If the seller does not purchase or borrow the securities for delivery within the normal” T+2 (sale date plus two days), they have “failed to deliver” (FTD), also known as a naked short or fraud for most people. However, the ability to sell securities and then fail to deliver a security is legal for a certain type of financial institution: a market maker (including broker-dealers that register as market makers). Under REG SHO Rule 203 (b) (2) (iii) market makers do not have to deliver shares on short sales for ‘bona-fide market making activities’, including for (iv) Transactions in security futures.[11] Although FTDS are often indicative of naked shorting they can on occasion be the result of innocuous administrative reasons, however where there are persistent FTDS red flags should be observed. The lack of public FTD reports in the United States does not rule out naked shorting either, there must be an actual obligation to report them and only one organisation is at the moment: the NSCC (National Securities Clearing Corporation).[12] [13] However, the NSCC operates a Continuous Net Settlement (CNS) system that creates a process that obfuscates the true number of FTDs by its nature. CNS accommodates settlement failures to promote market liquidity, transfers are delayed through a netting process that allows broker-dealers and the clearinghouse to offset transactions among multiple counterparties, possibly reusing of the same share for covering multiple FTDS, an effect referred to as multiplicity and is thought to conceal the true number of FTDS[14]; international Central Securities Depositories in Europe have imbedded algorithms that automatically lend shares from one member to another that doesn’t have shares to deliver when they’ve sold securities[15] avoiding FTD reports; broker-dealers and clearing firms have also engaged in creative but Illegal Options’ Trading in the past to reset REG SHO Close-Out obligations which also has the effect of concealing FTDS in the options’ chain[16]; a significant amount of trading is carried out directly between broker to broker and settled via private contract which is called ex-clearing[17] — the NSCC facilitates a maintenance service for these fails but does not disclose to the SEC amounts of FTDS included[18]; the Depository Trust Company (DTC) clears and settles trades between its participants and it doesn’t disclose any FTDS between them[19]; and, “Ex Parte” clearing when a market maker that may be using its ‘bona fide’ market making exemption and issuing naked shorts directly to a PFOF broker or other market participants[20]. Obviously, FTDS are not an accurate measure of naked shorting abuse in any meaningful way, and it ignores the possibility of fraudulent entries made to the digital ledgers at the share depositories, however, they are the only means an investor has to determine whether their investment is a target of it, so their disclosure is of utmost importance.
Consequences of Naked Shorting
Naked shorting exposes many important questions for retail investors: what exactly any of them has purchased- if anything- if they don’t receive any purchased or borrowed shares? “In this case, the brokers will place a marker or pledge to deliver the shares on the investors’ accounts, which are made by the seller’s clearing firm”.[21] 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[22] which could also lead to fraudulent vote results orchestrated by broker-dealers instead of shareholders; the multiplicity of shares can lead to significant financial losses to investors and issuing companies because the traded float may be many times the authorised and outstanding (the share price is artificially diluted)[23], which can lead to companies desperate for capital having to agree to dilute their shareholders further and unnecessarily, agree to predatory debt arrangements if they could not raise the appropriate levels of liquidity via a share offering or go bankrupt, in which case short-sellers would never have to close their short position. Unchecked and unsupervised Naked Shorting could be considered a financial weapon of mass destruction to capital formation, innovation, investors, and companies that fall victim to it.
US LAWS TO ‘PREVENT’ ABUSIVE NAKED SHORTING: SEC REGULATION on Short Selling “Reg SHO” / close-out obligations and FTDS
Rule 204 of Regulation SHO[24]
“The SEC adopted Regulation SHO to address concerns regarding persistent failures to deliver and potentially abusive “naked” short selling, e.g., the sale of securities that an investor does not own or has not borrowed. What most people consider fraud.
Accordingly, Rule 204(a) of Regulation SHO requires broker-dealers to take action to close out fail-to-deliver positions (fails or FTDs) resulting from short sales in equity securities by borrowing or purchasing securities of like kind and quantity by the beginning of regular trading hours on the settlement day following the settlement date.
A violation of Rule 204 of Regulation SHO is also a violation of FINRA Rule 2010, which requires members to observe high standards of commercial honour and just and equitable principles of trade in the conduct of their business”.[25]
Bi-monthly the SEC publishes FTD (Failure to Deliver) data collected from securities clearing and settlement carried out through the National Securities Clearing Corporation (NSCC)[26] in the United States and Canada. The NSCC is registered with the SEC, however, was only recently granted permission to do so in the European Union[27] and is a minor player there. The reason the SEC requires disclosure of FTD data is to be able to monitor and enforce its rules as adopted under Regulation SHO — Regulation of Short Sales[28] to discover if there has been any naked short abuse, or persistent FTD that is causing significant harm to capital formation for companies and loss of capital gains by retail investors.
What the SEC doesn’t publish is FTDs of US-issued securities that were traded and settled abroad- where significant trading of these securities takes place. Nor does the SEC publish FTD data of direct participants of the Depository Trust Company (DTC) in the United States that transfers equities to and from many international banks and broker-dealers to facilitate the use of U.S. equities for the purposes of collateral use and trading of U.S. equities in foreign markets.[color=red][color=red][/color][/color]
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