Wednesday, October 17, 2007

Naked short selling

Naked short selling, or naked shorting refers to the practice of selling a stock short without first borrowing the shares or making an "affirmative determination" that the shares can be borrowed. In the United States, the Securities and Exchange Commission issued a regulation, known as "Regulation SHO", seeking to curb abusive naked shorting. Many other countries and trading markets have developed similar regulations.

Regulatory policy

The Securities and Exchange Act of 1934 stipulates a settlement period up to three business days before a stock needs to be delivered.

The SEC states that "Naked short selling is not necessarily a violation of the federal securities laws or the Commission's rules. Indeed, in certain circumstances, naked short selling contributes to market liquidity." However, naked shorting to drive down share prices violates the law.

On American exchanges, under Regulation SHO, "a broker or dealer may not accept a short sale order" without having first borrowed or identified the stock being sold. However, this rule is exempted under these circumstances:

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.
The SEC contends that naked short selling has been falsely blamed on share price declines by stock promoters and corporate insiders, but can be used as a tool for illegal market manipulation.

Failures to deliver shares, possibly resulting from naked short sales, that persist for an extended period of time may result in large delivery obligations where stock settlement occurs. The SEC observes that fails can occur because of ordinary "long" stock sales and for reasons entirely unrelated to efforts to profit from share price declines.

Regulation SHO is intended to reduce the number of potential failures to deliver, and by limiting the time in which a broker can permit failures to deliver. The regulation requires broker-dealers to close-out 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."

On its Regulation SHO website ("Does Naked Shorting Drive Prices Down?" section), the SEC cites the prevalence of false claims of naked short selling in Pump and Dump fraud. The SEC downplays naked shorting as a factor in declining stock prices, stating that stock values ideally should be determined by "the quality of the company itself," "supply and demand" of the company's shares, and the company's ability to generate positive income.

The SEC says that naked short-selling has been frequently and falsely blamed for low stock prices in the wake of pump and dump scams involving companies that are in poor financial condition.

In July 2006, the SEC proposed to amend Regulation SHO, to close loopholes that could possibly be exploited via naked short selling. 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.

The North American Securities Administrators Association (NASAA) held a conference on naked short selling in November 2005. An official of the New York Stock Exchange stated that NYSE had found no evidence of widespread naked short selling, and alleged "fear mongering that there's this rampant naked shorting that's gone unregulated." Cameron Funkhouser, NASD senior vice president of market regulations, noted that although companies have alleged stock manipulation through the Berlin stock exchange, the NASD has seen not one instance of naked short selling [on the Berlin stock exchange]". Ralph Lambiase, head of the Connecticut Securities Agency and the NASAA, declared his disappointment at how the industry was handling the issue as a whole.[citation needed]

In March 2007, the Securities and Exchange Board of India (SEBI) approved short selling for institutional investors in the cash segment of the Indian stock market. Naked short selling will not be allowed and traders will have to fulfill delivery obligations by borrowing shares that have been lent from other investors who own the shares.

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.

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