SEC Follow Up Exhibits Part C SEC_OEA_FCIC_001760-2501

To: Jim Overdahl
From: Tim McCormick
Date: October 16, 2008
OEA DRAFT – INTERNAL
OFFICE OF ECONOMIC ANALYSIS
DRAFT MEMORANDUM
Re: “Gaming” to Prevent Stocks from Appearing on the Threshold List
This memo summarizes OEA’s analysis of potentially manipulative patterns in the closeout
of fails in order to prevent a stock from appearing on the threshold list. In this memo,
we specifically look at the 9 stocks that Mark Mitchell claimed experienced threshold list
manipulation. We find no evidence supportive of his claims.
We know from prior work that many fails tend to be short-lived. In fact, about 86.5% of
fail positions are closed out within 4 days of occurring. The threshold list criteria of
Regulation SHO attempts to identify securities with large fails that persist for longer than
4 days. Under Rule 203, stocks with large fails that persist for longer than 4 days are
deemed to have a problem with fails that require increased regulation. Therefore, it is
certainly possible that persons could be involved in a pattern of fails and close-outs in
order to avoid the increased regulatory requirements of the threshold list. On the other
hand, it may be difficult for one clearing firm to manipulate the threshold list because
they may be closing out their fails at the same time that another clearing firm creates a
new fail. So, the aggregate fails at the NSCC are not readily controllable by a single
clearing firm, except perhaps when a single clearing firm has a large and dominant fail
position at the NSCC. Further, since clearing firms tend to clear for multiple broker
dealers it would be difficult for one broker dealer or one trader to control the aggregate
fails at the NSCC for a security.
We note that the data we have on fails does not allow us to know intent. That is, a fails
position that disappears after 4 straight days may simply be due to the normal course of
business rather than any gaming strategy. In light of this constraint, the best approach we
have is to attempt to detect a pattern of fails - above the threshold list criteria of 0.5% of
shares outstanding for 4 days, then below 0.5% for a day or two, then above 0.5% for 4
days, then below 0.5% for a day or two and so on. The more repeats of the above-belowabove-below
pattern, the more confidence we have that the pattern of fails is not driven
by normal close-out activity. Also, if someone was gaming the threshold list, they would
want to take full advantage of the five consecutive day threshold criteria of 0.5%.
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