Goodbye to Naked Shorting

Naked short-selling.


In some circles, those are fighting words. There are companies that blame all their problems on that kind of trading, which is illegal if it is intended to manipulate the market. There are claims that it has destroyed thousands of public companies, although those making the claims have trouble naming any such companies.

But now, it appears, naked shorting — the practice of selling shares short without borrowing them — is almost gone. The Securities and Exchange Commission’s hurried changes of short-selling rules last fall appear to have all but eliminated the number of companies where such selling seems to be occurring. This appears to be an example of regulation working.

The primary example of the decline in naked short-selling is in the shares of, an Internet retailer whose chief executive, Patrick M. Byrne, has for years been on what he called a “jihad” against such trading. Overstock has sued many Wall Street firms for facilitating such trading, as well as a hedge fund and a research firm that it believes acted illegally in spreading negative information about the company. The suits have not yet gone to trial.

The primary evidence of naked short-selling is a large number of trades where shares were not delivered on time, causing a “fail” in Wall Street jargon. Naked short-selling can save a trader the costs of borrowing shares, or can make it possible to short a stock where borrowing is very difficult because so many others want to sell it short. A large number of fails does not prove naked short-selling, since there are other reasons for trades to fail, but such a number does indicate it is likely.

Critics of naked short-selling often say it produces “counterfeit shares,” but that term is misleading. Any short-seller, naked or not, takes on the same economic risks. If the price rises, the trader will lose money. If it falls, he will profit.

The stock exchanges publish “threshold lists” every day of stocks where there are substantial failures — at least one-half of 1 percent of the outstanding shares. Overstock spent months on the Nasdaq list, and at the height had 3.8 million failures to deliver in one day, a huge figure in comparison to the 22.8 million shares outstanding.

But it has not been on the list since Sept. 2, 2008, a few weeks before the S.E.C. imposed its new rules. On some days this year, there have been virtually no failures to deliver Overstock shares.

Over all, the threshold lists, which once had hundreds of companies on them each day, now list few companies. Of the handful of companies still remaining, few stay on the lists for more than a few days. That indicates that failures, when they occur, are quickly corrected.

So are those who used to bitterly complain about naked shorting praising the S.E.C. for solving the problem?

Not a bit. Dozens of letters blaming naked shorting for the decline in share prices have poured into the S.E.C. in recent weeks, in response to a request by the commission for comment on the possibility of imposing rules to make it harder to sell stocks short when share prices are falling.

“Why has the SEC not addressed the NAKED SHORTING issue?” asked one such letter, from an investor named Edwin J. Jewell. “It has hurt the average investor by this type of manipulation.”

Mr. Byrne told me this week that he thought there were numerous ways for Wall Street to hide failures to deliver. The list he offered ranged from the plausible to the dubious, but the evidence that there are many such failures is not easy to come by. When I asked Jonathan E. Johnson III, Overstock’s president, if he believed there was substantial naked shorting of his company’s shares despite the low number of failed trades, he declined to answer. He said such information was likely to come out in the trial of the suit Overstock filed against the brokerage firms, but there is no date set for that trial.

The S.E.C. rule that seems to have won the war against naked short-selling was one that simply eliminated an exemption previously available for those who made markets in stock options. The fact that fails soon plunged is evidence that that exemption was being abused.

That rule is set to expire July 31, but it seems probable that the commission will make it permanent before that.

Obviously "evil"?

The commission will hold a roundtable discussion this week on the wisdom of making it harder to sell stocks short, either by allowing such sales only at prices higher than the last different one, or by barring such sales at all when either the stock in question or the entire market has fallen by a large amount.

The participants in that roundtable will be asked to discuss evidence that short-selling is or is not responsible for the slide in prices, and what impact came from the temporary bans on short-selling imposed on financial stocks at the height of the panic last year.

To many people who wrote to the S.E.C., it is obvious that short-selling is evil and the cause of their losses. To a smaller number of others, it is obvious that short-sellers make the market more efficient. The S.E.C. clearly would like to find some real evidence on the subject, but there is heavy political pressure to do something whether or not such evidence can be found.

Wall Street historically defended the practice of short-selling, but the tune changed last summer when heads of investment banks demanded halts to short sales of their stocks, and the S.E.C. complied. The banks argued that short-sellers were driving down prices and destroying investor confidence — an argument heard for years from executives of smaller companies.

To many economists, such arguments, whether applied to normal short-selling or to naked short-selling, ring hollow. They believe in efficient markets and argue that if a share price is driven to excessively low prices, other investors will step in to buy the stock. An offer to acquire a company with a large short position can produce immediate and painful losses for those who bet against the stock. The failure of anyone to make such an offer may be an indication that the company lacks much fundamental value.

As for Overstock, the apparent end to naked short-selling has not led to higher prices of shares in the perennially unprofitable Internet retailer. The share price, around $28 when the number of failed trades hit its peak in 2006, had fallen to about $20 by the time it came off Nasdaq’s threshold list in September. Now it is under $14.