naked shorting

Naked short selling, or naked shorting, is the practice of short-selling a tradable asset of any kind without first borrowing the asset from someone else or ensuring that it can be borrowed. When the seller does not obtain the asset and deliver it to the buyer within the required time frame, the result is known as a " failure to deliver" (FTD). The transaction generally remains open until the asset is acquired and delivered by the seller, or the seller's broker settles the trade on their behalf.

Short selling is used to take advantage of perceived arbitrage opportunities or to anticipate a price fall, but exposes the seller to the risk of a price rise.

The oldest documented example of a naked short in securities trading appears to be a 1609 maneuver against the Dutch East India Company by the Dutch trader Isaac Le Maire.

Critics have advocated for stricter regulations against naked short selling. In 2005 in the United States, "Regulation SHO" was enacted, requiring that broker-dealers have grounds to believe that shares will be available for a given stock transaction, and requiring that delivery take place within a limited time period. In 2008, the SEC banned what it called "abusive naked short selling" in the United States, as well as some other jurisdictions, as a method of driving down share prices. Failing to deliver shares is legal under certain circumstances, and naked short selling is not ''per se'' illegal. In the United States, naked short selling is covered by various SEC regulations which prohibit the practice.

In August 2008, the SEC issued a temporary order restricting short-selling in the shares of 19 financial firms deemed systemically important, by reinforcing the penalties for failing to deliver the shares in time. Effective September 18, amid claims that aggressive short selling had played a role in the failure of financial giant Lehman Brothers, the SEC extended and expanded the rules to remove exceptions and to cover all companies, including market makers.

A 2014 study by researchers at the University at Buffalo, published in the ''Journal of Financial Economics'', found no evidence that failure to deliver stock "caused price distortions or the failure of financial firms during the 2008 financial crisis" and that "greater FTDs lead to higher liquidity and pricing efficiency, and their impact is similar to our estimate of delivered short sales".

Some commentators have contended that despite regulations, naked shorting is widespread and that the SEC regulations are poorly enforced. Its critics have contended that the practice is susceptible to abuse, can be damaging to targeted companies struggling to raise capital, and has led to numerous bankruptcies. However, other commentators have said that the naked shorting issue is a "devil theory", not a ''bona fide'' market issue and a waste of regulatory resources.

Description

"Normal" shorting

Short selling is a form of speculation that allows a trader to take a " negative position" in a stock of a company. Such a trader first borrows shares of that stock from their owner (the lender), typically via a bank or a prime broker under the condition that they will return it on demand. Next, the trader sells the borrowed shares and delivers them to the buyer who becomes their new owner. The buyer is typically unaware that the shares have been sold short: their transaction with the trader proceeds just as if the trader owned rather than borrowed the shares. Some time later, the trader closes their short position by purchasing the same number of shares in the market and returning them to the lender.

The trader's profit is the difference between the sale price and the purchase price of the shares. In contrast to "going long" where sale succeeds the purchase, short sale precedes the purchase. Because the seller/borrower is generally required to make a cash deposit equivalent to the sale proceeds, it offers the lender some security.

Naked shorts in the United States

Naked short selling is a case of short selling without first arranging a borrow. If the stock is in short supply, finding shares to borrow can be difficult. The seller may also decide not to borrow the shares, in some cases because lenders are not available, or because the costs of lending are too high. When shares are not borrowed within the clearing time period and the short-seller does not tender shares to the buyer, the trade is considered to have " failed to deliver". Nevertheless, the trade will continue to sit open or the buyer may be credited the shares by the DTCC until the short-seller either closes out the position or borrows the shares.

It is difficult to measure how often naked short selling occurs. Fails to deliver are not necessarily indicative of naked shorting, and can result from both "long" transactions (stock purchases) and short sales. Naked shorting can be invisible in a liquid market, as long as the short sale is eventually delivered to the buyer. However, if the covers are impossible to find, the trades fail. Fail reports are published regularly by the SEC, and a sudden rise in the number of fails-to-deliver will alert the SEC to the possibility of naked short selling. In some recent cases, it was claimed that the daily activity was larger than all of the available shares, which would normally be unlikely.

Extent of naked shorting

The reasons for naked shorting, and the extent of it, had been disputed for several years before the SEC's 2008 action to prohibit the practice. What is generally recognized is that naked shorting tends to happen when shares are difficult to borrow. Studies have shown that naked short selling also increases with the cost of borrowing.

In recent years, a number of companies have been accused of using naked shorts in aggressive efforts to drive down share prices, sometimes with no intention of ever delivering the shares. These claims argue that, at least in theory, the practice allows an unlimited number of shares to be sold short. A ''Los Angeles Times'' editorial in July 2008 said that naked short selling "enables speculators to drive down a company's stock by offering an overwhelming number of shares for sale".

The SEC has stated that naked shorting is sometimes falsely asserted as a reason for a share price decline, when, often, "the price decrease is a result of the company's poor financial situation rather than the reasons provided by the insiders or promoters."

Before 2008, regulators had generally downplayed the extent of naked shorting in the US. At a North American Securities Administrators Association (NASAA) conference on naked short selling in November 2005, an official of the New York Stock Exchange stated that NYSE had not found evidence of widespread naked short selling. In 2006, an official of the SEC said that "While there may be instances of abusive short selling, 99% of all trades in dollar value settle on time without incident." Of all those that do not, 85% are resolved within 10 business days and 90% within 20. That means that about 1% of shares that change hands daily, or about $1 billion per day, are subject to delivery failures, although the SEC has stated that "fails-to-deliver can occur for a number of reasons on both long and short sales", and accordingly that they do not necessarily indicate naked short selling.

In 2008, SEC chairman Christopher Cox said that the SEC "has zero tolerance for abusive naked short-selling" while implementing new regulations to prohibit the practice, culminating in the September 2008 action following the failures of Bear Stearns and Lehman Brothers amidst speculation that naked short selling had played a contributory role. Cox said that "the rule would be designed to ensure transparency in short-selling in general, beyond the practice of naked short-selling."

Claimed effects of naked shorting

As with the prevalence of naked shorting, the effects are contested. The SEC has stated that the practice can be beneficial in enhancing liquidity in difficult-to-borrow shares, while others have suggested that it adds efficiency to the securities lending market. Critics of the practice argue that it is often used for market manipulation, that it can damage companies and even that it threatens the broader markets.

One complaint about naked shorting from targeted companies is that the practice dilutes a company's shares for as long as unsettled short sales sit open on the books. This has been alleged to create "phantom" or "counterfeit" shares, sometimes going from trade to trade without connection to any physical shares, and artificially depressing the share price. However, the SEC has disclaimed the existence of counterfeit shares and stated that naked short selling would not increase a company's outstanding shares. Short seller David Rocker contended that failure to deliver securities "can be done for manipulative purposes to create the impression that the stock is a tight borrow", although he said that this should be seen as a failure to deliver "longs" rather than "shorts".

Robert J. Shapiro, former undersecretary of commerce for economic affairs, and a consultant to a law firm suing over naked shorting, has claimed that naked short selling has cost investors $100 billion and driven 1,000 companies into the ground.

Richard Fuld, the former CEO of the financial firm Lehman Brothers, during hearings on the bankruptcy filing by Lehman Brothers and bailout of AIG before the House Committee on Oversight and Government Reform alleged that a host of factors including a crisis of confidence and naked short selling attacks followed by false rumors contributed to the collapse of both Bear Stearns and Lehman Brothers. Fuld had been obsessed with short sellers and had even demoted those Lehman executives that dealt with them; he claimed that the short sellers and the rumour mongers had brought down Lehman, although he had no evidence of it. Upon the examination of the issue of whether "naked short selling" was in any way a cause of the collapse of Bear Stearns or Lehman, securities experts reached the conclusion that the alleged "naked short sales" occurred after the collapse and therefore played no role in it. House committee Chairman Henry Waxman said the committee received thousands of pages of internal documents from Lehman and these documents portray a company in which there was "no accountability for failure". In July 2008, U.S. Securities and Exchange Commission chairman Christopher Cox said there was no "unbridled naked short selling in financial issues".

Regulations in the United States

Securities Exchange Act of 1934

The Securities Exchange Act of 1934 stipulates a settlement period up to two business days before a stock needs to be delivered, generally referred to as " T+2 delivery".

Regulation SHO

The SEC enacted Regulation SHO in January 2005 to target abusive naked short selling by reducing failure to deliver securities, and by limiting the time in which a broker can permit failures to deliver."Key Points About Regulation SHO"
Security and Exchange Commission In addressing the first, it stated that a broker or dealer may not accept a short sale order without having first borrowed or identified the stock being sold. The rule had the following exemptions:
#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.

To reduce the duration for which fails to deliver are permitted to sit open, the regulation requires broker-dealers to close out open fail-to-deliver positions in threshold securities that have persisted for 13 consecutive settlement days. The SEC, in describing Regulation SHO, stated that failures to deliver shares that persist for an extended period of time "may result in large delivery obligations where stock settlement occurs".

Regulation SHO also created the "Threshold Security List", which reported any stock where more than 0.5% of a company's total outstanding shares failed delivery for five consecutive days. A number of companies have appeared on the list, including Krispy Kreme, Martha Stewart Omnimedia and Delta Air Lines. The Motley Fool, an investment website, observes that "when a stock appears on this list, it is like a red flag waving, stating 'something is wrong here!'" However, the SEC clarified that appearance on the threshold list "does not necessarily mean that there has been abusive naked short selling or any impermissible trading in the stock".

In July 2006, the SEC proposed to amend Regulation SHO, to further reduce failures to deliver securities. 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".

Developments 2007–2010

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.

In March 2008, SEC Chairman Christopher Cox gave a speech entitled the "'Naked' Short Selling Anti-Fraud Rule", in which he announced new SEC efforts to combat naked short selling. Under the proposal, the SEC would create an antifraud rule targeting those who knowingly deceive brokers about having located securities before engaging in short sales, and who fail to deliver the securities by the delivery date. Cox said the proposal would address concerns about short-selling abuses, particularly in the market for small-cap stocks. Even with the regulation in place, the SEC received hundreds of complaints in 2007 about alleged abuses involving short sales. The SEC estimated that about 1% of shares that changed hands daily, about $1 billion, were subject to delivery failures. SEC Commissioners Paul Atkins and Kathleen Casey expressed support for the crackdown.

In mid-July 2008, the SEC announced emergency actions to limit the naked short selling of government sponsored enterprises (GSEs), such as Fannie Mae and Freddie Mac

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