Naked short settlements "Overstock" (in bold) Naked shorting hit the headlines in the 2007-08 financial meltdown, when regulators tightened restrictions on the practice (and later, briefly, banned all shorting of bank stocks), fearful that it was being used to destablise markets. Though the issue has long since receded from front pages, it has continued to percolate, including in a long-running legal battle in America which the plaintiff portrays as a David-versus-Goliath struggle.
Overstock, an online retailer, claims that in 2004-07 Wall Street firms cooked up a manipulative scheme in conjunction with smaller trading outfits based in New York and New Jersey. The aim was to increase the supply of Overstock shares that could be sold short, and to profit from peddling them to hedge-fund shorts. This alleged manipulation was carried out in part by using complex trading strategies that avoided settling past transactions, in effect creating “phantom” shares. That, Overstock asserts, explains why at one point the number of shorted Overstock shares was higher than the number of shares the firm had issued.
The intention, Overstock maintains, was to profit from first creating and then lending out the illusory shares, and in the process to push down the retailer’s share price. At the time the company was on the so-called “threshold list” (of stocks with a high incidence of settlement failures) for a staggering 667 consecutive trading days—an indicator both of very high demand and of possible manipulation.
Overstock argues that Wall Street firms were attracted to the high fees they could earn from lending out its and other hard-to-borrow shares—as much as 50% of the share price, on an annualised basis—and from clearing related trades. Securities lending is not sexy, but it is a big business: $1.7 trillion-worth of stocks, bonds and other securities was on loan as of June 2015, according to DataLend.
By creating more stock for shorting, the alleged scheme would have put downward pressure on Overstock’s share price. That would have helped the brokers involved by making their trades cheaper to service. They could also have benefited if, as would have been likely, the downdraught increased demand for Overstock shares among hedge-fund short-sellers.
The small New York and New Jersey trading outfits were the ink-stained workmen in what Overstock alleges was the stock-lending equivalent of a back-room printing press for counterfeit banknotes. Some of these firms have since been fined by the Securities and Exchange Commission or other regulators for breaches of Reg SHO, a set of rules governing short-selling.
Overstock argues that the traders would have needed willing accomplices higher up the financial food chain. It initially sued a dozen Wall Street firms, later narrowing its focus to Goldman Sachs, the traders’ prime broker, and Merrill Lynch (now part of Bank of America), their clearing broker. Goldman settled with the retailer earlier this year, without admitting any wrongdoing. Merrill remains a target; the case is due to go to trial in March. Merrill, too, denies wrongdoing.
The case is complex, and many of the facts have been obscured by the sealing of key documents. Overstock fought for years to have these unsealed. Several media organisations (including The Economist) filed pleas in support of its call for transparency. After long deliberation, the court in California that is hearing the case recently made some of the documents public. They include Overstock’s fifth amended complaint in a racketeering suit that was ultimately unsuccessful (here). The firm was barred from filing this because it missed a court deadline, but says the complaint presents “the most accurate statement of what we will argue at the trial” (the case now rests on alleged violations of state securities laws). The court also released dozens of e-mails and other documents, some of which form the basis of Overstock’s claims (here).
At the heart of the alleged scheme were deliberate efforts to “fail to deliver”, meaning failing to produce for settlement shares supposedly borrowed for the purposes of short-selling. In one e-mail, a broker says that Scott Arenstein, one of the New Jersey-based traders, has large short positions in stocks “that everyone on the street is failing”. In another, a Merrill clearing executive says “We are NOT borrowing negatives?Why would we want to borrow them? We want to fail on them.” (“Negatives” is a reference to “negative rebate” stocks: those which are scarce and more expensive to borrow.) The only rational explanation for the trades was that the brokers and traders involved understood and agreed that “no borrowing and delivery will occur...In other words the short sale will be a naked short sale”, according to a court declaration by an expert hired by Overstock to review the trades, which forms part of the unsealed trove.
Merrill argues in a court filing that the litigation is “wasteful and expensive” and has produced no evidence that it was engaged in intentional market manipulation. The firm says that the trading and broking in question was in a legal grey area at the time, that it didn’t receive clear guidance from regulators on what was or wasn’t permitted under Reg SHO until 2007, and that this clarification closed a loophole which had been exploited by certain clients who “misrepresented” to Merrill the nature of their trading.
The SEC has increased its focus on naked shorting since the market quakes of 2008. But it has targeted mostly small firms, leading some to accuse it of skirting the issue. Some experts say it is difficult, if not impossible, for financial minnows to dodge the rules without help from bigger fish.
Moreover, although regulation has been tightened, and policing stepped up a bit, there are worries that trading strategies continue to evolve to allow canny operators to get around the latest rules. In 2013 the SEC issued a risk alert after observing the use of exotic trading techniques such as “buy-writes”, “married puts” and “customisable flex options”, sometimes in dizzying combinations, to evade settlement requirements—possibly to aid naked shorting. The Overstock case may relate to events a decade ago, but the issues it raises look anything but old.
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