Financial Regulatory Forum

ANALYSIS-Enforcement key to curbing naked short selling

By Reuters Staff
July 30, 2009

By Leah Schnurr
NEW YORK, July 29 (Reuters) – Efforts by U.S. securities regulators to clamp down on an abusive type of short selling could help prevent manipulation in the market, but the rules amount to nothing without better enforcement.

It is also a question of how widespread trading known as naked short selling is, as a push toward increased market regulation has made it more difficult to execute.

The Securities and Exchange Commission on Monday finalized a rule intended to restrict naked short selling, which happens when an investor sells a stock they have not actually borrowed.

“It has some merit to it and it has some promise,” said Dylan Wetherill, founder & president of ShortSqueeze.com. “However the actual implementation and the effectiveness of the actions they take to enforce it is yet to be seen.”

Normally, short investors borrow and then sell a stock they expect will fall in value. The strategy is to buy the stock back at the lower price and pocket the difference.

While naked shorting is illegal, it still occurs and can be an attempt to push stock prices down without needing to worry about the normal supply and demand of a share. It can also deprive the investor who agreed to buy the share of dividends and voting rights, if the seller fails to deliver in a timely manner.

To combat this, the SEC finalized a rule that was set to expire at the end of July that requires investors to deliver their shares within three days of shorting the stock. The aim is to ensure the shares are actually in the investor’s possession.

Even so, analysts said the key issue is enforcement.

“You have to make sure that when someone shorts a stock…that that individual or entity must go out first and borrow the shares,” said Michael Pento, chief economist at Delta Global Advisors.

“Otherwise, it’s a form of counterfeiting. You’re selling shares you don’t borrow or have any intention of covering and it’s tantamount to manipulation.”

Short investors can also unintentionally end up with a naked bet if the stock they are trying to sell is thinly traded and they are unable to borrow it.

“I think they are going to enforce it,” said Bill Rhodes at Rhodes Analytics in Boston.

“The question is are they going to make a distinction between the people who got short naked by accident and the people who are doing this on purpose?”

It is difficult to gauge the impact of naked positions on the market and who is doing them. The SEC says the number of transactions that were deemed as failures to deliver has decreased by about 57 percent since the fall of 2008, suggesting naked short selling is declining.

“It’s almost impossible to sell a stock without having borrowed it these days,” said Bill Fleckenstein, president at Fleckenstein Capital Inc in Seattle.

“Most reputable brokers, if you don’t get a borrow by the end of the day, they’re just going to break the trade.”

The SEC also said it is working with the industry’s self-regulatory organizations to improve the transparency of short sales by providing more public information.

The organizations are expected in the next few weeks to begin putting on their websites the aggregate short selling volume for each stock for that day. They will also publish information on short sale transactions on a one-month delayed basis.

The SEC will also begin providing information on fails to deliver twice a month for all equities, regardless of the fail rate.

Short sellers generally like to keep their bets close to the chest so as not to tip off others to their positions. The more public data could make the short investor’s job somewhat harder.

“It makes the short a little more vulnerable, but at the same time it provides the market with a lot better information about what’s going on,” said Rhodes.

“The benefit is your information about where the market is is much more timely.”
(Editing by Andrea Ricci) ((leah.schnurr@thomsonreuters.com; +1 646 223 6026; Reuters Messaging: leah.schnurr.reuters.com@reuters.net)) Keywords: USA MARKETS/NAKEDSHORTS

Wednesday, 29 July 2009 13:19:03RTRS [nN28148303] {C}ENDS

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