Brokers in an Uproar over Utah Law Cracking Down on "Naked Short Selling"

Lincoln Journal Star

SALT LAKE CITY — A bill approved by the Utah Legislature is causing an angry revolt among Wall Street firms with Utah operations.

The measure cracks down on a stock trading practice defended by some as necessary for orderly markets and assailed by others as easily exploited for stock manipulation.

At issue is short selling, the investors’ practice of borrowing stock and selling it, hoping the share price declines so they can buy cheaper shares, return them to the lender and pocket the difference.

Overstock.com Inc., a Utah Internet retailer, contends it has been a target of naked short selling: brokers’ sending IOUs to buyers when they can’t deliver shares borrowed earlier for short selling, then delivering the shares later after making a profit.

Overstock.com CEO Patrick Byrne says many brokers never settle these trades, allowing short sellers to profit without having to assume risk. The practice tends to lower a company’s share price by artificially creating more sellers than buyers.

The bill approved by the Legislature fines brokers who accumulate too many unsettled trades in a given company after five trading days. The fines start at $10,000 and can increase to cover the sum total of all unsettled trades.

“There’s blood in the water,” said Howard Headlee, president of the Utah Bankers Association, who said brokerage houses are “talking about not doing business in Utah.”

Tony Taggert, an officer for Morgan Stanley - which operates an industrial bank in Utah and employs almost 5,000 with Discover Card operations here - promised a lawsuit on behalf of the Securities Industry Association if Gov. Jon Huntsman signs the measure.

“I’m not saying we’re going to pull out of Utah, which has been perceived as very business and industry friendly,” said Taggert, Utah’s former securities director, who now handles state regulation and litigation for Morgan Stanley from New York. “This makes us wonder if that’s the case.”

Industry and government insiders said Fidelity Investments, Bear Stearns and Zions Bank, which operates a securities division, were among brokers upset over the legislation and embarrassed for missing legislative action on the bill.

None of the brokerages returned calls from The Associated Press.

“This is the single best thing Utah could do to attract entrepreneurs, especially in high-tech and biotech,” said the Overstock.com CEO, who celebrated victory late last week at the Utah Capitol by pledging to expand operations, doubling the company’s payroll.

Brokers and the clearinghouse managed by the Depository Trust and Clearing Corp. say stock IOUs are essential to maintain market trading. They dispute that unsettled trades - called “failures-to-deliver” - are more than a tiny aberration in the market, or that all of them are attributed to naked short sales.

What is naked short- selling, and why do some people hate it?

In a legitimate short sale, the seller first borrows a share of stock and then sells it, hoping to buy it at a lower price before he returns it to the lender. The profit is the difference between the sale price and the later buy price. It is a bet on a price decline, and legal as described. Sell high, buy low.

A naked short sale is a manipulative trading technique. It takes advantage of a structural deficiency in the system that allows a transaction to occur, and all moneys to be paid, before delivery of the stock occurs.

So a transaction goes by on the tape - a sale - and it is processed and has an effect on the price of the stock, but the delivery portion of the transaction is left for days later. Meanwhile, the depressive effect of thousands of these sales extracts its toll on the price - the naked sales are still sales and are treated as legitimate by the system.

Naked short-selling is illegal as described - it can be legal in certain limited circumstances: for a market maker that needs to provide shares in a fast moving market for a thinly traded security.

Smaller investors and some companies whose stock has suffered from the practice are up in arms about it.  They accuse institutions, particularly hedge funds, of routinely violating federal rules.

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