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Expert Financial Analysis and Reporting

Part 5 in Series on Illegal Naked Shorting’s Role in Stock Manipulation: Traditional Shorting Compared to Naked Shorting (Both Legal and Illegal)

Introduction

 This is the fifth blog in the series that I am writing to describe how illegal naked shorting is used broadly and massively to manipulate the stock prices of (primarily small) companies. I have been studying illegal naked shorting for nearly five years and I have found it to be incredibly complex and disturbingly it is widely practiced on Wall Street. My earlier blogs were intended to build a foundation needed to understand future blogs.

I am moving on in this blog to describe how illegal naked shorting is done and why securities laws and regulations have been almost totally unable to stop it. In this and upcoming blogs, I will be trying to interpret complex legal issues and it is necessary to issue a few precautionary warnings:

  • The securities laws are very complex and obviously I am not a trained lawyer. The SEC and the financial industry hire legions of lawyers to write and interpret these laws. As a layman with no training in the law, there is much that I do not know or understand.
  • The hedge funds and market makers who engage in widespread illegal naked shorting have been perpetrating this scheme for nearly three decades and have honed their skills to the point that they make Swiss cheese out of laws on illegal naked shorting by sculpting incredibly sophisticated strategies to avoid detection.
  • The data that is needed to determine the extent of illegal naked shorting is held in non-transparent, proprietary data bases lodged with the Prime Brokers and DTCC (owned by Prime Brokers) who tightly guard and block access to this data.
  • The illegal trades are done in a Wall Street that is now dominated by high frequency and algorithmic directed computer trading and is conducted often in dark pools in which trades are not reported publicly. Much illegality can be and is conducted in this shady environment. We outsiders can have no idea as to what is going on, nor apparently does the SEC.

It is probable that I will make some mistakes and misstatements in my future discussions. If this occurs and is pointed out to me I will welcome the information and correct errors. I am one person trying to come to grips with an issue that an entire agency of the federal government, the SEC, has proven almost totally ineffective or uninterested in dealing with.

In this report, I discuss traditional short sales and also legal and illegal naked shorting as well as a brief overview of Regulation SHO, the regulation passed in 2005 that has attempted (with almost no success) to curb illegal naked shorting.

Securities Laws Relating to Short Selling

Congress passed the Securities Act of 1933 and then in the Securities Exchange Act of 1934, it created the Securities and Exchange Commission (SEC). This was in response to the 1929 market crash and the goal was to help investors feel more comfortable about putting their money back into the stock market. The SEC is an independent federal government agency responsible for protecting investors, maintaining fair and orderly functioning of securities markets and facilitating capital formation.

There was a widespread belief that short selling had been major factor in the 1929 market collapse and this led to legislation in 1938 that addressed short selling. There was no further change in legislation until 2005 when Regulation SHO was implemented specifically to address naked shorting issues.

As I reported in an earlier blog, the system for clearing securities that existed until the 1960s was based on delivering paper securities in exchange for cash. This system was overwhelmed by a surge of trading and led to a dramatic change in the system. The result was that the system converted to a paperless system in which investors exchange electronic data entries instead of stock certificates. While this electronic solution was and is critical to the functioning of capital markets and the economy, huge loopholes enable widespread illegal naked shorting and stock manipulation, which would not have been possible in the pre-electronic age

Two of the key elements of Reg SHO among several are:

  • The locate requirement that requires a market maker to have reasonable belief that the equity to be short sold can be borrowed and delivered to a short seller on a specific date before short selling can occur.
  • The close-out requirement represents the increased amount of delivery requirements imposed upon securities that have experienced many extended delivery failures at a clearing firm. These are primarily companies targeted by short selling hedge funds.

Unfortunately, there are numerous exemptions which allow market makers and hedge funds to skirt the rules. Despite the intention to stop or control illegal naked shorting, Reg SHO is riddled like Swiss cheese with loopholes that enable widespread, illegal naked shorting. In my opinion and many others, it is largely ineffective. As a consequence, the manipulation of (particularly small) stocks with illegal naked shorting is a huge, highly profitable, fast growing and routine business on Wall Street.

What Is a Traditional Short Sale?

 Short selling is a legal investment strategy regulated by the SEC which I discussed in Part 2 of this series. In this transaction, the short seller is selling a stock that he does not own. Here is how it is supposed to work:

  • The broker for the short seller locates and borrows  shares of stock from a broker dealer,
  • The borrowed shares are then sold to a buyer of the stock and in exchange the short seller receives cash
  • At a future date, the short seller has to buy back the shares in the open market and return them to the account from which they were borrowed. This is referred to as closing out or covering the short sell.
  • If the price of the security drops as the short seller expects, he can purchase the stock in the open market at a lower price and keep the difference from the cash he has already received as profit.

The SEC has publicly stated that short selling benefits the market and sanctions the practice. It believes that short selling improves market liquidity by increasing the number of sellers in the market. The SEC argues that if there is a shortage of sellers in the market, market makers can use shorting to make more shares available to purchasers and improve liquidity. It says that this lowers the risk that the price paid for the shares will be artificially high due to a temporary shortage of stock available for sale. I find this a rather strange argument because I can argue with equal conviction that this creates an artificially large supply of shares for sale that depresses the stock price to the detriment of investors who own the stock. Indeed, this is exactly what the illegal naked short schemes do.

What Is a Naked Short Sale?

In a traditional short sell, the short seller borrows the stock from another investor who is long the stock before selling the borrowed shares to another investor. In naked shorting, a market maker sells “phantom” shares to a buyer without having borrowed the stock. Regulation SHO defines certain situations in in which naked short selling is allowed. For example, it gives a broker-dealer three days from the date of the trade to settlement (referred to as T+3) to locate and borrow shares. If this is done, the phantom shares are replaced with legitimate shares that are borrowed. In contrast, a traditional short sell requires borrowing the shares before the short sale.

The SEC believes that this type of naked shorting increases liquidity. Remember that market makers in a security are required to make a quoted offer to sell and a bid to buy at all times even if there are no buyers and/or sellers. The SEC argues that if the market is moving quickly with a lot of buy orders coming in, the market maker can agree to sell stock even if they can not immediately locate stock to borrow. Selling stock that the market maker does not own and has not borrowed results in a temporary Failure to Deliver (FTD). This is legal if the stock can be located and borrowed before settlement (T+3). Other parts of Reg SHO provide extensions that in certain cases allow longer periods for market makers to locate and borrow stock. However, I don’t want to make this discussion overly complicated so I will deal with these exceptions later.

It may be easier to understand the difference between traditional shorting and naked shorting if we use numbers to illustrate this idea. Let’s hypothesize that a short seller wants to short 100,000 shares of XYZ. In a traditional short sell:

  • Through a broker, they borrow 100,000 shares of XYZ
  • The short seller then sells the borrowed 100,000 shares to another investor and receives cash
  • The short seller has an obligation to buy and return the 100,000 shares of XYZ at some future point

In contrast, here is how the naked short sell works

  • The market maker representing the short seller sells 100,000 “phantom” shares without borrowing them and receives cash from a buyer at settlement (T+3) even if they can’t locate stock to borrow.
  • If the market maker can’t locate stock to borrow by T+3, it has artificially created 100,000 shares of stock that the Company has never registered. These are phantom or counterfeit shares
  • If the 100,000 shares can be located and borrowed in three days, there is no effective difference from a legal short sale and the phantom shares disappear.
  • If the 100,000 shares can not be located and borrowed by T+3, this is called a Fail to Deliver. There are now 100,000 counterfeit shares trading in the market alongside legitimately registered shares that are undistinguishable from each other. The share base of the Company has been increased by 100,000 without its knowledge, understanding or approval.
  • In effect the naked short seller has unilaterally converted a securities contract which should settle in three days after the trade date into an undated futures-type contract. This allows the naked short seller to deliver the shares at a future date when it is in his own best interest to do so, i.e. after the stock price has been driven down.

Illegal Naked Shorting

The SEC publicly states that naked shorting plays an important role in the functioning of the stock market by improving liquidity. (I can make a strong counter argument that this allows a collaboration between hedge funds and market makers to swamp the market with sell orders and decimate the stock price of a targeted company.) The SEC recognizes that Fails to Deliver may be indicative of illegal naked shorting if they are prolonged beyond T+3, lasting for weeks, months or years. Such shares are counterfeit because the company never registered or sold them and if the FTD is not corrected, these counterfeit shares are traded as if they are legitimate shares. This is blatantly illegal and later I will go into how this is perpetrated by hedge funds acting in concert with Prime Brokers and the DTCC (owned by Prime Brokers).

Illegal naked short selling allows hedge funds acting in concert to flood the market with phantom or counterfeit sales of a targeted company’s shares. They can sell an unlimited number of phantom or counterfeit shares to overwhelm natural buying interest in a stock. The object of this manipulation scheme is to drive the stock price down allowing the short seller to cover at much lower prices. The Holy Grail is to drive a company into bankruptcy and never have to cover. The hedge fund, Prime Broker/ DTCC collaboration has devised many strategies for illegal naked shorting, many of which I will discuss later.

 

 


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