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Friday, July 18, 2008

SEC Selectively Enforces Naked Short Selling Regulation

The SEC recently made a rather bizarre announcement. It was going to start stricly enforcing the ban on naked short selling, but only for FRE, FNM, and other financial stocks. That's like declaring "Stealing is illegal, but the police are instructed to enforce it only if you steal from our friends."

In a normal short sale, the trader borrows shares and sells them. A fee is usually paid to whoever loans the shares. The person buying the shares gets actual shares. The person owed shares validly lent out his shares.

In a naked short sale, the trader doesn't borrow shares. The person buying the shares gets a "failure to deliver" instead of actual shares. Instead of borrowing from someone, the naked short seller is forcing the buyer to loan him shares.

To illustrate the problem, consider this example. You buy a sofa. The seller charges your credit card for the purchase. Instead of delivering an actual sofa, the seller gives you a piece of paper that says "IOU one sofa." You would say "Where's my sofa?" The seller says that he "naked short sold" you a sofa, and what he did was perfectly legal.

Naked short selling is literally counterfeiting. The naked short seller is manufacturing extra shares of the stock and selling them, driving down the price. The naked short seller avoids paying stock borrowing fees. If there are no shares available for borrowing, then the naked short seller is forcing the buyer to loan him stock.

The stock clearing and settlement system treats "failure to delivers" as equivalent to actual shares. If you're the victim of a naked short sale, you never find out. Your broker has no obligation to tell you that a failure to deliver occurred. You can sell your shares as if you owned them.

The only distinctions are:

  1. If you get dividends, they count as ordinary income instead of qualifying for the favorable tax rate.
  2. If you try to vote your shares in the annual meeting, you can't vote them. You don't actually own your shares, so you don't get a vote. (There have been occasions where a corporation had trouble conducting their annual meeting, because they couldn't figure out who actually owned shares and who owned "failure to delivers".)
  3. The share price is artificially depressed, because the naked short seller is counterfeiting stock.
A naked short sale can happen by accident, due to a miscommunication. If it's an accident, then it is usually immediately corrected.

However, naked short selling can happen on purpose. If there is reason to doubt a corporation's finances, as is the case with FRE and FNM, then traders want to short sell. If there's no shares available for borrowing, then it pays for traders to start naked short selling.

Naked short selling damages the legitimate shareholders of the corporation. Suppose management of FRE or FNM want to raise capital by issuing more shares or convertible preferred stock. Due to the suppressed stock price, they can't do this at a favorable price. Naked short selling makes it hard for the victim corporation to raise capital.

However, corporations usually are the victim of naked short selling only if there are legitimate concerns about their business.

When a trader naked short sells on purpose, this is called "strategic naked short selling". The trader is intentionally breaking the law, hoping to profit.

The SEC has declared that strategic naked short selling is illegal. However, there is no penalty for naked short selling. If something is illegal, but there's no penalty, then it's effectively legal.

Due to "confidentiality rules", the SEC refuses to say who is naked short selling, and by how much! By refusing full disclosure of naked short selling, the SEC is protecting naked short sellers! If the SEC provided full disclosure about naked short selling, then it would be much riskier to naked short sell. Naked short sellers could be victimized by a "short squeeze" when other people buy to force short sellers to cover.

If the SEC were serious about stopping negative short selling, there are several easy rules they could pass. The SEC has not done this, which indicates they are not serious about stopping naked short selling.
  1. Publish a list of violators. For each failure to deliver, publish the stock, the broker, and number of shares.
  2. Fine violators. Each naked short sale has a mandatory fine of $0.01 per share per day, or in extreme cases (such as the SHO list), $1 per share per day. For accidental naked short selling, this would not be a burden. This would make strategic naked short selling unprofitable. (The list of "Regulation SHO" stocks are stocks that have a chronic problem of failure to delivers. This is usually an indication of strategic naked short selling.)
  3. Require brokers to notify customers when they are the victim of a "failure to deliver".
With FRE and FNM, the SEC decided to selectively enforce the law. Passing regulations without a penalty for violating them is pointless. When the SEC behaves in such an irresponsible manner, it undermines the legitimacy of government. The SEC is doing a great job!

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