In the United States, naked short selling is covered by various SEC regulations which, as of September 2008, prohibit the practice. In 2005, "Regulation SHO" was enacted to curb the practice, 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. As part of its response to the crisis in the North American markets in 2008, the SEC issued a temporary order restricting fails to deliver in the shares of 19 financial firms deemed systemically important. Effective September 18, 2008, amid claims that aggressive short selling had played a role in the failure of financial giant Lehman Brothers, the SEC made permanent and expanded the rules to remove exceptions and to cover all companies.
Some commentators have contended that despite regulations, naked shorting is widespread and that the SEC regulations are poorly enforced, although the SEC has denied these claims. However, the SEC and others have also defended the practice in limited form as beneficial for market liquidity. 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. Other commentators contend that naked shorting is more of a potential than a real problem, and have criticized the SEC for dealing with an issue that is tangential at best.
This short/borrow system provides the trader with shares to sell at current prices, in the hope that he will profit by repurchasing them later when the price has lowered. Because the seller/borrower is generally required to make a deposit for the full share price with the lender, it also provides the lender with interest on a position that he was not actively trading.
Naked short selling is a case of short selling without first arranging a borrow. If the stock is in short supply, finding the borrow can be difficult to arrange. The seller may also decide not to borrow the shares, in some cases because lenders are not available, or due to the costs of lending. In the case where a borrow is not arranged within the clearing time period and the shares are not given to the buyer, the trade is considered to have "failed to deliver." Nevertheless, the trade will continue to sit open and may eventually be filled.
It is difficult to measure how often naked short selling occurs. 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. A sudden rise in the number of fail reports 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.
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 focus on the fact that at least in theory, the practice allows an unlimited number of shares to be sold short. As stated in one editorial, naked short selling "enables speculators to drive down a company's stock by offering an overwhelming number of shares for sale.
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. 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. The SEC has also 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. However, the SEC chairman Christopher Cox has acknowledged naked shorting as a serious problem while implementing new regulations to prohibit the practice, culminating in the September 2008 action following the failures of Bear Sterns and Lehman Brothers amidst speculation that naked short selling had played a contributory role.
Robert J. Shapiro, former undersecretary of commerce for economic affairs, has claimed that naked short selling has cost investors $100 billion and driven 1,000 companies into the ground.
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.
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 Airlines. 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 March 2007, the Securities and Exchange Board of India (SEBI), which disallowed short sales altogether in 2001 as a result of the Ketan Parekh affair, reintroduced short selling under regulations similar to those developed in the United States. In conjunction with this rule change, SEBI outlawed all naked short selling.
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.
SEC Chairman Christopher Cox in March 2008 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 estimates about 1% of shares that change hands daily, about $1 billion, are subject to delivery failures. SEC Commissioners Paul Atkins and Kathleen Casey expressed support for the crackdown.
In 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 in an effort to limit market volatility of financial stocks. But even with respect to those stocks the SEC soon thereafter announced there would be an exception with regard to market makers. SEC Chairman Cox noted that the emergency order was "not a response to unbridled naked short selling in financial issues", saying that "that has not occurred". Analysts warned of the potential for the creation of price bubbles.
The emergency actions rule expired August 12, 2008. However, at September 17th, 2008, the SEC issued new, more extensive rules against naked shorting, making "it crystal clear that the SEC has zero tolerance for abusive naked short selling". Among the new rules is that market makers are no longer given an exception. As a result, options market makers will be treated in the same way as all other market participants, and effectively will be banned from naked short selling.
In 2005, the SEC notified Refco of intent to file an enforcement action against the securities unit of Refco for securities trading violations concerning the shorting of Sedona stock. The SEC sought information related to two former Refco brokers who handled the account of a client, Amro International, which shorted Sedona's stock. No charges had been filed by 2007.
In December 2006, the SEC sued Gryphon Partners, a hedge fund, for insider trading and naked short-selling involving PIPEs in the unregistered stock of 35 companies. PIPEs are "private investments in public equities," used by companies to raise cash. The naked shorting took place in Canada, where it was legal at the time. Gryphon denied the charges.
In March 2007, Goldman Sachs was fined $2 million by the SEC for allowing customers to illegally sell shares short prior to secondary public offerings. Naked short-selling was allegedly utilized by the Goldman clients. The SEC charged Goldman with failing to ensure those clients had ownership of the shares. SEC Chairman Cox commented, "That is an important case and it reflects our interest in this area.
In June 2007, executives of Universal Express, which had claimed naked shorting of its stock, were sanctioned by a federal court judge as “repeated and remorseless violators” of the securities laws. The SEC asserted that the company “appears to exist primarily as a vehicle for fraud.” Referring to a court ruling barring CEO Richard Altomare from serving as an officer of a public company, New York Times columnist Floyd Norris said: "In Altomare's view, the issues that bothered the judge are irrelevant. 'Long and short of it,' he said in a statement, 'this is a naked short hallmark case in the making.' Or it is proof that it can take a long time for the SEC to stop a fraud. Universal Express has claimed that 6,000 small companies have been put out of business by naked shorting, which the company says "the SEC has ignored and condoned. A receiver was subsequently appointed to administer the company.
In July 2007, Piper Jaffray was fined $150,000 by the New York Stock Exchange (NYSE). Piper violated securities trading rules from January through May 2005, selling shares without borrowing them, and also failing to "cover short sales in a timely manner", according to the NYSE. At the time of this fine, the NYSE had levied over $1.9 million in fines for naked short sales over seven regulatory actions.
Also in July 2007, the American Stock Exchange fined two options market makers for violations of Regulation SHO. SBA Trading was sanctioned for $5 million, and ALA Trading was fined $3 million, which included disgorgement of profits. Both firms and their principals were suspended from association with the exchange for five years. The exchange said the firms used an exemption to Reg. SHO for options market makers to "impermissibly engage in naked short selling.
In October 2007, the SEC settled charges against New York hedge fund adviser Sandell Asset Management Corp. and three executives of the firm for, among other things, shorting stock without locating shares to borrow. Fines totalling $8 million were imposed, and the firm neither admitted nor denied the charges.
The Depository Trust and Clearing Corporation has been criticized for its approach to naked short selling. DTCC has been sued with regard to its alleged participation in naked short selling, and the issue of DTCC's possible involvement has been taken up by Senator Robert Bennett and discussed by the NASAA and in articles disagreed with by DTCC in the Wall Street Journal and Euromoney Magazine.
While there is no dispute that illegal naked shorting happens, there is a fight as to the extent to which DTCC is responsible. Some blame DTCC as the keeper of the system where it happens, and say DTCC turns a blind eye to the problem. DTCC says naked shorting is not widespread enough to be a major concern. "We're not saying there is no problem, but to suggest the sky is falling might be a bit overdone," DTCC's chief spokesman Stuart Goldstein said. DTCC General Counsel Larry Thompson calls the claims "pure invention." The SEC, however, views naked shorting as a serious enough matter to have made two separate efforts to restrict the practice. And in July 2007, Senator Bennett suggested on the U.S. Senate floor that the allegations involving DTCC and naked short selling are "serious enough" that there should be a hearing on them with DTCC officials by the Senate Banking Committee. The committee's Chairman, Senator Christopher Dodd, indicated he was willing to hold such a hearing.
Critics also contend DTCC has been too secretive with information about where naked shorting is taking place. In 2007, WayPoint Biomedical sued DTCC for DTCC's refusal to comply with a subpoena request for documents Waypoint says it needs to track trades in the company's shares. Ten suits concerning naked short-selling filed against the DTCC were withdrawn or dismissed by May 2005.
A suit by Electronic Trading Group, naming major Wall Street brokerages, was filed in April 2006 and dismissed in December 2007.
Two separate lawsuits, filed in 2006 and 2007 by NovaStar Financial, Inc. shareholders and Overstock.com, named as defendants ten Wall Street prime brokers. They claimed a scheme to manipulate the companies' stock by allowing naked short selling. A motion to dismiss the Overstock suit was denied in July 2007.
In contrast, a study by Leslie Boni in 2004 found correlation between "strategic delivery failures" and the cost of borrowing shares. The paper, which looked at a "unique dataset of the entire cross-section of U.S. equities," credited the initial recognition of strategic delivery fails to Richard Evans, Chris Geczy, David Musto and Adam Reed, and found its review to provide evidence consistent with their hypothesis that "market makers strategically fail to deliver shares when borrowing costs are high."
An April 2007 study conducted for Canadian market regulators by Market Regulation Services Inc. found that fails to deliver securities were not a significant problem on the Canadian market, that "less than 6% of fails resulting from the sale of a security involved short sales" and that "fails involving short sales are projected to account for only 0.07% of total short sales.
Reviewing the SEC's July 2008 emergency order, Barron's said in an editorial: "Rather than fixing any of the real problems with the agency and its mission, Cox and his fellow commissioners waved a newspaper and swatted the imaginary fly of naked short-selling. It made a big noise, but there's no dead bug. Jenkins of the Wall Street Journal said the order was "an exercise in symbolic confidence-building" and that naked shorting involved technical concerns except for subscribers to a "devil theory". The Economist said the SEC had "picked the wrong target", mentioning a study by a Swiss academician who found that trading in the 19 financial stocks became less efficient. The Washington Post expressed approval of the SEC's decision to address a "frenetic shadow world of postponed promises, borrowed time, obscured paperwork and nail-biting price-watching, usually compressed into a few high-tension days swirling around the decline of a company." The Los Angeles Times called the practice of naked short selling "hard to defend," and stated that it was past time the SEC became active in addressing market manipulation.