Naked short sellingNaked short selling
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Schematic representation of naked short selling in two steps. The shortseller sells shares without owning them. He then purchases and deliversthe shares for a different market price. If the short seller cannotafford 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 practiceof short-selling a financial instrument without first borrowing the security or ensuring that the security canbe borrowed, as is conventionally done in a short sale. When the sellerdoes not obtain the shares within the required time frame, the result isknown as a "fail to deliver". The transaction generally remains openuntil the shares are acquired by the seller, or the seller's broker,allowing the trade to be settled.[1]Naked short selling can be used to fraudulently manipulate the price ofsecurities by driving their price down, and its use in this way isillegal.[2]
In the United States, naked short selling is covered by various SEC regulationswhich prohibit the practice.[3]In 2005, "Regulation SHO" was enacted, requiring that broker-dealershave grounds to believe that shares will be available for a given stocktransaction, and requiring that delivery take place within a limitedtime period.[4][5]As part of its response to the crisis in the North American markets in2008, the SEC issued a temporary order restricting short-selling in theshares of 19 financial firms deemed systemically important, byreinforcing the penalties for failing to deliver the shares in time.[6]Effective September 18, 2008, amid claims that aggressive short sellinghad played a role in the failure of financial giant Lehman Brothers, the SEC extended and expanded the rulesto remove exceptions and to cover all companies, including marketmakers.[7][8][9]
Some commentators have contended that despite regulations, nakedshorting is widespread and that the SEC regulations are poorly enforced.Its critics have contended that the practice is susceptible to abuse,can be damaging to targeted companies struggling to raise capital, andhas led to numerous bankruptcies.[3][7][10]However, other commentators have said that the naked shorting issue is a"devil theory",[11]not a bona fide market issue and a waste of regulatoryresources.[12]
[edit]Description
[edit]Normal shorting
Short selling is a a form of speculationthat allows a trader to take a "negative position" in a stock of a company. Such atrader first "borrows" shares of that stock from theirowner (the lender), typically via a bank or a prime broker under the condition that he willreturn it on demand. Next, the trader sells the borrowed shares anddelivers them to the buyer who becomes their new owner. The buyer istypically unaware that the shares have been sold short: his transactionwith the trader proceeds just as if the trader owned rather thanborrowed the shares. Some time later, the trader closes his shortposition by purchasing the same number of shares in the market andreturning them to the lender.
The trader's profit is the difference between the sale price and thepurchase price of the shares. In contrast to "going long," where salesucceeds the purchase, short sale precedes the purchase. Because theseller/borrower is generally required to make a cash deposit equivalentto the sale proceeds, it offers the lender some security.
[edit]Nakedshorts in the United States
Naked short selling is a case of short selling without firstarranging a borrow. If the stock is in short supply, finding shares toborrow can be difficult. The seller may also decide not to borrow theshares, in some cases because lenders are not available, or because ofthe costs of lending. When shares are not borrowed within the clearingtime period and the short-seller does not tender shares to the buyer,the trade is considered to have "failed to deliver."[13]Nevertheless, the trade will continue to sit open or the buyer may becredited the shares by the DTCC untileither the short-seller closes out the position or borrows the shares.[2]
It is difficult to measure how often naked short selling occurs.Fails to deliver are not necessarily indicative of naked shorting, andcan result from both "long" transactions (stock purchases) and shortsales.[4][14]Naked shorting can be invisible in a liquid market, as long as theshort sale is eventually delivered to the buyer. However, if the coversare impossible to find, the trades fail. Fail reports are publishedregularly by the SEC[15],and a sudden rise in the number of fails-to-deliver will alert the SECto the possibility of naked short selling. In some recent cases, it wasclaimed that the daily activity was larger than all of the availableshares, which would normally be unlikely.[13]
[edit]Extent of nakedshorting
The reasons for naked shorting, and the extent of it, have beendisputed for several years before the SEC's 2008 action to prohibit thepractice. What is generally recognized is that naked shorting tends tohappen when shares are difficult to borrow. Studies have shown thatnaked short selling also increases with the cost of borrowing.
In recent years, a number of companies have been accused of usingnaked shorts in aggressive efforts to drive down share prices, sometimeswith no intention of ever delivering the shares.[13][16]These claims focus on the fact that, at least in theory, the practiceallows an unlimited number of shares to be sold short. A Los AngelesTimes editorial in July 2008 said that naked short selling "enablesspeculators to drive down a company's stock by offering an overwhelmingnumber of shares for sale."[17]The SEC has stated that naked shorting is sometimes falsely asserted asa reason for a share price decline, when, often, "the price decrease isa result of the company's poor financial situation rather than thereasons provided by the insiders or promoters."[4]
Before 2008, regulators had generally downplayed the extent of nakedshorting in the US. At a NorthAmerican Securities Administrators Association (NASAA) conference onnaked short selling in November 2005, an official of the New York Stock Exchange stated that NYSE hadnot found evidence of widespread naked short selling. In 2006, anofficial of the SEC said that "While there may be instances of abusiveshort selling, 99% of all trades in dollar value settle on time withoutincident."[18]Of all those that do not, 85% are resolved within 10 business days and90% within 20.[18]That means that about 1% of shares that change hands daily, or about $1billion per day, are subject to delivery failures,[2]although the SEC has stated that "fails-to-deliver can occur for anumber of reasons on both long and short sales," and accordingly thatthey do not necessarily indicate naked short selling.[4][14]
In 2008, SEC chairman Christopher Cox said that the SEC "has zero tolerance forabusive naked short-selling" while implementing new regulations toprohibit the practice, culminating in the September 2008 actionfollowing the failures of Bear Sterns and Lehman Brothers amidst speculation that naked shortselling had played a contributory role.[8][19]Cox said that "the rule would be designed to ensure transparency inshort-selling in general, beyond the practice of naked short-selling."[8]
[edit]Claimedeffects of naked shorting
As with the prevalence of naked shorting, the effects are contested.The SEC has stated that the practice can be beneficial in enhancingliquidity in difficult-to-borrow shares, while others have suggestedthat it adds efficiency to the securities lending market. Critics of thepractice argue that it is often used for market manipulation, that it can damage companies andeven that it threatens the broader markets.
One complaint about naked shorting from targeted companies is thatthe practice dilutes a company's shares for as long as unsettled shortsales sit open on the books. This has been alleged to create "phantom"or "counterfeit" shares, sometimes going from trade to trade withoutconnection to any physical shares, and artificially depressing the shareprice.[16]However, the SEC has disclaimed the existence of counterfeit shares andstated that naked short selling would not increase a company'soutstanding shares.[5]Short seller David Rocker contended that failure to deliversecurities "can be done for manipulative purposes to create theimpression that the stock is a tight borrow," although he said that thisshould be seen as a failure to deliver "longs" rather than "shorts."[20]
Robert J. Shapiro, former undersecretaryof commerce for economic affairs, and a consultant to a law firm suingover naked shorting,[21]has claimed that naked short selling has cost investors $100 billionand driven 1,000 companies into the ground.[10]
Richard Fuld, the former CEO of the financial firm Lehman Brothers,during hearings on the bankruptcy filing by Lehman Brothers and bailoutof AIG before the House Committee on Oversight and Government Reformalleged that a host of factors including a crisis of confidence andnaked short selling attacks followed by false rumors contributed to boththe collapse of Bear Stearns and Lehman Brothers.[22]Fuld had been obsessed with short sellers and had even demoted thoseLehman executives that dealt with them; he claimed that the shortsellers and the rumour mongers had brought down Lehman, although hehadn't evidence of it.[23]Upon the examination of the issue of whether "naked short selling" wasin any way a cause of the collapse of Bear Stearns or Lehman, securitiesexperts reached the conclusion that the alleged "naked short sales"occurred after the collapse and therefore played no role in thecollapse. House committee Chairman Henry Waxman said the committeereceived thousands of pages of internal documents from Lehman and thesedocuments portray a company in which there was “no accountability forfailure".[24][23][25]In July 2008, U.S. Securities and Exchange Commission chairmanChristopher Cox said there was no "unbridled naked short selling infinancial issues."[26]
[edit]Regulationsin the United States
[edit]SecuritiesExchange Act of 1934
The Securities Exchange Act of 1934stipulates a settlement period up to three business days before a stockneeds to be delivered,[13]generally referred to as "T+3 delivery."
[edit]Regulation SHO
The SEC enacted Regulation SHO in January 2005 to target abusivenaked short selling by reducing failure to deliver securities, and bylimiting the time in which a broker can permit failures to deliver.[27]In addressing the first, it stated that a broker or dealer may notaccept a short sale order without having first borrowed or identifiedthe stock being sold.[28]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[29] through no fault of the customer or the broker-dealer.[28]
To reduce the duration for which fails to deliver are permitted tosit open, the regulation requires broker-dealers to close-out openfail-to-deliver positions in threshold securities that have persistedfor 13 consecutive settlement days.[27]The SEC, in describing Regulation SHO, stated that failures to delivershares that persist for an extended period of time "may result in largedelivery obligations where stock settlement occurs."[27]
Regulation SHO also created the "Threshold Security List," whichreported any stock where more than 0.5% of a company's total outstandingshares failed delivery for five consecutive days. A number of companieshave appeared on the list, including KrispyKreme, Martha StewartOmnimedia and Delta Airlines. The Motley Fool, an investment website, observesthat "when a stock appears on this list, it is like a red flag waving,stating 'something is wrong here!'"[13]However, the SEC clarified that appearance on the threshold list "doesnot necessarily mean that there has been abusive naked short selling orany impermissible trading in the stock."[27]
In July 2006, the SECproposed to amend Regulation SHO, tofurther reduce failures to deliver securities.[30]SEC Chairman Christopher Cox referred to"the serious problem of abusive naked short sales, which can be used as atool to drive down a company's stock price." and that the SEC is"concerned about the persistent failures to deliver in the market forsome securities that may be due to loopholes in Regulation SHO.[31]
[edit]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 KetanParekh affair, reintroduced short selling under regulations similarto those developed in the United States. In conjunction with this rulechange, SEBI outlawed all naked short selling.[32][33]
In June 2007, the SEC voted to remove the grandfather provision thatallowed fails-to-deliver that existed before Reg SHO to be exempt fromReg SHO. SEC Chairman Christopher Cox called naked short selling "afraud that the commission is bound to prevent and to punish." The SECalso said it was considering removing an exemption from the rule foroptions market makers.[34]Removal of the grandfather provision and naked shorting restrictionsgenerally have been endorsed by the U.S. Chamber of Commerce.[35]
In March 2008, SEC Chairman Christopher Cox gave a speech entitled the "'Naked' ShortSelling Anti-Fraud Rule," in which he announced new SEC efforts tocombat naked short selling.[36]Under the proposal, the SEC would create an antifraud rule targetingthose who knowingly deceive brokers about having located securitiesbefore engaging in short sales, and who fail to deliver the securitiesby the delivery date. Cox said the proposal would address concerns aboutshort-selling abuses, particularly in the market for small-cap stocks.Even with the regulation in place, the SEC received hundreds ofcomplaints in 2007 about alleged abuses involving short sales. The SECestimated that about 1% of shares that changed hands daily, about $1billion, were subject to delivery failures. SEC Commissioners PaulAtkins and Kathleen Casey expressed support for the crackdown.[37][38]
In mid-July 2008, the SEC announced emergency actions to limit thenaked short selling of governmentsponsored enterprises (GSEs), such as FannieMae and Freddie Mac, in an effort to limit marketvolatility of financial stocks.[39]But even with respect to those stocks the SEC soon thereafter announcedthere would be an exception with regard to market makers.[40]SEC Chairman Cox noted that the emergency order was "not a response tounbridled naked short selling in financial issues", saying that "thathas not occurred". Cox said, "rather it is intended as a preventativestep to help restore market confidence at a time when it is sorelyneeded."[26]Analysts warned of the potential for the creation of price bubbles.[40][41]
The emergency actions rule expired August 12, 2008.[42][43][44][45]However, at September 17, 2008, the SEC issued new, more extensiverules against naked shorting, making "it crystal clear that the SEC haszero tolerance for abusive naked short selling". Among the new rules isthat market makers are no longer given an exception. As a result,options market makers will be treated in the same way as all othermarket participants, and effectively will be banned from naked shortselling.[46]
On November 4, 2008, voters in South Dakota considered a ballotinitiative, "The South Dakota Small Investor Protection Act", to endnaked short selling in that state. The Securities Industry and FinancialMarkets Association of Washington and New York said they would takelegal action if the measure passed.[47]The voters defeated the initiative.[48]
In July 2009, the SEC, under what the Wall Street Journal describedas "intense political pressure," made permanent an interim rule thatobliges brokerages to promptly buy or borrow securities when executing ashort sale.[49]The SEC said that since the fall of 2008, abusive naked short sellinghad been reduced by 50%, and the number of threshold list securities(equity securities with too many "fails to deliver") declined from 582in July 2008 to 63 in March 2009.[50][51]
[edit]Regulationsoutside of the United States
Several international exchanges have either partially or fullyrestricted the practice of naked short selling of shares. They includeAustralia's Australian Securities Exchange,[52]India's Securities and ExchangeBoard,[53]the Netherlands's Euronext Amsterdam,[54]Japan's Tokyo Stock Exchange,[55]and Switzerland's SWX Swiss Exchange.[56][57]
Japan's naked shorting ban started on November 4, 2008, and wasoriginally scheduled to run until July 2009, but was extended throughOctober of that year.[58][59]Japan's FinanceMinister, Shoichi Nakagawa stated, "We decided (to move up theshort-selling ban) as we thought it could be dangerous for the Tokyostock market if we do not take action immediately." Nakagawa added thatJapan's FinancialServices Agency would be teaming with the Securities and Exchange Surveillance Commissionand Tokyo Stock Exchange to investigate past violations of Japaneseregulations on stock short-selling.[60]
The Singapore Exchange started to penalizenaked short sales with an interim measure in September, 2008. Theseinitial penalties started at $100 per day. In November, they announcedplans to increase the fines for failing to complete trades. The newpenalties would penalize traders who fail to cover their positions,starting at $1,000 per day. There would also be fines for brokerages whofail to use the exchange's buying-in market to cover their positions,starting at $5,000 per day. The Singapore exchange had stated that thefailure to deliver shares inherent in naked short sales threatenedmarket orderliness.[61]
On May 18th, 2010, the German Minister of Finance announced thatnaked short sales of euro-denominated government bonds, credit defaultswaps based on those bonds, and shares in Germany's ten leadingfinancial institutions will be prohibited. This ban went into effectthat night and is set to expire on March 31, 2011. [62][63]
[edit]Regulatoryenforcement actions
In 2005, the SEC notified Refco ofintent to file an enforcement action against the securities unit ofRefco for securities trading violations concerning the shorting ofSedona stock. The SEC sought information related to two former Refcobrokers who handled the account of a client, Amro International, whichshorted Sedona's stock.[64]No charges had been filed by 2007.
In December 2006, the SEC sued Gryphon Partners, a hedgefund, for insider trading and naked short-sellinginvolving PIPEs in the unregistered stock of 35 companies. PIPEs are"private investments in public equities," used by companies to raisecash. The naked shorting took place in Canada, where it was legal at thetime. Gryphon denied the charges.[65]
In March 2007, Goldman Sachs was fined $2 million by the SECfor allowing customers to illegally sell shares short prior to secondarypublic offerings. Naked short-selling was allegedly used by the Goldmanclients. The SEC charged Goldman with failing to ensure those clientshad ownership of the shares. SEC Chairman Cox said "That is an importantcase and it reflects our interest in this area."[66]
In July 2007, Piper Jaffray was fined $150,000 by the New York Stock Exchange (NYSE). Piper violatedsecurities trading rules from January through May 2005, selling shareswithout borrowing them, and also failing to "cover short sales in atimely manner", according to the NYSE.[67]At the time of this fine, the NYSE had levied over $1.9 million infines for naked short sales over seven regulatory actions.[68]
Also in July 2007, the American Stock Exchange fined twooptions market makers for violations of Regulation SHO. SBA Trading wassanctioned for $5 million, and ALA Trading was fined $3 million, whichincluded disgorgement of profits. Both firms and their principals weresuspended from association with the exchange for five years. Theexchange said the firms used an exemption to Reg. SHO for options market makers to "impermissibly engage in nakedshort selling."[69][70][71]
In October 2007, the SEC settled charges against New York hedge fundadviser Sandell Asset Management Corp. and three executives of the firmfor, among other things, shorting stock without locating shares toborrow. Fines totalling $8 million were imposed, and the firm neitheradmitted nor denied the charges.[72]
In October 2008 Lehman Brothers Inc. was fined $250,000 by theFinancial Industry Regulatory Authority (FINRA) for failing to properly document theownership of short sales as they occurred, and for failing to annotatean affirmative declaration that shares would be available by thesettlement date.[73]
[edit]Litigation and DTCC
The DepositoryTrust and Clearing Corporation (DTCC) has been criticized for itsapproach to naked short selling.[2][74]DTCC has been sued with regard to its alleged participation in nakedshort selling, and the issue of DTCC's possible involvement has beentaken up by Senator Robert Bennett and discussed bythe NASAA and in articles in the Wall Street Journal and EuromoneyMagazine.
There is no dispute that illegal naked shorting happens,[2][75]what is in dispute is how much it happens, and to what extent is DTCCto blame.[2][76]Some companies with falling stocks blame DTCC as the keeper of thesystem where it happens, and say DTCC turns a blind eye to the problem.[2]Referring to trades that remain unsettled, DTCC's chief spokesmanStuart Goldstein said, "We're not saying there is no problem, but tosuggest the sky is falling might be a bit overdone."[77][78]In July 2007, Senator Bennett suggested on the U.S. Senate floor that the allegations involvingDTCC and naked short selling are "serious enough" that there should be ahearing on them with DTCC officials by the Senate BankingCommittee, and that banking committee chairman Christopher Dodd hasexpressed a willingness to hold such a hearing.[79]
Critics also contend DTCC has been too secretive with informationabout where naked shorting is taking place.[2]Ten suits concerning naked short-selling filed against the DTCC werewithdrawn or dismissed by May 2005.[80]
A suit by Electronic Trading Group, naming major Wall Streetbrokerages, was filed in April 2006 and dismissed in December 2007.[81][82]
Two separate lawsuits, filed in 2006 and 2007 by NovaStar Financial,Inc. shareholders and Overstock.com,named as defendants ten Wall Street prime brokers. They claimed ascheme to manipulate the companies' stock by allowing naked shortselling.[83]A motion to dismiss the Overstock suit was denied in July 2007.[84][85]
A suit against DTCC by Pet Quarters Inc. was dismissed by a federalcourt in Arkansas, and upheld by the Eighth Circuit Court of Appeals inMarch 2009.[86]Pet Quarters alleged the Depository Trust & Clearing Corp.'sstock-borrow program resulted in the creation of nonexistent or phantomstock and contributed to the illegal short selling of the company'sshares. The court ruled: "In short, all the damages that Pet Quartersclaims to have suffered stem from activities performed or statementsmade by the defendants in conformity with the program's Commissionapproved rules. We conclude that the district court did not err indismissing the complaint on the basis of preemption." Pet Quarters'complaint was almost identical to suits against DTCC brought by WhistlerInvestments Inc. and Nanopierce Technologies Inc. The suits alsochallenged DTCC's stock-borrow program, and were dismissed.[87]
[edit]Studies
A study of trading in initial public offerings by two SEC staffeconomists, published in April 2007, found that excessive numbers offails to deliver were not correlated with naked short selling. Theauthors of the study said that while the findings in the paperspecifically concern IPO trading, "The results presented in this paperalso inform a public debate surrounding the role of short selling andfails to deliver in price formation."[88]
In contrast, a study by Leslie Boni in 2004 found correlation between"strategic delivery failures" and the cost of borrowing shares. Thepaper, which looked at a "unique dataset of the entire cross-section ofU.S. equities," credited the initial recognition of strategic deliveryfails to Richard Evans, Chris Geczy, David Musto and Adam Reed, andfound its review to provide evidence consistent with their hypothesisthat "market makers strategically fail to deliver shares when borrowingcosts are high."
An April 2007 study conducted for Canadian market regulators byMarket Regulation Services Inc. found that fails to deliver securitieswere not a significant problem on the Canadian market, that "less than6% of fails resulting from the sale of a security involved short sales"and that "fails involving short sales are projected to account for only0.07% of total short sales."[89][90]
A Government Accountability Office study, released in June 2009,found that recent SEC rules had apparently reduced abusive shortselling, but that the SEC needed to give clearer guidance to thebrokerage industry.[91]
[edit]Media Coverage
Some journalists have expressed concern about naked short selling,while others contend that naked short selling is not harmful and thatits prevalence has been exaggerated by corporate officials seeking toblame external forces for internal problems with their companies.[92]Others have discussed naked short selling as a confusing or bizarreform of trading.[16][93]
In June 2007, executives of Universal Express, which had claimed naked shorting of itsstock, were sanctioned by a federal court judge for violation ofsecurities laws. [94]Referring to a court ruling against CEO Richard Altomare, New York Times columnist FloydNorris said: "In Altomare's view, the issues that bothered thejudge are irrelevant. Long and short of it, this is a naked shorthallmark case in the making. Or it is proof that it can take a long timefor the SEC to stop a fraud."[95]Universal Express claimed that 6,000 small companies had been put outof business by naked shorting, which the company said "the SEC hasignored and condoned."[96]
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 itsmission, Cox and his fellow commissioners waved a newspaper and swattedthe imaginary fly of naked short-selling. It made a big noise, butthere's no dead bug."[12]Holman Jenkins of the Wall Street Journal said theorder was "an exercise in symbolic confidence-building" and that nakedshorting involved technical concerns except for subscribers to a "deviltheory".[11]The Economist said the SEC had "picked the wrongtarget", mentioning a study by Arturo Brisof the Swiss InternationalInstitute for Management Development who found that trading in the19 financial stocks became less efficient.[97]The Washington Post expressed approval of the SEC's decision to addressa "frenetic shadow world of postponed promises, borrowed time, obscuredpaperwork and nail-biting price-watching, usually compressed into a fewhigh-tension days swirling around the decline of a company."[98]The Los Angeles Times called the practice of naked short selling "hardto defend," and stated that it was past time the SEC became active inaddressing market manipulation.[99]
The Wall Street Journal said in an editorial in July 2008 that "theBeltway is shooting the messenger by questioning the price-settingmechanisms for barrels of oil and shares of stock." But it said theemergency order to bar naked short selling "won't do much harm," andsaid "Critics might say it's a solution to a nonproblem, but the SECdoesn't claim to be solving a problem. The Commission's move is intendedto prevent even the possibility that an unscrupulous short seller coulddrive down the shares of a financial firm with a flood of sell ordersthat aren't backed by an actual ability to deliver the shares tobuyers."[100]
The Washington Post's Frank Ahrens described naked shorting as "farmore dangerous than sexy" in a July, 2008 article. "It's a freneticshadow world of postponed promises, borrowed time, obscured paperworkand nail-biting price-watching, usually compressed into a fewhigh-tension days swirling around the decline of a company," Ahrenssays.[101]
In May 2009, the New York Times's chief financial correspondent FloydNorris reported that naked shorting is "almost gone." He said thatdelivery failures, where they occur, are quickly corrected.[102]
In an article published in October 2009, RollingStone writer Matt Taibbi contended that BearStearns and Lehman Brothers were flooded with"counterfeit stock" that helped kill both companies. Taibbi said thatthe two firms got a "push" into extinction from "a flat-outcounterfeiting scheme called naked short-selling".[103]
During a discussion on the inclusion of 'counterfeiting' in thecharges filed against Icelandic bankers, the host Max Keiser speculatedthat the charge might refer to naked short selling because "nakedshort-selling is the same as counterfeiting, in that it is sellingsomething that doesn't exist."
[