Is This The End Of Naked Short Selling?
Editor OilPrice.com
October 16, 2023·29 min read
In this article:
American investors have been taken for a trillion-dollar ride by naked short sellers, in what could turn out to be the biggest financial regulatory scandal in North American history.
While what is now an all-out war on naked short sellers intensifies, there is a new flashpoint on the front line–a potentially devastating ruling targeting those who are alleged to make illegal naked short selling possible: The Facilitators: bankers and brokers.
On September 29, Federal District Court Judge Lorna Schofield of the Southern District of New York issued a ruling that has the potential to significantly disrupt Wall Street compliance, and is a major first step towards protecting retail investors from fraud.
In Harrington Global Opportunity Fund Ltd. v. CIBC World Markets, Inc et.al, Judge Schofield found that broker-dealers may be primarily liable for manipulative trading initiated by their customers because they serve as “gate-keepers” of trading on securities exchanges.
These broker-dealers have a “continuing responsibility to ensure that their customer’s order flow ... is in compliance with all applicable rules, regulations and laws and detect and prevent manipulative or fraudulent trading … under the supervision and control of the firm,” the judge ruled.
The defendants in the case had motioned to dismiss Harrington’s claims of market manipulation and spoofing (when traders place market orders and then cancel them before the order is ever fulfilled, manipulating prices in the meantime). Judge Schofield denied the motion after hearing arguments that broker-dealers are not responsible for “their customers’ trading”.
Instead, the ruling recognizes that not only are broker-dealers the gate-keepers who can enable illegal naked short selling, but they are responsible, and thus liable for their customers’ actions. Schofield described broker-dealers as “reckless in not knowing that the trades being executed at their customers’ direction were manipulative”.
Naked Short Selling: ‘Financial Weapons of Mass Destruction’
Naked shorting creates a dangerous minefield for retail investors. But it’s a minefield that dealer-brokers may now be held liable for thanks to the recent ruling.
Short-selling itself isn’t illegal. In order to legally sell a stock short, traders must first secure a borrow against the shares they intend to sell. Where the September 29 ruling comes into play is at the point of the broker-dealer. Any broker who enters into a stock short on behalf of a trader must have assurances that his client will make a settlement.
As opposed to a “long” sale (where the seller owns the stock), a “short” sale can be either “covered” or “naked”.
If it’s covered, then there is no issue: the short seller has already borrowed or arranged to borrow the shares when the short sale is made.
When things get naked, the regulatory environment becomes riddled with compliance holes. With a naked short, the short seller is selling shares it doesn’t own and has made no arrangements to buy. That means the seller cannot cover or “settle” in this instance. More profoundly, it means they are selling ghost shares that simply do not exist without their further action. The ability to sell an unlimited number of non-existent shares in a publicly-traded company gives a short seller the ultimate power: To destroy and manipulate a company’s share price at will.
This illicit practice artificially dilutes share prices and then companies find themselves in a position where they have to scramble for capital, Bryan Barkley points out in in-depth research published by the Medium.
That scramble then leads to shareholder dilution in more capital raises, in the best cases, and bankruptcy, in the worst cases. If things get to bankruptcy, Barkley writes, then short sellers win big because they no longer need to close out their short positions.
Following the 2008/2009 financial crisis, naked short selling was classified as illegal in the United States, though that labeling has done nothing to thwart this lucrative game.
What makes the September ruling so impactful is this: Without the big banks and financial institutions’ complicity, this highly destructive form of naked short selling could never happen. Instead, they actively facilitate the destruction of shareholder value.
The reason some big banks allow it, despite their sizable compliance departments, appears quite simple: These illegal transactions are highly lucrative. The short-term windfall profits associated with the creation of counterfeit shares are too tempting to resist.
“[...] brokers will place a marker or pledge to deliver the shares on the investors’ accounts, which are made by the seller’s clearing firm”, Barkley explains. “Abusive and unchecked naked shorting can lead to a loss of shareholder rights, including disenfranchisement by overvoting and the resulting throwing out of votes by brokers to conceal the breadth of the naked shorting problem, which could also lead to fraudulent vote results orchestrated by broker-dealers instead of shareholders.”
It often goes well beyond “ghost” shares, too. The most nefarious of short sellers target companies with negative reports–sometimes with legitimate information, and sometimes with falsehoods or half-truths–to drive down share prices with maximum impact, thus ensuring that the companies lose their ability to obtain financing. Once that process is completed, naked shorters then begin to offer those same companies alternative financing (predatory debt), which they have no option but to accept.
When broker-dealers are complicit in this, the system is broken. And complicity takes many forms, including willful booking of client shares as “long” when they are actually “short”.
Gaps in the regulatory environment have continued to fail to subdue these illegal activities.
Keeping the Brokers in Check: A Global Loophole
Even before the 2008/2009 financial crisis, there were measures in place intended to protect retail investors and regulate the activities of brokers with respect to short selling.
The SEC’s Regulation SHO took effect in January 2005 and specifically targeted “persistent failures to deliver and potentially abusive ‘naked’ short selling”. Amendments intended to further strengthen these regulations were added in 2008, and in 2010, the SEC adopted Rule 201, restricting the price at which short sales could be made when a stock was experiencing significant downside pressure.
Additionally, the SEC notes:
Rule 204 requires firms that clear and settle trades to deliver securities to a registered clearing agency for clearance and settlement on a long or short sale in any equity security by the settlement date or to take action to close out failures to deliver by borrowing or purchasing securities of like kind and quantity by no later than the beginning of regular trading hours on the settlement day following the settlement date for short sale fails, or no later than at the beginning of trading hours on the third settlement day following the settlement date for long sale fails, and fails attributable to bona fide market making (“close out date”). If a firm that clears and settles trades has a failure to deliver that is not closed out by the beginning of regular trading hours on the applicable close-out date, the firm has violated Rule 204 and the firm, and any broker-dealer from which it receives trades for clearance and settlement, is subject to the pre-borrow requirement for that security.
However, as Barkley points out, the SEC does not publish FTDs (failures-to-deliver) of U.S.-issued securities traded and settled abroad (including Canada). This means a significant number of FTDs are never accounted for, essentially creating a naked free-for-all.
Last year, UBS Securities LLC conceded to having failed to close out an astounding 5,300 FTDs in the previous decade, yet still kept executing new short sales in the tens of thousands.
“This is naked shorting and FTD abuse on a significant scale, likely involving many billions of dollars,” Barkley writes.
UBS was fined $2.5 million for violating Regulation SHO. Shareholders were left holding the empty bag, though. And likely lost billions of Dollars in the process.
Also last year, Gar Wood Securities LLC was fined for accepting 2,000 short sale orders without the third-party brokers having located the securities they were borrowing against. Gar Wood was fined $100,000 (which is pathetic).
More recently, in August this year, California-based Wedbush Securities Inc. was fined $6 million by the CTFC (Commodity Futures Trading Commission) for failing to “supervise” trades from third-party brokers, and for dubious private communications. Separately, Wedbush was fined another $10 million by the SEC. And thirdly, in relation to failure to close out FTDs, Wedbush was fined a mere $975,000, a sum that appears to be simply the cost of doing business in the naked short arena.
With regard to violations of Regulation 204, a NYSE American LLC waiver notes:
During the Relevant Periods, the Firm failed to timely close out approximately 2,056 FTD positions due to the Firm failing to timely borrow shares, recall shares that were out on loan or otherwise acquire shares and deliver them in accordance with the requirements of Rule 204(a).
During the period between January 1, 2016 through July 31, 2020, on approximately 390 occasions, the Firm further failed to place a security in the penalty box as required by Regulation SHO Rule 204(b) and to send the notice required by Regulation SHO Rule 204(c).
Additionally, in December 2020, Canadian Cormark Securities Inc and two others pinged the SEC’s radar, with the SEC instituting cease-and-desist orders against Cormark and settling charges against Cormark and two other Canada-based broker-deals for “providing incorrect order-making information that caused an executing broker’s repeated violations of Regulation SHO”. According to the SEC, Cormark and ITG Canada caused more than 200 sale orders from a single hedge fund to the tune of more than $660 million (between August 2016 and October 2017) to be mismarked as “long” when they were, in fact, “short”—a clear violation of Regulation SHO. Cormark agreed to pay a penalty of $800,000, while ITG Canada—one of the other broker-dealers charged—agreed to pay a penalty of $200,000.
The Heroes of the Day
The plaintiffs in In Harrington Global Opportunity Fund Ltd. v. CIBC World Markets, Inc et.al, represented by Warshaw Burstein, LLP, have every reason to celebrate.
The judge’s ruling categorically means that going forward, big banks and financial institutions won’t just be fined for not actively closing shorts, they could be held liable for what so far has been an estimated trillion dollars in losses to retail investors, companies and the U.S. government.
“Brokers can no longer claim that they are not liable for their customers’ trading activities because they are only following their directions. A broker can now be held primarily liable under the federal securities laws when they recklessly fail to monitor, detect and prevent the manipulative or fraudulent trading of their customers,” Warshaw Burstein said in a statement following the judge’s September 29 ruling.
“This decision is a clear and unambiguous warning to broker-dealers that unless they fulfill their gate-keeper responsibilities of monitoring their customers’ trading they can be held primarily liable for their client’s manipulative conduct,” the law firm added.
Canada is one venue where this warning should be heeded first and foremost and where naked short sellers have in our view been fleecing U.S. retail investors and companies for years, taking advantage of a loophole that only requires them to have a “reasonable expectation” of settling a trade, without actually borrowing the stock. The U.S. September ruling adds further fire to a slower-moving regulatory crackdown in Canada by the OSC and the other regulatory authorities.
The game of capital market destruction is now hopefully coming to an end, and this latest ruling hopefully marks the beginning of the end. There is still a long way to go and this really should be front page news, but the banks are brokers have big marketing budgets so i imagine there will be very little coverage on this important news for investors in North America.
News 
Market Data 
Discover 
AI
