away from us, no banker could walk away from Google’s IPO (with the exception of Goldman, who was not involved, so adamant were they not to see a Dutch Auction IPO get any traction).
Due to quiet period restrictions Google was not able to explain their thinking to the world. I received a call from someone on the Google Board of Directors, asking me to explain to the public why Google was making the choice that they were making. I did so extensively on TV and in print , explaining why the conventional IPO system was corrupt, why a Dutch Auction was more honest, and why Google’s “Don’t Be Evil” ethic was what had made them choose the Dutch Auction IPO.
I started being asked to speak in business schools on the subject, and did so repeatedly.
In 2004, the SEC contacted me to ask me about the criticisms I was making of the IPO process. I went in to their San Francisco office without a lawyer, went under oath, and told them everything I had learned about the IPO process by doing one. The superb Mark Fickes and his boss Tracy ______ were the ones deposing me, and when the day was over, they told me that I may have been the first CEO in history to do such a thing.
In 2004, a plaintiff’s attorney named “Roger Kirby” (?) filed a class action suit against Wall Street banks for price fixing, on the grounds that all IPOs always went at 7% fees, with no variation. He asked me to testify. On Good Friday, I sat in New York City around a table with Kirby plus ≈ 20 lawyers from all the major banks, explaining what was wrong with the standard IPO process. I did not try to bury a knife in anyone’s back: I told the truth about my experience, and when I had exculpatory information, I went out of my way to share that, too. Yet I said that the 7% price fix was small potatoes, and that the grift was in the allocation process. Goldman’s lawyer, an attractive brunette, glared at me for hours. I left the room knowing that “pariah” was too weak a word for what I had become.
3) The Opening Bell
Summer of 2004: Lehman Brothers hosted a luncheon for me.
A fellow named “David Rocker” showed up.
Glenn Krevlin (a hedge fund manager specializing in Retail) was there, and told me he was going to dump his stock, explaining that, “It does not matter what you do now, once this guy Rocker gets involved there is no way for you to win. He and his buddies will sink you. They have ways of taking you down.”
Another person at the luncheon suggested to me that Rocker was Mobbed-up.
An “independent research” shop in Phoenix, Arizona named “Camelback” began publishing scurrilous analyses of our firm. I ignored them until they attacked my 77 year old friend, Gordon Macklin, at which point I began rebutting them (in an earnings call).
Within days of that earnings call I got a phone call from a hedge fund macher named Chase Coleman (from one of the Baby Tigers) as he was dashing for a jet to whisk him and his team to China.
He told me, “Don’t let these Camelback guys get to you. Look, it’s just their business model. Hedge funds pay them $25,000/year. For that, you get to pick up the phone twice each year and order a hatchet job . You get to dictate reports, and even write them yourself, you tell them when to publish them, and a few days before they publish you build up a big short position, the report gets published, the stock drops, you cover, and you clean up. It’s a quick way to make a couple million bucks. Don’t take it personally. We’re client ourselves.”
I thought for a moment before replying slowly, “Gosh, Chase…. I’m not sure that’s…. right.”
A few weeks later, during Thanksgiving 2004, I happened to be in Scottsdale, Arizona, and three whistle-blowers from Camelback got in touch and came to my hotel. They explained that Camelback, “journalist” Herb Greenberg, and Rocker (along with many other hedge funds) were all involved in a scheme whereby those hedge funds took short positions in stocks, instructed the Camelback “analysts” (who were actually kids hired from Burger King) to write hatchet jobs (sometimes the hedge funds drafted the reports themselves), instructed Herb Greenberg to prepare identical news stories to release on TheStreet.com and through CNBC, and that the hedge funds were controlling not just the content but the timing of the release of those reports to maximize the benefit of their front-running. In other words, they confirmed what Chase had explained (as a client), and what we had been experiencing.
And thus was launched my mitzvah (which wall Street knows as my jihad). In September, 2004 I was 41 and working on getting a waiver to join the Army as an 11-Bravo, and figured the mitzvah would take me four months. Little did I know that the Camelback affair was small potatoes, perhaps even misdirection, and that the main event was buried in the issue of securities settlement. Unraveling it would take me 10 years.
4) Reg SHO
In the years leading up to the summer of 2004, the public grew aware of and concerned by “strategic settlement failures” on Wall Street: that is, participants (generally sophisticated hedge funds) using a trading strategy of flooding the market with non-existent stock in order to manipulate prices.
Among various other methods, this was done by “ short selling ” while claiming that one has found stock to borrow and deliver in three days (as as is required when one sells short), then failing to deliver. Selling and failing to deliver is known colloquially as “naked short selling”. It should really be thought of as a class of activities that manipulates stock prices through settlement failures, only one of which is the simple method I just described , and many of which are much more complicated.
For example, in time we learned that the origin of a great deal of the slop was something called the “Option Market Makers’ Exception”. Option Market Makers had an exception to the rules so they could go about their job of market-making. In fact, however, there existed a complicated trade whereby they could (via the magic of derivatives) in essence “ rent out ” their exception to the rules to hedge funds who did not want to follow the rules. Because some years earlier Bernie Madoff (in his role of Chairman of the NASD) had fought for and institutionalized the exception, it was known colloquially as “the Madoff Rule” or “the Madoff Exception,” which let exist a variety of trades that had exactly the same effect as plain old vanilla naked short selling, but through the magic of options were scattered in ways much more difficult to discover.
The outcry from the public exceeded anything previously experienced by the SEC (this, according to Peter Chepucavage, a former SEC attorney who was involved with the drafting of Reg SHO and on whose account I am relying here). They resisted doing anything, but eventually the mass outcry forced them to agree to propose a rule (“Regulation Short Selling” aka “Reg SHO”) that would fix the problem complained of by the public.
To fulfill its obligations under the 1946 Administrative Procedures Act (which requires agencies to provide drafts of regulations for public comment before finalizing them), the SEC posted a draft of a quasi-flimsy version of the Reg SHO rule for public comment.
The public blew up at the SEC for the flimsiness of the proposed rules, and thousands of comments were received demanding a much stiffer Reg SHO.
After the requisite waiting period, the SEC published its final Reg SHO: it had gone from being quasi-flimsy to hyper-flimsy (that is, in the opposite direction of the public outcry). In other words, the SEC had gamed the Administrative Procedures Act to get the weakest possible Reg SHO into place.
An interesting point about this is that before Reg SHO, the SEC was adamant that there was no problem of “strategic settlement failures”. The SEC hired an economist to study the question: Leslie Boni. Dr Boni studied it and wrote a report: “Strategic Delivery Failures in US Capital Markets”, which concluded that it was indeed a problem. Among its findings:
The putative counterbalance for traders practicing Strategic Settlement Failures is a brokerage process called a “buy-in”. She reviewed 65,000 cases and found that this corrective action of a “buy-in” had been initiated in 2 of them. In other words, brokers let each other get away with it 99.997% of the time.
On Christmas Eve, 2006 I telephoned Dr. Boni at the university to which she had moved. She told me that I had read only the unclassified version of her report, and that a classified version of it was in the hands of the SEC and was even more frightening. While she refused to go into detail, she said, “Let me put it this way, Patrick: after finishing writing that report, I called everyone in my family and told them to get every last dollar out of the stock market.”
In mid 2004 Reg SHO was adopted, and went into effect in early 2005.
One aspect of the flimsiness of Reg SHO was that the remedy it invoked was for a list to be published every day of publicly-listed firms experiencing settlement failures beyond a reasonable threshold. No information was to be provided to the public about who was doing the bad thing: just a list of the firms to whom the bad thing was being done, updated daily. Many noted that this would be like chum to the sharks who wanted to do more of it (as there is an incentive for them to swarm targeted firms).
Another oddity of Reg SHO is that within it, the SEC forgave all the settlement failures that were already in the market. On their FAQ page, the SEC wrote the following: “The grandfathering provisisons of Regulation SHO were adopted because the Commission was concerned about creating excessive market volatility where there were large preexisting open positions.” That is to say, they flipped from saying the problem does not exist, to saying the problem is so big that if we don’t forgive all that already exists and instead try to reverse it, the market will crack.
Another odd aspect of Reg SHO was that it did not disclose how many settlement failures already existed, on the grounds that doing so would “reveal the proprietary trading strategies of market participants.” That is to say, they went from saying that “hedge funds do not use this technique as a trading strategy,” to saying “we cannot disclose how much is in the market because that would reveal the trading strategy of the hedge funds who are doing it.”
Putting the two previous points together, the SEC went from holding this position, It does not really exist in quantity and it is not being done deliberately, to saying There is so much of it in the market it needs to be forgiven lest it blow up the market but we cannot tell you how much there is because that would disclose the strategies of the hedge funds we just said were not doing it strategically.
Please don’t gloss over that previous point. It is important, it really happened, and it tells you an immense amount about the world. In fact, it was coming across these pieces over a few nights in February 2005 that my slide down the rabbit hole began.
The SEC’s defense of the hyper-flimsy quality of Reg SHO was that it was still strong enough that it would be impossible for any firm to be on the Reg SHO list for more than 3 trading days (or perhaps, at the very most, 13 trading days).
Overstock’s experience – Reg SHO went into effect in January 2005. Immediately Overstock appeared on the Reg SHO list, and stayed on the Reg SHO list not for 3 days, not for 13 days, but for 998 straight trading days. This was nearly four years.
This occurred while Overstock was nearly unique in being an EBITDA-profitable eCommerce firm, growing quickly, and doing it all on 1/10 – 1/50th of the capital of our major competitors. That meant that, in an industry where every half-baked competitor could get capital to compete with us on the most generous of terms, we were never able to raise capital at the true market clearing price of the stock, because the market was not in fact clearing and settling our stock.
This meant, effectively, that despite an extraordinary childhood, the firm was locked out of the capital markets (while the rest of the industry accessed capital on the most generous of terms despite billions in losses).
5) The SEC Tries to Sink OSTK
During these years the SEC brought 6 actions against Overstock.
In the case of three of them, the SEC had to provide what is called a “letter admitting they found nothing and were dropping the investigation” (there is a technical term for this whose name I forget, but that is what it means).
In three of them they extracted the tiniest restatements in the history of the SEC: collectively, they totaled (as I recall) ≈ 5/100’s of 1% of Overstock revenue during the periods in question.
So OSTK took three SEC scalps, SEC plucked three OSTK hairs.
One of those SEC actions was timed in a particularly odd way.
We had dealings with two different offices of the SEC at once, and there were different deadlines on various events related to each. They created the most Kafkaesque situation I can imagine any regulator ever created. The intricacies of the trap I will not explain here (Jonathan could recreate it), but they created a trap created such that we could not go forward with filing quarterly numbers until one thing happened with one SEC office, and that could not happen until another thing happened with a different SEC office, and that could not happen until we filed the thing that they had just made it impossible to file. The notifications and letters they sent were done in an staggered way on precisely the dates they needed to be done to trap us in the timing bind I just described.
We finally broke the impasse by filing to the public through their electronic system unreviewed quarterly numbers, a move that no firm had ever done and which the SEC had not anticipated, so it slipped through the system and out to the public (thus meeting our legal obligation) before they could stop it. We then were able to unravel the rest of the legal knot they had tied.
Any lingering question I had about whether the SEC was trying to sabotage our firm was cleared up.
Also around that time, some information from within the SEC was leaked to me: a number of people within the SEC (I was informed by a whistleblower) were personally short OSTK. Two of them were high ranking figures, including an Assistant Director of Enforcement.
If true, that meant that while they were trying to construct nightmarish regulatory hogties for us, and letting our firm’s stock languish on their “3 day” Reg SHO list for four years, and and piling on us endlessly with six investigations (three of which each led to them plucking one hair from us, and three of them leading to them having to write us letters dropping their investigations empty-handed), in the face of all data and arguments about why when it came to our stock they were being indolent in performing their most basic job duties (prompt clearing and settlement of trading in OSTK), it turned out (I was told) that there were individual employees of the SEC who would personally stand to benefit from letting us be destroyed by this treatment.
Some years later, a journalist submitted a FOIA request for data regarding SEC employees who were personally short OSTK while these odd and unprecedented regulatory decisions were being made regarding us, and while they let us languish for four years on their 3-day Reg SHO list. The SEC’s response was as obstructionist as a FOIA response can be. That journalist soldiered on in an attempt to get those records, but I intervened and requested the journalist drop the FOIA (I was trying to pour oil on troubled waters with the SEC, and actually trying to help them rebuild the shattered confidence of the public in their work: this was probably 2012-2013).
Jonathan and I realized somewhere in there that we were in a political fight of some kind. We thought everything was about rules and laws and facts, but we came to understand there was a political dimension to whatever we were fighting, and we had to mount a political effort if we were going to save our firm.
6) “All Politics Are Local” -Tip O’Neil
In 2005-2006 Jonathan and I worked to get the State of Utah legislature to pass the requisite legislation that would govern any brokers in Utah. All the major New York banks have operations in Utah: thus, it would have been a back-door way to get the issue solved for the entire country. It was sponsored by Utah State Senator Curt Bramble, and signed that evening by Governor Huntsman.
In one three day period, Governor Huntsmen went from having publicly signed the bill hours after it passed and taking credit at a press conference for having fixed the US capital markets…. to deciding with no notice or explanation to delay implementation of the bill for one year. How odd.
The task of killing the bill was given to the chief real estate lobbyist in Utah: Greg Something-or-Other.
Senator Curt Bramble had been the sponsor of the Utah bill that was passed. In the months he was not a legislator, Senator Bramble is a tax accountant.
In the following 6 months, three large real estate developers in Nevada and Utah shifted their tax accounting business to Bramble.
Bramble showed up for the legislative session that began a few months later, and sponsored a midnight no-notice no-committee session to overturn the very bill he had gotten passed the previous year. How odd.
7) Johnson & Byrne Go to Washington
Starting in 2005 Jonathan and I also started going to Washington, DC attempting to get help from forces regarding manipulation in our stock, manipulation that was so notorious that it went on to become historic (a handful of other highly manipulated companies spent 40 or 50 days in the Reg SHO list of manipulated companies, but OSTK spent 998 days). Some of those efforts involved asking the SEC itself simply to start enforcing its own rules, such as the “buy-in” that is supposed to be the standard way for the system to police itself, but which the SEC’s own economist Leslie Boni had discovered had happened in only two of the 65,000 cases she studied, and in the case of OSTK, went 998 straight trading days without happening. But some of the efforts centered on getting the rules tightened.
Without getting too legalistic, there were two ways the problem could have been addressed.
One was by convincing the SEC to enforce its own rules;
The other was getting Congress to tighten four words in one line of one rule so that the prime brokers would not have any room within which to continue wiggling or allowing their hedge fund clients to wiggle. Those four words in question were “….reasonable good faith belief….”
In other words, when hedge funds and prime brokers were pressed on how they were committing massive settlement failures over and over and over, the defense they made was, “as long as we had ‘reasonable good faith belief’ that our trade would settle, we are not in violation of the rule.”
How does one ever prove that someone did not have “a reasonable good faith belief” about anything? It is such a squishy standard that SEC enforcement actions are impossible to bring. Even when someone does it for 998 trading days straight, they could maintain that they had had reasonable good faith belief that the next time their trades would settle, and that their belief had happened to be wrong….. over and over again every day 998 days in a row. Again, no kidding: that excuse got them off the hook.
Attempts to get the SEC to enforce its own rules were met with a response best described in Kafka’s “Man Before the Law” parable.
As a result, our efforts gradually turned into a campaign led Jonathan Johnson (now CEO of Overstock) to get others in Washington to do something about the problem. We had a reason to do so for our shareholders: until the SEC forced the massive quantities of failures of OSTK to settle, our shareholders could not know the true market-clearing price of our securities (nor could we raise capital fairly).
I wish to note that the Party Line PhD-NPC response to this claim was, “Short selling, including failures to deliver, do not affect the price of the underlying security.” That is a silly claim put out by Finance PhD’s (whom Buffett describes as, “People who spent 4 years in a room learning to talk to each other in Greek letters”). Yet it was enough for NPC journalists to have something to recite.
How can we know it was a silly claim? Because this past summer Overstock tried to issue a blockchain-based dividend (hence, one that could not “fail to deliver”). What happened? The SEC called “Bazoomba!” and threatened the board (I am told) with a stock manipulation action. Thus, in the mind of the SEC, failures to deliver do not affect the price of a security, but forcing failures to deliver to settle does affect the price of a security, and therefore counts as stock manipulation. Got it?
So the mission of Jonathan and me (but 90% of the time, just Jonathan) became to go to various committees in the House and Senate to explain how those four vague words could be tightened slightly and end the problem for the entire market.
Wherever we went, the prime brokers showed up lobbying against tightening those four words of vagueness.
For example, New Mexico Senator Pete Dominici (D) had a senior staffer who was himself being a former banker from (if I recall correctly) Morgan Stanley. He pulled me aside one visit and said, “You are right about all this, you know. The thing is, for every time you are in here telling the Senator this, Goldman Sachs is in here 10 times, 20 times, telling him to ignore you.”
Over and over Jonathan explained four things to the politicians:
Get the SEC to remove the “Grandfather” clause for the slop that was already in the market, to force the hedge funds to settle the failed trades from the past.
Eliminate the Option Market Maker exception (a.k.a. “the Madoff Exception”) whereby market makers rent out to hedge funds the exception to the rules enjoyed by those market makers.
Change the requirement to “Locate” stock before short-selling from the squishy standard of “reasonable good faith belief” to something enforceable (since the SEC and DOJ themselves were telling us the standard as it existed was unenforceable).
Lastly, we argued that the disclosure should be not of the companies that were being victimized, but rather, what should be Disclosed should be the amount of the victimization (which would have created opportunities for other traders to spot and trade against it, perhaps bringing market pressure against the problem), and arguably, who was failing to deliver .
Jonathan came up with a clever acronym: he argued for a “GOLD Standard” (meaning, end the Grandfathering, restrict the Option Market Maker exception [Madoff Rule], tighten the four words “reasonable good faith belief” that one had Located stock to borrow so one would not fail to deliver, and Disclose the failure data: “GOLD”). Again, Wall Street showed up and fought against every inch of this with every senator and congressmen we visited.
While Jonathan worked to awake Washington to the problem, and followed the normal processes citizens use to get laws changed and enforced, I handled a different prong. I became extremely interested in how the organs of government were responding to the efforts we were making. After all, we had a lead-pipe-cinch: we had whistle-blowers, we had economists, we had data galore, we had everything necessary to convince any rational observer that the savings of America were being looted, companies were being destroyed, and Wall Street was going to melt down. Yet the system did not change. It went well beyond bureaucracy: something deep and mysterious was fighting against us. Mapping and fighting that force became my job.
In time (and please pay attention to this story, because in the future its relevance will become more apparent), my efforts led me into the arms of the United States Senate Judiciary Committee.
This happened because the Constitution gives oversight of the government to Congress, and the Senate has oversight of the Department of Justice, which includes the court system, and is (at least theoretically) the highest court in the land (e.g., it holds the power to impeach). The Senate’s Judiciary Committee has oversight of any activity covered by a civil or criminal penalty in the United States of America. That is a broad mandate indeed, and in practice it means this: the Senate Judiciary Committee is the ultimate player on anything regarding corruption in America.
I have often publicly said that in those years we fought to save our company (and by extension, the US capital market) from the harm this faulty settlement system was creating, I learned that Washington was “turtles all the way down” (to borrow an old gag). This was false: I was always hiding the involvement of the Senate Judiciary Committee. As the people who have the ultimate responsibility of stopping corruption in the United States, the Senate Judiciary Committee became intrigued by the same thing that was intriguing me: Why were the organs of the federal government that should have been responding to the overwhelming evidence we were bringing them, in fact staying indolent and non-responsive, if not outright hostile
Over time I was introduced to most of the Senators and staffers of both parties on the committee. They were smart, hospitable, and intellectually interested in precisely the right issue: What was the reception we were getting from all the parts of government with which we were interacting? Their staffers (both parties) were sharp as tacks and intellectually curious, and rather than having to fight to get time on their schedules, these Senators and staffers were anxious for us to come see them, to fill them in on what we were learning as we bounced around the corridors of power in DC.
I began to bring witness after witness to the Senate Judiciary Committee, expert economists, 30 year Wall Street participants, whistle-blowers who came to me, etc. It started as something I was doing to force the manipulation in our own stock to end, and then I realized how much harm the market manipulation was causing other small market-cap companies, and then I realized how much money was being robbed from American investors by the practice, and eventually I realized that it was going to crater the US financial system.
It culminated in a rather unusual day: in 2006 I was invited to prepare for a hearing in a chamber of the Senate, and bring a number of experts and whistle-blowers who had been working with me. We had a month to prepare.
When we went in, myself and 4-5 other people were directed to sit in the seats in the hearing room where Senators normally sit.
The room was filled with about 40 people from across the federal bureaucracy: FBI/DOJ, Treasury, GAO, and who knows what other agencies.
I acted as ringmaster for it all.
Just as I called the meeting to order, Senator Goldman Sachs (née Chuck Schumer) came storming in with two of his staffers, and rudely inserted himself between myself and the microphone.
Pointing out that he was the only Senator on both the Banking and the Judiciary committees, he insisted that the subject of the meeting violated his prerogatives in some way and demanded it be shut down.
A young staffer working for Chairman Arlen Specter (a Democrat turned Republican turned [later] a Democrat) stood up to Senator Goldman. he said, “Chairman Specter has asked us to schedule this meeting, it is being done on his say-so, and the meeting is going to proceed.”
Senator Goldman and his entourage glared at me then stalked off in a huff.
That young staffer was named Brett Tolman, and he went on to become a United States Attorney. He is also the man who speaks at minute 1:20 of this video about me.
The whistle-blowers I had brought spoke for about three hours to the ≈ 40 federales in attendance. They walked through details, they covered every aspect of criminality on Wall Street you could imagine. Soon they were providing names, dates, and information so detailed we all began squirming about what the ramifications might look like.
When we were finished and were breaking up, a man who had been in the back of the room approached me. Again, in one of those conversations I will cherish to my dying day, this is what was said.
He pulled out a badge showing that he was in the Secret Service. I said, “That’s part of the Treasury, right?” He said something like, I spent my career as part of the Treasury, but in a recent reorganization we became part of the Department of Homeland Security (I happen to remember that).
He told me, “Patrick, you wait 20 years in this job for people like this to come through the door and answer questions like this. I have no idea how you got this to happen. Is there anything we can do for you?”
I told him, “Sir, to be honest, I am dancing right at the edge of the law here. I’m dealing with whistle-blowers, I’m doing some wild things. I think I have to because my company is being destroyed and the marketplace is going to melt down if we don’t get this sorted out, but I fear you are going to be seeing me in handcuffs someday.”
PLEASE REMEMBER THE PRECEDING STORY. IN THE MONTHS AHEAD IT MAY PROVE IMPORTANT.
Global Financial Crisis of 2008
As has been explained elsewhere in this blog, Alan Greenspan attributed the crisis of 2008 to the failure of the settlement system (along with “fraud” such as Bernie Madoff and “securitization” such as Mortgage Backed Securities). That was precisely what I had understood was coming and had lost sleep over for four years.
We started receiving calls from Washington asking for information regarding trading in firms in the jurisdictions of various House and Senate members, and we helped them by providing immense amounts of data. Some of that drew on a system that I had spent $2 million of my own money building, buying data from various sources, hiring database engineers, and piping it all together.
Congress told me that they could not rely on me, they needed to recreate it themselves. We told them how to do so.
Two weeks later the House Permanent Subcommittee on investigations called us back, saying, We have learned this will cost a couple of million dollars to build! Will you really just give us all the data?
I said, “We will,” and signed some piece of paper that said, Whatever research you ask us for, we will provide you the straight data without alteration. My team then just continued providing them all that work for free.
I kept up my obligations in helping the feds with their requests. By the end of 2009, I received that call (described elsewhere) that “you are going to see handcuffs coming out this week, and you have to live the rest of your life knowing that everyone you see us arrest understands that your fingerprints are on their problems.”
The reader might imagine that the days of the crisis were celebratory ones for me for having been vindicated, but the opposite is true. I grew more and more sickened. In truth, I checked out. I hired off-duty SWAT guys to protect me, I started packing a weapon (one exhausted day this happened: when I got out of jail I went home and found my socks in the gun safe), and eventually I checked out of the whole thing. While the rest of America had its heart broken to realize what Wall Street had become at its core, emotionally I moved on. My heart had broken in 2005-2009. Once everything that I had lost sleep over began happening, I (who had lived it 100 times in my nightmares) could not watch anymore. I wrote the odd blog when appropriate, but I was over it. I focused on Overstock, and we turned in 7 years of GAAP profits, without ever seeing our stock move in response, and thus, without being able to raise capital and expand as we would have been able to do were we any other eCommerce firm in America.
There was one exception to this. National Security circles began paying a lot of attention to Deep Capture. I was invited to give several talks, such as this that appears here in non-classified form as Economic Warfare as an Instrument of Transnational Organized Crime. The National Security community came to understand the sloppiness of our settlement system as a vulnerability of the nation, and my understanding is that they leaned on the SEC and forced them to change their tune. Sometime about seven years ago, the SEC got significantly more serious about enforcing rules on settlement.
In 2006 my mentor General Jack Vessey rebuked me for being so harsh about the SEC. He said, “You should not be so tough on them. No federal employee goes into work each day hoping to do a bad job.” We saw each other in January, 2009, and he told me, “I rescind all previous advice I gave you about the SEC.”
But actually, my feelings about the SEC softened. Once it was too late to stop the 2008 crisis from happening, I tried to be supportive of the SEC, in time. I knew that one of their missions is to promote the public’s faith and confidence in the capital market. I knew that there were people there who felt that they had let the USA down. Once I was no longer having to shout at them from the rooftops, and saw that they were trying to address their issues, I began trying to be more positive about them as the years ticked by. I wanted to be a good citizen, by helping them restore that public faith and confidence in the market.
But mostly, as people went to jail, books got written, and our lawsuits wound up, I just moved on.
https://www.deepcapture.com/2019/11/the-sec-me-metoo-part-i/
disclosure .. long term investor in Overstock ..
The SEC & Me, Part I: #MeToo
November 10, 2019 24 min read
1) “Pariah for Life on Wall Street”
In 2002 Overstock went public using the Hambrecht Dutch Auction method. How did that come about?
The conventional IPO system is corrupt. I have given the full explanation numerous times in B-school talks, and will write it out here another day, but this is the basic principle: when people are in a position to allocate guaranteed profits they generally demand kick-backs, and that is true whether one is talking about Customs officials in Paraguay or white-shoe Wall Street bankers.
In late summer of 2001 one of our early board members, Gordon Macklin, an honest, straight-laced guy from Findlay, Ohio who had gone on to be the first CEO of NASD, asked me to the Bohemian Grove for a long weekend. Several times over the weekend he told me, “You gotta meet this guy Bill Hambrecht. He’s your cup of tea. He’s really Left, a limousine liberal, pals around with Nancy Pelosi and Dianne Feinstein, but you two are gonna love each other. You are both ‘up the organization’ type of guys. He’s really your cup of tea.” Gordon must have said it three times.
Gordon explained that Bill Hambrecht had come up with a way to defeat the kickback principle outlined above by using an action to make IPO allocations (thus removing the need for bankers to make IPO allocations, and hence, their opportunity to demand kickbacks).
By Christmas Eve 2001 we were working with Hambrecht on organizing an IPO for Spring 2002.
During 2001 numerous banks (e.g., Goldman, Lehman, CSFB, and half-a-dozen second and third tier banks) had been sniffing around (e.g., visiting us in Utah, having me come speak at their conferences) in anticipation of running our IPO. As things got rolling with Hambrecht, we let them all know the train was leaving the station, and Hambrecht would be involved. Goldman let us know immediately that they were not interested, but all the others expressed interest in participating. However, they all raised the same three objections:
The deal was too small (≈ $25 million), whereas even though the IPO market was dead that year, they claimed they had recently raised their minimums to ≈ $50 – $60 million;
The fees Hambrecht was willing to share (≈ 3%?) were too small, whereas they all demanded 7% (precisely 7%, no “≈” about it);
They would not “go to the right” of Hambrecht. The lead banker in an IPO puts its name in the upper left of the cover of the prospectus, and the space goes to any of the (then five) bulge bracket bank involved. Then the names step down and to the right in order of posh: second tier banks, third tier banks, etc. If two banks from the same tier are involved in an IPO, they squabble between themselves, but a bulge bracket (for example) does not “go the right” of a second-tier bank.
Throughout the months of run-up to the IPO road show, we tried to get the non-Hambrecht banks to join in, and even though the IPO market was dead-as-disco, no bank would budge on their demands.
Our firm’s Wilson Sonsini lawyer was part of these discussions, and he advised me, “Patrick, you’re smoking crack if you go public with Hambrecht when you could go public with Lehman or CSFB.”
Simply to satisfy my own curiosity (and only after receiving Bill Hambrecht’s permission), a few days before the finalization of the deal, I caved on all three points.
I called each of the other banks who had expressed an interest, and told them we change the deal to meet their needs. We would raise the deal to $60 million, we would raise the fees to 7%, and Hambrecht would go to the right of all the other banks. Just one thing (I added): “Hambrecht’s Dutch Auction does the allocation.”
Every single bank said, “No.” That was odd, as I had caved on all the of the points that had ostensibly separated us.
Finally one banker said aloud what I had just proven to myself: “Patrick, we will not be involved in any deal with Hambrecht.”
Another team of bankers flew to Utah, and delivered the same message, adding, “If we worked with Hambrecht there would be repercussions for us in other syndicates.”
An SVP of a well-known bank (and himself a good guy) flew out to Utah to meet myself and Jason Lindsey (then CFO of Overstock), to say, “Patrick, if you go through with this you will be a pariah for life on Wall Street”.
I thought about the short story I read in junior high school, something about a guy showing up at a party with a Black friend, and being told, “You can come into the party, but you’re friend cannot.” And I decided, “Screw it, we’ll do it alone with Hambrecht.” And we did.
Technically, the last night of the roadshow, Cantor Fitzgerald put their name on the deal as well.
We welcomed their doing so, as their firm had largely been wiped out by 9/11).
When the IPO was over, I sent a dozen roses to the SEC examiner who had been on our issue. I never heard back so I don’t know if she got them. Yet odd as it may sound now, I grew up in the Holy Church of Capital Markets, and I revered the SEC and its mission. I was raised to see a capital market as a web of millions of promises that people make to each other, and the SEC as the organization that makes those millions of promises be kept in good faith.
2) Salting the Wound
In early 2004 Google revved up to do their IPO, and as part of their “Don’t Be Evil” ethic they decided to be the second Dutch Auction IPO.
They came under intense pressure from Wall Street to back down, but while Wall Street walked away from us, no banker could walk away from Google’s IPO (with the exception of Goldman, who was not involved, so adamant were they not to see a Dutch Auction IPO get any traction).
Due to quiet period restrictions Google was not able to explain their thinking to the world. I received a call from someone on the Google Board of Directors, asking me to explain to the public why Google was making the choice that they were making. I did so extensively on TV and in print , explaining why the conventional IPO system was corrupt, why a Dutch Auction was more honest, and why Google’s “Don’t Be Evil” ethic was what had made them choose the Dutch Auction IPO.
I started being asked to speak in business schools on the subject, and did so repeatedly.
In 2004, the SEC contacted me to ask me about the criticisms I was making of the IPO process. I went in to their San Francisco office without a lawyer, went under oath, and told them everything I had learned about the IPO process by doing one. The superb Mark Fickes and his boss Tracy ______ were the ones deposing me, and when the day was over, they told me that I may have been the first CEO in history to do such a thing.
In 2004, a plaintiff’s attorney named “Roger Kirby” (?) filed a class action suit against Wall Street banks for price fixing, on the grounds that all IPOs always went at 7% fees, with no variation. He asked me to testify. On Good Friday, I sat in New York City around a table with Kirby plus ≈ 20 lawyers from all the major banks, explaining what was wrong with the standard IPO process. I did not try to bury a knife in anyone’s back: I told the truth about my experience, and when I had exculpatory information, I went out of my way to share that, too. Yet I said that the 7% price fix was small potatoes, and that the grift was in the allocation process. Goldman’s lawyer, an attractive brunette, glared at me for hours. I left the room knowing that “pariah” was too weak a word for what I had become.
3) The Opening Bell
Summer of 2004: Lehman Brothers hosted a luncheon for me.
A fellow named “David Rocker” showed up.
Glenn Krevlin (a hedge fund manager specializing in Retail) was there, and told me he was going to dump his stock, explaining that, “It does not matter what you do now, once this guy Rocker gets involved there is no way for you to win. He and his buddies will sink you. They have ways of taking you down.”
Another person at the luncheon suggested to me that Rocker was Mobbed-up.
An “independent research” shop in Phoenix, Arizona named “Camelback” began publishing scurrilous analyses of our firm. I ignored them until they attacked my 77 year old friend, Gordon Macklin, at which point I began rebutting them (in an earnings call).
Within days of that earnings call I got a phone call from a hedge fund macher named Chase Coleman (from one of the Baby Tigers) as he was dashing for a jet to whisk him and his team to China.
He told me, “Don’t let these Camelback guys get to you. Look, it’s just their business model. Hedge funds pay them $25,000/year. For that, you get to pick up the phone twice each year and order a hatchet job . You get to dictate reports, and even write them yourself, you tell them when to publish them, and a few days before they publish you build up a big short position, the report gets published, the stock drops, you cover, and you clean up. It’s a quick way to make a couple million bucks. Don’t take it personally. We’re client ourselves.”
I thought for a moment before replying slowly, “Gosh, Chase…. I’m not sure that’s…. right.”
A few weeks later, during Thanksgiving 2004, I happened to be in Scottsdale, Arizona, and three whistle-blowers from Camelback got in touch and came to my hotel. They explained that Camelback, “journalist” Herb Greenberg, and Rocker (along with many other hedge funds) were all involved in a scheme whereby those hedge funds took short positions in stocks, instructed the Camelback “analysts” (who were actually kids hired from Burger King) to write hatchet jobs (sometimes the hedge funds drafted the reports themselves), instructed Herb Greenberg to prepare identical news stories to release on TheStreet.com and through CNBC, and that the hedge funds were controlling not just the content but the timing of the release of those reports to maximize the benefit of their front-running. In other words, they confirmed what Chase had explained (as a client), and what we had been experiencing.
And thus was launched my mitzvah (which wall Street knows as my jihad). In September, 2004 I was 41 and working on getting a waiver to join the Army as an 11-Bravo, and figured the mitzvah would take me four months. Little did I know that the Camelback affair was small potatoes, perhaps even misdirection, and that the main event was buried in the issue of securities settlement. Unraveling it would take me 10 years.
4) Reg SHO
In the years leading up to the summer of 2004, the public grew aware of and concerned by “strategic settlement failures” on Wall Street: that is, participants (generally sophisticated hedge funds) using a trading strategy of flooding the market with non-existent stock in order to manipulate prices.
Among various other methods, this was done by “ short selling ” while claiming that one has found stock to borrow and deliver in three days (as as is required when one sells short), then failing to deliver. Selling and failing to deliver is known colloquially as “naked short selling”. It should really be thought of as a class of activities that manipulates stock prices through settlement failures, only one of which is the simple method I just described , and many of which are much more complicated.
For example, in time we learned that the origin of a great deal of the slop was something called the “Option Market Makers’ Exception”. Option Market Makers had an exception to the rules so they could go about their job of market-making. In fact, however, there existed a complicated trade whereby they could (via the magic of derivatives) in essence “ rent out ” their exception to the rules to hedge funds who did not want to follow the rules. Because some years earlier Bernie Madoff (in his role of Chairman of the NASD) had fought for and institutionalized the exception, it was known colloquially as “the Madoff Rule” or “the Madoff Exception,” which let exist a variety of trades that had exactly the same effect as plain old vanilla naked short selling, but through the magic of options were scattered in ways much more difficult to discover.
The outcry from the public exceeded anything previously experienced by the SEC (this, according to Peter Chepucavage, a former SEC attorney who was involved with the drafting of Reg SHO and on whose account I am relying here). They resisted doing anything, but eventually the mass outcry forced them to agree to propose a rule (“Regulation Short Selling” aka “Reg SHO”) that would fix the problem complained of by the public.
To fulfill its obligations under the 1946 Administrative Procedures Act (which requires agencies to provide drafts of regulations for public comment before finalizing them), the SEC posted a draft of a quasi-flimsy version of the Reg SHO rule for public comment.
The public blew up at the SEC for the flimsiness of the proposed rules, and thousands of comments were received demanding a much stiffer Reg SHO.
After the requisite waiting period, the SEC published its final Reg SHO: it had gone from being quasi-flimsy to hyper-flimsy (that is, in the opposite direction of the public outcry). In other words, the SEC had gamed the Administrative Procedures Act to get the weakest possible Reg SHO into place.
An interesting point about this is that before Reg SHO, the SEC was adamant that there was no problem of “strategic settlement failures”. The SEC hired an economist to study the question: Leslie Boni. Dr Boni studied it and wrote a report: “Strategic Delivery Failures in US Capital Markets”, which concluded that it was indeed a problem. Among its findings:
The putative counterbalance for traders practicing Strategic Settlement Failures is a brokerage process called a “buy-in”. She reviewed 65,000 cases and found that this corrective action of a “buy-in” had been initiated in 2 of them. In other words, brokers let each other get away with it 99.997% of the time.
On Christmas Eve, 2006 I telephoned Dr. Boni at the university to which she had moved. She told me that I had read only the unclassified version of her report, and that a classified version of it was in the hands of the SEC and was even more frightening. While she refused to go into detail, she said, “Let me put it this way, Patrick: after finishing writing that report, I called everyone in my family and told them to get every last dollar out of the stock market.”
In mid 2004 Reg SHO was adopted, and went into effect in early 2005.
One aspect of the flimsiness of Reg SHO was that the remedy it invoked was for a list to be published every day of publicly-listed firms experiencing settlement failures beyond a reasonable threshold. No information was to be provided to the public about who was doing the bad thing: just a list of the firms to whom the bad thing was being done, updated daily. Many noted that this would be like chum to the sharks who wanted to do more of it (as there is an incentive for them to swarm targeted firms).
Another oddity of Reg SHO is that within it, the SEC forgave all the settlement failures that were already in the market. On their FAQ page, the SEC wrote the following: “The grandfathering provisisons of Regulation SHO were adopted because the Commission was concerned about creating excessive market volatility where there were large preexisting open positions.” That is to say, they flipped from saying the problem does not exist, to saying the problem is so big that if we don’t forgive all that already exists and instead try to reverse it, the market will crack.
Another odd aspect of Reg SHO was that it did not disclose how many settlement failures already existed, on the grounds that doing so would “reveal the proprietary trading strategies of market participants.” That is to say, they went from saying that “hedge funds do not use this technique as a trading strategy,” to saying “we cannot disclose how much is in the market because that would reveal the trading strategy of the hedge funds who are doing it.”
Putting the two previous points together, the SEC went from holding this position, It does not really exist in quantity and it is not being done deliberately, to saying There is so much of it in the market it needs to be forgiven lest it blow up the market but we cannot tell you how much there is because that would disclose the strategies of the hedge funds we just said were not doing it strategically.
Please don’t gloss over that previous point. It is important, it really happened, and it tells you an immense amount about the world. In fact, it was coming across these pieces over a few nights in February 2005 that my slide down the rabbit hole began.
The SEC’s defense of the hyper-flimsy quality of Reg SHO was that it was still strong enough that it would be impossible for any firm to be on the Reg SHO list for more than 3 trading days (or perhaps, at the very most, 13 trading days).
Overstock’s experience – Reg SHO went into effect in January 2005. Immediately Overstock appeared on the Reg SHO list, and stayed on the Reg SHO list not for 3 days, not for 13 days, but for 998 straight trading days. This was nearly four years.
This occurred while Overstock was nearly unique in being an EBITDA-profitable eCommerce firm, growing quickly, and doing it all on 1/10 – 1/50th of the capital of our major competitors. That meant that, in an industry where every half-baked competitor could get capital to compete with us on the most generous of terms, we were never able to raise capital at the true market clearing price of the stock, because the market was not in fact clearing and settling our stock.
This meant, effectively, that despite an extraordinary childhood, the firm was locked out of the capital markets (while the rest of the industry accessed capital on the most generous of terms despite billions in losses).
5) The SEC Tries to Sink OSTK
During these years the SEC brought 6 actions against Overstock.
In the case of three of them, the SEC had to provide what is called a “letter admitting they found nothing and were dropping the investigation” (there is a technical term for this whose name I forget, but that is what it means).
In three of them they extracted the tiniest restatements in the history of the SEC: collectively, they totaled (as I recall) ≈ 5/100’s of 1% of Overstock revenue during the periods in question.
So OSTK took three SEC scalps, SEC plucked three OSTK hairs.
One of those SEC actions was timed in a particularly odd way.
We had dealings with two different offices of the SEC at once, and there were different deadlines on various events related to each. They created the most Kafkaesque situation I can imagine any regulator ever created. The intricacies of the trap I will not explain here (Jonathan could recreate it), but they created a trap created such that we could not go forward with filing quarterly numbers until one thing happened with one SEC office, and that could not happen until another thing happened with a different SEC office, and that could not happen until we filed the thing that they had just made it impossible to file. The notifications and letters they sent were done in an staggered way on precisely the dates they needed to be done to trap us in the timing bind I just described.
We finally broke the impasse by filing to the public through their electronic system unreviewed quarterly numbers, a move that no firm had ever done and which the SEC had not anticipated, so it slipped through the system and out to the public (thus meeting our legal obligation) before they could stop it. We then were able to unravel the rest of the legal knot they had tied.
Any lingering question I had about whether the SEC was trying to sabotage our firm was cleared up.
Also around that time, some information from within the SEC was leaked to me: a number of people within the SEC (I was informed by a whistleblower) were personally short OSTK. Two of them were high ranking figures, including an Assistant Director of Enforcement.
If true, that meant that while they were trying to construct nightmarish regulatory hogties for us, and letting our firm’s stock languish on their “3 day” Reg SHO list for four years, and and piling on us endlessly with six investigations (three of which each led to them plucking one hair from us, and three of them leading to them having to write us letters dropping their investigations empty-handed), in the face of all data and arguments about why when it came to our stock they were being indolent in performing their most basic job duties (prompt clearing and settlement of trading in OSTK), it turned out (I was told) that there were individual employees of the SEC who would personally stand to benefit from letting us be destroyed by this treatment.
Some years later, a journalist submitted a FOIA request for data regarding SEC employees who were personally short OSTK while these odd and unprecedented regulatory decisions were being made regarding us, and while they let us languish for four years on their 3-day Reg SHO list. The SEC’s response was as obstructionist as a FOIA response can be. That journalist soldiered on in an attempt to get those records, but I intervened and requested the journalist drop the FOIA (I was trying to pour oil on troubled waters with the SEC, and actually trying to help them rebuild the shattered confidence of the public in their work: this was probably 2012-2013).
Jonathan and I realized somewhere in there that we were in a political fight of some kind. We thought everything was about rules and laws and facts, but we came to understand there was a political dimension to whatever we were fighting, and we had to mount a political effort if we were going to save our firm.
6) “All Politics Are Local” -Tip O’Neil
In 2005-2006 Jonathan and I worked to get the State of Utah legislature to pass the requisite legislation that would govern any brokers in Utah. All the major New York banks have operations in Utah: thus, it would have been a back-door way to get the issue solved for the entire country. It was sponsored by Utah State Senator Curt Bramble, and signed that evening by Governor Huntsman.
In one three day period, Governor Huntsmen went from having publicly signed the bill hours after it passed and taking credit at a press conference for having fixed the US capital markets…. to deciding with no notice or explanation to delay implementation of the bill for one year. How odd.
The task of killing the bill was given to the chief real estate lobbyist in Utah: Greg Something-or-Other.
Senator Curt Bramble had been the sponsor of the Utah bill that was passed. In the months he was not a legislator, Senator Bramble is a tax accountant.
In the following 6 months, three large real estate developers in Nevada and Utah shifted their tax accounting business to Bramble.
Bramble showed up for the legislative session that began a few months later, and sponsored a midnight no-notice no-committee session to overturn the very bill he had gotten passed the previous year. How odd.
7) Johnson & Byrne Go to Washington
Starting in 2005 Jonathan and I also started going to Washington, DC attempting to get help from forces regarding manipulation in our stock, manipulation that was so notorious that it went on to become historic (a handful of other highly manipulated companies spent 40 or 50 days in the Reg SHO list of manipulated companies, but OSTK spent 998 days). Some of those efforts involved asking the SEC itself simply to start enforcing its own rules, such as the “buy-in” that is supposed to be the standard way for the system to police itself, but which the SEC’s own economist Leslie Boni had discovered had happened in only two of the 65,000 cases she studied, and in the case of OSTK, went 998 straight trading days without happening. But some of the efforts centered on getting the rules tightened.
Without getting too legalistic, there were two ways the problem could have been addressed.
One was by convincing the SEC to enforce its own rules;
The other was getting Congress to tighten four words in one line of one rule so that the prime brokers would not have any room within which to continue wiggling or allowing their hedge fund clients to wiggle. Those four words in question were “….reasonable good faith belief….”
In other words, when hedge funds and prime brokers were pressed on how they were committing massive settlement failures over and over and over, the defense they made was, “as long as we had ‘reasonable good faith belief’ that our trade would settle, we are not in violation of the rule.”
How does one ever prove that someone did not have “a reasonable good faith belief” about anything? It is such a squishy standard that SEC enforcement actions are impossible to bring. Even when someone does it for 998 trading days straight, they could maintain that they had had reasonable good faith belief that the next time their trades would settle, and that their belief had happened to be wrong….. over and over again every day 998 days in a row. Again, no kidding: that excuse got them off the hook.
Attempts to get the SEC to enforce its own rules were met with a response best described in Kafka’s “Man Before the Law” parable.
As a result, our efforts gradually turned into a campaign led Jonathan Johnson (now CEO of Overstock) to get others in Washington to do something about the problem. We had a reason to do so for our shareholders: until the SEC forced the massive quantities of failures of OSTK to settle, our shareholders could not know the true market-clearing price of our securities (nor could we raise capital fairly).
I wish to note that the Party Line PhD-NPC response to this claim was, “Short selling, including failures to deliver, do not affect the price of the underlying security.” That is a silly claim put out by Finance PhD’s (whom Buffett describes as, “People who spent 4 years in a room learning to talk to each other in Greek letters”). Yet it was enough for NPC journalists to have something to recite.
How can we know it was a silly claim? Because this past summer Overstock tried to issue a blockchain-based dividend (hence, one that could not “fail to deliver”). What happened? The SEC called “Bazoomba!” and threatened the board (I am told) with a stock manipulation action. Thus, in the mind of the SEC, failures to deliver do not affect the price of a security, but forcing failures to deliver to settle does affect the price of a security, and therefore counts as stock manipulation. Got it?
So the mission of Jonathan and me (but 90% of the time, just Jonathan) became to go to various committees in the House and Senate to explain how those four vague words could be tightened slightly and end the problem for the entire market.
Wherever we went, the prime brokers showed up lobbying against tightening those four words of vagueness.
For example, New Mexico Senator Pete Dominici (D) had a senior staffer who was himself being a former banker from (if I recall correctly) Morgan Stanley. He pulled me aside one visit and said, “You are right about all this, you know. The thing is, for every time you are in here telling the Senator this, Goldman Sachs is in here 10 times, 20 times, telling him to ignore you.”
Over and over Jonathan explained four things to the politicians:
Get the SEC to remove the “Grandfather” clause for the slop that was already in the market, to force the hedge funds to settle the failed trades from the past.
Eliminate the Option Market Maker exception (a.k.a. “the Madoff Exception”) whereby market makers rent out to hedge funds the exception to the rules enjoyed by those market makers.
Change the requirement to “Locate” stock before short-selling from the squishy standard of “reasonable good faith belief” to something enforceable (since the SEC and DOJ themselves were telling us the standard as it existed was unenforceable).
Lastly, we argued that the disclosure should be not of the companies that were being victimized, but rather, what should be Disclosed should be the amount of the victimization (which would have created opportunities for other traders to spot and trade against it, perhaps bringing market pressure against the problem), and arguably, who was failing to deliver .
Jonathan came up with a clever acronym: he argued for a “GOLD Standard” (meaning, end the Grandfathering, restrict the Option Market Maker exception [Madoff Rule], tighten the four words “reasonable good faith belief” that one had Located stock to borrow so one would not fail to deliver, and Disclose the failure data: “GOLD”). Again, Wall Street showed up and fought against every inch of this with every senator and congressmen we visited.
While Jonathan worked to awake Washington to the problem, and followed the normal processes citizens use to get laws changed and enforced, I handled a different prong. I became extremely interested in how the organs of government were responding to the efforts we were making. After all, we had a lead-pipe-cinch: we had whistle-blowers, we had economists, we had data galore, we had everything necessary to convince any rational observer that the savings of America were being looted, companies were being destroyed, and Wall Street was going to melt down. Yet the system did not change. It went well beyond bureaucracy: something deep and mysterious was fighting against us. Mapping and fighting that force became my job.
In time (and please pay attention to this story, because in the future its relevance will become more apparent), my efforts led me into the arms of the United States Senate Judiciary Committee.
This happened because the Constitution gives oversight of the government to Congress, and the Senate has oversight of the Department of Justice, which includes the court system, and is (at least theoretically) the highest court in the land (e.g., it holds the power to impeach). The Senate’s Judiciary Committee has oversight of any activity covered by a civil or criminal penalty in the United States of America. That is a broad mandate indeed, and in practice it means this: the Senate Judiciary Committee is the ultimate player on anything regarding corruption in America.
I have often publicly said that in those years we fought to save our company (and by extension, the US capital market) from the harm this faulty settlement system was creating, I learned that Washington was “turtles all the way down” (to borrow an old gag). This was false: I was always hiding the involvement of the Senate Judiciary Committee. As the people who have the ultimate responsibility of stopping corruption in the United States, the Senate Judiciary Committee became intrigued by the same thing that was intriguing me: Why were the organs of the federal government that should have been responding to the overwhelming evidence we were bringing them, in fact staying indolent and non-responsive, if not outright hostile
Over time I was introduced to most of the Senators and staffers of both parties on the committee. They were smart, hospitable, and intellectually interested in precisely the right issue: What was the reception we were getting from all the parts of government with which we were interacting? Their staffers (both parties) were sharp as tacks and intellectually curious, and rather than having to fight to get time on their schedules, these Senators and staffers were anxious for us to come see them, to fill them in on what we were learning as we bounced around the corridors of power in DC.
I began to bring witness after witness to the Senate Judiciary Committee, expert economists, 30 year Wall Street participants, whistle-blowers who came to me, etc. It started as something I was doing to force the manipulation in our own stock to end, and then I realized how much harm the market manipulation was causing other small market-cap companies, and then I realized how much money was being robbed from American investors by the practice, and eventually I realized that it was going to crater the US financial system.
It culminated in a rather unusual day: in 2006 I was invited to prepare for a hearing in a chamber of the Senate, and bring a number of experts and whistle-blowers who had been working with me. We had a month to prepare.
When we went in, myself and 4-5 other people were directed to sit in the seats in the hearing room where Senators normally sit.
The room was filled with about 40 people from across the federal bureaucracy: FBI/DOJ, Treasury, GAO, and who knows what other agencies.
I acted as ringmaster for it all.
Just as I called the meeting to order, Senator Goldman Sachs (née Chuck Schumer) came storming in with two of his staffers, and rudely inserted himself between myself and the microphone.
Pointing out that he was the only Senator on both the Banking and the Judiciary committees, he insisted that the subject of the meeting violated his prerogatives in some way and demanded it be shut down.
A young staffer working for Chairman Arlen Specter (a Democrat turned Republican turned [later] a Democrat) stood up to Senator Goldman. he said, “Chairman Specter has asked us to schedule this meeting, it is being done on his say-so, and the meeting is going to proceed.”
Senator Goldman and his entourage glared at me then stalked off in a huff.
That young staffer was named Brett Tolman, and he went on to become a United States Attorney. He is also the man who speaks at minute 1:20 of this video about me.
The whistle-blowers I had brought spoke for about three hours to the ≈ 40 federales in attendance. They walked through details, they covered every aspect of criminality on Wall Street you could imagine. Soon they were providing names, dates, and information so detailed we all began squirming about what the ramifications might look like.
When we were finished and were breaking up, a man who had been in the back of the room approached me. Again, in one of those conversations I will cherish to my dying day, this is what was said.
He pulled out a badge showing that he was in the Secret Service. I said, “That’s part of the Treasury, right?” He said something like, I spent my career as part of the Treasury, but in a recent reorganization we became part of the Department of Homeland Security (I happen to remember that).
He told me, “Patrick, you wait 20 years in this job for people like this to come through the door and answer questions like this. I have no idea how you got this to happen. Is there anything we can do for you?”
I told him, “Sir, to be honest, I am dancing right at the edge of the law here. I’m dealing with whistle-blowers, I’m doing some wild things. I think I have to because my company is being destroyed and the marketplace is going to melt down if we don’t get this sorted out, but I fear you are going to be seeing me in handcuffs someday.”
PLEASE REMEMBER THE PRECEDING STORY. IN THE MONTHS AHEAD IT MAY PROVE IMPORTANT.
Global Financial Crisis of 2008 As has been explained elsewhere in this blog, Alan Greenspan attributed the crisis of 2008 to the failure of the settlement system (along with “fraud” such as Bernie Madoff and “securitization” such as Mortgage Backed Securities). That was precisely what I had understood was coming and had lost sleep over for four years.
We started receiving calls from Washington asking for information regarding trading in firms in the jurisdictions of various House and Senate members, and we helped them by providing immense amounts of data. Some of that drew on a system that I had spent $2 million of my own money building, buying data from various sources, hiring database engineers, and piping it all together.
Congress told me that they could not rely on me, they needed to recreate it themselves. We told them how to do so.
Two weeks later the House Permanent Subcommittee on investigations called us back, saying, We have learned this will cost a couple of million dollars to build! Will you really just give us all the data?
I said, “We will,” and signed some piece of paper that said, Whatever research you ask us for, we will provide you the straight data without alteration. My team then just continued providing them all that work for free.
I kept up my obligations in helping the feds with their requests. By the end of 2009, I received that call (described elsewhere) that “you are going to see handcuffs coming out this week, and you have to live the rest of your life knowing that everyone you see us arrest understands that your fingerprints are on their problems.”
The reader might imagine that the days of the crisis were celebratory ones for me for having been vindicated, but the opposite is true. I grew more and more sickened. In truth, I checked out. I hired off-duty SWAT guys to protect me, I started packing a weapon (one exhausted day this happened: when I got out of jail I went home and found my socks in the gun safe), and eventually I checked out of the whole thing. While the rest of America had its heart broken to realize what Wall Street had become at its core, emotionally I moved on. My heart had broken in 2005-2009. Once everything that I had lost sleep over began happening, I (who had lived it 100 times in my nightmares) could not watch anymore. I wrote the odd blog when appropriate, but I was over it. I focused on Overstock, and we turned in 7 years of GAAP profits, without ever seeing our stock move in response, and thus, without being able to raise capital and expand as we would have been able to do were we any other eCommerce firm in America.
There was one exception to this. National Security circles began paying a lot of attention to Deep Capture. I was invited to give several talks, such as this that appears here in non-classified form as Economic Warfare as an Instrument of Transnational Organized Crime. The National Security community came to understand the sloppiness of our settlement system as a vulnerability of the nation, and my understanding is that they leaned on the SEC and forced them to change their tune. Sometime about seven years ago, the SEC got significantly more serious about enforcing rules on settlement.
In 2006 my mentor General Jack Vessey rebuked me for being so harsh about the SEC. He said, “You should not be so tough on them. No federal employee goes into work each day hoping to do a bad job.” We saw each other in January, 2009, and he told me, “I rescind all previous advice I gave you about the SEC.”
But actually, my feelings about the SEC softened. Once it was too late to stop the 2008 crisis from happening, I tried to be supportive of the SEC, in time. I knew that one of their missions is to promote the public’s faith and confidence in the capital market. I knew that there were people there who felt that they had let the USA down. Once I was no longer having to shout at them from the rooftops, and saw that they were trying to address their issues, I began trying to be more positive about them as the years ticked by. I wanted to be a good citizen, by helping them restore that public faith and confidence in the market.
But mostly, as people went to jail, books got written, and our lawsuits wound up, I just moved on.
https://www.deepcapture.com/2019/11/the-sec-me-metoo-part-i/
disclosure .. long term investor in Overstock ..
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