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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."

Naked Short Sellers often employ Short and Distort tactics to slash share prices. A short and distort campaign is the exact opposite of the pump and dump. Both forms of market abuse exist and both are loathed by market participants.

Controversy

Some investors defend the use of the practice as just another tool of the market, and caution against federal regulation. Naked short-sellers claim that they are exerting market pressure against overpriced and undertraded small-cap stocks - a conceit that simultaneously assumes that they know better than the market what a stock is worth, and that using an illegal trading technique is justified by their superior valuation skills. These claims consistently ignore that the practice is illegal, as they practice it, and violates SEC rules requiring prompt settlement of trades.

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." The SEC doesn't articulate how a purchase is concluded absent delivery of the product purchased, however.

Harvey Pitt, the former Chairman of the SEC from 2001 to 2003, formalized his understanding of the practices damaging impact in a recent Forbes Magazine editorial .

Regulation SHO requires the close-out of securities that linger on Regulation SHO, but it is not enforced as there are stocks that have been listed for over 1 year. Every day there are new stocks that exceed the 13 day closed-settlement date. The fact that there are securities on Regulation SHO for more than 13 days has led many observers to comment on the inadequacy of the regulation.

Regulators Respond

The allegations of the anti-naked shorting movements are denied by Securities and Exchange Commission and the self-regulatory organizations (SROs) that regulate the U.S. markets.

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 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." Ironically, the NYSE is now on the Reg SHO Threshold List.

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.

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.

At a speech given in July of 2006, SEC Chairman Christopher Cox reffered 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 has proposed amending the two year old Regulation SHO, to close loopholes critics said promoted naked short selling. A host of recognized authorities, including regulators, economists, academics, and elected officials, support amending Reg SHO, as well as expressing considerable concern over naked short selling, in their comment letters to the SEC: 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

Pegasus Wireless's stock allegedly was naked shorted in an "independent secondary offering". http://www.forbes.com/business/2006/10/02/pegasus-attacks-shorts-biz-cx_lm_1003pegasus.html

External links

• Short Selling FAQ: Securities and Exchange Commission

Blog dedicated to naked short selling http://www.thesanitycheck.com/BobsSanityCheckBlog/tabid/56/Default.aspx

• Stock market