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Thursday, March 17, 2011

What is naked short selling of stock?

Naked short selling is the selling of shares without actual exchange of shares between a buyer and a seller. Naked short selling is legal within U.S. exchanges to some extent, but is also subject to regulatory limitation based on time period, volume, settlement of shares and percentage proportion of shares that are naked short sold. An example of naked short selling would be when a broker offers shares for sale that have not been formally purchased from a dealer, the company itself or other market makers.

Theoretically, the practice of naked short selling can allow a volume of shares sold to be greater than the number of shares available for sale and potentially cause unnatural downward pressure on a security. Unsettled and excessive naked short selling is tracked by regulatory agencies and stock exchanges and information on naked short selling activity is available to the public. A key indicator used in tracking naked short sales is a metric known as the 'fail to deliver rate' that indicates how many shares of a particular company are sold without actual ownership of the security.

This article will discuss the legality of naked short selling in addition to the regulation of the practice within the United States stock exchanges. In doing so, it will illustrate the dynamics of naked short selling, what is involved and complications in assessment of the practice. Additionally, potential impacts and shareholder sources of naked short selling information will be referred to.

Legal vs illegal naked short selling


Within U.S. exchanges, legal naked short selling is facilitated by 'market makers' i.e. large institutions that buy, hold and sell shares to assist in providing sufficient availability of shares for exchange in the market i.e. liquidity. Legal naked short selling takes place when an excess demand for shares takes place for which a 'market maker' lacks sufficient share holdings. In such case, the institutional trader/specialist may engage in naked short selling to facilitate purchase of shares even though actual purchase of shares for short sale have not been purchased by the market maker. These shares must be settled within 3 days to be legal (sec.gov/spotlight).

Contrarily, illegal naked short selling occurs when institutional brokers knowingly engage in naked short selling for 1) the motive of price manipulation and/or 2) in violation of regulation SHO of the Securities and Exchange Commission (SEC). Since the practice of illegal naked short selling can sometimes be difficult to prove, the practice is not completely regulated and therefore may or may not occur in an ongoing manner. The subject is somewhat a matter of theoretical debate and warrants both due diligence and a keen awareness of shareholders not familiar with institutional market making for particular securities.

Regulation of naked short selling within the U.S.


The exchange of stocks is regulated by the Securities and Exchange Act of 1934 and amendments thereafter. One such amendment is "regulation SHO" (investopedia.com) enacted by the securities and exchange commission in 2005 and further adjusted in 2007. In 2008 an Anti-Fraud rule was also proposed by the Securities and Exchange Commission (sec.gov/rules). This latter amendment proposes liability indemnification from parties engaging in illegal naked short selling. Furthermore, during the credit crisis of 2007-2008, the U.S. Federal Government via the SEC, imposed a 30 day ban on naked short selling of key financial corporations in an effort to stabilize financial conditions (USA Today) rather than limit the practice of naked short selling. While this latter action does not necessarily indicate additional government regulation of naked short selling, it does indicate the negative affect naked short selling can have on financial markets.

Moreover, due to the potential for stock manipulation and disproportional price movements associated with naked short selling, legal restrictions on naked short selling were enacted by regulation SHO of the Securities and Exchange Commission. According to regulation SHO, short sales can take place after any price movement in securities but must also comply with two rules specifically reasonable belief regarding obtaining of shares sold without supply aka 'locate rule' in addition to settling of shares within 3 days with what is effectively a 10 grace period thereafter in which the positions must be 'closed out' (investopedia.com) i.e. settled before potential public disclosure.

The result of regulation SHO is that while short sales can be performed regardless of price movements up or down, naked short sales must be performed with reasonable belief that the shares sold short without a supplier i.e. naked short selling can be found within a 3 day period and that no more than 13 days can pass before the naked short sales are closed out before being listed on a 'threshold' list. The formal definition of threshold naked short sale does not apply until 5 days have passed (nasdaqtrader.com).

Specific requirements exist to become 'threshold listed' Those requirements include share volume naked short sold i.e. 10,000 or more shares,  percentage proportion of outstanding shares i.e. more than of 1 percent and  securities of companies not listed as a "self regulatory organization" are not listed on the exchange listings (nasdaqtrader.com). These threshold lists can be obtained from exchanges themselves in addition to a number of privately run independent sources.

Impact of naked short selling on share prices


The impact of naked short selling on share prices can be mild to great depending on the exchange in which the activity takes place. For example, in the Berlin stock exchange, naked short selling is unregulated meaning no restrictions are places on the sale of stock that have not been formally exchanged. Some proponents of naked short selling contest the practice aids the liquidity of the market (sec.gov/comments) by facilitating exchange of otherwise sparsely owned and traded shares. Others however, believe the practice is not regulated enough as evident in proponents of the SEC's Anti-fraud proposition.

Since there exists a 'gray area' of motive behind short selling and price manipulation is not always easy to prove, illegal naked short selling may sometimes go unchecked. For example, if a company has relatively low volume and a sudden demand for shares to sell short arises in the market, a broker may suddenly require a need to naked short sell. This may lead to a decline in share price however the motive behind the increased demand for shares to sell short may not necessarily be connected to the market maker if such motive exists.

Information on naked short selling


To obtain a list of securities that have become 'threshold' listed, one can refer to stock exchange listings such as the NASDAQ, AMEX and NYSE. Several online websites report activity on naked short selling which can assist investors and shareholders in assessing naked short selling activity for a particular company that remains on the threshold list for more than 13 days. Naked short sales of companies that exceed the regulatory compliance restrictions set out by the Securities and Exchange Commission can be viewed at the following exchange websites.

Regulation SHO 'Threshold' Lists


• New York Stock Exchange (NYSE):
http://www.nyse.com/regulation/memberorganizations/Threshold_Securities.shtml

• Nasdaq Stock Exchange (NASDAQ):
http://www.nasdaqtrader.com/Trader.aspx?id=RegSHOThreshold

•American Stock Exchange (AMEX): http://www.amex.com/amextrader/?href=/amextrader/tradingData/RegSHO/TrDa_RegSHO.jsp

Sources:

1. http://www.investopedia.com/terms/f/failuretodeliver.asp
2. http://findarticles.com/p/articles/mi_qn4188/is_20070614/ai_n19291043
3. http://www.usatoday.com/money/markets/2008-07-15-sec-limits-short-sales_N.htm
4. http://www.sec.gov/rules/proposed/2008/34-57511fr.pdf
5. http://64.233.167.104/search?q=cache:8XdxZ9hsamwJ:www.fredlaw.com/articles/corporate/busi_0409_bm_ma.html+naked+short+selling+unregulated+in+germany&hl=en&ct=clnk&cd=1&gl=us&client=safari
6. http://www.sec.gov/spotlight/keyregshoissues.htm
7. http://tinyurl.com/6aa4qos (Freshpatents.com)
8. http://en.wikipedia.org/wiki/Naked_short_selling
9. http://www.investopedia.com/terms/n/nakedshorting.asp
10. http://www.investopedia.com/terms/r/regsho.asp