Naked short selling

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Naked short selling, or naked shorting, is a controversial form of selling shares of securities short. 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]

Contents

[edit] 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.[1] 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.

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]

[edit] SEC Comments on Naked Shorting

On its Regulation SHO website in a section titled "Does Naked Shorting Drive Prices Down?", the SEC has made extensive comments on Naked Shorting. They cite both the prevalence of false claims of naked short selling in Pump and Dump fraud, and the possible abuse of markets through illegal naked short selling.

In these comments, the SEC downplays the blaming of naked shorting for declining stock prices. They emphasize 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 states that speculative stocks, especially Pink Sheets and microcap stocks should be thoroughly researched by investors. Pink Sheet listed companies in particular tend to be thinly traded and not meet minimum listing requirements for major exchanges. Many of these companies do not file periodic reports or audited financial statements with the SEC, making it very difficult for investors to find reliable information about those companies. The SEC also claims that naked short-selling has been falsely cited in pump and dump schemes by company insiders and stock promoters, when often the price decrease is possibly the result of the company's poor financial situation.

The SEC further states that actual naked short selling can have negative effects on stocks, and could be used as a tool for illegal market manipulation. Failures to deliver, possibly resulting from naked short sales, that persist for an extended period of time may result in large delivery obligations where stock settlement occurs. 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. Regulation SHO 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]

[edit] Controversy

Some investors defend naked short-selling as necessary tool of the market, and caution against further federal regulation. Naked short-sellers claim that they are enacting market pressure against overpriced and undertraded small-cap stocks. In the bubble of the late 1990s, they argue, regulations against naked short-selling would have caused an even greater boom and bust.[5]

Penny stock brokerages urge all investors to keep their stocks in cash accounts so that no shares can be shorted. The penny stock fraudsters can then illegally hype the stock to very high prices allowing the penny stock fraudsters to pump and dump their shares. Naked shorting keeps the penny stock brokerages from driving prices above the true value of the stock. The free market in this case could prevent the crime of pumping and dumping without any additional police or raising taxes. Pump and dump organizations sometimes are run by the Mafia.[6]

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."[7]

In recent years, however, the SEC has acted against naked shorting in part due to pressure from a handful of small and microcap companies.[5] 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."[8]

Critics of the naked shorting campaign contend the practice is not harmful and its prevalence exaggerated. Opponents include Wall Street Journal, which criticized the naked shorting allegations in an editorial, and columnist Joseph Nocera of the New York Times [9]. Author and journalist Gary Weiss criticized the anti-naked shorting campaign in his book Wall Street Versus America, as an interference with the mechanisms by which the bubbles created by pump-and-dump artists might otherwise be burst, and as a diversion of regulatory resources from the pursuit of the pump/dumpers.

A number of companies, including Pet Quarters, Overstock.com and Nanopierce Technologies, have filed lawsuits alleging naked shorting[citation needed]. Ten suits alleging naked short-selling filed against the Depository Trust and Clearing Corporation have been withdrawn or dismissed as of May 2005.[10] Other such lawsuits naming other defendants including hedge funds and prime brokers are in the early stages of litigation.

Responding to charges that by Overstock.com CEO Patrick Byrne that investors are harmed by fails to deliver, Nocera said, "Except for a few fellow-traveling Web sites, where Mr. Byrne is viewed as a heroic figure, most people who understand the issue or have looked into it think it's pretty bogus."[11]

[edit] Regulators Respond

The extent of the problem of naked short selling has been a subject of debate by the Securities and Exchange Commission and the self-regulatory organizations (SROs) that regulate the U.S. markets.

In a forum[12] sponsored by the North American Securities Administrators Association (NASD) in November 2005, an official of the New York Stock Exchange stated that NASD had found no evidence of widespread naked short selling, and decried "this fear mongering that there's this rampant naked shorting that's gone unregulated."[12] Cameron Funkhouser, NASD senior vice president of market regulations, noted that although companies have alleged stock manipulation through the Berlin stock exchange: "We have seen not one instance of naked short selling or any abusive short activity [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.

In July 2006, the SEC proposed to amend Regulation SHO, to close loopholes that could possibly be exploited via naked short selling.[13]. In a speech the same month, 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...". Cox further stated 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. [14] The SEC also published public comments on the proposed amendments.[15]

In March 2007, Goldman Sachs was fined $2 million by the SEC for allowing customers to illegally sell shares short just prior to secondary public offerings. Naked short-selling was allegedly utilized by the Goldman clients, who sold shares they didn't own and then misrepresented this to their broker. Goldman then later had to lend the shares to the clients to complete the sales. The SEC accused Goldman of 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."[16]

[edit] Recent developments

Naked shorting allegations played a role in the recent scandal surrounding the Refco commodities trading firm. Refco allegedly engaged in naked shorting of a company called Sedona Corp.[17] Civil suits by the US SEC and a criminal complaint by the US Department of Justice are continuing against various parties allegedly involved in manipulation of Sedona stock.[18]

In October 2006, a Forbes.com article said that Pegasus Wireless's stock may have been naked shorted because "there may be as many as 30 million more shares out there than it has on record."[19]

In December 2006, the SEC sued the Gryphon Partners hedge fund for alleged insider trading and naked short-selling involving PIPEs in the unregistered stock of 35 companies. PIPEs are "private investments in public equities," a financing tool used by small companies. The naked shorting took place in Canada, where it was legal at the time. Gryphon denied the charges.[20]

In 2006, Utah legislation aimed to curb naked short-selling, and championed by local company Overstock.com's Patrick Byrne, was passed. The legislation was repealed in March 2007, resulting in some spirited discourse between Byrne and Utah legislators. The legislators said they repealed the law with the understanding that the SEC would act on a federal level to alleviate naked shorting concerns, while Byrne alleged that legislators had caved in to lobbying from the Securities Industry and Financial Markets Association. Columnist Joseph Nocera opined that Byrne's anti naked shortselling campaign was in "meltdown."[21] Byrne's colorful language on naked shorting was also featured in a lively exchange on a New York Times blog.[22]

In March 2007, Bloomberg Television aired a half-hour special on Naked Short Selling called "Phantom Shares."[23]

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. Investors will have to fulfill delivery obligations by borrowing shares that have been lent from other investors who own the shares. SEBI also will allow the lending investors to earn a fee for shares lent.[24]

[edit] References

  1. ^ a b U.S. SEC. Division of Market Regulation: Responses to Frequently Asked Questions Concerning Regulation SHO.
  2. ^ University of Cincinnati College of Law. Securities Lawyer's Deskbook, Rule 200.
  3. ^ University of Cincinnati College of Law. Securities Lawyer's Deskbook, Rule 203.
  4. ^ U.S. SEC (April 11, 2005). Division of Market Regulation: Key Points About Regulation SHO.
  5. ^ a b Gary Weiss (December 8, 2003). Commentary: Don't Force The Shorts To Get Dressed.
  6. ^ Weiss, Gary [May 2003]. Born to Steal: When the Mafia Hit Wall Street. Warner Books. ISBN 978-0-446-52857-3. 
  7. ^ Nevada Supreme Court (February 2,2006). Brief of the Securities and Exchange Commission, re Nanopierce Corp, et al v. Depository Trust and Clearning Corp.
  8. ^ Norris, Floyd. "A New S.E.C. Rule Fails to Raise Share Prices, and Some Are Angry", The New York Times, 2005-02-18. Retrieved on 2007-01-17.
  9. ^ "Do Nudists Run Wall Street?" The Wall Street Journal, April 12, 2006
  10. ^ "Nevada Court Dismisses Nanopierce Lawsuit Against DTCC On Naked Short Selling," Depository Trust Clearing Corporation, http://www.dtcc.com/Publications/dtcc/may05/nanopierce.html, May 2005. Accessed February 5, 2007
  11. ^ Nocera, Joseph, "New Crusade for Master of Overstock," The New York Times, June 10, 2006
  12. ^ a b NASAA Conference on Short-Selling (November 30, 2005).
  13. ^ US SEC. [Proposed SEC 17 CFR PART 242 (Release No. 34-54154; File No. S7-12-06) RIN 3235-AJ57 Amendments to Regulation SHO.
  14. ^ Christopher Cox (July 12, 2006). Opening Statements at the US Securities and Exchange Commission Open Meeting.
  15. ^ United States Securities and Exchange Commission. Comments on Proposed Rule: Amendments to Regulation SHO [Release No. 34-54154; File No. S7-12-06].
  16. ^ TimesOnline and AP (March 15, 2007). Goldman Sachs fined $2m over short-selling.
  17. ^ Daniel Kadlec (November 14, 2006). Watch Out, They Bite!.
  18. ^ Liz Moyer (February 12, 2007). Naked and Confused; How a Tiny Software Outfit Fell Victim to an Illegal but Unrestrained Practice Known as Naked Short Selling.
  19. ^ Liz Moyer (October 3, 2006). Attack On Pegasus.
  20. ^ Dow Jones/AP (December 13,2006). Fund Manager Accused of Illegal Trading.
  21. ^ Joseph Nocera (March 10,2007). Revisiting Overstock.com and Utah.
  22. ^ Weekend Reading: Profile of a Short Seller (April 14, 2006).
  23. ^ Bloomberg Television (March 12,2007). Phantom Shares.
  24. ^ The Financial Express (March 22,2007). Sebi allows all to sell short.

[edit] External links

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