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| 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." | 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 ] 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." | In recent years, however, the ] 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." | ||
| One particular area of controversy raised by opponents of Naked Short Selling involves some text within the FAQ published by the SEC. In particular, the following excerpts: | |||
| '''IV. A. 7. F. Grandfathering Under Regulation SHO''' | |||
| ''The requirement to close-out fail to deliver positions in threshold securities that remain for 13 consecutive settlement days does not apply to positions that were established prior to the security becoming a threshold security. This is known as "grandfathering." For example, open fail positions in securities that existed prior to the effective date of Regulation SHO on January 3, 2005 are not required to be closed out under Regulation SHO. '''The grandfathering provisions of Regulation SHO were adopted because the Commission was concerned about creating volatility where there were large pre-existing open positions.''' The Commission will continue to monitor whether grandfathered open fail positions are being cleaned up under existing delivery and settlement guidelines or whether further action is warranted.'' | |||
| Opponents point to this paragraph as an admission that Naked Short Selling exists in such extremes in our markets that forcing settlement would cause undesirable volatility. | |||
| '''V. 11. Can I obtain fails information?''' | |||
| ''Currently, threshold lists include the name and ticker symbol of securities that meet the threshold level on a particular settlement date. Some investors have requested that the SROs provide more detailed information for each threshold security, including the total number of fails, the total short interest position, the name of the broker-dealer firm responsible for the fails, and the names of the customers of responsible brokers and dealers responsible for the short sales. '''The fails statistics of individual firms and customers is proprietary information and may reflect firms' trading strategies.''' The release of this information could be used to engage in unlawful upward manipulation of the price of the securities in order to "squeeze" the firms improperly.'' | |||
| Opponents argue that this paragraph expresses evidence that some firms use Naked Short Selling as a trading strategy rather then just a tool to maintain liquidity in a security as is allowed by the SEC. | |||
| == Regulators Respond == | == Regulators Respond == | ||
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| == External links == | == External links == | ||
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Revision as of 14:53, 5 March 2006
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 they do 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.
Does Naked Shorting Drive Stock Prices Down?
The Securities and Exchange Commission addresses that 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."
Some claim that "fails to deliver" result in "counterfeit shares." These claims are vigorously denied by regulators and by the Depository Trust & Clearing Corporation (DTCC). Regulators point out that the vast majority of FTDs are unrelated to abusive naked short-selling, and that shareholders are not disadvantaged when a fail occurs.
Many contend that naked short-selling has been advanced by owners of small public companies as an excuse to divert attention of price declines caused by corporate shortcomings and regulatory problems.
In a recent legal brief intervening in a suit against the DTCC, the SEC explained that "fails to deliver" did not hurt investors, saying that under the "Uniform Commercial Code, 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 Uniform Commercial Code 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." and .
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 that regulations against short-selling would have caused an even greater boom and bust.
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."
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 (NASD), denied that naked short-selling is a signficant problem.
Cameron Funkhouser, NASD's senior vice president of market regulations, 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."
Funkhouser also 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.
Rumors 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.