Naked short selling, or naked shorting, is the practice of selling a stock short without first borrowing the shares or ensuring that the shares can be borrowed. In the United States, the Securities and Exchange Commission issued a regulation in 2004, known as "Regulation SHO," seeking to curb abusive naked shorting.^[1] India, which disallowed short sales altogether in 2001 as a result of the Ketan Parekh affair, has reintroduced short selling under regulations similar to those developed in the United States.

Description

Normal shorting

Short selling is a form of speculation that allows a trader to sell securities that he does not own, effectively taking a "negative position". He/she does this when she/he expects the value of the securities to decrease in the market, allowing him or her to sell securities at today's price and then buy them back when they decrease in value. With a large enough move in the price, the trader can purchase the securities, "covering" their position, for less money than he received for selling it earlier. The opposite case can also occur; if the price increases he or she will be forced to cover at a higher cost, a money-losing trade.

In order to sell securities he/she does not own, a trader arranges to "borrow" securities from a current shareholder, typically a bank or prime broker, agreeing to return them at some future date. The trader then delivers these borrowed shares to the buyer, a third party. The lender generally charges an interest fee on the share value during the time when the position is being held by the trader. When the trader wants to "unwind" the position, she/he buys back the shares in the market and return those to the lender. This short/borrow system ensures the trader has shares to deliver to his/her buyer, and the lender makes some money on a position that she/he was not actively trading.

Naked shorts

Naked short selling is a case of short selling the shares without first arranging a borrow. The Securities Exchange Act of 1934 stipulates a settlement period up to three business days before a stock needs to be delivered,^[2] generally referred to as "T+3 delivery".

If the stock is illiquid or simply has a small number of outstanding shares, finding the borrow might be difficult to arrange. In these cases the trader normally arranges for the borrow before making the trade, just to be sure. In the case when a borrow cannot be arranged within that time period and the shares cannot be given to the buyer, the trade is considered to have "failed to deliver".^[2] The SEC states that "Naked short selling is not necessarily a violation of the federal securities laws or the Commission's rules. Indeed, in certain circumstances, naked short selling contributes to market liquidity."^[3]

Naked shorting to drive down share prices violates US law. In recent years, a number of companies have been accused of using naked shorts in order to make profits at the expense of share prices. To do this, the trader simply enters a naked short with no intention of ever delivering the shares.^[2] A large enough short sale could cause the price to fall, as is the case with any stock being sold, so as long as the trade is large enough to move the share price, the short is likely to be profitable. Normally this would be risky; if the price did move back up for other reasons, the trader would be driving the price up with every purchase, a condition known as a "short squeeze".^[4] But as long as the buyer turns around and shorts it back into the market, the price continues dropping, making the trades profitable even though no one actually holds any of the shares.^[2]

"Legal" naked shorting would normally be invisible in a liquid market, as long as the short sell is eventually delivered to the buyer. However, if the covers are impossible to find, the trades fail. A sudden rise in number of fail reports will alert the SEC that something irregular is going on. In some recent cases, it was claimed that the daily activity was larger than all of the available shares, which would normally be unlikely.^[2]

The North American Securities Administrators Association (NASAA) held a conference on naked short selling in November 2005. An official of the New York Stock Exchange stated that NYSE had found no evidence of widespread naked short selling, and alleged "fear mongering that there's this rampant naked shorting that's gone unregulated." Cameron Funkhouser, NASD senior vice president of market regulations, noted that although companies have alleged stock manipulation through the Berlin stock exchange, the NASD has seen not one instance of naked short selling [on the Berlin stock exchange]". Ralph Lambiase, head of the Connecticut Securities Agency and the NASAA, declared his disappointment at how the industry was handling the issue as a whole.

A report issued in early 2006 found no evidence of naked short selling in US markets, despite allegations from many companies.^[5] The SEC's short selling FAQ also cites common misconceptions about the practice, such as the belief that naked shorting causes "phantom" shares to enter the market, as one source of confusion over the practice's market effect. Naked short selling, the SEC said, would not increase a company's shares outstanding shares nor result in "counterfeit shares."^[1]

Statistics on failures to deliver securities are sometimes used as evidence of naked short selling in specific stocks. However, the U.S. Securities and Exchange Commission stated in January 2008 that "fails-to-deliver can occur for a number of reasons on both long and short sales. Therefore, fails-to-deliver are not necessarily the result of short selling, and are not evidence of abusive short selling or 'naked' short selling," ^[6]

Current legal naked shorting rules allow brokerages to make large profits doing "bona-fide market making" while stock markets are falling. The market maker exemption to the rules governing the practice is intended to allow market makers to naked short sell on a very temporary basis, in order to increase liquidity and stabilize markets.

Regulations

Regulation SHO

The SEC enacted Regulation SHO in January 2005 to target abusive naked short selling by reducing failure to deliver securities.^[7] It states that a broker or dealer may not accept a short sale order without having first borrowed or identified the stock being sold.^[8] The rule has the following exemptions:

1. Broker or dealer accepting a short sale order from another registered broker or dealer
2. Bona-fide market making
3. Broker-dealer effecting a sale on behalf of a customer that is deemed to own the security pursuant to Rule 200^[9] through no fault of the customer or the broker-dealer.^[10]

Regulation SHO also created the "Threshold Security List," which reported any stock where more than 0.5% of a company's total outstanding shares failed delivery for five consecutive days. A number of companies have appeared on the list, including Krispy Kreme, Martha Stewart Omnimedia and Delta Airlines. The Motley Fool, an investment website, observes that "when a stock appears on this list, it is like a red flag waving, stating 'something is wrong here!'"^[2] However, the SEC states that appearance on the threshold list "does not necessarily mean that there has been abusive naked short selling or any impermissible trading in the stock." ^[11] Wall Street Journal columnist Holman Jenkins observed that fails were "more like an acceptable kludge, helping the market work better, than a cesspot of corruption liable to bring down the financial system."^[12]

The SEC, in describing Regulation SHO, says that failures to deliver shares that persist for an extended period of time "may result in large delivery obligations where stock settlement occurs."^[7] However, the SEC observes that fails can occur because of ordinary "long" stock sales and for reasons entirely unrelated to efforts to profit from share price declines.

Regulation SHO is intended to reduce the number of potential failures to deliver, and by limiting the time in which a broker can permit failures to deliver. The regulation requires broker-dealers to close-out open fail-to-deliver positions in threshold securities that have persisted for 13 consecutive settlement days.^[13]

On its Regulation SHO website ("Does Naked Shorting Drive Prices Down?" section), the SEC cites the prevalence of false claims of naked short selling in Pump and Dump fraud. The SEC downplays naked shorting as a factor in declining stock prices, stating that stock values ideally should be determined by "the quality of the company itself," "supply and demand" of the company's shares, and the company's ability to generate positive income.

Further developments

In July 2006, the SEC proposed to amend Regulation SHO, to further reduce failures to deliver securities.^[14] SEC Chairman Christopher Cox referred to "the serious problem of abusive naked short sales, which can be used as a tool to drive down a company's stock price." and that the SEC is "concerned about the persistent failures to deliver in the market for some securities that may be due to loopholes in Regulation SHO.^[15]

In March 2007, the Securities and Exchange Board of India (SEBI) outlawed all naked short selling, in conjunction with a rule change allowing short selling in the cash market.^[16][17]

In June 2007, the SEC voted to remove the grandfather provision that allowed fails to deliver that existed before Reg SHO to be exempt from Reg SHO. SEC Chairman Christopher Cox called naked short selling a fraud that the commission is bound to prevent and to punish.The SEC also said it was considering removing an exemption from the rule for options market makers. ^[18] Removal of the grandfather provision and naked shorting restrictions generally have been endorsed by the U.S. Chamber of Commerce.^[19]

SEC Chairman Christopher Cox in March 2008 gave a speech entitled the "'Naked' Short Selling Anti-Fraud Rule," in which he announced new SEC efforts to combat naked short selling.[2] Under the proposal, the SEC would create an antifraud rule targeting those who knowingly deceive brokers about having located securities before engaging in short sales, and who fail to deliver the securities by the delivery date. Cox said the proposal would address concerns about short-selling abuses, particularly in the market for small-cap stocks. Even with the regulation in place, the SEC received hundreds of complaints in 2007 about alleged abuses involving short sales. The SEC estimates about 1% of shares that change hands daily, about $1 billion, are subject to delivery failures. SEC Commissioners Paul Atkins and Kathleen Casey expressed support for the crackdown.[3]

Other legislation

In 2006, the Utah legislature passed legislation aimed to curb naked short-selling, passed largely due to the advocacy of Overstock.com CEO Patrick M. Byrne. The legislation was repealed in February 2007, after litigation brought by the Securities Industry and Financial Markets Association (SIFMA), which sought to have the federal courts declare the law invalid.

Legislators said they repealed the law with the understanding that the SEC would act on a federal level to alleviate naked shorting concerns. Byrne described the repeal as a cave-in to self-interested industry pressure. Utah state senate majority leader Curtis Bramble said at the time of repeal that he now believed that Overstock's motives were "highly suspect." Bramble said, "There are those who believe Overstock has been using the Legislature as a distraction against its own problems. It raises serious questions."^[20]

Regulatory enforcement actions

In 2005, the SEC notified Refco of intent to file an enforcement action against the securities unit of Refco for securities trading violations concerning the shorting of Sedona stock. The SEC sought information related to two former Refco brokers who handled the account of a client, Amro International, which shorted Sedona's stock. ^[21] No charges had been filed by 2007.

In December 2006, the SEC sued Gryphon Partners, a hedge fund, for insider trading and naked short-selling involving PIPEs in the unregistered stock of 35 companies. PIPEs are "private investments in public equities," used by companies to raise cash. The naked shorting took place in Canada, where it was legal at the time. Gryphon denied the charges. ^[22]

In March 2007, Goldman Sachs was fined $2 million by the SEC for allowing customers to illegally sell shares short prior to secondary public offerings. Naked short-selling was allegedly utilized by the Goldman clients. The SEC charged Goldman with failing to ensure those clients had ownership of the shares. SEC Chairman Cox commented, "That is an important case and it reflects our interest in this area."^[23]

In June 2007, executives of Universal Express, which had claimed naked shorting of its stock, were sanctioned by a federal court judge as repeated and remorseless violators” of the securities laws. The SEC asserted that the company appears to exist primarily as a vehicle for fraud. ^[24] Referring to a court ruling barring CEO Richard Altomare from serving as an officer of a public company, New York Times columnist Floyd Norris said: "In Altomare's view, the issues that bothered the judge are irrelevant. 'Long and short of it,' he said in a statement, 'this is a naked short hallmark case in the making.' Or it is proof that it can take a long time for the SEC to stop a fraud."^[25] Universal Express has claimed that 6,000 small companies have been put out of business by naked shorting, which the company says "the SEC has ignored and condoned."^[26] A receiver was subsequently appointed to administer the company.

In July 2007, Piper Jaffray Cos. was fined $150,000 by the New York Stock Exchange (NYSE). Piper violated securities trading rules from January through May of 2005, selling shares without borrowing them, and also failing to "cover short sales in a timely manner", according to the NYSE. ^[27] At the time of this fine, the NYSE had levied over $1.9 million in fines for naked short sales over seven regulatory actions.^[28]

Also in July 2007, the American Stock Exchange fined two options market makers for violations of Regulation SHO. SBA Trading was sanctioned for $5 million, and ALA Trading was fined $3 million, which included disgorgement of profits. Both firms and their principals were suspended from association with the exchange for five years. The exchange said the firms used an exemption to Reg. SHO for options market makers to "impermissibly engage in naked short selling." ^{[29] [30][31]}

In October 2007, the SEC settled charges against New York hedge fund adviser Sandell Asset Management Corp. and three executives of the firm for, among other things, shorting stock without locating shares to borrow. Fines totaling $8 million were imposed, and the firm neither admitted nor denied the charges.^[32]

Litigation

The Depository Trust and Clearing Corporation has been criticized for its approach to naked short selling.^[33][34] DTCC has been sued with regard to its alleged participation in naked short selling, and the issue of DTCC's possible involvement has been taken up by Senator Robert Bennett and discussed by the NASAA and in articles -- disagreed with by DTCC -- in the Wall Street Journal and Euromoney Magazine.

While there is no dispute that illegal naked shorting happens, there is a fight as to the extent to which DTCC is responsible. Some blame DTCC as the keeper of the system where it happens, and say DTCC turns a blind eye to the problem. DTCC says naked shorting is not widespread enough to be a major concern. "We're not saying there is no problem, but to suggest the sky is falling might be a bit overdone," DTCC's chief spokesman Stuart Goldstein said.^[35][36] DTCC General Counsel Larry Thompson calls the claims "pure invention."^[36] The SEC, however, views naked shorting as a serious enough matter to have made two separate efforts to restrict the practice.^[37] And in July 2007, Senator Bennett suggested on the U.S. Senate floor that the allegations involving DTCC and naked short selling are "serious enough" that there should be a hearing on them with DTCC officials by the Senate Banking Committee. The committee's Chairman, Senator Christopher Dodd, indicated he was willing to hold such a hearing.^[38] The North American Securities Administrators Association, representing state stock regulators, filed a brief saying that if the claims were correct, its shareholders "have been the victims of fraud and manipulation at the hands of the very entities that should be serving their interest."^[39][4][5]

Critics also contend DTCC has been too secretive with information about where naked shorting is taking place.^[37] In 2007, WayPoint Biomedical sued DTCC for DTCC's refusal to comply with a subpoena request for documents Waypoint needs to track trades in the company's shares.^[40] Ten suits concerning naked short-selling filed against the DTCC were withdrawn or dismissed by May 2005.^[41]

A suit by Electronic Trading Group, naming major Wall Street brokerages, was filed in April 2006 and dismissed in December 2007.^[42].^[43]

Two separate lawsuits, filed in 2006 and 2007^[44] by NovaStar Financial, Inc. shareholders and Overstock.com, named as defendants ten Wall Street prime brokers. They claimed a scheme to manipulate the companies' stock by allowing naked short selling.^[45] A motion to dismiss the Overstock suit was denied in July 2007.^[46][47]

Studies

A study of trading in initial public offerings by two SEC staff economists, published in April 2007, found that excessive numbers of fails to deliver were not correlated with naked short selling. The authors of the study said that while the findings in the paper specifically concern IPO trading, "The results presented in this paper also inform a public debate surrounding the role of short selling and fails to deliver in price formation." ^[48]

Even though fails to deliver are viewed by some as a way of measuring the degree of naked short sales, the SEC economists said the delivery failures seen in the IPO market "cannot be explained by short selling in general or 'naked' short selling specifically."^[49]

An April 2007 study conducted for Canadian market regulators by Market Regulation Services Inc. found that fails to deliver securities were not a significant problem on the Canadian market, that "less than 6% of fails resulting from the sale of a security involved short sales" and that "fails involving short sales are projected to account for only 0.07% of total short sales." ^[50][51]

Media coverage

Some major media outlets contend that naked short selling is not harmful and its prevalence has been exaggerated by corporate officials seeking to blame external forces for their own shortcomings.

Wall Street Journal columnist Holman W. Jenkins, Jr., has derided naked shorting allegations. ^[12].

In the New York Times, several columnists have criticized the campaign against naked short selling. Chief financial correspondent Floyd Norris contended that investors of stocks that are being shorted "might do better to try to understand why some think the shares are overvalued, rather than simply rail about unfair short selling."^[52].

New York Times financial columnist Joseph Nocera has criticized naked shorting allegations as diversionary complaints, and said that "most people who understand the issue or have looked into it think it's pretty bogus."^[53]

Author, columnist and former Business Week investigative reporter Gary Weiss has maintained that the SEC enacted Regulation SHO in part due to pressure from a handful of small and microcap companies.^[54] He also says that some investors defended naked short-selling as a necessary tool of the market against overpriced stocks, and cautions against further regulation as it would have caused an even greater stock market bubble in the late 1990's.^[54] Weiss believes that naked shorting enables the free market to help prevent pump and dump scams that regulatory agencies are not able to catch due to limited resources. He also says that the campaign against naked shorting is a diversion of regulatory resources from more significant issues.^[55]

In March 2007, Bloomberg Television featured a special on naked short selling, "Phantom Shares."^{[56] [57]} In May 2007, Max Keiser reported on naked short selling as part of a report on Al Jazeera's People and Power show. ^[58]

References

External links

• Short Selling FAQ: Securities and Exchange Commission
• Naked Short Selling FAQ: Depository Trust and Clearing Corp.
• Who's behind Naked-shorting? - Fool.com
• AMEX's daily and monthly Regulation SHO threshold security list
• NASDAQ's Regulation SHO threshold security list
• NYSE's Regulation SHO threshold security list