Why is Naked Short Selling Both Illegal and Common Practice?

The stock market is a tough game to monitor with many players playing and large amounts of money at stake. Large volumes of securities are bought, sold and traded and not everyone is interested in playing by the rules. Many have more sinister plans in mind, such as cheating the game.

One prominent example of cheating the system is known as naked short selling. It is illegal, but widely practiced.

What is naked short selling?

To understand naked short selling, it is important to first have an understanding of short selling. Short selling a stock is a legal trading technique where a trader borrows securities from a shareholder with the understanding that they will be returned upon demand. The trader then sells and delivers the securities to a buyer. A trader does this in hopes that the price of the securities will drop so that he or she can buy them back and return them to the lender, thus making a profit.

Naked short selling is closely related, but it has an illegal twist. Short sales are considered naked when securities are sold without first being borrowed from a shareholder. Because no real securities have been sold, they are often not delivered in time.

When the securities are not delivered by T+3 it is called “failing to deliver”.

Shares must legally be delivered by the transaction day plus three business days, otherwise known as T+3. Buyers are often unaware of a failure to deliver, because their accounts will be show a “securities entitlement” credit and they will believe that they have purchased stock, when all they actually hold is “phantom stock”.

At times, these invalid entitlements are represented to be real to buyers by their brokers, because their brokers have made a commission on the sale and do not wish to lose it. This deception can lead to counterfeit shares being bought and sold as real.

What are the effects of naked short selling?

The effects of naked short selling can be far reaching. Some argue that the practice can enhance the liquidity of shares that are difficult to move and that it adds efficiency to securities lending. However, most argue that this practice creates counterfeit stocks that can drive a company’s stock prices down by flooding the market with fake stock so that the supply exceeds the demand.

This stock manipulation practice can make investors shy away from certain stocks, serve to put companies out of business and even threaten the market as a whole.

How did it become so pervasive?

The practice of naked short selling seems to be a common practice for a variety of reasons. Some argue that it is primarily because those who have profited on these illegal transactions such as hedge funds, brokers and dealers don’t want to give any money back, and there are no real regulations in place to make them do so.

The Depository Trust & Clearing Corporation or DTCC (the final depository where all U.S. trades are settled and cleared) cannot settle fraudulent trades. According to the DTCC website, "We don’t have any power or legal authority to regulate or stop short-selling, naked or otherwise.”

While DTCC may not have the authority to regulate any short selling, it could create computer programs that would track share holdings to determine if they are real shares or simply entitled. Some believe that the DTCC chooses not to monitor these transactions more closely, because they make money on the interest and the loaning of these shares.

So, what can be done to stop naked short selling?

One suggestion would be a return to the old system where no money could be exchanged until securities are delivered. This would seem like a rather obvious approach, but with the thousands of electronic transfers that occur daily it does not seem entirely practical.

In the past, the SEC has made attempts to screen for and resolve failure to deliver issues. They implemented Regulation SHO on September 7, 2004. According to the SEC website, this rule was designed to:

Fulfill several objectives, including (1) establish uniform locate and delivery requirements in order to address problems associated with failures to deliver, including potentially abusive “naked” short selling (i.e., selling short without having borrowed the securities to make delivery); (2) create uniform marking requirements for sales of all equity securities; and (3) establish a procedure to temporarily suspend Commission and SRO short sale price tests in order to evaluate the overall effectiveness and necessity of such restrictions.

Regulation SHO helped a bit with the naked short selling situation in the marketplace, but whatever relief it provided was short-lived. Later in 2004, the SEC adopted Rule 17Ad-20, which prohibited issuers from withdrawing their securities from DTCC so that they could be settled by their transfer agencies. This rule made little sense, as transfer agencies are the only ones that keep a true record of shareholder lists for each corporation.

The rule only served to make DTCC more powerful, and it enabled them to hide certain activities from the SEC and issuers nationwide. Perhaps it is time for DTCC to "enter the age of transparency" and build a much-needed tracking system into their clearing and settlement software.

In the meantime, the SEC has come up with other ways to try to thwart the spread of naked short selling. In July of 2008, the SEC issued a month-long emergency order to stop all naked short sales on the securities of 18 large companies.

On October 17, 2008 the SEC adopted Rule 10b-21. This rule addressed naked short selling and the resulting failure to deliver of securities. Its intent was to hold those who have engaged in the illegal practice, such as brokers and dealers, liable when they deceive others about their ability to deliver securities by a scheduled settlement date.

With all of the rules in place to discourage the practice of naked short sales some might think twice before engaging in the deceptive practice…others may not. Until there is either a transparency-based software tracking system put in place, or Rule 17Ad-20 is rescinded, however, there will always be some who will try to outwit the current structure.