THC Science

A naked short sale, (or naked shorting), is a controversial form of selling shares of securities short. It is viewed by critics as a device to depress stock prices.

However, the extent to which this practice takes place has been widely exaggerated, and allegations of naked short-selling have historically been used as a scapegoat by pump-and-dump scam operators wishing to shift blame for the inevitable decline in manipulated stocks.

Allegations concerning naked short-selling have long swirled around the capital markets, and were the subject of a cover story in Forbes magazine on February 8, 1988. At that time, stock promoters involved in the Creative Securities and Haas Securities stock swindles were alleging that their firms' shares -- subsequently found to have been a subject of pump and dump fraud -- were pushed down by naked short-sellers. In fact, these stocks collapsed after the stock fraud ended, and no naked shorting was proven.

In an ordinary short sale, stocks are borrowed and then sold, with the aim of profiting when a stock price declines. In a "naked" short sale, the short-seller does not borrow or arrange to borrow the securities in time for settlement (in the major United States capital markets, settlement typically takes place three days after the transaction).

Advantages for the market of naked short selling

In criminal stock fraud operations, retail investors are encouraged by either a stock promoter or bucket shop to buy a stock pushing it's value far beyond its true value. This is also called pump and dump. If naked shorting were allowed by SEC rules, other brokerages would step in and naked short the stock bringing it back to true value. In essence, SEC rules against naked shorting allows criminal stock fraud operations to exist and make large profits.

By making naked shorts illegal, volume of trading is reduced resulting in higher spreads and illiquidity. Also, present naked shorting rules allow brokerages to make large profits doing "bona-fide market making" while stock markets are falling. Since retail investors are not allowed to do naked shorting, this presents an unfairness or uneven playing field.

Disadvantages for the market of naked short selling

Naked Short Selling causes a drop in share price. Companies who are doing a stock offering will have to issue more shares to raise the same amount of cash. Critics of the practice also charge that naked short-selling could theoretically result in trading in fictitious shares, because the shares are not located or borrowed before they are sold short. However, regulators have released no evidence of that actually taking place.

Controversy

Critics charge that naked short selling can threaten the stability of stock prices because stocks can be sold without having to first acquire them from existing owners. In practice, true naked shorts cannot be maintained by public investors since they must either have the shares borrowed for them by their brokers in advance or promptly deliver the physical shares. Therefore, true naked shorts are typically done by broker-dealers and market makers who are able to maintain such naked short positions in secrecy via simple electronic journaling or book-keeping, intra-firm, to customers who bought and who simply need to see share figures on their statements to feel assured.

Illegal In Most Instances

Naked short selling is illegal as described - it can be legal in certain limited circumstances: for a market maker that needs to provide shares in a fast moving market for a thinly traded security, but in that instance it will buy the share back a few cents below where it sold it - Sell at $4.20, buy at $4,00 - which is part of legitimate market making. Or an options market maker will do so to hedge its sale of put options. These are legal, limited-time frame exceptions. All other instances are illegal.

The industry term for a naked short sale is a Fail to Deliver (FTD), because the seller fails to deliver. The DTCC reports that the FTD problem amounts to $6 billion a day, marked to market. It is unclear whether that includes the ex-clearing transactions or not - the language used is ambiguous, and allows for different interpretations. Many have asked for clarification, and none has been offered - the DTCC doesn't like to talk about this, to anyone, including the regulators.

Some companies, have fought back against alleged naked shorting by suing short-sellers and the Depository Trust Clearing Corporation.

In the United States, the Securities and Exchange Commission enacted Regulation SHO to prohibit Naked Short Selling. Regulation SHO was enacted under concerted pressure from opponents of naked short-selling, Critics of Regulation SHO say that it lacks specifics as to the size of the naked short problem and there is no penalty for violating the rule.

Regulation SHO put in place a warning system against the risk of stock price instability by publicly identifying securities where short positions composed more than 10,000 shares and more than 0.5% of the Total Shares Outstanding for 5 consecutive settlement days or more.

Criticism

Critics of naked shorting have emphatically asserted that the practice constitutes a major scandal on the stock market, and that "hundreds if not thousands of companies"have been victimized by the practice. Some critics have contended that there is a "massive stock counterfeiting" conspiracy, with one vocal critical, Overstock Inc. chief executive officer Patrick Byrne, maintainingthat there is a "Sith Lord" behind naked shorting machinations -- a claim that has been met by widespread derision.

Congress mandated in Rule 17A of the 1934 Securities Exchange Act that our markets have prompt, accurate clearance and delivery. It reads, "The prompt and accurate clearance and settlement of securities transactions, including the transfer of record ownership and the safeguarding of securities and funds related thereto, are necessary for the protection of investors and persons facilitating transactions by and acting on behalf of investors.”

That seems pretty clear. BOTH clearing (booking the sale and paying for it) and settling (delivery) need to happen promptly, and further, the transfer of record ownership needs to occur. The rule makers understood the temptation to come up with a way to game this, so were clear on the necessary predicates. Clear AND Settle, including transfer of ownership.

Counter criticism

In 2003, the SEC implemented a new rule to ban the practice. The ruling was designed to protect vulnerable stocks to aggressive short-selling. However, opponents of this rule have been arguing that "if naked-shorting had not taken place during the micro-cap crime wave of the 1990s, such stocks would have climbed even higher before they crashed". [1]

Critics of naked shorting are themselves frequently the subjects of harsh criticism, with skeptics pointing out a near total absence of evidence that the practice even exists. Indeed, the entire subject was pretty well laid to rest at a November 2005 forum on naked short-selling conducted by the North American Securities Administrators Association, in which regulators testifiedthat has been little or no evidence of extensive naked short selling,

James Brigagliano, assistant director of market regulation at the SEC, said, "While there may be instances of abusive short selling, 99% of all trades in dollar value settle on time without incident." Brigagliano said the SEC conducted examination at 45 broker/dealers and asked the markets to look into the trading of securities in which large amounts of "fails to deliver" have been registered.

Cameron Funkhouser, NASD's senior vice president of market regulations, told the forum that NASD had found no evidence of rampant naked short selling. He 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 foreign stock exchanges, he had found no evidence of such activity. "We took (these allegations) very seriously," Funkhouser said. "We have seen not one instance of naked short selling or any abusive short activity" through foreign exchanges."

Despite the overwhelming evidence that "naked shorting" is a nonissue that is a drain on regulatory resources, opponents of naked short-selling continue to press their campaign.

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