Homeland Security Corporation (HSCC)

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The 'phantom shares' menace: naked short selling distorts shareholder control -Regulation,

Spring, 2008 by John W. Welborn

In 1985, the National Association of Securities Dealers (NASD) commissioned Irving M. Pollack, a securities law expert and former Securities and Exchange commissioner, to conduct a comprehensive review of short selling in NASDAQ securities. The NASD sought to determine what, if any, additional short selling regulation was needed for the NASDAQ market. The result was the now-famous "Pollack Study," which described the short selling landscape of the day and made important recommendations regarding the disclosure, reporting, and settlement of short sales.

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Pollack concluded that short selling was a vital source of liquidity and a valuable mechanism for efficient price discovery. He added, however, that without proper institutions to guarantee prompt clearance and settlement of short sales, short selling was open to abuse. Of the settlement regime, he cautioned that it "effectively insulates the clearing corporation and brokers from fails to deliver and receive by contra-parties; but it permits fails to deliver and receive to develop without an automatic check." He issued a sober warning:

The fail-to-deliver/fail-to-receive problem has the potential for causing serious difficulties in a lengthy bear market. While the evidence does not suggest that delivery problems exist in many
securities, the fact that there is no automatic mechanism
preventing the substantial buildup of short positions at the
clearing corporation and of fails to receive in brokerage firms
carries the potential for serious problems, particularly in the
event of crisis market conditions.

The phrase "short positions at the clearing corporation" refers to "failures to deliver" (FTDS), which effectively increase the net supply of an issue in circulation and, by definition, depress price. This price depression is, of course, more significant for small and medium cap companies than for large cap companies with greater liquidity.