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Naked Shorts Law Challenged
Liz Moyer, 07.28.06, 5:35 PM ET

More than two months after being whipsawed by the enactment of a Utah law designed to clamp down on abusive stock short-selling, Wall Street's trade and lobbying group has filed suit in federal court to block it from going into effect.

The Securities Industry Association filed the lawsuit Friday in Utah's federal district court, naming Utah Division of Securities Director Wayne Klein as the defendant. The SIA is claiming federal preemption of state laws and asks for a temporary restraining order.

The bill was passed in May after a special session of the Utah legislature, and Gov. Jon Huntsman Jr. signed it into law May 26. It requires broker-dealers licensed to operate in the state to notify the Division of Securities within 24 hours when there is a "fail-to-deliver" in the stock of a Utah company. Violators would have to pay the issuers $10,000 for each day they fail to provide the documentation on the failed trade.

The law, which takes full effect in October, could affect Goldman Sachs Group (nyse: GS - news - people ), Morgan Stanley (nyse: MS - news - people ), Fidelity Brokerage and many other broker-dealers. When it was enacted under a storm of protest from Wall Street, there was talk that some of the broker-dealers would stop doing business in Utah or would stop handling trades of shares in Utah companies.

The trade group is arguing that federal securities laws usurp state laws. It also tries to come down on the side of those who champion regulatory simplicity.

"Already, companies launching IPOs shop globally for more accommodating regulatory environments," said SIA's president, Marc Lackritz. "Allowing each state to add its own regulatory regime would only exacerbate this growing problem, further reducing the competitiveness of U.S. financial markets."

A spokesman for Gov. Huntsman said, "We stand by our law and feel it addresses a real issue. It has shined a very bright light on the pressing concern of naked short-selling."

The SIA was caught flatfooted by the revival of the legislation in a special session of the Utah legislature and failed to block its passage even after a last-minute lobbying effort. Wall Street firms complain that its documentation requirements are too burdensome and that it is too broadly written to include all "fails-to-deliver," not just the questionable ones.

The law is universally thought to have been designed by and for hometown Salt Lake City company Overstock.com (nasdaq: OSTK - news - people ). Overstock is a heavily shorted stock, and its chief executive, Patrick Byrne, has waged what he calls a "crusade" to raise awareness of the problems of manipulative short-selling in the markets. He also happens to be one of the state's largest individual political donors.

Stock transactions are supposed to clear in three days. It is the responsibility of the broker-dealer handling a transaction to locate the stock, or at least have reasonable belief that he will be able to locate the stock, and make sure it gets delivered to the buyer. If that delivery doesn't happen, the trade is deemed "failed to deliver."

Most times, failures are cleared up in a matter of hours or days and are related merely to administrative snafus.

But people like Byrne contend that aggressive short-sellers also can manipulate the system (with broker-dealers looking the other way) and trade, despite getting "fails-to-deliver." That's what's called naked short-selling. In effect, it creates phantom shares in a company and drives down the price of its stock.

In January 2005, the Securities and Exchange Commission's new regulation designed to clamp down on that activity, Reg SHO, went into effect. It requires the major stock exchanges to publish daily lists of stocks that have high degrees or frequencies of "fails." Overstock, along with Netflix (nasdaq: NFLX - news - people ), Novastar Financial (nyse: NFI - news - people ), Martha Stewart Living Omnimedia (nyse: MSO - news - people ) and Fairfax Financial Holdings (nyse: FFH - news - people ), have been on these Reg SHO lists practically from their inception.

Three lawsuits have been filed since April, two in New York federal court and one in California state court, all making variations on the allegation that the nation's largest brokerage firms collude to allow "fails-to-deliver" to go through to reduce their operating costs, all to the detriment of the traders borrowing the shares, or the shareholders of the stocks in question.

Most recently, 40 holders of Kansas City, Mo.-based specialty finance company Novastar filed suit in California contending that 11 Wall Street firms participated in a "massive, illegal stock market manipulation scheme."

Representatives from Bank of America (nyse: BAC - news - people ), Bank of New York (nyse: BK - news - people ), Bear Stearns Cos. (nyse: BSC - news - people ), Credit Cuisse Group (nyse: CSR - news - people ), Deutsche Bank (nyse: DB - news - people ), Goldman, Lehman Brothers (nyse: LEH - news - people ), Morgan Stanley, and UBS (nyse: UBS - news - people ) declined to comment or weren't available Thursday. Citigroup (nyse: C - news - people ) and Merrill Lynch (nyse: MER - news - people ) spokesmen said the suit was without merit.

Regulators have heeded the complaints of some of those in the markets. Earlier this month, SEC Chairman Christopher Cox said he would move to close the loopholes in Reg SHO that seem to have enabled rogue traders to continue to trade illegally.

In response to e-mailed questions earlier this week, Overstock's Byrne said the SEC's efforts to close the loopholes are welcome but may not be enough. "He is trying to transform a quisling regulator into an aggressive regulator," Byrne said of Cox at the SEC. "But he is fighting the deepest pockets in the world, and they want to keep it a quisling."

http://www.forbes.com/2006/07/28/naked-shorts-hedgefund-cx_lm_0728hedgefolo.html?partner=msn