03/28/07 Example of being solicited to Short your own stock - Investor's Village

An example of soliciting a client's assets to fuel short selling

Schwab solicits stock in cash account to fuel short selling

Schwab Overnighted Me Their Securities Lending Fully Paid Program Package

As a follow-up to my messages from Monday (3/26), I received a UPS overnight package this morning from Charles Schwab for brochures pertaining to their "Schwab Securities Lending Fully Paid Program."

They want me to lend my FRPT shares to them and in return they'll pay me 1 1/2% on the market value of my outstanding shares while I own FRPT. I'M NOT GOING TO DO THIS BECAUSE I KNOW THEY WANT TO BORROW MY SHARES SO THEY CAN BE SHORTED.

The package came from Howie Kennedy (Director, Securities Lending at Charles Schwab in San Fran.), and contains a brochure on the Schwab Securities Lending Fully Paid Program, an Auditor's Report on Schwab's 12/31/06 Consolidated Statement of Financial Condition, and a contract for me to sign and mail back to them ASAP.

The addendum to their audited 12/31/06 Statement of Financial Condition, states their policy on securities lending, which is "client securities may be loaned temporarily to other brokers in connection with Schwab's securities lending activities. Schwab receives cash as collateral for the securities loaned. Increases in security prices may cause the market value of the securities loaned to exceed the amount of cash received as collateral. In the event the counterparty to these transactions does not return the loaned securities or provide additional cash collateral, Schwab may be exposed to the risk of acquiring the securities at prevailing market prices in order to satisfy its client obligations. Schwab mitigates this risk by requiring credit approvals for counterparties, by monitoring the market value of securities loaned, and by requiring additional cash as collateral when necessary. The market value of Schwab's client securities pledged in securities lending transactions to other broker dealers was $1.3 billion at December 31, 2006. Additionally, Schwab borrows securities from other broker-dealers to fulfill short sales of its clients. The market value of these borrowed securities was $401 million at December 31, 2006.

I'm sure that many of you shareholders will be receiving similar brochures and contracts from your brokerages for lending your shares. My advice is DO NOT LEND YOUR SHARES. It's apparent that someone desperately wants to short FRPT, and is willing to pay for borrowing the shares he'll need to short against. If we all resolve not to lend our shares, then the short(s) will run out of legitimate avenues for shorting.

Good luck with your investing.

09/25/07 Do Retail Investors Hold The Aces? -Forbes

Do Retail Investors Hold The Aces?


Financial Services
Do Retail Investors Hold The Aces?
Liz Moyer, 09.25.07, 4:40 PM ET

Retail investors wield more power than they think when it comes to short-sellers.

With $3.6 trillion worth of stock held in their non-margin accounts, brokerage customers are viewed to be the next big Gold Rush for Wall Street traders. That's because that stock has the potential to be lent out to short- sellers for a fee, and increasingly it's the retail customer getting a cut of the profits.

A report by New York-based Vodia Group says retail brokerage customers have the potential to shake up the securities lending market, estimated at $4.8 trillion globally, of that $717 billion of stock lent out in the U.S. at any one moment.

Retail investors have $9 trillion of assets in their accounts, a little over one-third in stocks and the rest in other assets. Institutions, such as pension funds, have $26 trillion of available assets, one-quarter of that stock.

Securities lending reaps $8 billion to $10 billion annually in fees for Wall Street, but is a business largely unknown to the general public.

Still, some retail investors are getting savvy and asking questions. Since Forbes first wrote about this phenomenon in December; Merrill Lynch and Fidelity Brokerage have joined Smith Barney and Charles Schwab in establishing stock lending programs for retail customers, according to Vodia Group.

There are a number of caveats with these programs, mostly qualification requirements, and the brokerage industry has to do a fair amount of education to get retail customers past their natural wariness of short-sellers. But, writes Vodia's managing principal Josh Galper, "this investor is looking, cautiously, at securities lending to generate additional portfolio returns while minimizing risk."

Participation in a stock loan program requires a bit of cynicism on the part of the individual investor. Presumably, that investor holds a stock hoping it will go up. Lending those shares to a short-seller has the potential to drive the price of the asset down (that's the short-seller's raison d'etre, after all). But if the stock is in hot enough demand, the fee to lend it may more than compensate for the decline in the share price, plus the temporary loss of voting and dividend rights. It's sort of like an insurance policy in case your long strategy proves erroneous.

It's important to note this is about so called fully paid accounts, not margin accounts, which have always been available to brokerages for the purpose of lending stock to short-sellers. With margin accounts, the retail customer (the owner of the stock) doesn't get a cut of the lending fee. In these fully-paid account programs, the customer gets a piece of the pie.

It's also potentially good for short-sellers, who are scrambling for access to stock. Short-sellers borrow shares and sell them, hoping the stock will fall and they can buy it back later at a discount, cover the loan and keep the difference. The hotter the demand for a particular stock to borrow, the harder, and more expensive, it gets to borrow.

So it goes without saying that a larger pool of available stock inventory, particularly for the hardest to borrow stocks, would lower the costs of business for short-sellers.

Short interest is at near record levels, an indication that traders are certainly hungry for more stock to borrow. At the NYSE Group, short positions in the most recent month represented 11.8 billion shares. That's down from the peak of 12.9 billion shares in July but certainly well above the 9.7 billion shares logged last year around this time.

The popularity of so-called 130/30 mutual funds is in part driving this demand. These funds use leverage to take on long positions of 130% of the portfolio and short positions of 30%, the theory being everything nets to 100% at the end of the day.

The funds mimic hedge funds in many ways, but with lower fees, and are attracting billions from pensions and other institutions chasing the new, new thing. High profile managers are jumping in, includingBarclays, State Street, and Goldman Sachs. There are an estimated $50 billion to $75 billion of assets in 130/30 funds now.

Hard to borrow securities held by retail brokers is estimated at $146 billion, which would add another 20% to the inventory available to short-sellers in the most in-demand stocks. That's where the individual investors come in.

If enough retail investors make enough money lending their shares out, who knows? Maybe hedge funds won't be viewed as such bad guys after all, says Galper. Investors "will gain more comfort with securities lending as a revenue generator, leading to perhaps a warmer popular sentiment towards hedge funds as legitimate market actors," he says.

That is, until the next big blow up.

12/11/06 Shortchanged - Forbes

Shortchanged

On The Cover/Top Stories
Shortchanged
Liz Moyer 12.11.06

Your broker may be making a pretty penny lending your stock to a hedge fund without your knowledge. Here's how to get a cut of the action.

Roger Metzler, a retired mergers and acquisitions attorney in Walnut Creek, Calif., likes his investment in NovaStar Financial: The stock pays a $5.60 dividend, for a yield of 18.5%. He doesn't mind that NovaStar, a Kansas City, Mo. real estate investment trust, is the target of hard-charging short-sellers who for nearly two years have kept the shares among the most heavily shorted stocks on the New York Stock Exchange. In fact, he is counting on this short-selling to continue.

Metzler profits from it by lending his 32,000 NovaStar shares to traders through his brokerage account at Smith Barney. In exchange, Smith Barney pays him 13% a year. The arrangement adds up to income of $129,000 annually--that's $4 a share on top of his $5.60 dividend. "If I'm going to hold it, I might as well get as much money out of it as I can," he says.

Metzler is an exception, not the rule. Wall Street securities houses rake in $10 billion a year in revenue from lending the shares of long-term holders to active traders. The borrowers could be hedge funds, who either are trying to short a stock or scrambling to cover a stock loan that has been called in, or they could be investment houses that need an underlying instrument for a derivatives contract. Until recently very little of the revenue from stock lending has found its way into the pockets of retail investors, says Joshua Galper, managing principal of Vodia Group, a New York City consulting firm that analyzes securities lending.

To understand the economics of stock lending, consider what happens when the borrowed shares are readily available. Short-seller S borrows a share of, say, ExxonMobil from lender L and sells it for $72. In place of the missing share, S hands L a ticket entitling L, in effect, to all the dividends on that share.

S also pledges that L will get a slice of something else: S places 102% of the share's value, meaning $73.44, in Treasury bills paying 5.25%. The lender ends up collecting, in this case, perhaps a fifth of the interest this kicks off.

S is in a position to demand good terms because there are lots of ExxonMobil shares sitting in pension funds and, so long as the stock loan is well collateralized, there is no harm to the lender in surrendering the share in exchange for a total-return ticket.

Now, what if the stock in question is not a blue chip but rather a REIT with a poorly covered dividend and a focus on the subprime mortgage business, which many expect to come under pressure? Then there will be many short-sellers eager to borrow shares but not many shares available to borrow. L can demand good terms--keeping all 5.25 points of the interest or even, for a really hard stock to find, that plus another 8 points of premium.

In fact, if Metzler is getting a 13% annual fee on NovaStar, then Smith Barney is probably charging the short-seller a bit more than that.

Besides collateral, there is one other thing that some lenders have to concern themselves with, and that is taxes. Pension funds don't care, but an individual lending shares owes tax at up to 35% on cash in lieu of the dividend. A genuine dividend (from ExxonMobil, albeit not from a REIT) would be taxed at only 15%.

U.S. pension funds have $14 trillion of stock available to be lent out, usually through intermediaries like Goldman Sachs. But the rapid growth in loan demand from hedge funds has forced brokerages to turn increasingly to their retail customers. The three largest online brokerages collectively have $935 billion worth of stock to lend.

Now here's Wall Street's dirty secret: Brokerage firms are free to lend out any shares that customers put in margin accounts, the kind of account that allows the customer to borrow against his securities. Take a look at the fine print on your brokerage application. If you see a line of credit attached you've probably got a margin account.

Does your brokerage pass along to you any of the profits it gets from its stock loan department? Probably not. But straight-arrow brokerages at least make up to you the tax cost of not getting genuine dividends.

If you want to profit by lending shares of a sought-after stock like NovaStar, you may have to first move them (or threaten to) out of your margin account into a cash account where the broker can't touch them without your permission. Charles Schwab has a program allowing retail customers with hard-to-borrow stocks to get some of the fee revenue.

The firm refuses to quote rates, but customers contacted by FORBES report Schwab paying 8% for NovaStar shares. Fidelity Brokerage says it is looking into setting up a similar program for its retail customers.

It is easy for investors to find out if they own shares that are likely to command premiums. The stock exchanges publish daily lists on the most heavily shorted stocks, thus the hardest to borrow. Netflix,Martha Stewart Living Omnimedia, Krispy Kreme, NovaStar, and even at times the NYSE Group itself have made the list. Overstock.com, an online retailer that sells brand-name products at clearance prices, is such a favorite of short-sellers that lenders are charging 54% a year for the shares, according to Vodia Group.

A price war in online brokerage has all but eliminated commissions for active traders who keep big balances. Competition may come next to fee sharing by the stock loan department. At the moment brokers are reluctant to share fees unless the customer has a large block, a cutoff of $100,000 worth of shares being typical. A work-around for smaller investors is to pool resources with family and friends. Mary Helburn, a Denver, Colo. investor, and many of her family are together lending 59,000 shares of NovaStar through their Smith Barney accounts. That yields income of $19,800 a month.

A word of warning before you buy a stock with the intention of lending it. Short-sellers don't go after ExxonMobil. They tend to go after companies with weak balance sheets or disappointing cash flows, and sometimes they are vindicated. Over the past year NovaStar's price is up slightly but Overstock.com's has halved.

Modern Investment Management and the Prudent Man rule

Modern Portfolio Management and the Prudent Man Rule
Jan 1987 (sadly very outdated but perhaps insightful historically)
" the book uses illustrations drawn from such traditionally suspect categories of investment fiduciaries as securities lending, real estate, venture capital, options and futures and repurchaser agreements. An unusual examination of the interaction of the worlds of law and finance, this work will be of interest to fiduciaries who are subject to some from of prudent man rule and all others, including judges, lawyers and investment managers, who are called upon to interpret and apply that legal standard."

page 90 had an interesting indirect discussion of securities lending history and the prudent man rule...
goes pretty far back actually... pretty interesting in that they show the income falling dramatically as more and more institutions entered the picture competing for fees drove the fees collected downward...
no discussion on whether SL in itself wasn't prudent but does point out the if everyone else does it, it must be prudent mentality of innovation.

Example of state laws and the prudent man rule

The prudent man rule:
http://en.wikipedia.org/wiki/Prudent_man_rule

Prudent Investment state law example

Notice no mention of security lending.
Note originally:
As with any fiduciary relationship, margin accounts and short selling of uncovered securities are also prohibited.
We know that in order to lend out securities in a brokerage account you needed a margin feature and yet today we have institutions lending out stock in volume... what the heck happened to fiduciary duty and prudent investment concepts?

institutions discussing security lending

Do you make use of securities lending?
 " There are two basic reasons for borrowing: one is to receive a tax advantage on the dividends, which we cannot get, and the other one is to short. "
The managers note 2 motivations of those who borrow... a dividend capture strategy and short selling...
clearly they are aware of the risk to short sellers but re-engage in securities lending regardless.
Note to self.. research this tax thing... If its a tax thing then they are essentially sharing in the tax adv by lending it to those with the adv....

another point has to do with timing the market ...
"But since the financial crisis, demand for borrowing stocks, particularly in order to short, has cooled down although we believe it might pick up again."


so we have recognition that there may be "safer" periods to loan out stock when short sellers aren't behind the borrowing...
surely there could be closer arrangements made between lending securities out and preventing the sales of the securities by the person who borrows it. 


By retinkering the contracts one should be able to limit the lending to the tax shelter folks and not the short sellers. I think its a failure of the institutions in not playing a stronger hand " you want my stock you gotta hold it" and setup the infrastructure to enforce it (IE NO CHEATING POSSIBLE).

The Uptick Rule Returns On Capitol Hill

Lawmaker Calls for Return of 'Uptick' Rule

Couldn't help but notice Charles Schwab advocated this:
"This is a critical and necessary step to reduce volatility and restore investor confidence" Schwab wrote in a letter to lawmakers. "The SEC should move on its own to restore the uptick rule, but if it won't, this legislation will compel the agency to do so."


Sadly I think nothing was done...
uptick wiki (discussion tab good too)

I would say that if one can legally view through another amendment to the investment company acts perhaps that Security Lending would violate a fiduciary duty as well as be legally treated as malfeasance by the custodians and if the brokerages were prevented from pairing margin accounts with lending out stock that we would be miles ahead of any uptick rule...
simply put you would not lend out your house to someone that will destroy it unless you think you will be compensated for that risk... lending fees for securities lending and being allowed to use margin features are not reasonable compensation for the risks of "lending your house on Pacific Heights to Charles Hayes" /lending out your stock marauding short sellers.