Naked short selling, or naked shorting, is a form of selling shares of securities short that seeks to profit from share price declines.

Short selling is the practice of borrowing stock, then selling it in hopes that the price will go down and it can be bought back at a lower price with shares to replace the borrowed ones. "Naked shorting" refers to short selling a stock for sale without first borrowing the shares or making an "affirmative determination" that the shares can be borrowed. The U.S Securities and Exchange Commission has issued a regulation, known as Reg SHO, seeking to curb abusive naked shorting.^[1]

Regulatory policy

On American exchanges, pursuant to Rule 203(b)(2) of Regulation SHO these short sales of securities may be legally permitted: (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^[2] through no fault of the customer or the broker-dealer.^[3]

The SEC contends that naked short selling has been falsely blamed in stock scams, but can be used as a tool for illegal market manipulation. Failures to deliver shares, possibly resulting from naked short sales, that persist for an extended period of time may result in large delivery obligations where stock settlement occurs. 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" (i.e., securities that have experienced a substantial number of extended delivery failures) that have persisted for 13 consecutive settlement days."^[4]

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.

The SEC says that naked short-selling has been frequently and falsely blamed for low stock prices in the wake of pump and dump scams involving companies that are in poor financial condition.

In July 2006, the SEC proposed to amend Regulation SHO, to close loopholes that could possibly be exploited via naked short selling.^[5]. 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.^[6]

The North American Securities Administrators Association (NASD) held a conference on naked short selling in November 2005. An official of the New York Stock Exchange stated that NASD 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.^{[citation needed]}

In March 2007, the Securities and Exchange Board of India (SEBI) approved short selling for institutional investors in the cash segment of the Indian stock market. Naked short selling will not be allowed and traders will have to fulfill delivery obligations by borrowing shares that have been lent from other investors who own the shares.^[7]

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. ^[8]

SEC enforcement actions

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. ^[9]

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 which not ensuring those clients had ownership of the shares. SEC Chairman Cox commented, "That is an important case and it reflects our interest in this area."^[10]

State 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."^[11]

Private lawsuits

Ten suits alleging naked short-selling filed against the Depository Trust and Clearing Corporation were withdrawn or dismissed by May 2005.^[12] Other such lawsuits originated by companies such as Electronic Trading Group [1]and Overstock.com [2] naming other defendants including hedge funds and prime brokers are in the early stages of litigation.

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." ^[13] 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."^[14]

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." ^[15][16]

Media coverage

Some major media outlets contend that naked short selling is not harmful and its prevalence exaggerated by corporate officials seeking to blame external forces for their own shortcomings. The Wall Street Journal has criticized naked shorting allegations in an editorial^[17]. In the New York Times, several columnists have criticized the campaign against naked short selling. 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."^[18]. Joseph Nocera 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."^[19] Nocera also reported that a leader of an anti-naked short-selling campaign, CEO Patrick Byrne, was in a "meltdown" during a meeting with Utah legislators, where he was "belligerent" and "cursing".^[20]

Author and 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.^[21] He also says that some investors defended naked short-selling as a necessary tool of the market against overpriced stocks, and caution against further regulation as it would have caused an even greater stock market bubble in the late 1990's.^[21] 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.^[22]

In March 2007, Bloomberg Television featured a special on naked short selling, "Phantom Shares."^{[23] [24]} In May 2007, Max Keiser reported on naked short selling as part of a report on Al Jazeera's People and Power show. ^[25]

References

External links

• Short Selling FAQ: Securities and Exchange Commission
• Naked Short Selling FAQ: Depository Trust and Clearing Corp.