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'''Naked short selling''', or '''naked shorting''' refers to the practice of ] without first borrowing the shares or making an "affirmative determination" that the shares can be borrowed. In the United States, the ] issued a regulation, known as "Regulation SHO", seeking to curb abusive naked shorting<ref name=secfaq>{{cite web|url=http://sec.gov/divisions/marketreg/mrfaqregsho1204.htm|author=U.S. SEC|title=Division of Market Regulation: Responses to Frequently Asked Questions Concerning Regulation SHO}}</ref>. Many other countries and trading markets have developed similar regulations.{{Fact|date=October 2007}} | '''Naked short selling''', or '''naked shorting''' refers to the practice of ] without first borrowing the shares or making an "affirmative determination" that the shares can be borrowed. In the United States, the ] issued a regulation, known as "Regulation SHO", seeking to curb abusive naked shorting<ref name=secfaq>{{cite web|url=http://sec.gov/divisions/marketreg/mrfaqregsho1204.htm|author=U.S. SEC|title=Division of Market Regulation: Responses to Frequently Asked Questions Concerning Regulation SHO}}</ref>. Many other countries and trading markets have developed similar regulations.{{Fact|date=October 2007}} | ||
Illegal naked short selling is fraud. It is the creation of a sale transaction, for which the buyer's funds are taken, but no product is delivered. Apologists for the practice seek to introduce a number of straw man arguments, none of which address the core fraud in the practice, which as noted before, is illegal in all but a few instances - such as market maker exemptions. | |||
It is difficult to argue with a straight face that there are benefits for the market to be had by defrauding investors, however that doesn't stop the perpetrators of the practice from advancing arguments supporting the practice. Some common arguments are that naked short selling is good for the market, as it can be used to combat other fraudulent activity, such as pump and dump schemes, where promoters pump a stock's value above fair value. It is simple to see the logical fallacy here, as it really argues that one fraud can be countered by allowing a different fraud - the "two wrongs make a right" fallacy. | |||
Another canard that is floated by apologists for the illegal variant is that it increases liquidity, which is an argument that says that by increasing the amount of fraud, you increase the amount of trading, which increases the ability to buy and sell easily, and decreases spreads. Again, this argues for allowing investors to be defrauded, as the benefits to an efficient market in trading these frauds are supposed to outweigh the damage from the fraud itself. | |||
Current legal naked shorting rules allow brokerages to make large profits doing "bona-fide market making" while stock markets are falling. The market maker exemption to the rules governing the practice is intended to allow market makers to naked short sell on a very temporary basis, in order to increase liquidity and stabilize markets. When this practice extends for more than a few days, it too crosses over from the legal variant, to the illegal variant - fraud. | |||
== Regulatory policy == | == Regulatory policy == |
Revision as of 13:53, 7 December 2007
Naked short selling, or naked shorting refers to the practice of selling a stock short without first borrowing the shares or making an "affirmative determination" that the shares can be borrowed. In the United States, the Securities and Exchange Commission issued a regulation, known as "Regulation SHO", seeking to curb abusive naked shorting. Many other countries and trading markets have developed similar regulations.
Regulatory policy
The Securities and Exchange Act of 1934 stipulates a settlement period up to three business days before a stock needs to be delivered.
The SEC states that "Naked short selling 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." However, naked shorting to drive down share prices violates the law.
On American exchanges, under Regulation SHO, "a broker or dealer may not accept a short sale order" without having first borrowed or identified the stock being sold. However, this rule is exempted under these circumstances:
- 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.
The SEC contends that naked short selling has been falsely blamed on share price declines by stock promoters and corporate insiders, but can be used as a tool for illegal market manipulation.
Failures to deliver shares, possibly resulting from naked short sales, that persist for an extended period of time may result in large delivery obligations where stock settlement occurs. The SEC observes that fails can occur because of ordinary "long" stock sales and for reasons entirely unrelated to efforts to profit from share price declines.
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. The regulation 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."
On its Regulation SHO website ("Does Naked Shorting Drive Prices Down?" section), the SEC cites the prevalence of false claims of naked short selling in Pump and Dump fraud. The SEC downplays naked shorting as a factor in declining stock prices, stating 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 says that naked short-selling has been frequently and falsely blamed for low stock prices in the wake of pump and dump scams involving companies that are in poor financial condition.
In July 2006, the SEC proposed to amend Regulation SHO, to close loopholes that could possibly be exploited via naked short selling. 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.
The North American Securities Administrators Association (NASAA) held a conference on naked short selling in November 2005. An official of the New York Stock Exchange stated that NYSE had found no evidence of widespread naked short selling, and alleged "fear mongering that there's this rampant naked shorting that's gone unregulated." Cameron Funkhouser, NASD senior vice president of market regulations, noted that although companies have alleged stock manipulation through the Berlin stock exchange, the NASD has seen not one instance of naked short selling ". 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 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 and traders will have to fulfill delivery obligations by borrowing shares that have been lent from other investors who own the shares.
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. SEC Chairman Christopher Cox called naked short selling “a fraud that the commission is bound to prevent and to punish.” The SEC also said it was considering removing an exemption from the rule for options market makers. Removal of the grandfather provision and naked shorting restrictions generally have been endorsed by the U.S. Chamber of Commerce.
Regulatory enforcement actions
In 2005, the SEC notified Refco of intent to file an enforcement action against the securities unit of Refco for securities trading violations concerning the shorting of Sedona stock. 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. The naked shorting took place in Canada, where it was legal at the time. 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. Naked short-selling was allegedly utilized by the Goldman clients. The SEC charged Goldman with failing to ensure those clients had ownership of the shares. SEC Chairman Cox commented, "That is an important case and it reflects our interest in this area."
In June 2007, executives of Universal Express, which had claimed naked shorting of its stock, were sanctioned by a federal court judge as “repeated and remorseless violators” of the securities laws. The SEC asserted that the company “appears to exist primarily as a vehicle for fraud.” Referring to a court ruling barring CEO Richard Altomare from serving as an officer of a public company, New York Times columnist Floyd Norris said: "In Altomare's view, the issues that bothered the judge are irrelevant. 'Long and short of it,' he said in a statement, 'this is a naked short hallmark case in the making.' Or it is proof that it can take a long time for the SEC to stop a fraud." Universal Express has claimed that 6,000 small companies have been put out of business by naked shorting, which the company says "the SEC has ignored and condoned." A receiver was subsequently appointed to administer the company.
In July 2007, Piper Jaffray Cos. was fined $150,000 by the New York Stock Exchange (NYSE). Piper violated securities trading rules from January through May of 2005, selling shares without borrowing them, and also failing to "cover short sales in a timely manner", according to the NYSE. At the time of this fine, the NYSE had levied over $1.9 million in fines for naked short sales over seven regulatory actions.
Also in July 2007, the American Stock Exchange fined two options market makers for violations of Regulation SHO. SBA Trading was sanctioned for $5 million, and ALA Trading was fined $3 million, which included disgorgement of profits. Both firms and their principals were suspended from association with the exchange for five years. The exchange said the firms used an exemption to Reg. 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. and three executives of the firm for, among other things, shorting stock without locating shares to borrow. Fines totaling $8 million were imposed, and the firm neither admitted nor denied the charges.
Legislation
In 2006, the Utah legislature passed legislation aimed to curb naked short-selling, passed largely due to the advocacy of Overstock.com CEO Patrick M. Byrne. The legislation was repealed in February 2007, after litigation brought by the Securities Industry and Financial Markets Association (SIFMA), which sought to have the federal courts declare the law invalid.
Legislators said they repealed the law with the understanding that the SEC would act on a federal level to alleviate naked shorting concerns. Byrne described the repeal as a cave-in to self-interested industry pressure. Utah state senate majority leader Curtis Bramble said at the time of repeal that he now believed that Overstock's motives were "highly suspect." Bramble said, "There are those who believe Overstock has been using the Legislature as a distraction against its own problems. It raises serious questions."
Litigation
The Depository Trust and Clearing Corporation has been criticized for its approach to naked short selling. Ten suits concerning naked short-selling filed against the DTCC were withdrawn or dismissed by May 2005.
Other lawsuits by companies such as Electronic Trading Group, and naming other defendants such as hedge funds, began in mid-2006.
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 a scheme to manipulate the companies' stock by allowing naked short selling. A motion to dismiss the Overstock suit was denied in July 2007.
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. The authors of the study said that while the findings in the paper specifically concern IPO trading, "The results presented in this paper also inform a public debate surrounding the role of short selling and fails to deliver in price formation."
Even though fails to deliver are viewed by some as a way of measuring the degree of naked short sales, the SEC economists said the delivery failures seen in the IPO market "cannot be explained by short selling in general or 'naked' short selling specifically."
An April 2007 study conducted for Canadian market regulators by Market Regulation Services Inc. 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."
Media coverage
Some major media outlets contend that naked short selling is not harmful and its prevalence exaggerated by corporate officials seeking to blame external forces for their own shortcomings.
The Wall Street Journal has criticized naked shorting allegations in an editorial.
In the New York Times, several columnists have criticized the campaign against naked short selling. Chief financial correspondent Floyd Norris contended that investors of stocks that are being shorted "might do better to try to understand why some think the shares are overvalued, rather than simply rail about unfair short selling.".
New York Times financial columnist Joseph Nocera has criticized naked shorting allegations as diversionary complaints, and said that "most people who understand the issue or have looked into it think it's pretty bogus." Nocera also reported that a leader of an anti-naked short-selling campaign, CEO Patrick Byrne, was in a "meltdown" during a meeting with Utah legislators, where he was "belligerent" and "cursing".
Author, columnist and former Business Week investigative reporter Gary Weiss has maintained that the SEC enacted Regulation SHO in part due to pressure from a handful of small and microcap companies. He also says that some investors defended naked short-selling as a necessary tool of the market against overpriced stocks, and caution against further regulation as it would have caused an even greater stock market bubble in the late 1990's. Weiss believes that naked shorting enables the free market to help prevent pump and dump scams that regulatory agencies are not able to catch due to limited resources. He also says that the campaign against naked shorting is a diversion of regulatory resources from more significant issues.
In March 2007, Bloomberg Television featured a special on naked short selling, "Phantom Shares." In May 2007, Max Keiser reported on naked short selling as part of a report on Al Jazeera's People and Power show.
References
- U.S. SEC. "Division of Market Regulation: Responses to Frequently Asked Questions Concerning Regulation SHO".
- http://www.fool.com/investing/high-growth/2005/03/24/the-naked-truth-on-illegal-shorting.aspx
- U.S. SEC (April 11, 2005). "Division of Market Regulation: Key Points About Regulation SHO".
- University of Cincinnati College of Law. "Securities Lawyer's Deskbook, Rule 203".
- University of Cincinnati College of Law. "Securities Lawyer's Deskbook, Rule 200".
- University of Cincinnati College of Law. "Securities Lawyer's Deskbook, Rule 203".
- Key Points About Regulation SHO
- US SEC. ["Proposed SEC 17 CFR PART 242 (Release No. 34-54154; File No. S7-12-06) RIN 3235-AJ57 Amendments to Regulation SHO" (PDF).
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value (help) - Christopher Cox (July 12, 2006). "Opening Statements at the US Securities and Exchange Commission Open Meeting".
- The Financial Express (March 22,2007). "Sebi allows all to sell short".
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(help) - Floyd Norris, The New York Times (June 14,2007). "S.E.C. Ends Decades-Old Price Limits on Short Selling".
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(help) - "US Chamber Urges Further SEC Curbs On Naked Short Sales," Dow Jones News Service, Sept. 14, 2007
- CNN (October 20, 2005). "More woes for Refco, execs: Reports Newspapers say creditors eye over $1B insiders made from stock, while SEC probes "naked shorting"".
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has generic name (help) - "SEC Complaint against Gryphon Partners" (PDF). December 12,2006.
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(help) - TimesOnline and AP (March 15, 2007). "Goldman Sachs fined $2m over short-selling".
- "S.E.C. Requests Receiver for Universal Express," The New York Times, June 23, 2007
- A Sad Tale of Fictional SEC Filings, The New York Times, June 22, 2007
- Universal Express statement, June 28, 2007
- "Member Firm Disciplined for Violations of SEC Rule on Short Sales and Operational and Supervisory Violations," NYSE Regulation, July 11, 2007
- "Piper Fined by the NYSE Over Short-Sale Violations", Edgar Ortega, Bloomberg News
- Amex Discplinary Decisions, ALA Trading
- Amex Discplinary Decisions, SBA Trading
- American Stock Exchange announcement of disciplinary action, July 31, 2007
- "SEC Charges New York Hedge Fund Adviser With Short Sale Violations in Connection With Hibernia-Capital One Merger," SEC Press Release, Oct. 10, 2007
- Revisiting Overstock.com and Utah, The New York Times, Mar. 10, 2007
- "Blame the 'Stock Vault'?" The Wall Street Journal, July 5, 2007
- DTCC response to Wall Street Journal Article, July 6, 2007
- "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
- Moyer, Liz (2006-04-13). "Naked Shorts". Forbes. Retrieved 2007-10-10.
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(help) - "Naked Short Victim Strikes Back". 2007-02-02. Retrieved 2007-10-10.
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(help) - A Naked Short Victim Strikes Back, Forbes.com, Feb. 2, 2007
- "Naked Shorting Case Gains Traction". July 18, 2007.
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suggested) (help) - Overstock Shares Rise on Court Ruling in Broker Suit, Bloomberg News, July 18, 2007
- Amy K. Edwards and Kathleen Weiss Hanley (April 18,2007). "Short Selling and Failures to Deliver in Initial Public Offerings".
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(help) - The Wall Street Journal (April 24,2007). "SEC Finds No 'Naked Short'-IPO Issue".
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(help) - Investment Executive (April 15,2007). "No evidence of excessive failed trades on Canadian marketplaces: study".
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(help) - Market Regulation and Services (April 13,2007). "Results of the Statistical Study of Failed Trades April 13, 2007".
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(help) - "Do Nudists Run Wall Street?" The Wall Street Journal, April 10, 2006
- Norris, Floyd (2005-02-18). "A New S.E.C. Rule Fails to Raise Share Prices, and Some Are Angry". The New York Times. Retrieved 2007-01-17.
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(help) - Nocera, Joseph, "New Crusade for Master of Overstock," The New York Times, June 10, 2006
- "Revisiting Overstock.com and Utah"
- ^ Gary Weiss (December 8, 2003). "Commentary: Don't Force The Shorts To Get Dressed".
- Weiss, Gary. Wall Street Versus America: The Rampant Greed and Dishonesty That Imperil Your Investments. Portfolio. ISBN 1-59184-094-5.
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ignored (help) - Bloomberg Television (March 12,2007). "Phantom Shares".
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(help) - Bloomberg Television (March 14,2007). "`Phantom Shares,' Failed Trades and Naked Shorts: (Transcript)".
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(help) - Max Keiser, Al Jazeera Network (May 20, 2007). "Rigged Markets".
External links
- Short Selling FAQ: Securities and Exchange Commission
- Naked Short Selling FAQ: Depository Trust and Clearing Corp.
- Who's behind Naked-shorting? - Fool.com