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Naked short selling, or naked shorting, is a controversial form of selling shares of securities short. Some forms of naked short-selling are legal and some are not. The 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..

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. . When one sells short a non-borrowed stock, one is selling something that one does not possess. 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.

Legally, on American exchanges, only a "market maker" in a security may sell a stock short without first locating a borrow.

Does Naked Shorting Drive Stock Prices Down?

The Securities and Exchange Commission addresses the issue this way:

"There are many reasons why a stock may decline in value. The value of a stock is determined by the basic relationship between supply and demand. If many people want a stock (demand is high), then the price will rise. If a few people want a stock (demand is low), then the price will fall. The main factor determining the demand for a stock is the quality of the company itself. If the company is fundamentally strong, that is, if it is generating positive income, its stock is less likely to lose value.

"Speculative stocks, such as microcap stocks, often have a high probability of declining in value and a low probability of experiencing above average gains. For example, investors should take extra care to thoroughly research any company quoted exclusively in the Pink Sheets. With the exception of a few foreign issuers, the companies quoted in the Pink Sheets tend to be closely held, extremely small or thinly traded. Most do not meet the minimum listing requirements for trading on a national securities exchange, such as the New York Stock Exchange or the Nasdaq Stock Market. 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, unbiased information about those companies.

"There also may be instances where a company insider or paid promoter provides false and misleading excuses for why a company's stock price has recently decreased. For instance, these individuals may claim that the price decrease is a temporary condition resulting from the activities of naked short sellers. The insiders or promoters may hope to use this misinformation to move the price back up so they can dump their own stock at higher prices. Often, the price decrease is a result of the company's poor financial situation rather than the reasons provided by the insiders or promoters.

"Naked short selling, however, can have negative effects on the market. Fraudsters may use naked short selling as a tool to manipulate the market. Market manipulation is illegal. The SEC has toughened its rules and is vigilant about taking actions against wrongdoers. Fails to deliver that persist for an extended period of time may result in a significantly large unfulfilled delivery obligation at the clearing agency where trades are settled. Regulation SHO is intended to address these effects by reducing the number of potential failures to deliver, and by limiting the time in which a broker can permit a fail to deliver to persist. For instance, as explained above, Regulation SHO requires brokers and dealers to close-out the 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."

Controversy

Critics of naked short selling contend that it is nothing less than fraud, "counterfeiting" of shares, and amounts to "taking a buyer's money and not delivering the product."

The SEC denies that this is the case, and recently elaborated its position in a legal brief intervening in a suit against DTCC. The brief asserts, without irony, that "fails to deliver" (FTDs) do not "hurt" investors, that an FTD "does not mean that the customer's purchase is not completed," and that under the "Uniform Commercial Code (UCC), a securities broker-dealer may credit a customer’s account with a security even though that security has not yet been delivered to the broker-dealer’s account by NSCC. In that event, the customer receives what is defined under the UCC as a 'securities entitlement,' which requires the broker-dealer to treat the person for whom the account is maintained as entitled to exercise the rights that comprise the security." , The SEC's point, however, overlooks the fact that the UCC, Article 8 contemplates eventual delivery, whereas naked short selling by definition contemplates no delivery. Cf. UCC Sec. 8-503(b): "An entitlement holder's property interest with respect to a particular financial asset under subsection (a) is a pro rata property interest in all interests in that financial asset held by the securities intermediary"

In addition to the SEC, the Depository Trust & Clearing Corporation (DTCC) and other critics deny that FTDs result in "counterfeit shares." They believe that the vast majority of FTDs are unrelated to abusive naked short-selling, and that shareholders are not disadvantaged when a fail occurs. Rather, such critics contend that naked short-selling has been advanced by owners of small public companies in order to divert attention of price declines caused by corporate shortcomings and regulatory problems. The naked short selling defenders argue that the practice is just another tool of the market and caution against federal regulation; that is, they claim that naked short selling exerts an important and necessary counterbalancing function against market buying-pressure chasing overpriced small-cap stocks. In the bubble of the 1990s, they argue, regulations against short-selling would have caused an even greater boom and bust.

Critics of naked shorting point out that liquidity is a function of supply and demand, which should be left to the market and not the arbitrary decision of a market maker or professional. They point out that except for certain very narrowly described instances (and even then, only for very short duration), naked short selling is illegal except by true market makers. Moreover, they point out, notwithstanding the SEC's position on the issue, the arguments of naked short sellers to date do not disprove that naked short selling actually results in counterfeit shares. A 2004 study by Professor Leslie Boni, for example, showed that during the sample period studied, "4% of U.S. equity issues had that would have classified them as 'threshold' securities with mandatory close-out requirements under Regulation SHO" and that oftentimes market professionals make a strategic decision to maintain a naked short position on an equity far beyond that which is necessary to "make a market" in the equity.

Recently, the SEC has shown signs of modifing its denial of (or stance towards) naked shorting somewhat, apparently in part due to pressure from small and microcap companies. This campaign has drawn criticism.

To defend the practice of naked short selling, however, is essentially to defend a different kind of theft or fraud in the market. The favored argument among naked short sellers is that they "protect" the market, and yet, at best, they merely step into the shoes of pump and dump fraudsters to take existing investors' money. Supporters of naked short selling have yet to offer any proof that "the market"--or such investors--ever benefit(s) from the practice.

Regulators Respond

In a forum sponsored by the North American Securities Administrators Association in November 2005, some regulators, including a high official of the National Assn. of Securities Dealers, denied that naked short-selling is a signficant problem. An official of the New York Stock Exchange also told the forum that NASD had found no evidence of widespread naked short selling. He decried "this fear mongering that there's this rampant naked shorting that's gone unregulated." Further, Cameron Funkhouser, NASD's senior vice president of market regulations, noted that although a number of companies have in the past alleged their shares have been manipulated through the listing of their stocks on the Berlin stock exchange, he had found no evidence of naked short selling there. "We took (these allegations) very seriously," Funkhouser said. "We have seen not one instance of naked short selling or any abusive short activity" at that exchange. Lastly, at the NASAA Forum the head of the Connecticut Securities Agency and current head of the NASAA, Ralph Lambiase, declared his "disappointment" at how the industry was handling this issue as a whole. Rumors had spread in some circles in February 2006 that the state of Connecticut was investigating the Depository Trust & Clearing Corporation over its alleged role facilitating fraudulent short sales, and that the DTCC was defying a subpoena. On Feb. 17, the DTCC and the state together issued a statement denying those rumors.

Such backpeddling and denials notwithstanding, public officials have at numerous times in the past pointed to abusive shorting, including naked shorting, as a "problem" in the markets. At a speech given in July of 2006, for example, the SEC's own Chairman, Christopher Cox refered to "the serious problem of abusive naked short sales, which can be used as a tool to drive down a company's stock price to the detriment of all of its investors. The Commission is particularly concerned about persistent failures to deliver in the market for some securities that may be due to loopholes in the Commission's Regulation SHO, adopted just two years ago."

Recent developments

Naked shorting continued in the news through 2006, with opponents of the practice contending it contributes to the demise of companies. Overstock CEO Patrick Byrne continued to push the anti-naked shorting cause in interviews and Internet postings, including a lively exchange on a New York Times blog.

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.

The SEC bowed to mounting pressure to amend the two year old Regulation SHO, to close loopholes some critics said promoted naked short selling.

A number of highly regarded experts in the field of securities regulation, and the clearing and settlement system, have written comment letters to the SEC in their request for commentary on proposed amendments to Reg SHO.

Here are some of the examples - from the Utah Securities Regulator , from the CT AG :, from the former Undersecretary of Commerce , from the US Chamber of Commerce , from the UTAH Chamber of Commerce, and from numerous members of Congress

Global Links sues the DTCC over naked shorting:

External links

• Short Selling FAQ: Securities and Exchange Commission
• Naked Short Selling FAQ: Depository Trust and Clearing Corp.

Listing of Weblogs Journalling Naked Short Selling http://www.thesanitycheck.com/BobsSanityCheckBlog/tabid/56/Default.aspx

• Stock market