Goldman, Merrill E-Mails Show Naked Shorting, Filing Says

Bloomberg | May 15, 2012
By Karen Gullo

Goldman Sachs Group Inc. and Merrill Lynch & Co. employees discussed helping naked short-sales by market-maker clients in e-mails the banks sought to keep secret, including one in which a Merrill official told another to ignore compliance rules, Inc. said in a court filing.

The online retailer accused Merrill, now part of Bank of America Corp., and Goldman Sachs of manipulating its stock from 2005 to 2007, causing its shares to fall. Clearing operations at the banks intentionally failed to locate and deliver borrowed shares for clients shorting stocks, including two traders who were fined and suspended from the industry, Overstock’s attorneys said in court papers filed earlier this year.

Lawyers for Overstock, whose California state court lawsuit in San Francisco was dismissed in January, asked a judge to make public e-mails sent in 2005 and 2006 that it said “reflect business decisions to put profits and corporate ambition over compliance” at Goldman Sachs and Merrill. Defendants’ decisions to intentionally fail to deliver Overstock stock caused large- scale naked short selling of Overstock stock, the filing states.

After a Merrill executive expressed concern that a colleague intentionally failed, or didn’t complete, a short sale, an executive at the clearing unit responded with an expletive, telling the executive to ignore “the compliance area -- procedures, schmecedures,” Overstock lawyers said in the filing, citing an excerpt from a May 2005 e-mail. The Merrill executive later told a judge the statement was a joke, Overstock said in the court document.

In June 2005, Thomas Tranfaglia, then president of Merrill’s clearing unit, said in an e-mail about the possibility of failing market-maker trades, “Why would we have to borrow them? We want to fail on them,” according to the filing.

‘Totally Unacceptable’

“As far as I’m concerned, this is totally unacceptable -- we are failing when we have over a million shares of stock available,” said another Merrill executive in an e-mail cited by Overstock in its filing. “Is there a blanket agreement that we allow every market-maker client to continue failing even if there is enough availability?” the executive asked in the e- mail. “There needs to be some assessment done here, and fails cleaned up regardless of who is causing them.”

Four media organizations, including Bloomberg LP, the New York Times, Wenner Media and The Economist, intervened in the Overstock case and joined the company’s request to unseal court files. Bloomberg News obtained a copy of the March 1 filing describing the e-mails. The document was filed by attorneys for Goldman Sachs and Merrill as an exhibit to another filing, said Karl Olson, an attorney for Bloomberg and other news outlets.

The full text of the e-mails isn’t included in the court filing by Overstock.

Bank of America

William Halldin, a spokesman for Charlotte, North Carolina- based Bank of America, said Tranfaglia is no longer at the bank and didn’t immediately comment on the document. Michael DuVally, a spokesman for New York-based Goldman Sachs, also didn’t immediately comment on the document. Tranfaglia didn’t return a call or e-mail seeking comment. Both banks have denied any wrongdoing.

In short selling, investors sell shares they have borrowed in anticipation of making a profit by purchasing stock to return to the lender after its price has fallen.

In naked short selling, traders never borrow the stock and can drive down prices by flooding the market with orders to sell shares they don’t have.

A “failure to deliver” or “fail” is when the short- seller doesn’t deliver the shares for a short sale prior to the trade’s settlement date, usually three days later. A “locate” refers to the ability of a broker to find shares that can be delivered on behalf of the short-seller.

Naked Shorting

In October 2008, naked shorting mostly ended after the U.S. Securities and Exchange Commission put in place rules that made it harder to short a stock without first borrowing it or locating it.

Overstock lawyers said the information in the e-mails “concerns obsolete procedures from six or seven years ago that were unlawful at the time and that are further blocked by the enactment of new federal regulations in 2008.”

Overstock, based in Salt Lake City, claimed in its lawsuit that large portions of its stock were the subject of naked shorting, leading to instances in which the short position in its stock exceeded the entire supply of outstanding shares.

“We have to be careful not to link locates to fails [because] we have told the regulators we can’t,” an unidentified Goldman Sachs executive wrote in an undated e-mail cited in Overstock’s filing.

The case is v. Morgan Stanley, CGC-07-460147, Superior Court of the State of California (San Francisco).