LEGALITIES and ILLEGALITIES of Shorting and "Naked Shorting"....
By a well respected ZSUN contributor:
Shorting and Naked Shorting: This article was printed by Copley Pacific on short selling entitled..."Understanding Undeclared Short Selling and How it may be impacting Your Company".
Does it sometimes seem that no matter what you do your stock has trouble climbing in price? If this the case, your company's stock may be facing downward pressure as a result of undeclared short selling.
Short selling can be divided into two categories, declared and undeclared. Many dynamic growth companies have been damaged by undeclared short selling. Created by market professionals, the practice consists of creating stock that doesn't exist. It isn't borrowed but created and it creates enormous negative pressure on a stock price.
The Mechanics of undeclared short selling are as follows: Nonexistent stock is sold short. This nonexistand stock increases a company's float. The nonexistent stock makes it difficult for investors to profit from their risk capital speculations. The short sellers make the profit. The practice hurts the public companies, themselves. It adds massive costs to maintaining a market in a stock and it reduces a company's business options.
The basis of declared short selling is borrowed stock. A short seller provides 50% or more of the value of the stock to his or her broker. This is done in a margin account. The margin protects the broker against any increase in the share price. The broker borrows the stock from a depository trust company. he then sells the stock and adds the money to his client's margin account. Later, the client buys stock (covers) to replace this borrowed stock. The difference between the price the client sold the borrowed stock and the price the client paid to replace the borrowed stock (covered) is the profit or loss from the transaction.
Most declared short players are institutional money managers and fringe group market profesionals, not small capital public investors who seldom participate. Declared short positions risk being squeezed. If the company can double its share price, the short seller will be forced to increase his margin collateral in order to maintain the short position. At such time, the short seller may elect to buy (cover) the stock instead of adding to his margin. This adds to the upward movement of the share price.
Undeclared short sellers don't borrow stock. They don't margin the sale of their short positions. Because they are market insiders they can use various techniques to sell stock that doesn't exist. Is there money to be made by undeclared short sellers? Estimates are that undeclared short sellers make multi-millions of dollars annually.
Complaints to regulatory agencies haven't stopped the practice of undeclared short selling. However, one way companies can protect themselves is to recommend to shareholders that they take physical delivery of their stock certificates. When physical delivery of stock certificates is demanded by a significant number of shareholders, the
creators of nonexistent stock can be squeezed. The short sellers won't have stock certificates to deliver and thus they will cause losses for them and wil cause them to move their undeclared short activities elsewhere.
End of article.
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Sec.71. Mandatory Close-Out for Short Sales
A contract involving a short sale in Nasdaq securities described in subparagraph (a) below, for the account of a customer or for a member?s own account, which has not resulted in delivery by the broker-dealer representing the seller within 10 business days after the normal settlement date, must be closed by the broker-dealer representing the seller by purchasing for cash or guaranteed delivery securities of like kind and quantity.
(a) This requirement shall apply to Nasdaq securities, as published by the Association, which have clearing short positions of 10,000 shares or more and that are equal to at least one-half (1/2) of one percent of the issue?s total shares outstanding.
(b) This mandatory close-out requirement shall not apply to bona fide market making transactions and transactions that result in bona fide fully hedged or bona fide fully arbitraged positions.
New Section 71 of the UPC requires the short seller?s broker/dealer to close out a short sale of specific securities 10 days after the normal settlement date if delivery of securities has not occurred and the transaction is not exempt. Securities subject to the close-out requirement are those with an aggregate ?clearing? short position of 10,000 shares or more that equals or exceeds one half of one percent of the total shares outstanding. The NASD will identify these securities daily based on data from the National Securities Clearing Corporation (NSCC) and will compile a ?restricted list.?2 Any subsequent short-sale transaction in a security on the list that is not completed by delivery of shares within the prescribed time frames will be subject to mandatory close-out if a ?fail-to-deliver? situation exists 10 days after normal settlement date.
The rule applies to customer and proprietary short sales, but exempts ?bona fide? market-making activities and short sales that result in a ?bona fide? fully hedged or arbitraged position3. For example, the close-out rule applies if a broker/dealer sells a restricted security short from its proprietary account to another broker/dealer and fails to deliver the security within 10 days of normal settlement date. The rule also applies if the firm makes the same transaction for a customer4. However, if the short sale is part of a bona fide market-making transaction or if the sale of a restricted security results in a fully hedged or fully arbitraged position, it is exempt from the mandatory close-out requirement.
In response to certain comments submitted to the SEC about persistent open clearing positions, the NASD noted that short selling isn?t the only reason certain securities have unsettled trades at clearing corporations for lengthy periods. Other reasons include a member firm?s segregation requirements under SEC Rule 15c3-3, transfer delays, or some characteristic of the security that prevents delivery5. The NASD concluded that nearly all stocks that develop large, persistent fails-to-deliver conditions at clearing corporations would be covered by the close-out rule because the rule focuses on persistent rather than temporary fail-to-deliver situations.
In response to concerns regarding possible evasion of the rule by selling assets used to hedge an exempted short position, the NASD found that hedged positions accounted for less than 2 percent of the total shares of reported short interest in the stocks covered by its analysis. The NASD Market surveillance Department will monitor compliance with the rule, and previous violations of short-sale rules have been subject to disciplinary action by the Market Surveillance Committee. The close-out rule will add substantially to the ability of the NASD to eliminate naked short selling as a regulatory problem and will address the few cases where unsettled trades may create regulatory or market concern.
In response to comments concerning the restrictive warrant hedging exemptions, the NASD believes that easing the rule would create a substantial loophole. Transactions envisioned by certain commenters would enable short selling without the need to close out transactions under the rule. A warrant price near zero would permit virtually unlimited short selling, with no delivery requirement. While normally the number of shares necessary to establish a hedge could be determined by calculating a hedge ration, only 80-90 securities will be subject to the rule on a given date and those that are subject to the rule are for the most part thinly traded, making calculation of a hedge ratio inefficient. In addition, basing the exemption on a hedge ratio would severely complicate surveillance of compliance with the rule as well as increase compliance and surveillance costs. The rule attempts to balance the need to require delivery of a certain class of securities with the desirable warrant-hedging function.
Accordingly, Section 71 provides that short positions offset by long positions in corresponding convertible debentures, options, or warrants with a ?call? feature are ?bona fide fully hedged,? provided the corresponding position is ?in the money? (i.e., the strike/conversion price is below the current market value of the security) and exercisable or convertible within 90 days6. Section 71 also provides that short positions offset by warrants that are ?out of the money? are exempt from the close-out procedures up to the value of the warrant7.
In July 1986, the NASD issued a report detailing a study of short-sale practices in Nasdaq securities (Pollack study). As a result of recommendations contained in the Pollack study, the NASD took a number of regulatory initiatives regarding short selling. The NASD now requires members to:
(1) mark all sale transactions either ?long? or ?short?;
(2) mark an affirmative determination that they will receive delivery of a security from a customer or that they can borrow a security for a customer before accepting a short sale from a customer;
(3) make an affirmative determination that they can borrow the security before effecting a short sale for their own account (certain transactions in corporate debt securities, bona fide market-making activities, and fully hedged or arbitraged positions are exempt);
(4) buy-in for cash or guaranteed delivery Nasdaq securities, if the buyer is not an NASD member, on failure of a clearing corporation to effect delivery pursuant to a buy-in notice; and
(5) report, as of the 15th of each month, aggregate short positions in all customer and proprietary accounts in securities listed on The Nasdaq Stock MarketSM. In addition, the NASD has proposed a rule change to prohibit short sales of Nasdaq National Market© securities at or below the current inside bid when that bid is lower than the previous inside bid.
In addition to these changes, the Pollack study recommended that the NASD address the fail-to-deliver/fail-to-receive problem created by naked short selling1. The Pollack study indicated that the lack of an automatic mechanism for preventing the build-up of short positions at clearing corporations carried the potential for serious problems, especially in times of market stress. As a result of Pollack study recommendations and member comment, the NASD proposed that members close out short sales in certain securities.
As mentioned in the Pollack study, the fail-to-deliver/fail-to-receive problem could cause serious difficulties in a lengthy bear market. Large unsettled trades can disrupt market mechanisms. Public customers reasonable expectations that their securities have been delivered should be met. Additionally, naked short selling can present substantial manipulative concerns. While naked short sellers must deposit margin with either their broker/dealer or with a clearing corporation, they enjoy greater leverage than if they had to close out their short positions within a reasonable time frame. The ability of naked short sellers to employ this leverage to effect bear raids supports the decision to impose additional discipline on naked short selling via a close-out requirement.
Thus, the rule change will assist in preventing manipulation of Nasdaq securities through excessive naked short selling. As originally recommended in the Pollack study, a buy-in or close-out requirement will add to the stability of the marketplace by assuring that securities are available to cover short positions, especially in times of volatility. Such a requirement also will help enhance the integrity of The Nasdaq Stock Market. In addition, the close-out rule may help to prevent short-selling abuses that could harm investors and the public interest.
Questions concerning this Notice may be directed to Dorothy L. Kennedy, Assistant Director, Nasdaq Operations, at (212) 858-4030 until August 20, 1993; after August 23, 1993, call (203) 375-9609. |
