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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. 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. 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.

On American exchanges, pursuant to Rule 203(b)(2) of Regulation SHO these short sales of securities may be legally permitted: (1) broker or dealer accepting a short sale order from another registered broker or dealer; (2) bona-fide market making; (3) 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.

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

Some investors defend the practice as just another tool of the market, and caution against federal regulation. Naked short-sellers claim that they are enacting market pressure against overpriced and undertraded small-cap stocks. In the bubble of the 1990s, they argue, regulations against short-selling would have caused an even greater boom and bust.

Penny stock brokerages urge all investors to keep their stocks in cash accounts so that no shares can be shorted. The penny stock fraudsters can then illegally hype the stock to very high prices allowing the penny stock fraudsters to pump and dump their shares. Naked shorting keeps the penny stock brokerages from driving prices above the true value of the stock. The free market in this case could prevent the crime of pumping and dumping without any additional police or raising taxes. Pump and dump organizations sometimes are run by the Mafia.

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."

In recent years, however, the SEC has acted against naked shorting in part due to pressure from a handful of small and microcap companies. This campaign has drawn criticism. Financial columnist Floyd Norris of the New York Times observed that "Investors who own shares might do better to try to understand why some think the shares are overvalued, rather than simply rail about unfair short selling."

Critics of the naked shorting campaign contend the practice is not harmful and its prevalence exaggerated. Opponents include Wall Street Journal, which criticized the naked shorting allegations in an editorial, and columnist Joseph Nocera of the New York Times. Author and journalist Gary Weiss criticized the anti-shorting campaign in his book Wall Street Versus America, as an interference with the mechanisms by which the bubbles created by pump-and-dump artists might otherwise be burst, and as a diversion of regulatory resources from the pursuit of the pump/dumpers.

Responding to charges that by Overstock.com CEO Patrick Byrne that investors are harmed by fails to deliver, Nocera said, "Except for a few fellow-traveling Web sites, where Mr. Byrne is viewed as a heroic figure, most people who understand the issue or have looked into it think it's pretty bogus."

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 NASD, denied that naked short-selling is a significant 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."

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.

However, public officials have pointed to abusive shorting, including naked shorting, as a problem in the markets.

At a speech given in July of 2006, 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 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.com 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. Civil suits by the US SEC and a criminal complaint by the US Department of Justice are continuing against various parties allegedly involved in manipulation of Sedona stock. In July 2006, the SEC bowed to mounting pressure, proposing to amend the two year old Regulation SHO, to close loopholes some critics said promoted naked short selling.. The SEC also published public comments on the proposed amendments.

Forbes Magazine said in October of 2006 that Pegasus Wireless's stock may have been naked shorted because "there may be as many as 30 million more shares out there than it has on record."

In December 2006, the SEC sued the Gryphon Partners hedge fund for alleged insider trading and naked short-selling involving PIPEs in the unregistered stock of 35 companies. PIPEs are "private investments in public equities," a financing tool used by small companies. The naked shorting took place in Canada, where it was legal at the time. Gryphon denied the charges.

A number of private companies, including Pet Quarters, Overstock.com and Nanopierce Technologies, have filed lawsuits alleging naked shorting. Ten of the suits, filed against the Depository Trust and Clearing Corporation, were withdrawn or dismissed as of May 2005. The remainder are in the early stages of litigation.

References

1. ^ U.S. SEC. "Division of Market Regulation: Responses to Frequently Asked Questions Concerning Regulation SHO".
2. University of Cincinnati College of Law. "Securities Lawyer's Deskbook, Rule 200".
3. University of Cincinnati College of Law. "Securities Lawyer's Deskbook, Rule 203".
4. U.S. SEC (April 11, 2005). "Division of Market Regulation: Key Points About Regulation SHO".
5. ^ Gary Weiss (December 8, 2003). "Commentary: Don't Force The Shorts To Get Dressed".
6. Weiss, Gary. Born to Steal: When the Mafia Hit Wall Street. Warner Books. ISBN 978-0-446-52857-3. {{cite book}}: Unknown parameter |origmonth= ignored (help)
7. Nevada Supreme Court (February 2,2006). "Brief of the Securities and Exchange Commission, re Nanopierce Corp, et al v. Depository Trust and Clearning Corp" (PDF). {{cite web}}: Check date values in: |date= (help)
8. 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. {{cite news}}: Check date values in: |date= (help)
9. Nocera, Joseph, "New Crusade for Master of Overstock," The New York Times, June 10, 2006
10. ^ "NASAA Conference on Short-Selling" (PDF). November 30, 2005.
11. Christopher Cox (July 12, 2006). "Opening Statements at the US Securities and Exchange Commission Open Meeting".
12. "Weekend Reading: Profile of a Short Seller". April 14, 2006.
13. Daniel Kadlec (November 14, 2006). "Watch Out, They Bite!".
14. Liz Moyer (February 12, 2007). "Naked and Confused; How a Tiny Software Outfit Fell Victim to an Illegal but Unrestrained Practice Known as Naked Short Selling".
15. 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). {{cite web}}: Check |url= value (help)
16. United States Securities and Exchange Commission. "Comments on Proposed Rule: Amendments to Regulation SHO [Release No. 34-54154; File No. S7-12-06]".
17. Liz Moyer (October 3, 2006). "Attack On Pegasus".
18. Dow Jones/AP (December 13,2006). "Fund Manager Accused of Illegal Trading". {{cite web}}: Check date values in: |date= (help)
19. "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

External links

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

The Dark Side of the Looking Glass, a presentaiton written and narrated by Patrick Byrne, CEO of Overstock.com

• Stock market