SEC Tightens Short-Selling Rules, but Critics Are Still Dissatisfied

If you’ve been following the news, you know that short-selling abuses are a subject of intense discussion and controversy.  Short selling is the practice of borrowing stock (usually from a broker-dealer or institutional investor), then selling it in anticipation that the price will go down.

Traditionally, short-sellers close out their position by purchasing equivalent stock on the open market, or by using equivalent stock they already own, thereby returning the borrowed stock.[1]  Short sellers hope to profit by buying the stock back at a lower price. “Naked shorting” is attempting to perform this transaction without having first borrowed the stock.  Accordingly, they fail to make delivery within the standard three-day settlement period. [2] Officers of some well-known companies, including Utah-based Overstock.com, and Martha Stewart Living Omnimedia, have alleged that their stocks were unfairly targeted by naked short sellers.  Defenders of the practice, including Business Week, have argued that naked shorting constitutes a legitimate market force against “overhyped -- or even fraudulent”  microcap stocks. [3] Although critics argue that taking a buyer's money and not delivering the product paid for should be regarded as fraud, a court filing made by the SEC has stated that a fail to deliver does not invalidate completion of a customer's stock purchase.[4]

The SEC has noted that, in the absence of manipulative intent, naked shorting “is not necessarily a violation of the federal securities laws or the Commission's rules.”[5]  Indeed, you may be surprised to learn that failing to deliver within the “T+3” three-day settlement period is not illegal. Rather, Exchange Act  Rule 15c6-1 merely prohibits broker-dealers from contracting to settle transactions later than T+3. However, NASD Rule 3370 provides that before a firm executes a short sale in a security in which it is not a bona fide market maker, it must make an affirmative determination that it can borrow or provide the securities for delivery by settlement date.[6]  This rule leaves open the possibility of regulatory enforcement against firms that fail to make such a determination. [7]

Dr. Patrick Byrne, the CEO of Overstock.com, has led a virtual jihad against an alleged naked short-selling conspiracy, which he has stated is orchestrated by a "Sith Lord."[8] Byrne represents an advocacy group, the “National Coalition Against Naked Short Selling-Failing to Deliver,” which, according to its Web site, describes failing to deliver as “an imminent threat to the credibility of the U.S. financial system."[9]  However, others have accused Dr. Byrne of trying to distract investors from Overstock’s less-than-stellar financial results.[10] 

To address problems associated with failures to deliver, the SEC promulgated a short-selling rule, Regulation SHO, which had a January 3, 2005 compliance date.  Among other things, Rule 203(b)(1)(ii) permits a broker or dealer to accept a short sale order in an equity security only if the broker-dealer has reasonable grounds to believe that the security can be borrowed so that it can be delivered on the settlement date. “Reasonableness” is determined based on the facts and circumstances of the particular transaction. The rule requires the stock exchanges to keep a daily list of “threshold” stocks of reporting companies that show an excessive level of failures to deliver.[11]    Brokerage firms must “close-out" failure-to-deliver positions ("open fails") in threshold securities that have persisted for 13 consecutive settlement days. However, this rule does not apply to positions that were established prior to the stock becoming a threshold stock.  Accordingly, open fail positions in securities that existed prior to the effective date of Regulation SHO on January 3, 2005 are not required to be closed out.  Finally, Rule 202T of Regulation SHO created procedures for a one-year pilot program under which existing short sale price tests would be temporarily suspended as to a group of securities to evaluate the effectiveness of these restrictions.[12]  This program began on May 2, 2005, and will end on April 28, 2006. [13]

Critics have attacked the SEC from both sides of this issue.  Those opposed to naked short selling generally argue that Regulation SHO is too lenient because, among other things, it pardons failures to deliver occurring prior to a stock being placed on a threshold list, and establishes no penalties for violating the rule. [14] However, certain industry commentators argued that prohibiting short sales without reasonably believing that securities may be borrowed for delivery will play into the hands of stock manipulators by encouraging “squeezing” short sellers.[15]  In March 2005, Senate Banking Committee, Sen. Robert Bennett (R-UT) brought up the subject of Reg SHO's shortcomings with then-SEC Chairman William Donaldson.  The only certainty about this issue is it will continue to generate more media attention in 2006.   

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[1] SEC Division of Market Regulation:  Responses to Frequently Asked Questions Concerning Regulation SHO, see http://sec.gov/divisions/marketreg/mrfaqregsho1204.htm

[2] Id. 

[3]   Don’t Force the Shorts to Get Dressed, Business Week (Dec. 8, 2003).

[4]  See Amicus Curiae Brief filed by SEC at p. 11, Nanopierce Technologies, Inc. v. DTC Corp., No. 45364 (Nev. Feb. 2, 2006).

[5] Division of Market Regulation: Key Points About Regulation SHO (April 2005). Surprisingly, elements of the mainstream media maintain that “naked short selling is illegal, barring certain exceptions for brokers trying to maintain an orderly market.” See Watch Out, They Bite,  Time.com ( Nov. 9, 2005), see http://www.time.com/time/insidebiz/article/0,9171,1126706-1,00.html

[6] The SEC imposes a similar requirement for Nasdaq and American Stock Exchange stocks.  See Rel. Nos. 34-35207 and 34-37773.

[7] See, e.g., In the Matter of John Fiero, CAF 980002, Oct. 28, 2002 (NASD National Adjudicatory Council).

[8] Thomas J. Catino, Overstock President Patrick Byrne Pursues Naked Short Selling Jihad (Nov. 8, 2005), http://www.antandsons.com/therealdeal/overstockshortselling/

[9] See http://www.ncans.net/

[10] See Cincinnati Post, Overstock.com’s Naked Short-Selling Problem Feb. 7, 2006, see http://news.cincypost.com/apps/pbcs.dll/article?AID=/20060207/BIZ/602070330/1001.  Among other things, the author of the article notes that Overstock recently reported a $18 million net loss for the fiscal year ended September 30, 2005.

[11]  The Regulation requires the self-regulatory organizations to disseminate a daily list of “threshold” securities, defined as equities with an aggregate fail to delivery position totaling at least 10,000 shares for five consecutive settlement date, equal to at least .5% of the issuer’s total outstanding shares.  Among other places, these lists are available at http://www.nasdaqtrader.com/aspx/regsho.aspx.

[12] For example, the tick test of Rule 10a-1 of the Securities Exchange Act of 1934 provides that, subject to certain exceptions, an exchange-listed security may only be sold short: (i) at a price above the immediately preceding reported price ("plus tick"), or (ii) at the last sale price if it is higher than the last different reported price ("zero-plus tick"). The New York Stock Exchange has a similar tick test under NYSE Rule 440B, and NASD has a bid test under NASD Rule 3350.

[13]  See Regulation SHO – Pilot Program,” http://www.sec.gov/spotlight/shopilot.htm.

[14] Bob O’Brien, The Lies We Are Told, and Those Who Tell Them (Jan. 19, 2006), http://www.thesanitycheck.com/BobsSanityCheckBlog/tabid/56/EntryID/33/Default.aspTo further illustrate the colorful nature of the short-selling debate, O’Brien is apparently a pseudonym that the author purportedly uses to hide from potentially vindictive hedge fund operatives.  See Karl Thiel, The Naked Truth on Illegal Shorting (March 24, 2005), http://www.rgm.com/articles/motleyfool.html.

[15] See comments of Willkie Farr & Gallagher, L.L.P., on behalf of J.P. Morgan Securities, Inc. and UBS Securities, L.L.C. (as summarized in Summary of Comments: Related to Proposed Short Sale Rule, Regulation SHO, Exch. Act. Rel. No. 48709 (July 28, 2004), http://www.sec.gov/rules/extra/s72303comsum.htm#list.