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Motley Fool News 3-30-05 on Naked Shorting

"Who's Behind Naked Shorting" news story out today.
Swamp

http://www.fool.com/news/commentary/2005/commentary05033008.htm

Who's Behind Naked Shorting?
By Karl Thiel
March 30, 2005

Last week, I wrote about naked short sellers and Regulation SHO, suggesting none too subtly that the new rules seem to deal pretty lightly with any bad guys operating outside the law. If the SEC is acknowledging a problem, as it seems to be, then Reg SHO seems like a pretty weak tool for controlling it.

But that was last week's subject. Having gotten to that point, I was left wondering how extensive the problem really is. As I said then, I'm deeply skeptical of some conspiracy theories that suggest short selling is not only rampant, but also a part of a coordinated scheme involving brokers, media, and regulators trying to bring down targeted companies. In fact, let me say at the outset that after spending many hours looking at this issue, I remain unconvinced of the larger conspiracy theories and agnostic on how extensive naked short selling is or how exactly it happens. There is no shortage of theories -- some of which I'll discuss here -- but little in the way of concrete answers. So the first and most obvious question is, how much of this is going on?

Rare or everywhere?
Unfortunately, nobody seems to know. The Depository Trust & Clearing Corporation (DTCC), a holding company that clears and guarantees almost all trades in the U.S., very recently posted an interesting Q&A on naked short selling, which is well worth reading by anyone interested in the subject. "While naked short selling occurs," says DTCC First Deputy General Counsel Larry Thompson in the document, "the extent to which it occurs is in dispute." Ain't that the truth.

Nevertheless, the DTCC has a good reason to say something public about the issue. The subject of naked short selling has gained some momentum with the introduction of Reg SHO early this year and a rising tide of complaint from companies like Overstock.com (Nasdaq: OSTK) and others. But in addition to this general attention, 12 separate lawsuits have accused the DTCC itself of engineering naked short-selling schemes. Nine of these, according to Thompson, have been dismissed or withdrawn, while three are still pending.

The basic accusation is that the DTCC itself counterfeits shares through its stock borrow program. This program has been around for more than 20 years and is used to help guarantee transactions where one party fails to produce promised shares. While the DTCC itself doesn't own shares, a network of participating broker-dealers lists shares available for borrowing with the program, and these are called on to complete failed transactions.

Lawsuits have claimed that the DTCC loans out shares it never collects from participants. These in turn presumably show up as new "fails to settle" transactions, but from the point of view of the market, appear to be new shares floating around (in electronic form, that is, without stock certificates to back them up). These can then be re-listed, the theory goes, as available for borrowing, and the process repeats itself, allowing the folks manipulating the system to essentially manufacture any number of phantom shares.

Thompson calls these accusations "either an intentional misrepresentation of the SEC-approved system, or a profoundly ignorant characterization of this component of the process of clearing and settling transactions." I want to stress that I'm not supporting these accusations -- I mention them because they describe one popular theory of how naked short sellers operate.

Something's going on here
But if we rule this out, how does one explain the suspicious volumes and consistent, ongoing settlement failures experienced by companies like BioLase Technology (Nasdaq: BLTI), Netflix (Nasdaq: NFLX), or Rule Breakers pick Taser (Nasdaq: TASR) on the Threshold Security lists? Thompson, while acknowledging that naked shorting does happen, suggests that many settlement failures are innocent. "An investor can get a physical certificate to his broker too late for settlement," he suggests. "An investor might not have signed the certificate, or signed in the wrong place. There may have been human error, in that the wrong stock (or CUSIP) was sold, so the delivery can't be made. Last year, 1.7 million physical certificates were lost," he continues, "and sometimes that isn't discovered until after an investor puts in an order to sell the security. There are literally dozens of reasons for a 'fail to deliver,' and most of them are legal. Reg SHO also allows market makers to legally 'naked short' shares in the course of their market making responsibilities, and those obviously result in fails," he concludes.

But can unsigned or lost certificates really explain why some companies have lingered on the list for weeks, meaning that more than 10,000 shares per day or over 0.5% of the company's entire float is subject to failed settlement on a daily basis? If that's the root cause, it would certainly seem to point to some pretty shoddy settlement practices among broker-dealers. If that's really all there is to this, then maybe Reg SHO will serve its greatest purpose in embarrassing some of brokers into improving their settlement procedures.

Who's making the market?
Yet, as I noted last week, it is the market-making exemption that still seems to me like a source of potential trouble. Market makers don't have to locate shares before executing short sales in most circumstances. The reason for this is that their role is to keep an inventory of readily available stock, to smooth volatility, and to manage their own risk, and this sometimes requires them to short shares. A prime example of why this is sometimes a valuable function and even protects investors can occasionally be seen with companies emerging from bankruptcy.

When US Airways (OTCBB: UAIRQ.OB) was planning to re-emerge from bankruptcy in 2003, for instance, its old common stock, trading on the OTCBB, rallied -- apparently because some investors mistakenly thought the news was somehow good for shareholders in the old common stock. But the plan called for the issuance of new stock, and the old shares were to become worthless. Market makers, by shorting the old common shares, could burst a speculative mini-bubble in the making and stop more ill-informed investors from losing their shirts. (Of course, one wonders why stocks are allowed to trade at all in these situations, but that's another matter). In any case, this is an extreme example of one function legitimate market makers serve by shorting stock and why they are given an exemption to the rules.