Interesting Post:
Someone showed me this is on another thread and thought it might go well here...
I've been reviewing the case law on naked short selling and what I found was surprising.
Apparently, there are no laws or regulations that prevent market makers from selling shares they don't own. In the one case I found that addresses short selling of penny stocks, a market maker sold short 170 million shares of a company that only had 122 million shares outstanding. At trial, the market maker admitted he had no intention of delivering any of the stock that he sold short. When buy orders came in, the MM discouraged them by selling short more and more stock. The court found that the MM had not violated any federal law or regulation, and that he had not violated the rights of the shareholders because they had no reasonable basis for believing "that the number of shares of a stock that is being sold short does not exceed the total number of shares in existence"! In other words, because there are no laws prohibiting naked short selling, the shareholders "could not count on the volume of short sales being capped at the total number of shares outstanding." The court even noted that naked short selling served a legitimate purpose by helping to move the market price toward the true value of the stock.
Admittedly, the case had unique circumstances, since it addressed short selling in the face of bankruptcy proceedings and the pending re-issuance of new, lower-valued stock, but it does establish the general principle that naked short selling is in and of itself not illegal. Other cases suggest that naked short selling, when part of a broader scheme by MMs to manipulate market price, is illegal under Section 10b (which prohibits the "use or employment, in connection with the purchase or sale of any security . . . of any manipulative of deceptive contrivance").
For anyone interested in the case discussed above, it is Sullivan & Long v. Scattered Corporation, 47 F.3d 857 (7th Cir. 1994).
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