Noront Resources

In the case of legitimate short selling, the short seller borrows stock and sells it, hoping to buy it back at a lower price before he returns it to the original lender of the stock.

However, in practice, due to a loophole in the current system, all monies are first exchanged and settlement of the stock may occur several days later.

The intent is that the short seller first issues an IOU for stock to the buyer with the understanding that he will buy stock as soon as possible to eliminate the IOU. The IOU is treated exactly like a stock and the new holder of the IOU is unaware of the difference.

While there may be legitimate reasons for the delay, the naked short seller knowingly issues IOUs without any intention of replacing them with stock. This fraudulent stock transfer is known as a strategic failure to deliver (FTD) – strategic in the sense that it was deliberately planned.

The immediate result of these FTDs is that the stock price is depressed due to the increased apparent supply of stock. This can drive a stock to a penny-stock status thereby destroying shareholder equity. One prolific writer has long speculated on the naked shorting practices used within the commodity exchanges, notably the COMEX to suppress the price of silver.

A paper by Dr. John Finnerty at the Fordham University in March 2005 found that the current system was “… conducive to manipulative short-selling.” In his paper he states, “…naked short selling can routinely occur within the securities clearing system in the United States…”, that it is “particularly effective and damaging…” and has a “… potentially severe market impact…”.

Under the Freedom of Information Act (FOIA) the SEC has released data related to the occurrence of FTD’s in the system suggesting that over 8% of all trades on the NYSE and NASDAQ fail to deliver. This data only did not include failures to deliver of fewer than 10,000 shares, nor did it include ex-clearing information of stock being exchanged directly between broker houses without using the Depository Trust & Clearing Corporation (DTCC) as an intermediary.


Regulation SHO

In January 2005 the SEC effected a regulation designed to tighten the loophole that allows naked shorting to occur. However, three clauses clearly demonstrate the lack of will on the part of the SEC to clean up the practice of failing to deliver.

I. The Grandfathering Clause

The regulation grandfathered those FTDs that were already pre-existing. This can be found under Section IV.F of the regulation. The stated reason,

“The grandfathering provisions of Regulation SHO were adopted because the Commission was concerned about creating volatility where there were large pre-existing open positions.” (SEC: Key Points About Regulation SHO, Section IV-F)


II. Mandatory Close-Out of Threshold Securities

Under section IV-A.6 the SEC states that a broker or dealer may not effectively naked short for more than 13 days. If they do so, in order to further sell sales they are required to enter a bona fide agreement to borrow the security.


III. Illegal Trading "Strategies" Protected as Proprietary Information

Farther down, under section V.11, the number of FTD’s issued by a particular firm is considered to be proprietary information.

“The fails statistics of individual firms and customers is proprietary information and may reflect firms' trading strategies. The release of this information could be used to engage in unlawful upward manipulation of the price of the securities in order to "squeeze" the firms improperly.” (SEC: Key Points About Regulation SHO, Section V-11)


IV. The Key Questions to Ask

1) Why is the SEC unwilling to release information on pre-existing FTD’s? The use of the word “volatility” a euphemism for collapse, suggests that the current system would be damaged somehow if the public was aware of the real number of FTD’s present. For instance, suppose the number of FTD's exceeded the number of actual genuine stock available and the original issuer of the FTD was forced to buy up his naked shorts. The sudden uptick in demand would result in a phenomenon known as a "short squeeze". This could result in the brokerage declaring insolvency and represents a potential systemic risk that could collapse the entire system.

2) What is the stated penalty for naked short selling within Regulation SHO?

3) Why illegal stock transactions are protected from the public? Why is it that downward manipulation of stock is protected by law because it is considered “proprietary” and not released because it may be used as an upward stock manipulation by “squeezing” the naked short seller? Why protect the one and not the other? Could it be that the SEC is a captured regulator by the massive hedge funds? It seems that money flowing into Wall Street from the general public receives less protection than the stock manipulations of the hedge funds and Wall Street firms that can issue fraudulent stock as a “proprietary trading strategy”.


V. Additional Information

This article was inspired by “The Darkside of the Looking Glass: Corruption in Our Capital Markets” an online slideshow that explores the phenomenon of naked short selling. I highly recommend watching the one-hour presentation.

The NCANS (National Coalition Against Naked Short Selling) website provides a useful link on naked short selling. An introduction explaining the mechanism of naked short selling is available here.

The Sanity Check is another market reform movement with useful information on issues of market manipulation and naked short selling.