Talk:Naked short selling/Notes 1

These notes are mainly for my own use, but they may be useful as a general reference. Please do feel free to amend. --Anticipation of a New Lover's Arrival, The 16:33, 9 March 2008 (UTC)

Regulatory bodies and industry organizations

 * U.S. Securities and Exchange Commission (SEC)
 * a United States government agency having primary responsibility for enforcing the federal securities laws and regulating the securities industry/stock market.
 * National Association of Securities Dealers, Inc. (NASD)
 * is an industry organization representing persons and companies involved in the securities industry in the United States. It is also the primary self-regulatory organization (SRO) responsible for the regulation of its industry, with oversight from the SEC
 * North American Securities Administrators Association (NASAA)
 * founded in Kansas in 1919, is the oldest international investor protection organization. NASAA was created to protect consumers who purchase securities or investment advice, and its jurisdiction extends to a variety of issuers and intermediaries who offer and sell securities to the public.

Other bodies

 * Depository Trust & Clearing Corporation (DTCC)
 * based primarily at 55 Water Street in New York City, is the world’s largest post-trade financial services company. It was set up to provide an efficient and safe way for buyers and sellers of securities to make their exchange, and thus "clear and settle" transactions.  It also provides custody of securities.
 * User-owned and directed.
 * Has attracted much criticism and many lawsuits for allegedly turning a blind eye to illegal naked short selling or otherwise enabling it. This has a been discussed on the floor of the US Senate as recently as July, 2007.
 * American Stock Exchange (AMEX)
 * an American stock exchange situated in New York. AMEX is a mutual organization, owned by its members. Until 1929 it was known as the New York Curb Exchange.''
 * New York Stock Exchange (NYSE)
 * the largest stock exchange in the world by dollar volume.
 * NASDAQ
 * (acronym of National Association of Securities Dealers Automated Quotations) is an American stock exchange. It is the largest electronic screen-based equity securities trading market in the United States. With approximately 3,200 companies, it lists more companies and on average trades more shares per day than any other U.S. market.''

People

 * Christopher Dodd
 * Senior Senator for Connecticutt
 * Chairman of the Senate Banking Committee
 * Bob Bennett
 * Junior Senator from Utah
 * Member of the Senate Banking Committee
 * But I have discovered something that appears to be a way around the SEC rules. Here is the transaction: Broker A shorts 1,000 shares. At the end of 13 days, which is the period he has to produce the shares, he has been unable to find any--probably hasn't even looked--but he has this requirement under the SEC rule to produce 1,000 shares. So he goes to broker B and says quietly: Sell me a thousand shares. Broker B says: I don't have any. Broker A says: It doesn't matter; sell me a thousand shares so I can cover. Broker B: All right. I will sell you a thousand shares so you can cover and there will be no passage of money; this is a deal between the two of us--a rollover. At the end of 13 days, broker B has to deliver a thousand shares, so broker A sells the same 1,000 phantom shares back to broker B, and they ping-pong these back and forth for as long as they want. (US Senate floor, July 20, 2007)

Lead paragraph, 9 March, 2008

 * Naked short selling, or naked shorting, is the practice of selling a stock short without first borrowing the shares or making an "affirmative determination" that the shares can be borrowed.


 * See revision as of 14:34, 9 March 2008

Global perspective
This article is almost exclusively written from a US standpoint. Different markets have different practices and operate under different legislative and regulatory systems. While we may not be able to expand the coverage quickly, one change we could perform immediately would be to acknowledge that the term discussed is a term of art in use on the US stock exchanges, and statements in this context may not apply globally.

Historic events

 * Wall Street Crash of 1929
 * Modern US financial regulation apparatus came out of this

Federal legislation
Securities regulation in the United States
 * Securities Act of 1933
 * Congress enacted the Securities Act of 1933 (the "1933 Act," the "Truth in Securities Act" or the "Federal Securities Act") 48 Stat. 74 (May 27, 1933), codified at et seq., in the aftermath of the stock market crash of 1929 and during the ensuing Great Depression.  Legislated pursuant to the interstate commerce clause of the Constitution, it requires that any offer or sale of securities using the means and instrumentalities of interstate commerce be registered pursuant to the 1933 Act, unless an exemption from registration exists under the law.  It was the first major federal legislation to regulate the offer and sale of securities.  Prior to that time, regulation of securities was chiefly governed by state laws (commonly referred to as  blue sky laws). When Congress enacted the 1933 Act, it left in place the patchwork of existing state securities laws to supplement federal laws in part because there were questions as to the constitutionality of federal legislation.
 * Securities Exchange Act of 1934, "The 1934 Act" (now )
 * is a law governing what is and is not legal in the secondary trading of securities (stocks, bonds, and debentures).
 * U.S. Securities and Exchange Commission was born here (Section 4)
 * Trust Indenture Act of 1939
 * The United States Trust Indenture Act of 1939 (TIA), codified at through, supplements the Securities Act of 1933 in the case of the distribution of debt securities.  Generally speaking, the TIA requires the appointment of a suitably independent and qualified trustee to act for the benefit of the holders of the securities, and specifies various substantive provisions for the trust indenture that must be entered into by the issuer and the trustee.  The TIA is administered by the U.S. Securities and Exchange Commission (SEC), which has made various regulations under the act.
 * Investment Company Act of 1940
 * Securities Investor Protection Act of 1970

History of "affirmative determination"
The term "affirmative determination", which appears in the definition of naked short selling in our lead section, seems to have originated in 1990 amendments to the NASD Board of Governors' Interpretation on Prompt Receipt and Delivery of Securities, requiring members making a sale "for their own proprietary account or the account of a customer" to make such affirmative determinations as to stock availability. (See NASD Notices 90-51, link below). The term was intended to distinguish an actual determination associated with a sale from "blanket" or standing assurances that securities are available for borrowing (typically the latter would consist of a fax message listing borrowable stocks for that day). The affirmative determination involved recording the name of the person contacted and the number of shares for each sale.

Although the requirement applied to both short and long sales, an associated annotation requirement applied only to long sales. In September 1994 the SEC approved a rule change to close the loophole, and from November of that year members were also required to annotate the affirmative determination (which they were required to carry out anyway) for a short sale. (See NASD Notices 94-80, link below)

There were exemptions to these requirements--as now.
 * The 1990 rule change noted exemptions "(1) in corporate debt securities, (2) for bona fide market-making transactions by a member in NASDAQ securities for which it is a registered market maker and in non-NASDAQ securities for which it publishes a two-sided quotation in an independent quotation medium, and (3) for transactions that result in fully hedged or arbitraged positions."
 * In making the 1994 rule change, NASD noted that the change "does not modify any exemptions from the affirmative determination requirements that are presently in the Interpretation. Specifically, transactions in corporate debt securities, bona fide market making transactions by members in securities in which they are registered as Nasdaq® market makers, bona fide market-maker transactions in non-Nasdaq securities in which the market maker publishes two-sided quotations in an independent quotation medium, and proprietary transactions by members that result in fully hedged or arbitraged positions, are still exempt from the affirmative determination requirements for short sales."


 * 90-51 SEC Approval of Amendment to Board of Governors' Interpretation on Prompt Receipt and Delivery of Securities
 * 94-80 SEC Approves NASD Proposal Requiring Members To Annotate Their Affirmative Determinations As To Stock Availability Made In Connection With Short Sales

Uptick rule

 * Under the 1934 Act, introduced the Uptick rule or "price test" (Rule 10a-1) for short sales.
 * This was abolished by SEC in July, 2007. SEC thenceforth prohibited any self-regulatory organization ("SRO") from having a price test.
 * This was after a two-year experiment 2005-2007 during which 1,000 so-called Pilot Stocks were made exempt from the uptick rule.

Regulation SHO

 * Spotlight On: Short Sales
 * All the major SEC stuff on Regulation SHO and short sales in general is here
 * Regulation SHO full text, Securities Lawyer's Deskbook 

Failure to deliver
In Key Points About Regulation SHO, the SEC uses a definition different from the one in the current lead above (this isn't to say ours is wrong, it's just different):


 * In a "naked" short sale, the seller does not borrow or arrange to borrow the securities in time to make delivery to the buyer within the standard three-day settlement period. As a result, the seller fails to deliver securities to the buyer when delivery is due (known as a "failure to deliver" or "fail").

Thus it seems that the SEC adopts the approach that you don't know a naked short until a "failure to deliver" occurs, while Wikipedia currently adopts the approach that a naked short is any short sale in which the Prompt Receipt and Delivery of Securities requirements of NASD are not followed (or which is exempt from the requirements--a diminishing subspecies!) This applies to the March 9 version of the article. "Affirmative determination" wording was later removed.

Regulation SHO FAQ
In Responses to Frequently Asked Questions Concerning Regulation SHO, the SEC defines short selling in passing as "selling short without having borrowed the securities to make delivery". This is a very loose definition that--if interpreted literally--would include many short sales in which NASD's Prompt Receipt and Delivery of Securities requirements had been followed both to the letter and the spirit by making and fully annotating the required affirmative determination. For that reason--and because the definition is given in a parenthetical clause to the main statement, it probably shouldnt be taken too seriously. But it does illustrate the very loose way in which the term has been used.

DTCC

 * Industry issues: Naked Short Selling is their web-based collection of items on the subject

That page also contains a definition of naked short selling:
 * Naked short selling is selling stock you don't own, but not borrowing it and making no attempt to do so.

This is close to SEC's definition.


 * Naked Short Selling and the Stock Borrow Program, Q&A with DTCC First Deputy General Counsel Larry Thompson
 * Status of Litigation Current status of litigation against DTCC involving naked short selling.
 * Has not been updated since May, 2006.
 * Lists 14 filed cases, none of which appear to have prevailed. Some not served on DTCC, others DTCC defendants were dropped from the case, or dismissed by motion by the defendants. One dismissal (Whistler Investments, Inc. v. DTCC, et al.) under appeal in the 9th Circuit.

SEBI
According to The Hindu Business Line, Securities and Exchange Board of India (SEBI) defines naked short selling as
 * The illegal practice of short selling shares that have not been affirmatively determined to exist. What is short selling?, Business Line, December 23, 2007

Definitions given by individuals
These are various definitions given by people. They aren't intended to impute prominence or authority to any person, they're simply stuff I pulled out of links from the current revision of our article. Some of these definitions are off the cuff and deliberately oversimplify, as is to be expected in discourse.

Bob Bennett

 * I am talking about a practice that occurs in the stock market that has the very interesting name of naked short selling. That conjures up all kinds of interesting images in many people's minds, but this is what it is: It is a practice where somebody sells short a particular stock and never ever has to cover the sale. Senator Bennett Discusses Naked Short Selling on the Senate Floor, Bob Bennett, July 20, 2007

Karl Thiel

 * Karl Thiel, Bio and Archives
 * The Naked Truth on Illegal Shorting
 * While legal short sellers must borrow the shares they sell, naked short sellers sell shares of stock they haven't borrowed, have no intention of borrowing, and that may not even exist.

Holman W. Jenkins Jr

 * a journalist, editorial writer and member of the Wall Street Journal Editorial Board. He writes the weekly "Business World" column appearing every Wednesday. Aside from his writings in The Wall Street Journal, he has also written for Policy Review and National Review''.
 * Briefly, legitimate short selling occurs when a speculator borrows shares and sells them, hoping to buy them back later at a cheaper price. Naked shorting is selling stock without having it or making plans to borrow it. Do Nudists Run Wall Street?, April 12, 2006

Christopher Cox

 * The need for Regulation SHO grew out of long-standing and growing problems with failures to deliver stock by the end of the standard three day settlement period for trades, some of which were symptoms of abusive "naked" short selling. Selling short without having stock available for delivery, and intentionally failing to deliver stock within the standard three-day settlement period, is market manipulation that is clearly violative of the federal securities laws. Speech by SEC Chairman: Opening Statements at the Commission Open Meeting, July 12, 2006

Cox here is targeting the unequivocally illegal side of short selling.

Floyd Norris

 * The 5-to-0 vote, ending a rule that had been in place since 1938, when short sellers were blamed by some critics for having caused the 1929 market crash and the Depression that followed, came as the commission also voted to make it harder to engage in naked shorting, the practice of selling shares that have not been purchased or borrowed. -S.E.C. Ends Decades-Old Price Limits on Short Selling, New York Times, June 14, 2007

Joe Nocera

 * A typical short seller, who is betting that a stock is going to decline, borrows shares at a high price and then buys them when the price drops, pocketing the difference. A naked short seller, on the other hand, doesn’t bother to borrow the shares within the allotted settlement period --Revisiting Overstock.com and Utah, Talking Business column, New York Times, March 10, 2007

Opinions
Including an opinion on this list isn't intended as a statement about its significance. It just means that I was able to ascertain somebody's stated opinion on something and decided to record it.

Impact

 * Chris Cox: "We will be discussing the close-out requirement this morning. This requirement, among other things, targets potentially abusive "naked" short selling. Generally, this abusive practice, which involves selling short while knowingly and intentionally failing to have stock available for delivery within the standard three-day settlement period, is a fraud that the Commission is bound to prevent and to punish."
 * Bob Bennett: Now, people who hear the complaints about naked short selling say: It only represents a tiny percentage of the trillions of dollars' worth of trading activity that goes on in American markets every day. They are right. It is only a tiny percentage. But that is small comfort to those who have gotten a few dollars together, formed a business, gone to the market to try to raise some capital to support the business, put on the marketplace, say, 25 percent of their shares, holding the other 75 percent for themselves, and then getting some support in the market so that the shares edge up from 25 cents to 50 cents to $1, to $1.25 and then suddenly see the short sellers come in and say: OK, we will drive that stock back down from $1.25 to 2.5 cents, and we will do it by selling stock that doesn't exist and in the process we will ruin the company.

Theory

 * Efficient market hypothesis
 * Behavioral economics
 * Capital asset pricing model (CAPM)
 * Arbitrage pricing theory

An interesting review of the literature and the law on naked shorting is given in an unpublished paper: Christopher L. Culp (Lexecon, Inc.) and J.B. Heaton (Bartlit Beck Herman Palenchar & Scott LLP), "Naked Shorting" (April 26, 2007).


 * Christopher Culp
 * J.B. Heaton

In the introduction, Culp and Heaton note:
 * According to widespread conventional wisdom, short selling drives down the price of the stock being sold. The SEC consistently receives excited opposition to the practice of short selling, much of which invokes accusations of conspiracy theory and nearly religious fervor against short selling in general and naked short selling in particular. At the same time, financial economists have long been skeptical of the value of regulations that constrain speculative short selling because of a conviction that short sale constraints may allow overpriced securities to remain overpriced.

Their footnote for this says:


 * ''The classic explanation is put forth in Edward M. Miller, “Risk, Uncertainty, and Divergence of Opinion,” 32 J. Fin. 1151 (1977) (describing the role of short sale constraints in allowing prices to reflect the opinions of a badly informed minority); see also Michael Harrison and David Kreps, Speculative investor behavior in a stock market with heterogeneous expectations, 92 Quarterly J. Econ. 323 (1978).; Douglas W. Diamond and Robert E. Verrecchia, “Constraints on Short–selling and Asset Price Adjustment to Private Information,” 18 J. Fin. Econ. 277 (1987); Joseph Chen, Harrison Hong, and Jeremy Stein, “Breadth of ownership and stock returns,” 66 J. Fin. Econ. 171 (2002); Charles M. Jones and Owen A. Lamont, “Short-sale constraints and stock returns,” 66 J. Fin. Econ. 207 (2002) (finding that stocks that are expensive to short or which enter the borrowing market have high valuations and low subsequent returns); Harrison Hong and Jeremy Stein, “Differences of opinion, short-sales constraints and market crashes,” 16 Rev. Fin. Studies 487 (2003); José Scheinkman and Wei Xiong, “Overconfidence and speculative bubbles,” 111 J. Pol. Econ. 1183 (2003); Harrison Hong, José Scheinkman, and Wei Xiong, “Asset Float and Speculative Bubbles,” 61 J. Fin. 1073 (2006); Lauren Cohen, Karl B. Diether, and Christopher J. Malloy, “Supply and Demand Shifts in the Shorting Market,” unpublished working paper, May 9, 2006, available at fisher.osu.edu/~diether_1/papers/shifts.pdf.

Culp and Heaton go on to argue that there is little meaningful economic distinction between permissible short selling and illegal naked short selling, but nevertheless go on to show how the law on short selling can be used as a basis for suits by long sellers and, in some cases, issuers.

Anomalies
From a presentation by Mark Rubinstein:


 * overpricing of IPOs
 * “Monday effect”
 * momentum factor in stock returns
 * stocks with high turnover have lower returns
 * high beta stocks have too low returns
 * closed-end fund discounts
 * smirk in index option prices
 * excess volatility of stock returns
 * asymmetry of market crashes over market rises
 * Internet bubble

History of manipulative short selling
Not all of this relates directly or solely to naked shorts.

Notes from Finnerty (2005)

 * Finnerty, John D., "Short Selling, Death Spiral Convertibles, and the Profitability of Stock Manipulation" (March 2005).


 * Available at SSRN: http://ssrn.com/abstract=687282 or DOI: 10.2139/ssrn.687282

History of market manipulation through short selling "dates back to the origins of organized stock markets".


 * Bear pools operated on the Amsterdam Stock Exchange during the late seventeenth century, carefully timed bear raids to maximize selling pressure. Planting false rumors to drive the stock price down.


 * Similar problems on London Stock Exchange led to Westminster passing a law prohibiting short selling in 1734.
 * "The law was not repealed until 1860, and short selling was not specifically authorized under English law until 1893"
 * 1920s, 1930s, large investment pools concentrate short selling for maximum impact
 * "Manipulative short selling was blamed for causing the Great Crash, although a subsequent Senate investigation found that other factors played a bigger role in causing the crash."
 * House Report No. 102-414, in 1991 found that manipulative short sellers sometimes instigated an SEC investigation to drive a stock's share price down.
 * Jacob Little, "Great Bear of Wall Street" (nineteenth century). Sell short, spread insolvency rumors, cover position from the resulting drop in share value

Finnerty's paper reviews manipulative short selling and argues that floating price convertible securities can be used by speculators to resolve the unravelling problem and thus facilitate the intensification of manipulative sort selling.

Biovail

 * "60 Minutes Blows Biovail Story: SEC sues drug maker Lesley Stahl defended" Dean Starkman, CJR, 26 Mar 2008

The background to this piece is this 60 Minutes segment presented by Lesley Stahl aired by CBS News in March, 2006 about a lawsuit brought by Canadian pharmaceuticals firm Biovail against a Connecticutt-based Hedge Fund, SAC Capital, which it claimed was conducting a bear raid on its stock.

The latest news is that it turns out that the SEC has now sued Biovail. . One thing 60 Minutes apparently missed stated, but not prominently, was that the company had been under SEC investigation since 2003 (and had quite properly announced this fact to its shareholders promptly).

Biovail also settled the SEC suit promptly.

This case doesn't involve naked shorting. Not all manipulative short selling, real or imaginary, is naked.

Ouch!

Non-US items

 * ASIC Release - Short Selling (ASX)
 * Short shrift for short sellers (commentary) Australia
 * Negative sentiment: Short-sellers under ever closer scrutiny Analysis piece in FT