Naked Short Selling
He then purchases and delivers the shares for a different market price. If the short seller cannot afford the shares in the second step, or the shares are not available, a "fail to deliver" results.
Naked short selling, or naked shorting, is the practice of short-selling a financial instrument without first borrowing the security or ensuring that the security can be borrowed, as is conventionally done in a short sale.
When the seller does not obtain the shares within the required time frame, the result is known as a "fail to deliver". The transaction generally remains open until the shares are acquired by the seller, or the seller's broker, allowing the trade to be settled. Naked shorting 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. But it is illegal when manipulators use the practice to force stock prices down by temporarily increase the supply of stock, some people argue. However, the practice is not considered abusive or illegal when utilized by market makers, if they fulfill the close-out and pre-borrow requirements, as they are not exempt. It's also not illegal when there is a legitimate reason for failing in the delivery of the stock.
In the United States, naked short selling is covered by various SEC regulations which prohibit the practice. In 2005, "Regulation SHO" was enacted, requiring that broker-dealers have grounds to believe that shares will be available for a given stock transaction, and requiring that delivery take place within a limited time period. As part of its response to the crisis in the North American markets in 2008, the SEC issued a temporary order restricting short-selling in the shares of 19 financial firms deemed systemically important, by reinforcing the penalties for failing to deliver the shares in time. Effective September 18, 2008, amid claims that aggressive short selling had played a role in the failure of financial giant Lehman Brothers, the SEC extended and expanded the rules to remove exceptions and to cover all companies.
Some commentators have contended that despite regulations, naked shorting is widespread and that the SEC regulations are poorly enforced. Conventionally, the trader will "borrow" securities from a current shareholder, typically a bank or prime broker, agreeing to return them on demand.
The seller delivers these shares to a buyer, who takes full ownership and likely does not know that he is participating in a short sale. When the seller wants to "unwind" the position, he buys back equivalent shares in the market and returns them to the lender.
This short/borrow system provides the trader with shares to sell at current prices, in the hope that he will profit by repurchasing them later when the price has lowered.
If the stock is in short supply, finding shares to borrow can be difficult. When shares are not borrowed within the clearing time period and the short-seller does not tender shares to the buyer, the trade is considered to have "failed to deliver." Nevertheless, the trade will continue to sit open or the buyer may be credited the shares by the DTCC until either the short-seller closes out the position or borrows the shares.
It is difficult to measure how often naked short selling occurs.
Fails to deliver are not necessarily indicative of naked shorting, and can result from both "long" transactions (stock purchases) and short sales. Naked shorting can be invisible in a liquid market, as long as the short sale is eventually delivered to the buyer. In some recent cases, it was claimed that the daily activity was larger than all of the available shares, which would normally be unlikely.
Extent of naked shorting
The reasons for naked shorting, and the extent of it, have been disputed for several years before the SEC's 2008 action to prohibit the practice.
What is generally recognized is that naked shorting tends to happen when shares are difficult to borrow. Studies have shown that naked short selling also increases in correlation with the cost of borrowing.
In recent years, a number of companies have been accused of using naked shorts in aggressive efforts to drive down share prices, sometimes with no intention of ever delivering the shares. These claims focus on the fact that, at least in theory, the practice allows an unlimited number of shares to be sold short.
A Los Angeles Times editorial in July 2008 said that naked short selling "enables speculators to drive down a company's stock by offering an overwhelming number of shares for sale." The SEC, however, says that naked shorting is sometimes falsely asserted as a reason for a share price decline, when in fact "the price decrease is a result of the company's poor financial situation rather than the reasons provided by the insiders or promoters."
Before 2008, regulators had generally downplayed the extent of naked shorting in the US. At a North American Securities Administrators Association (NASAA) conference on naked short selling in November 2005, an official of the New York Stock Exchange stated that NYSE had not found evidence of widespread naked short selling.
In 2006, an official of the SEC said that "While there may be instances of abusive short selling, 99% of all trades in dollar value settle on time without incident." Of all those that do not, 85% are resolved within 10 business days and 90% within 20. That means that about 1% of shares that change hands daily, or about $1 billion per day, are subject to delivery failures, although the SEC has stated that "fails-to-deliver can occur for a number of reasons on both long and short sales," and accordingly that they do not necessarily indicate naked short selling.
In 2008, SEC chairman Christopher Cox said that the SEC "has zero tolerance for abusive naked short-selling" while implementing new regulations to prohibit the practice, culminating in the September 2008 action following the failures of Bear Sterns and Lehman Brothers amidst speculation that naked short selling had played a contributory role. Cox said that "the rule would be designed to ensure transparency in short-selling in general, beyond the practice of naked short-selling."
Claimed effects of naked shorting
As with the prevalence of naked shorting, the effects are contested. Shapiro, former undersecretary of commerce for economic affairs, and a consultant to a law firm suing over naked shorting, has claimed that naked short selling has cost investors $100 billion and driven 1,000 companies into the ground.
Richard Fuld, the former CEO of the financial firm Lehman Brothers, during hearings on the bankruptcy filing by Lehman Brothers and bailout of AIG before the House Committee on Oversight and Government Reform alleged that a host of factors including a crisis of confidence and naked short selling attacks followed by false rumors contributed to both the collapse of Bear Stearns and Lehman Brothers. The Wall Street Journal's Dealbook blog said that Fuld was "obsessed" with short sellers, and that "when Fuld was questioned about the shorts’ connection to Goldman, he grumbled that he had no evidence but didn’t sound convinced." Upon the examination of the issue of whether "naked short selling" was in any way a cause of the collapse of Bear Stearns or Lehman, securities experts reached the conclusion that the alleged "naked short sales" occurred after the collapse and therefore played no role in the collapse.
House committee Chairman Henry Waxman said the committee received thousands of pages of internal documents from Lehman and these documents portray a company in which there was “no accountability for failure". In July 2008, U.S. Securities and Exchange Commission chairman Christopher Cox said there was no "unbridled naked short selling in financial issues."
Regulations in the United States
Securities Exchange Act of 1934
The Securities Exchange Act of 1934 stipulates a settlement period up to three business days before a stock needs to be delivered, generally referred to as "T+3 delivery."
Regulation SHO
The SEC enacted Regulation SHO in January 2005 to target abusive naked short selling by reducing failure to deliver securities, and by limiting the time in which a broker can permit failures to deliver. In addressing the first, it stated that a broker or dealer may not accept a short sale order without having first borrowed or identified the stock being sold. The rule had the following exemptions:
Broker or dealer accepting a short sale order from another registered broker or dealer
Bona-fide market making
Broker-dealer effecting a sale on behalf of a customer that is deemed to own the security pursuant to Rule 200 through no fault of the customer or the broker-dealer.
To reduce the duration for which fails to deliver are permitted to sit open, the regulation requires broker-dealers to close-out open fail-to-deliver positions in threshold securities that have persisted for 13 consecutive settlement days. The SEC, in describing Regulation SHO, stated that failures to deliver shares that persist for an extended period of time "may result in large delivery obligations where stock settlement occurs."
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.
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!'" However, the SEC clarified 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."
In July 2006, the SEC proposed to amend Regulation SHO, to further reduce failures to deliver securities. 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.
Developments, 2007 to the present
In March 2007, the Securities and Exchange Board of India (SEBI), which disallowed short sales altogether in 2001 as a result of the Ketan Parekh affair, reintroduced short selling under regulations similar to those developed in the United States. In conjunction with this rule change, SEBI outlawed all naked short selling.
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.
Even with the regulation in place, the SEC received hundreds of complaints in 2007 about alleged abuses involving short sales. Cox said, "rather it is intended as a preventative step to help restore market confidence at a time when it is sorely needed." Analysts warned of the potential for the creation of price bubbles.
The emergency actions rule expired August 12, 2008. However, at September 17, 2008, the SEC issued new, more extensive rules against naked shorting, making "it crystal clear that the SEC has zero tolerance for abusive naked short selling".
Among the new rules is that market makers are no longer given an exception. The SEC sought information related to two former Refco brokers who handled the account of a client, Amro International, which shorted Sedona's stock. 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. Gryphon denied the charges.
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.
The SEC charged Goldman with failing to ensure those clients had ownership of the shares. SBA Trading was sanctioned for $5 million, and ALA Trading was fined $3 million, which included disgorgement of profits.
SHO for options market makers to "impermissibly engage in naked short selling."
In October 2007, the SEC settled charges against New York hedge fund adviser Sandell Asset Management Corp. 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, and that banking committee chairman Christopher Dodd has expressed a willingness to hold such a hearing.
Critics also contend DTCC has been too secretive with information about where naked shorting is taking place. Ten suits concerning naked short-selling filed against the DTCC were withdrawn or dismissed by May 2005.
A suit by Electronic Trading Group, naming major Wall Street brokerages, was filed in April 2006 and dismissed in December 2007.
Two separate lawsuits, filed in 2006 and 2007 by NovaStar Financial, Inc.
was dismissed by a federal court in Arkansas, and upheld by the Eighth Circuit Court of Appeals in March 2009. Pet Quarters alleged the Depository Trust & Clearing Corp.'s stock-borrow program resulted in the creation of nonexistent or phantom stock and contributed to the illegal short selling of the company's shares. We conclude that the district court did not err in dismissing the complaint on the basis of preemption." Pet Quarters' complaint was almost identical to suits against DTCC brought by Whistler Investments Inc.
The suits also challenged DTCC's stock-borrow program, and were dismissed.
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. 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."
A Government Accountability Office study, released in June 2009, found that recent SEC rules had apparently reduced abusive short selling, but that the SEC needed to give clearer guidance to the brokerage industry.
Coverage in newspapers and magazines
While concern expressed by the regulator has been echoed by journalists, some commentators contend that naked short selling is not harmful and that its prevalence has been exaggerated by corporate officials seeking to blame external forces for their own shortcomings. Others have discussed naked short selling as a confusing or bizarre form of trading.
Reviewing the SEC's July 2008 emergency order, Barron's said in an editorial: "Rather than fixing any of the real problems with the agency and its mission, Cox and his fellow commissioners waved a newspaper and swatted the imaginary fly of naked short-selling.
"In some cases, may be perfectly legal, but usually it's not.