What Is a Naked Short Sale? Securities Lawyer 101

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Securities Lawyer 101 Blog

The Short Seller Scape Goat

In recent years, the activities of short sellers have been the subject of controversy.  While short selling is a simple process it is widely misunderstood.  While the average investor profits when he invests in a stock whose price goes up, a short seller profits when it invests in a stock whose price goes down. Simply put, a short sale is the sale of a security that the seller does not own.  The trader borrows stock, sells it into the market, and then buys to cover his position when the stock has fallen to his target price.

In some instances short sellers seek to hedge the risk of a long position in the same security, if they believe the security is in for a short-term drop, but that is a conservative strategy employed to preserve capital.

Naked Short Sales

In a naked short sale, the seller sells shares “short” without first having borrowed the shares.

Failure to Deliver l Short Sales

If a seller or its broker-dealer fails to deliver the shorted security by T+3, a “failure to deliver” occurs.  Where the seller or its broker-dealer does not locate or delivery the security, a naked short sale occurs.

As the SEC points out, however, not all failures to deliver have to do with naked shorting: “…Failures to deliver can occur for a number of reasons on both long and short sales.  Therefore, failures to deliver are not necessarily the result of short selling, and not evidence of abusive short or “naked” short selling.”

Failures to deliver can have a negative effect on shareholders, potentially depriving them of the benefits of security ownership.  Abusive short selling – when it does occur – can create a misleading impression of the market for an company’s securities.  Failures to deliver most often result when market makers sell short thinly traded, illiquid securities and then are unable to cover when delivery is required.

Permissible Short Sales l Market Making

Many times short sales are in compliance with the securities laws.  Broker-dealers who make a market in a security must be ready to buy and sell the security on a regular and continuous basis at the publicly quoted price, even if there are no other buyers or sellers.  This results in market makers selling the security to a buyer even when no stock is immediately available.  Because it may take the market maker considerable time to purchase or arrange to borrow the security, he may need to sell the security short without having the immediate ability to borrow shares.  This is most common for market makers in thinly traded, illiquid stocks such as securities quoted on the OTCMarkets.

Problematic Short Sales

Selling stock short without having located stock for delivery at settlement violates Regulation SHO, except for short sales by market makers engaged in bona fide market making.  Market makers do not have to locate stock before selling short; however, they are not exempt fromRegulation SHO’s close-out and pre-borrow requirements.

Selling stock short and failing to deliver shares at the time of settlement doesn’t necessarily violate any rules unless it was done for the purpose of driving down the security’s price.  This is considered to be manipulative activity and violates the securities laws, including Rule 10b-5 under the Securities Exchange Act of 1934.

Regulation SHO l Short Sales

The SEC adopted Regulation SHO to address short sale abuses.  Regulation SHO includes:

♦ “Locate” and”close-out” requirements in order to address failures to deliver, including potentially abusive “naked” short selling.
♦ Requiring broker-dealers to have reasonable grounds to believe that the security sold can be borrowed to cover short sales so delivery occurs on the required delivery date before effecting a short sale order in any equity security.
♦ Imposing additional delivery requirements on broker-dealers for securities if there are a substantial number of delivery failures at a registered clearing agency (“threshold securities”).
♦ Creating uniform order marking requirements of “long”, “short” or “short exempt for sales of equity securities.

Rule 204T

Rule 204T requires that the short seller’s broker-dealer, as opposed to the short seller, locate an entity that the broker reasonably believes can deliver the shares within three days after the trade (“T+3”).  If reasonable, the broker-dealer may rely on the short seller’s assurance that he or she has located a lender who can deliver the security in time for settlement.  Rule 204T made it a violation of Regulation SHO and imposes penalties if a clearing firm fails to purchase or borrow shares to close-out a failure to deliver that results from a short sale in any equity security by no later than the beginning of trading on the day after the fail first occurs (T+4).  Investors in OTC securities, and some OTC companies themselves, often blame declining stocks prices on naked shorting.  In reality, “Shorty” is nearly always simply a convenient scapegoat for corporate nonperformance and shareholders” poor investment decisions.  If there are no threshold failures to deliver, there can be no gigantic naked short position.  It’s that simple.

For further information about this securities law blog post, please contact Brenda Hamilton, Securities Attorney at 101 Plaza Real S, Suite 202 N, Boca Raton, Florida, (561) 416-8956, by email at [email protected] or visit  www.securitieslawyer101.com.  This securities law blog post is provided as a general informational service to clients and friends of Hamilton & Associates Law Group and should not be construed as, and does not constitute, legal and compliance advice on any specific matter, nor does this message create an attorney-client relationship.  Please note that the prior results discussed herein do not guarantee similar outcomes.

Hamilton & Associates | Securities Lawyers
Brenda Hamilton, Securities Attorney
101 Plaza Real South, Suite 202 North
Boca Raton, Florida 33432
Telephone: (561) 416-8956
Facsimile: (561) 416-2855