TradeStation Caught Up in Shorting Probe

TheStreet.com
By Matthew Goldstein
February 20, 2006

Securities regulators are moving to crack down on an online brokerage for allegedly permitting a controversial Wall Street trading practice called "naked shorting.''

Online brokerage TradeStation (TRAD:Nasdaq) disclosed that regulators at the NASD have notified the firm that some of its customers may have engaged in improper short sales. The Florida-based brokerage said in a filing that regulators could fine the firm for nearly 200 infractions that took place in 2004.

An official with TradeStation, a brokerage geared to daytraders, declined to comment. A NASD spokesman also declined to comment.

Last year, the NASD and other securities regulators announced they were conducting a broad inquiry into allegations of improper shorting on Wall Street. The regulators are specifically trying to determine whether brokerages are complying with a new series of regulations designed to prevent abusive short-selling, such as naked shorting.

The case against TradeStation predates those tougher regulations, but the alleged violations at the brokerage are similar to the abusive that trading regulators say they are trying to stamp out.

To be clear, regulators have no problem with conventional short-sellers, traders who bet a stock will fall in price. In fact, regulators are among the first to say that short-selling provides a necessary check-and-balance on the market. Short-sellers, for instance, are particularly good at smoking out companies that are either engaged in fraud or misleading investors.

It's naked shorting, a manipulative practice that enables traders to defy the laws of supply and demand, that regulators are trying to stop.

In a typical short sale, a trader borrows shares from a broker, sells them, and then hopes the stock falls, so he can replace his borrowed stock at a lower price. The short-seller makes money by pocketing the difference between the shares he borrowed and the ones he purchased.

But in a naked short sale, a trader places short bets without actually borrowing the stock first or even determining that any shares are available to borrow. This way, naked short-sellers are freed from a key check of the short-sale process -- the need to find willing stock lenders. Critics claim such operations create excessive downward pressure on certain stocks and can create chaos as buyers await undeliverable shares.

Left unchecked, naked shorting can lead to an anomalous situation in which the total number of shares sold short on a stock exceeds its float, or the number of shares available for trading.

TradeStation says regulators have found 172 improper short trades made during a two-month period in 2004. The trades allegedly were improper because they were made without an "affirmative determination" that TradeStation could either "receive delivery of the security on behalf of the customer'' or "borrow the security on behalf of the customer.''

TradeStation says the short sales being examined by regulators were "authorized and arranged'' by Bear Stearns (BSC:NYSE), the big Wall Street firm that processes and executes trades for the smaller brokerage. A Bear Stearns spokesman declined to comment.

Bear Stearns maintains one of the biggest clearing operations on Wall Street, providing back-office services for smaller firms that lack its processing muscle. One of the duties of a clearing firm is to lend stock to customers looking to short a stock.

The issue of just how widespread naked shorting is on Wall Street is a matter of considerable dispute, despite the regulatory crackdown.

Some contend the unsavory practice has all but disappeared since the NASD and SEC instituted new rules last year making it more difficult to engage in naked shorting. The new rules, commonly referred to as Regulation SHO, prohibit brokers from letting traders short a stock unless there are "reasonable grounds" for believing there are shares available to borrow.

Others, meanwhile, insist Wall Street firms such as Bear Stearns, Goldman Sachs (GS:NYSE) and Citigroup (C:NYSE) have an economic incentive to look the other way at naked shorting because they collect fees from short-sellers who borrow stock.

The most outspoken critics of naked shorting say it remains a rampant practice among a group of nefarious short-sellers and brokers. Many of these critics are zealots, believing the SEC and NASD are part of a grand conspiracy to permit naked short-sellers to drive companies out of business.

Most notably, Patrick Byrne, the CEO of online discount retailer Overstock.com (OSTK:Nasdaq), has blamed a cabal of naked short-sellers for targeting his company and seeking to destroy his stock. He claims the campaign against his company is led by "one of the master criminals of the 1980s," whom he has likened to the evil "Sith Lord" of Star Wars fame.

Last summer, Byrne and Overstock sued Rocker Partners, accusing the well-known short-selling hedge fund of spearheading a campaign to drive down the company's share price. The hedge fund, led by David Rocker, owns about 5% of the shares of TheStreet.com, the publisher of this Web site. Byrne also sued Gradient Analytics, a research outfit Overstock implied was in league with the short-sellers.

Short-sellers point out, however, that many of the companies often cited as victims of naked shorting are businesses that were either losing money or had failed business strategies.

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