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

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 filings 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. The banks’ decisions to intentionally fail to deliver Overstock shares caused large-scale naked short selling of the company’s stock, according to the filing.

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 Feb. 9 court document.

Largest Client

According to the Overstock filing, Wolverine Trading LLC, the Goldman Sachs clearing unit’s largest client, was told in an undated e-mail that “we will let you fail,” in response to an inquiry by Wolverine about whether there was an effort “at cleaning up” fails. The sender isn’t identified in the filing.

An e-mail sent by John Masterson included “nonpublic data concerning customer short positions in Overstock and four other hard-to-borrow stocks to Maverick Capital, a large hedge fund that sells stocks short,” Overstock lawyers said in the document. Michael DuVally, a spokesman for Goldman Sachs, said a John Masterson worked at the bank as a managing director.

Fraser Seitel, a spokesman for Maverick, said the company hasn’t been able to locate the e-mail and declined further comment on the Overstock filing.

Clearing Unit

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.

“As far as I’m concerned, this is totally unacceptable -- we are failing when we have over a million shares of stock available,” another Merrill executive said 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.”

The vast majority of Merrill’s fails to deliver in Overstock shares correspond to market-makers Scott Arenstein and Steven Hazan, Overstock’s lawyers said in the filing. Goldman Sachs purchased “conversion” trades, or naked short sales, according to Overstock, from both men through their companies.

In its filing, Overstock’s lawyers said conversions involved the purchase of stock from a counterparty who sold short, combined with options to hedge risk.

An undated Goldman Sachs e-mail cited in the filing refers to Arenstein and his company SBA Trading as “providing very aggressive liquidity to Goldman” in the form of conversion trades with Goldman Sachs’s securities lending group.


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 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.

Goldman Sachs’s DuVally said the information allegedly sent by Masterson involved providing “market color information” to clients regarding activity in the securities lending marketplace on a “security specific or sector specific basis.”

‘Short Balances’

“In accordance with the firm’s guidelines, Mr. Masterson shared with the client aggregate and anonymous information regarding overall short balances in certain securities,” DuVally said in an e-mail. “The information he provided did not disclose the short positions or any other information of any client.” He declined to immediately comment on the other items in the document.

The e-mails show Bank of America’s efforts to ensure proper handling of short-sale transactions, said William Halldin, a spokesman for the Charlotte, North Carolina-based bank.

“When regulatory requirements changed in early 2005, our compliance team worked closely to implement those changes and, when necessary, address any issues that arose,” Halldin said in a telephone interview.

Tranfaglia is no longer at the bank and didn’t respond to a voice-mail message seeking comment. Both banks have denied any wrongdoing.

Goldman Sachs and Bank of America persuaded a judge to dismiss Overstock’s lawsuit, originally filed in 2007. Judge John Munter in San Francisco agreed with the banks that the lawsuit had to be thrown out because none of the conduct alleged in the complaint happened in California.

Wolverine Trading

Cory Burke, a spokesman at Wolverine Trading, a Chicago-based market making firm, declined to comment.

Arenstein and his company were fined $3.6 million in July 2007 for naked short selling by the former American Stock Exchange. He was suspended from the exchange for five years. He declined to comment on the filing.

Hazan agreed to pay $4 million in 2009 to settle Securities and Exchange Commission claims that the firm made naked short sales. Hazan and his New York-based Hazan Capital Management LLC were accused of betting that share prices would fall without borrowing and delivering the shares, the SEC said. Hazan was barred from working with any brokerage.

The New York Stock Exchange in a related action in 2009 said it barred Hazan from trading for seven years. Michael Bachner, a lawyer for Hazan, declined to comment on Overstock’s filing.

Borrowed in Anticipation

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.

Options market makers at the time the e-mails were sent had an exception to trading rules requiring that borrowed shares be located. Market makers had 13 days to clear up fails.

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

‘Obsolete Procedures’

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.

“Like all other prime brokers, the firm regularly receives requests for ‘locates’ from its clients and may grant locates when there are reasonable grounds to believe shares will be available by settlement date to cover a short sale by the customer,” said DuVally.

Goldman Sachs can’t link a specific locate to a net fail-to-deliver position that may occur at the Continuous Net Settlement System, he said in an e-mail. The system is a unit of the Depository Trust and Clearing Corp., which provides clearing and settlement of equities and other financial instruments.

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

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