Covering Up Naked Shorts
By Harvey Pitt
July 11, 2006

As crisis after crisis afflicts the business community and our capital markets, all too often the response is a form of reverse laissez faire. Business waits for government to tell it three things: if it has done something wrong, why it's wrong and how to fix it. The ineluctable result is that, like Rick's crooked police pal, Captain Renault, in the movie Casablanca, we're "shocked, shocked to discover" we don't like the government's responses.

Unfortunately (or fortunately, depending upon one's perspective), the business community's repeated crises has given it an opportunity to modify its laissez faire attitude. But so far, it hasn't shown the resolve.

A case in point is the current crisis in short-selling. Short-selling is a useful and critically important capital market phenomenon, but only if done appropriately. Among other things, it provides essential liquidity in thinly traded stocks, enables thoughtful traders to limit the degree of risk to which their portfolio holdings are subject and serves as an effective counterbalance to the herd mentality too many analysts and investors exhibit.

In a real sense, short-sellers are marketplace lone wolves (or, more precisely, lone bears), ignoring the herd, trading against conventional wisdom and sometimes uncovering real corporate frauds far ahead of self-regulators, regulators, prosecutors or even plaintiffs' attorneys. On the other hand, companies have been victimized by professional short-sellers, some of whom, on occasion, resort to dubious tactics--and even market manipulation--to ensure the success of their bearish gambles.

The problem with our current short-selling paradigm isn't short-selling itself, as many CEOs might prefer to believe. It's the ability of short-sellers to sell stocks they haven't actually borrowed in advance of their short sale. It's a phenomenon described, somewhat lasciviously, as "naked" short-selling. Naked shorts expose sellers and those "linked" to the sales to the risk that, when settlement day arrives and shares must be delivered, the short-seller won't have the necessary shares available.

The U.S. Securities and Exchange Commission recognizes this is a problem, but its efforts thus far haven't generated much success. In 2004, the agency adopted Regulation SHO, which, among other things, requires short-sellers and their brokers to have reasonable grounds to believe securities being sold short can be "borrowed so that [they] can be delivered at settlement."

What constitutes "reasonable grounds?" That depends on whom you ask. Many prime brokers, for example, satisfy the requirement of reasonable grounds by assuming that, if large long positions reside somewhere in-house, they can borrow from those long positions without bothering to check if the shares are actually available for borrowing and without ascertaining if those same shares have already provided reasonable grounds to permit another short sale of the same security.

This can lead to "over-shorting" of securities, a phenomenon in which the number of shares shorted can even exceed the number of shares physically available for trading. To combat naked shorting of heavily shorted securities, technically known as "threshold" securities, the SEC's rule requires brokers planning to effect a short sale in a threshold security to have in place, prior to shorting, a definitive arrangement to borrow those shares.

In addition, in May 2006, self-regulatory organizations adopted SEC guidance that any shares bought-in by a broker to satisfy undelivered shorted shares must be applied to the earliest undelivered shorts. This essentially requires brokers to buy-in all shares they've failed to deliver once any shares must be bought-in. In January 2005, there were 520 threshold securities. Today, even with the SEC's efforts, there are still 235, including some that were on the list of threshold securities back when the concept was first created. On Wednesday, July 12, the SEC takes its third stab at trying to solve the problem.

Because of the legitimate concerns this situation engenders, state governments are roiling the waters. Utah has adopted its own law to dictate how short transactions should be effected, and Connecticut has threatened to enter the fray as well. We're in danger of facing a quilted patchwork of state regulations to govern an important facet of what are uniquely national (and global) markets.

At the same time, plaintiffs' lawyers are pressing lawsuits accusing brokers of collecting fees for lending shares to short-sellers without actually having borrowed the shares. If these allegations are proved, the result could be a black eye for the brokerage community, large payments to aggrieved parties and much tighter regulation.

The securities industry and clearing agencies don't seem to recognize that it's only a matter of time before these problems catch up with them and kill off the goose that is, at present, laying very golden eggs. The securities industry needs to seize control and propose effective remedies to increase transparency in stock lending and borrowing.

Securities and clearing firms need to act quickly. Or else they, to paraphrase Will Rogers, will have to be content to live with even more government than they're already paying for.

Harvey L. Pitt is the CEO of Kalorama Partners. He was chairman of the SEC from 2001 to 2003, currently serves on the audit committees of Approva and the National Cathedral School, and writes a monthly column for ComplianceWeek.

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