How Market Makers are naked short selling stocks known as Cellar boxing
Cellar boxing is defined as a fraudulent financial institution tactic used to drive a company's stock price down to a deficient but tradable level, typically at the sub-penny level.
Article Originally written by blurring
A type of securities fraud known as naked short selling is becoming increasingly popular and profitable for market makers who engage in it. The term "CELLAR BOXING" refers to the fact that the NASD and SEC were forced to arbitrarily set a minimum level at which a stock can trade. This threshold was set at $.0001 (one hundredth of a penny). This level is appropriately referred to as "the CELLAR". This $.0001 level serves as a "backstop" for various market maker and naked short selling manipulations.
Since 1999, when the market switched to a "decimalization" basis, "CELLAR BOXING" has been one of the most popular security scams. In the pre-decimalization days the minimum market spread for most stocks was set at 1/8th of a dollar and the market makers were guaranteed a healthy "spread". Since decimalization, those one-eighth-dollar spreads are often only a penny, as evidenced by Microsoft's quote throughout the day. Where did the shady MMs go to make up for all of this lost revenue? They went "south" to the OTCBB and Pink Sheets, where naked short selling protections such as Rule 10-a and NASD Rules 3350, 3360, and 3370 do not exist.
The need for an arbitrary "CELLAR" level is unique in that the smallest possible incremental gain above this CELLAR level represents a 100% spread available to MMs making a market in these securities. When compared to Microsoft's typical spread of perhaps four-tenths of 1%, this is pretty tempting territory. In fact, there is an infinite spread when the market is no bid to $.0001 offer.
To participate in "CELLAR BOXING," the MMs must first reduce the price per share to these levels. The lower they can force the share price, the wider the percentage spreads they can exploit. This is easily accomplished through standard naked short selling. In fact, if the MM is large enough and has enough visibility of buy and sell orders as well as order flow, he can use his right hand to act as a conduit for the sale of nonexistent shares through Canadian co-conspiring broker/dealers and their associates while his left hand is naked short selling into every buy order that appears through its own proprietary accounts.The key here is to be a powerful enough market maker to see these buy orders. This is known as "broker/dealer internalization" or naked short selling through the market maker's trading desk. While the right hand is busy flooding the victim company's market with "counterfeit" shares that can be sold at any time, the left hand is counteracting any upward pressure on the share price by neutralizing demand for the securities. The net result is a lack of demonstrable demand for shares and a massive oversupply of shares, resulting in a downward spiral in share price.
Indeed, until the "improved" version of Rule 3370 (Affirmative determination in writing of "borrowability" by settlement date) becomes effective, U.S. MMs have been "legally" processing naked short sale orders out of Canada and other offshore locations, despite the fact that they and the clearing firms involved knew from history that these shares would never be delivered. The question then becomes, how can "the system" allow these obviously bogus sell orders to clear and settle?To find the answer, look no further than Addendum "C" to the Rules and Regulations of the DTCC's NSCC subdivision. This gaping loophole allows the DTCC, which is basically the 11,000 b/ds and banks known as "Wall Street," to borrow shares from investors who are foolish enough to hold these shares in "street name" at their brokerage firm. This represents approximately 95% of us. In theory, this "borrow" was intended to allow trades to clear and settle that involved LEGITIMATE 1 OR 2 DAY delivery delays. This "borrowing" is done without the investor's knowledge and amounts to possibly the largest "conflict of interest" known to mankind. The question is whether these investors would knowingly lend their shares without compensation to those whose intent is to bankrupt their investment if they knew that the loan process was the key mechanism required for the naked short sellers to achieve their goal. Another question is whether the investor's b/d, which just earned a commission and thus owes its client a fiduciary duty of care, should act as the intermediary in this loan process, given that this b/d is being paid the cash value of the shares being loaned as a means of collateralizing the loan, all unbeknownst to his client, the purchaser.
At these "CELLAR" levels, an interesting phenomenon occurs. Because NASD Rule 3370 allows MMs to legally naked short sell into markets with a plethora of buy orders but few sell orders, an MM can theoretically "legally" sit at the $.0001 level and sell nonexistent shares all day because there is obviously a huge disparity between buy orders and sell orders at no bid and $.0001 ask. Every time the share price tries to get off the CELLAR floor and onto the first step of the stairway at $.0001, someone is there to step on the hands of the victim corporation's market.
Once a microcap corporation is "boxed in the CELLAR," it doesn't have many options for climbing its way out. One obvious option would be to reverse split its way out of the CELLAR, but history has shown that this is counter-productive as market capitalization is typically hammered and the post-split share price level begins to revert to its original pre-split level.
Another option is to organize a sustained buying effort and muscle your way out of the CELLAR, but there will almost always be a naked short sell order there to meet every buy order. The shareholder base can sometimes muster enough buying pressure to keep the market at $.0001 bid and $.0002 offer for a limited time. Later, the market makers will typically pound the $.0001 bids with a blitzkrieg of selling, erasing all bids and returning the market to no bid and $.0001 offer. When weak-kneed shareholders see this a few times, they usually decide to sell their shares the next time a $.0001 bid appears and get out of Dodge. For weak-kneed investors, this phenomenon is known as "shaking the tree," and it is very effective.
The market will occasionally go to $.0001 bid and $.0003 offer. This creates a juicy 200% spread for the MMs and discourages buyers from reaching the "lofty" level of $.0003. If a $.0002 bid appears from an MM who is not "playing ball" with the unscrupulous MMs, it will be hit so quickly that Level 2 will never reveal its existence. The $.0001 bid at $.0003 offer market creates a "stalemate" in which market makers can leisurely enjoy the huge spreads while the victim company gradually dilutes itself to death by paying the monthly bills with "real" shares sold at ridiculously low levels. Because all of these development-stage corporations must pay their monthly bills, time favors the naked short sellers.
At times, it appears that unscrupulous market makers are not actively trying to kill the victim corporation, but rather want to milk the situation for as long as possible and allow the corporation to die slowly by dilution. The reality is that it is extremely easy to take away 99% of a victim company's share price or market cap and keep the victim corporation "boxed" in the CELLAR, but it is extremely difficult to kill a corporation, particularly after management and the shareholder base have figured out the game being played at their expense.
Market makers make a fortune with these huge percentage spreads over time, but the net aggregate naked short positions become astronomical as time passes. This causes some concern among the co-conspiring MMs. The problem is that they can't even stop naked short selling into every buy order that appears because doing so will cause the share price to gap, putting tremendous pressure on net capital reserves for the MMs and margin maintenance requirements for the co-conspiring hedge funds and others operating out of the more than 13,000 naked short selling margin accounts set up in Canada. Of course, covering the naked short position is out of the question because they can't even stop the day-to-day naked short selling in the first place, and you can't cover while naked short selling.
In these cases, the victim company is forced to massively dilute its share structure due to the constant payment of the monthly burn rate with money received from the sale of "real" shares at artificially low levels. The naked short sellers' goal is then to point out to investors, usually through paid "Internet bashers," that with, say, 50 billion shares currently issued and outstanding, this lousy company is not worth the $5 million market cap it is trading at, especially if it is just a shell company whose primary business plan was wiped out earlier on due to the naked short sellers' tortuous interference.
The truth is that the single most valuable asset of these victim companies is frequently the astronomically large aggregate naked short position that has accumulated during the initial "bear raid" as well as the "CELLAR BOXING" phase. The victim company's goal is now to avoid the naked short sellers' three main goals: bankruptcy, a reverse split, or the forced signing of a death spiral convertible debenture out of desperation.
As long as the victim company can pay the monthly burn rate, the game plan becomes to make some of the strategic moves that hundreds of victim companies have been forced to make, such as name changes, CUSIP # changes, cancel/reissue procedures, dividend distributions, amending by-laws and Articles of Corporation, and so on. Nevada-based companies typically cancel all of their shares in the system, real and fake, and require shareholders and their b/ds to PROVE ownership of the old "real" shares before receiving a new "real" share. Many people also file civil suits around this time.
This indirect forcing of hundreds of US microcap corporations to go through all of these extraneous hoops and hurdles in order to survive, whether due to regulatory apathy or a lack of resources, is likely one of the biggest black eyes the US financial system has ever sustained. In an ideal world, it would be the regulators who audit the "C" and "D" sub-accounts at the DTCC, the proprietary accounts of the MMs, clearing firms, and Canadian b/ds, and force the buy-in of counterfeit shares detected above the Rule 11830 guidelines for allowable "failed deliveries" of one half of 1% of the shares issued. Microcap corporations in the United States should not be required to "purge" their share structure of counterfeit electronic book entries on a regular basis, but if regulators refuse to do so, management has a fiduciary duty to do so.
A lot of management teams become overwhelmed with grief and guilt in regards to the huge increase in the number of shares issued and outstanding that have accumulated during their "watch". The truth is that as long as management followed proper corporate governance procedures throughout this ordeal, a massive number of issued and outstanding shares is unavoidable and often indicative of an astronomically high naked short position, which is nothing to be ashamed of. These massive naked short positions must be viewed as massive assets that must be developed. Hopefully, regulators will recognize the reality of naked short selling and tactics like "CELLAR BOXING" and address this fraud, which has decimated thousands of US microcap corporations and the tens of millions of US investors who have invested in them.
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