Sabject: Meeting the parents

Sabject: Meeting the parents

I thank you for meeting with Ken Salomon, John Welborn and me yesterday afternoon to 

discuss Reg SHO, naked short selling and the SEC's recent emergency order. As a 
follow-up, I want to emphasize the following points: 
1. OSTK continues to believe that it is critical that the SEC extend the pre-borrow 
requirement of the emergency order to the entire market, not just the 19 select 
companies. OSTK requests that the SEC promptly undertake swift rulemaking so that 
this protection applies fairly across the market. 
2. OSTK continues to support the prompt and full elimination of the option market 
maker exception, an exception that swallows up the good intentions of Reg SHO. During 
yesterday's meeting, we discussed the relationship between the markets for equities and 
their corresponding derivatives (including listed options). You stated that options market 
makers enjoy an exception from the Reg SHO requirement that they locate and/or deliver 
shares when hedging against options positions. I am not sure that I would read Reg SHO 
to say that. However, under your theory, if an options market maker sells a put with a 6-
month expiration, then that same market maker has the legal right to naked short and fail 
to deliver an equivalent amount of the underlying equity (leaving the option market 
maker "delta neutral”) for six months. This exception is unnecessary and open to 
abuse/manipulation, particularly with the married puts that often occur in Reg SHO 
threshold securities. Further, OSTK does not believe that such a transaction is “net 

neutral"—that is, that this introduces no additional long or short pressure into the market 
for an issue, as a whole. That would be true if the options market maker entered into a 
legitimate short sale arrangement to borrow shares for the duration of the options 
contract. The act of naked shorting and failing to deliver in perpetuity, however, creates a 
"net change" in the aggregate “risk profile” of an issue (that is, the sum of all long/short 
positions, both in the derivatives space and in the underlying equity). Furthermore, the 
change in the gross sum of tradable securities entitlements in the equity market can drive 
the price below its equilibrium level, both in the short run and long run. In addition, the 
option market maker exception has the added effect of depressing stock loan rebate rates, 
as the options market has become a surrogate for the stock loan market. The option 
market maker exception is not only unnecessary, it is tool used for market distortion and 
manipulation. 
3. OSTK applauds the SEC for beginning to disclose the daily volume of failures-to-
deliver on a company by company basis. This is useful information that investors need to 
be able to access. OSTK urges the SEC to disclose (or perhaps better yet require either 
the exchanges or the DTCC to disclose) this information on a much more timely basis.
The current lagged disclosure is as much as five months stale. At the very least, this 

failure-to-deliver data should be available to investors at least as frequently as the 

legitimate short interest data (which the exchanges release twice a month). 
4. OSTK (along with many others) has long advocated including a pre-borrow 
requirement in Reg SHO. Yesterday you asked whether in a world where shares are 
always delivered, is such a pre-borrow requirement necessary. Assuming such world, 
OSTK believes the answer is "no" -- with several caveats: 
o
Without strict and constant surveillance and regular and meaningful 

enforcement and penalties to ensure delivery, such a world is hard to 

imagine.
o
There would need to be no exceptions to the delivery requirement.

o
A pre-borrow requirement focuses on the front end of the trade and would 

ensure that no trade would result in a failure-to-deliver; a hard delivery 
requirement focuses on the back end of the trade and creates a period ripe 
for fraud. I suspect this is why theatres require patrons to present a ticket 
prior to entering the show, rather than allow them to watch the show and 
deliver a ticket five days later. 
o
A hard delivery requirement still allows for an intra-period raid (the period 

would be a day if the hard delivery period was T+1 or a week if the hard 

delivery requirement was T+5). A trader (day trader, market maker, etc.) 
could raid a stock on naked short sales and cover under the panic sell that 
day. Without a pre-borrow requirement, a naked short selling trader never 
engages in a borrow so long as he covers during the required period.
Having no pre-borrow allows the trader to sell as many shares as he likes, 
so long as he covers within the hard delivery period. There is a lot that 
can be masked by such trading activities, especially by hedge funds with 
the financial firepower to use fast trading technique to create the panic 
selling into a profitable cover. 
As the SEC considers the differences between a pre-borrow requirement and a hard 
delivery requirement, OSTK suggests that it consider the emerging technology (e.g., the 
Lendex platform) that may allow for maximum liquidity in a pre-borrow world. 
5. Attached is a spreadsheet showing the $8.5b mark-to-market value of all of the 
failures-to-deliver that occurred with in the DTCC on March 31, 2008 (the most recent 
date for which failure-to-deliver data is available to the public). Companies listed on the 
Reg SHO threshold list make up $6.1b (72.5%) of the value. These numbers do not 
include failures-to-deliver occurring outside the DTCC. In addition, OSTK believes that 
the mark-to-market calculation is an overly conservative way to calculate the effect of the 
failures-to-deliver because those creating the failures-to-deliver would likely be unable to 
cover them at the market prices -- especially in stocks where the failures-to-deliver are a 
large part of (or exceed) the float. 


<<2008.03.31 (SEC) Total FTD Value.pdf>> 
6. OSTK urges the SEC to expand the purview of Reg SHO to include transactions that 

occur outside the DTCC. As the SEC looks to improve Reg SHO, it makes sense to 

expand its purview to all trades. Otherwise, those that use Reg SHO's current loopholes 
to distort and manipulate the market will just move their abusive practices to ex-clearing 
transactions. 
Again, I thank you for taking yesterday's meeting and for your thoughtful consideration 
of the above points. 
Regards, 
Jonathan 
Jonathan Johnson 
Overstock.com, Inc.