Naked short selling, or naked shorting, is a controversial form of selling shares of securities short. Some forms of naked short-selling are legal and some are not. The controversy has surrounded naked short-selling aimed at profiting from share price declines. The U.S. Securities and Exchange Commission has issued a regulation seeking to curb naked shorting abuses.[1]

The Practice

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, generating profit and allowing one to return like shares for the borrowed ones.

"Naked shorting" refers to "shorting" a stock for sale without first borrowing it. [2]. When one sells short a non-borrowed stock, one is selling something that they do not possess. The risk that one may not be able to then acquire the shares needed to deliver on the sale, is a contributing factor to the controversy surrounding this practice.

Its Effects

The pervasiveness of naked short-selling, and its impact on the market, is subject to sharp dispute. Critics say that since naked short selling theoretically can be done limitlessly, its effect can be to significantly depress the value of stocks. Suporters of the practice say that naked short selling functions as a mechanism for correcting abuses in the marketplace, particularly in the market for microcap stocks. [3]

Some alleged targets of naked short-selling include Overstock.com and Martha Stewart Living Omnimedia. However, critics maintain that the prices of those shares fell because of other corporate events.

Overstock CEO Patrick Byrne has supported a group that seeks to have existing rules against naked short selling enforced. In essence, these rules require delivery of stock after sale, with forced buy-in the remedy that would be expected. [4]

Smaller companies have claimed damage from the practice. Pet Quarters claims the practice caused their stock to fall from $4 to under 10 cents, which led to the company filing for bankruptcy. Some have filed suit against alleged naked shorts and other parties, but their suits have been almost invariably dismissed. [5]

In an article on TIME.com, Robert Shapiro estimated that naked short selling has cost legitimate investors $100 billion and caused the failure of 1,000 companies. [6]. However, critics of the anti-naked shorting campaign maintain that there is no proof to substantiate these and other allegations of the anti-shorting forces.[7]

Critics including the Depository Trust & Clearing Corporation, whose stock loan program is at the center of the naked short-selling controversy, contend that naked short-selling has been advanced by owners of small public companies to divert attention of price declines caused by corporate shortcomings and regulatory problems. [8]

One alleged effect of naked short-selling, according to opponents of the practice, is that it results in "counterfeit shares." The SEC has denied that this effect occurs. [9]

Critics say that one indication of large naked short positions are large numbers of "fails to deliver." Such "fails" have been advanced by critics as evidence of "massive fraud" in the markets. [10]. Recent statistics showed a large number of "fails" for one stock caught up in the naked shorting controversy, Overstock, Inc.

Regulators Respond

The allegations of the anti-naked shorting movements are denied by Securities and Exchange Commission and the self-regulatory organizations(SROs) that regulate the U.S. markets. The allegations have also been criticized by journalists and market commentators.

On the "fails" issue, the DTCC, the SRO responsible for handling the trades, says that "fails" can occur for many reasons other than naked short-selling. [11]. The SEC concurs, observing in a recent legal brief that fails to deliver do not result in any disadvantage to customers and do not necessarily result from naked short-selling. [12]

Opponents of naked short-selling also charge that that fails to deliver result in loss of voting rights to shareholders, and that they are they are not genuine "shares." This too is denied by the SEC, which notes that under the Uniform Commercial Code, broker-dealers are required to "treat the person for whom the account is maintained as entitled to exercise the rights that comprise the security." [13]

In a forum sponsored by the North American Securities Adminatrations Association in November 2005, some regulators, including a high official of the National Assn. of Securities Dealers (NASD), denied that naked short-selling is a signficant problem.

Cameron Funkhouser, NASD's senior vice president of market regulations, told the forum that NASD had found no evidence of widespread naked short selling. He decried "this fear mongering that there's this rampant naked shorting that's gone unregulated."[14]

Funkhouser also noted that although a number of companies have in the past alleged their shares have been manipulated through the listing of their stocks on the Berlin stock exchange, he had found no evidence of naked short selling there. "We took (these allegations) very seriously," Funkhouser said. "We have seen not one instance of naked short selling or any abusive short activity" at that exchange.

Controversy

Some investors defend the practice as just another tool of the market, and caution against federal regulation. Naked short-sellers claim that they are enacting market pressure against overpriced and undertraded small-cap stocks. In the bubble of the 1990s, they argue that regulations against short-selling would have caused an even greater boom and bust.

Critics contend that the naked shorting is fraud, and that it constitutes "taking a buyer's money and not delivering the product." However, the SEC denies that occurs, saying that a fail to deliver "does not mean that the customer's purchase is not completed." [15]

In recent years, however, the SEC has acted against naked shorting in part due to pressure from small-cap companies organizing under the banner of the National Association Against Naked Short-Selling (NAANSS). [16] This campaign has drawn criticism. Financial columnist Floyd Norris of the New York Times observed that "Investors who own [allegedly shorted] shares might do better to try to understand why some think the shares are overvalued, rather than simply rail about unfair short selling." [17]

External links

• Don't Force the Shorts to Get Dressed from Business Week
• Short Selling FAQ: Securities and Exchange Commission
• Short Selling FAQ: Depository Trust and Clearing Corp.
• Effects of New SEC Regulation: New York Times
• SEC Summary of Comments on Regulation SHO
• Watch Out, They Bite! from TIME.com