Naked Before Byrne

By Kevin Kelleher
TheStreet.com
August 18, 2005

Naked shorts. There's something about those two words that begs for sensational coverage. But the scarcity of hard data on the illicit trading tactic so far has only polarized the debate on how serious a problem it has become.

Since TheStreet.com ran a story questioning whether a new law aimed at curbing naked short-selling was being enforced, the topic has become something of a media phenomenon. Not really because of TheStreet.com, but because of Overstock.com (OSTK:Nasdaq) CEO Patrick Byrne, who is like watching Lost -- always entertaining if sometimes a little hard to follow.

In what will surely go down as one of the least orthodox investor calls ever, Byrne set out to explain a lawsuit his company filed against Rocker Partners, a high-profile hedge fund.

Along the way, he described what he called a "Miscreants Ball," where hedge funds like Rocker waltzed with regulators, research firms and journalists at Barron's, The Wall Street Journal and, yes, TheStreet.com. Byrne also made shoutouts to fictional characters like Lord Sith as well as Wayne and Garth. If you're weary from chewing over dry SEC filings, this transcript is a real palate cleanser.

The issue got a further hearing Wednesday on CNBC when Byrne appeared opposite hedge fund manager Jeff Matthews, who was highly critical of Byrne but denied being part of any cabal against Overstock.

(Rocker Partners owns about an 8% stake in TheStreet.com (TSCM:Nasdaq) , and the site's star columnist, Jim Cramer, as well as two former writers, were named by Byrne as guests at the Miscreants Ball. Rocker Partners said today that it plans to countersue Overstock, alleging that Byrne's recent media appearances hurt the firm's reputation.)

Byrne's call pushed the topic of naked short-selling into heavy rotation at CNBC and gave it a wider airing. In so doing, it revived the question of how serious of a threat naked short-selling really is. Some, especially those working at hedge funds, say it's a straw man -- that most of the positions created by failed deliveries are related to options trading and not a concerted effort to drive stocks down.

That may be the case. But without better data on stocks that failed to deliver, the rest of us will never know for sure. Meanwhile, what little data are available suggest that naked shorting may indeed be out of control and that a much-ballyhooed trading rule known as Regulation SHO has so far done little to rein it in.

First, a little background. Shorting stocks, or selling shares you borrowed from another shareholder, isn't illegal. Abusive shorting, done to manipulate a stock price, is. And selling the stock of a badly managed company to a less-thoughtful investor is fair -- if brutal -- game in a market where stupidity is a sin. Over the past two decades, shorting has gone from a controversial strategy to an accepted practice that, nearly everyone agrees, weeds weak and fraudulent companies from the field.

More recently, the controversy has moved to naked short-selling. Naked shorting is in essence make-believe short-selling. In the same way kids play doctor without the medical equipment, naked shorters sell unborrowed stocks -- stocks that no one has borrowed and possibly never will. The SEC allows naked shorting in two cases: to maintain liquidity in hard-to-find shares and for anyone who shorted unborrowed shares before 2005. That second exemption has generated its own share of controversy.

As is often the case, stock newsletters were among the first to suspect a problem. The straw-man theory argues that critics of naked shorting are burned investors or corrupt executives who blame hedge funds the way failed businessmen blame the government for their own failures. But in recent months, newsletters like CrossCurrents and Biotech Monthly have sounded alarms on naked shorting.

"I'm quite confident that this is a much larger issue than anyone cares to consider," says CrossCurrents editor Alan Newman. It's hard to find bears any harder-core than Newman, who in February 2000 put a then-unthinkable 3000 target on Nasdaq and who today expects the Dow to sink to 8500. When the uber-bears are worried about the adverse impact of shorting, it's time to start worrying.

Newman explains naked short-selling in eye-opening clarity. Selling unborrowed shares means the buyer doesn't get delivery of the shares he bought. "There are now two actual owners of the same shares. The exact same shares now show up long in both accounts," Newman says. "Every 100 shares of a naked short is a duplication of real shares, just as if the shares had been photocopied and distributed."

So how extensive is the naked shorting? According to Larry Thompson, the First Deputy General Counsel at the Depository Trust and Clearing Corporation, a central clearinghouse for trade settlement, about 1.5% of the dollar volume of stocks traded each day fail to deliver. In a Q&A published this March on the DTCC site, "fails to deliver and receive amount to about $6 billion daily ... including both new fails and aged fails."

Overall, 1.5% of volume may not be much of an impact. But judging from the way some stocks spend weeks and months on the threshold list of shares that face persistent delivery failures, the naked shorting is concentrated in illiquid shares known to be hedge fund targets. The bulk are traded over the counter, but some are well known, such as Netflix (NFLX:Nasdaq) , Netease (NTES:Nasdaq) , Shanda Interactive (SNDA:Nasdaq) and Taser International (TASR:Nasdaq) .

Perhaps the most telling data came from a simple Freedom of Information Act filed by an individual investor who asked the SEC for aggregate data on failed deliveries on the NYSE and Nasdaq. Before Regulation SHO was passed in September 2004, an average of about 155 million shares a day failed to deliver on the two exchanges, excluding OTC and Pink Sheet stocks, the data showed.

After Regulation SHO was passed, the delivery failures rose, averaging 205 million shares a day in December and rising as high as 259 million on Dec. 22 alone. Since the law went into effect on Jan. 3, the delivery failures have declined, but are still only about 20% below their levels of last summer.

The SEC, wanting to avoid short-squeezes in dozens of stocks caused by the closing out of naked short positions, opted to "grandfather in" any failed deliveries before Jan. 3. But that opened the door to another problem: In the four months between the date Regulation SHO went into effect and the date it took effect, the grandfather provision gave anyone who was so inclined a generous period of time to build up naked short positions in any stock he liked.

Or, to use the counterfeit analogy, imagine outlawing the printing of funny money, but giving everyone four months to print up as much as they'd like. Only then would counterfeit dollars be illegal -- but only to print, not to use.

And it wasn't as if regulators weren't expecting this. The NASD, in a 2004 proposal to tighten rules on naked short-selling, wrote, "Naked short-selling ... can result in long-term failures to deliver, including aggregate failures to deliver that exceed the total float of a security. NASD believes that such extended failures to deliver can have a negative effect on the market."

"Among other things, by not having to deliver securities, naked short-sellers can take on larger short positions than would otherwise be permissible, which can facilitate manipulative activity," the proposal read. "Further, significant failures to deliver can impact certain rights of buyers, such as the right to vote shares or the treatment of dividends."

So the hedge funds may be right in that many of the companies suffering from short-selling are badly run or on the path to insolvency anyway. And it may be that none of them are engaging in naked shorting in the era of Regulation SHO.

But if they are, it raises a serious question: Isn't there a better way to pursue their noble ends?

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