SEC takes dim view of abusive naked short selling

On the Money
From the  April 3, 2009 print edition

As the world economy collapsed last fall, (and some would say it’s premature to use the past-tense of that verb), regulators took aim at activities that have a depressing effect on the financial markets. One of the activities that drew the SEC’s ire was the practice of “abusive naked short selling.”

As opposed to “long trading,” which is purchasing a stock for cash and selling it later after the price has increased, “short trading” is the reverse. That is, the short-seller borrows a stock and sells it, and at a later time buys the stock in the market, hopefully at a lower price, and returns the shares that were borrowed.

Notice that the first part of a short sale is borrowing the stock, not selling it. That might seem obvious. After all, how can anyone sell something they don’t own? Enter the abusive naked short-seller.

In an abusive naked short transaction, the seller doesn’t actually borrow the stock, and fails to deliver it to the buyer. For this reason, naked shorting can allow manipulators to force prices down far lower than would be possible in legitimate short-selling conditions. This generates what’s known as a “failed to deliver.”

These “fails to deliver” when left “open” indefinitely are at the heart of abusive naked short selling. The unresolved or “open” failure to deliver creates what are called “phantom shares,” or “vapor-shares” in the market, which weakens the price of the underlying stock and creates artificial dilution by creating a false total shares outstanding.

In very plain terms, the naked short-seller makes a deal with a willing and equally unscrupulous participant to borrow shares they both know don’t really exist. As long as the lender “scofflaw” will never have to deliver those shares, the shares remain “vapor.”

Therefore, the decision to short-sell securities naked brings destruction, fueled by the specious lending activities underneath.

Has the abusive naked short-seller actually borrowed the shares? No. Legitimately borrowing the shares slows down the naked short-seller, who must locate the shares, make arrangements for a share loan, and pay fees to the share lender and often an intermediary.

In September, SEC Chairman Christopher Cox said, “…the SEC has zero tolerance for abusive naked short selling.”

To put action behind the words, the commission adopted Rule 10b-21, which expressly targets fraudulent short-selling transactions. The SEC chose to adopt the rule under the 10(b) fraudulent transaction provisions of the Securities Exchange Act of 1934 to emphasize the gravity of abusive naked short selling; it is fraud.

The new rule covers short-sellers who deceive broker-dealers or any other market participants. Specifically, the new rule makes clear that those who lie about their intention or ability to deliver securities in time for settlement are violating the law when they fail to deliver. This rule became effective Oct. 17, 2008.

Rule 10b-21 specifically provides that it is a “manipulative or deceptive device or contrivance” (as used in Section 10(b) of the Exchange Act) for any person to submit an order to sell an equity security if such person deceives a broker or dealer, a registered clearing agency participant or a purchaser about the person’s intention or ability to deliver the security on or before the settlement date, and such person fails to deliver the security on or before the settlement date.

Our financial markets abhor deceptive contrivances, and this rule targets short-sellers who deceive their broker-dealers about their source of shares for borrowing and sellers who misrepresent to their broker-dealers that they own the shares being sold. The rule also applies to brokers acting for their own accounts who, in this case, would be considered sellers.

Legitimate securities lending has been a part of the financial system for a long time. Established brokerage firms such as Wachovia, State Street, Bank of New York Mellon and even the venerable Brown Brothers Harriman tout their expertise in supporting trading activities that include share lending, short selling and selling on margin. However, with the new Rule 10b-21, even these firms will need to exercise caution to avoid open “fails to deliver.”

Fail-to-deliver data is available from the SEC. To access the data, go tohttp://www.sec.gov/foia/docs/failsdata.htm. A downloadable text file contains the information recorded in the National Securities Clearing Corp.’s (“NSCC”) Continuous Net Settlement system aggregated over all NSCC members when that security has a balance of total fails-to-deliver of at least 10,000 shares as of a particular settlement date.

© C. Stephen Guyer for American City Business Journals Inc. All rights reserved.