Regulation of Naked Short Selling
Regulation of Naked Short Selling
Mark Jickling
Specialist in Public Finance
Government and Finance Division
Summary
Short sellers borrow stock, sell it, and hope to profit if they can buy back the same
number of shares later at a lower price. A short sale is a bet that a stock’s price will fall.
A short sale is said to be “naked” if the broker does not in fact borrow shares to deliver
to the buyer. When executed on a large scale, naked short sales can equal a large portion
of total shares outstanding, and can put serious downward pressure on a stock’s price.
Critics of the practice characterize it as a form of illegal price manipulation. The
Securities and Exchange Commission (SEC) in 2004 adopted Regulation SHO, a set of
rules designed to control short selling abuses, focusing on small-capitalization stocks
where the number of shares held by the public was relatively small. Until the current
financial crisis, the SEC did not view short selling of large, blue-chip stocks as a
problem. In July 2008, however, the SEC temporarily banned naked short sales of the
stock of Fannie Mae, Freddie Mac, and 17 other large financial institutions. On
September 18, 2008, the SEC banned all short selling of the shares of more than 700
financial companies in an emergency action that expired on October 8, 2008. On
October 1, the SEC adopted a rule requiring short sellers’ brokers to actually borrow
shares to deliver to buyers, within the normal three-day settlement time frame. This
report will be updated as events warrant.
Short selling was best described by Daniel Drew, the Gilded Age speculator and
robber baron: “He that sells what isn’t his’n, must buy it back or go to prison.” Short
sellers borrow shares from a broker, sell them, and make a profit if the share price
subsequently drops, allowing them to buy back the same number of shares for less money.
In other words, short selling is a bet that the price of a stock will fall.
Short sellers have always been unpopular on Wall Street. Like skeletons at the feast,
they seem to stand against rising share values, expanding wealth, and general prosperity.
However, most market participants recognize that they provide a valuable service to the
extent that they identify companies and industries that are overvalued by investors in the
grip of irrational exuberance. By bringing such valuations down to earth, short selling can
prevent economically wasteful over-allocation of resources to those firms and sectors.
Manipulation by Short Sellers
Another persistent complaint against short sellers is that they cause artificial price
volatility. A form of manipulation common in the 19th century was the “bear raid” — a
gang of speculators would sell a stock short, causing the price to drop. They would
follow with another wave of short sales, depressing the price still further, and so on, until
the stock’s price was driven to the floor.
In the 1930s, the Securities and Exchange Commission (SEC) adopted a regulation
to prevent bear raiding. The “uptick rule”1 stated that a short sale may occur only if the
last price movement in a stock’s price was upward. This prevents short sellers from
piling onto a falling stock and setting off a downward price spiral. In the words of a
standard securities law textbook, the tick test (and related rules) “seem pretty well to have
taken the caffeine out of the short sale.”2 In 2007, the SEC concluded that growth in the
market made the rule unnecessary, and it was repealed.3
However, in recent years, complaints about manipulative short selling have
reappeared. Many shareholders and officers of smaller firms have identified “naked”
short selling as a source of price manipulation and have criticized the SEC’s enforcement
record. At the same time, the SEC has identified short selling in connection with
spreading rumors as an abuse that may raise fears about the solvency of the target firm
and cut off its access to credit, potentially leading to the destruction of the firm, as was
the case with Bear Stearns in March 2008.
Naked Shorting
A short sale always involves the sale of shares that the seller does not own. The
buyer, however, expects to receive real shares. Where do those shares come from?
Normally, they are borrowed by the broker from another investor or from a brokerage’s
own account. This is usually not difficult to do if the shares are issued by a large
company, where millions of shares change hands daily and where many shares are not
registered to the actual owners, but are held in “street name,” that is, in the broker’s
account. With smaller corporations, however, the number of shares in circulation may be
limited, and brokers may find it difficult to locate shares to deliver to the buyer in a short
sale transaction.
When shares are not located to “cover” a short sale, the short position is said to be
naked. If shares are not found by the time the transaction must be settled, there is a
“failure to deliver” shares to the buyer. If it occurs sporadically and on a small scale,
naked short selling does not raise serious manipulation concerns. However, when the
number of shares sold short represents a significant fraction of all shares outstanding,
there may be a strong impact on the share price. In such cases, when naked short selling
1 Rule 10a-1(a). The rule technically applies only to exchange-listed stocks, but a comparable
rule was extended to Nasdaq National Market System stocks in 1994.
2 Louis Loss, Fundamentals of Securities Regulation (Boston: Little Brown, 1983), p. 717.
3 Release No. 34-55970, “Regulation SHO and Rule 10a-1,” June 28, 2007. See also CRS Report
RL34519, The Uptick Rule: The SEC Removes a Limit on Short Selling, by Gary Shorter.
creates a virtually unlimited quantity of shares, a market based on supply and demand can
be seriously distorted. The SEC notes that “naked short sellers enjoy greater leverage
than if they were required to borrow securities and deliver within a reasonable time
period, and they may use this additional leverage to engage in trading activities that
deliberately depress the price of a security.”4
The case against naked short selling has been that by permitting short sales to occur
when there is no possibility of actually delivering shares to the buyers, brokers and dealers
accommodate manipulation. When naked short selling drives prices down, holders of the
stock understandably feel cheated. They do not believe the stock is overvalued; they are
not selling; but the price drops anyway.
It is important to note that naked short selling is not always evidence of intent to
manipulate prices. Under certain circumstances, a market maker5 may engage in naked
short selling to stabilize the market. For example, assume that there is a sudden flurry of
buy orders for a stock. The market maker may judge the buying interest to be temporary
and not justified by any real news about the company’s prospects. It may be the result of
a questionable press release or a rumor in an Internet chat room. The market maker may
choose to sell short to avoid what in its view would be an unjustified run-up in the stock’s
price. In this situation, naked short selling by the market maker may protect investors
against manipulation.
It is also worth noting that while restrictions on short selling discourage certain
forms of manipulation, they may encourage or facilitate others. Manipulations that
involve artificially inflating stock prices are probably more common than techniques (like
naked shorting) that seek to depress them. Rumors, false press releases, and unexpected
purchases may all cause sudden run-ups of stock prices, which may be followed (in the
classic “pump-and-dump” fraud) by sudden collapse, as the manipulators sell their shares
to the unwary. Without short selling as a counterweight, the magnitude and duration of
such fraudulent run-ups are likely to be greater
Until July 2008, the SEC viewed the problem of naked shorting as largely confined
to smaller firms, particularly small-capitalization “penny” stocks listed on the Nasdaq
bulletin board market (OTCBB).6 In these companies, the bulk of outstanding shares may
be owned by corporate insiders or by securities dealers who act as market makers, so that
relatively few shares are available for purchase on the open market. This means that
transactions have a proportionately greater impact on the stock price than do trades of the
same size in the shares of a larger company, making manipulation easier. In addition to
OTCBB stocks, however, smaller companies listed on the exchanges or the Nasdaq
national market may also be vulnerable to short selling abuse.
4 Release No. 34-48709, “Short Sales: Proposed Rule,” October 28, 2003.
5 Market makers are dealers who stand ready to buy or sell a stock at any time and who publish
the prices at which they are willing to trade. They are the key intermediaries on the Nasdaq; on
the New York Stock Exchange, they are called specialists.
6 The uptick rule does not apply to OTCBB stocks.
Regulation SHO
After several years of deliberation, the SEC in 2004 adopted rules designed to
control abusive naked short selling. Regulation SHO7 took effect on January 3, 2005.
The new regulation replaced existing exchange and Nasdaq rules with a uniform national
standard. Under Regulation SHO, a broker may not accept a short sale order from a
customer, or effect a short sale for its own account, unless it
!has either borrowed the security, or made a bona fide arrangement to
borrow it; or
!has reasonable grounds to believe that it can locate the security, borrow
it, and deliver it to the buyer by the date delivery is due; and
!has documented compliance with the above.
The appearance of a stock on an exchange’s “easy to borrow” list constituted
reasonable grounds for believing that the stock can be located. Stocks on such lists tend
to be highly capitalized, with large numbers of shares in circulation.
If a broker executes a short sale, and then fails to deliver shares to the purchaser,
further restrictions on short selling may come into force. If the “fail to deliver” position
is 10,000 shares or more, for five consecutive trading days, and the position amounts to
at least 0.5% of total shares outstanding, the stock becomes a threshold security. The
exchanges and Nasdaq are now required to publish daily lists of threshold securities.
Regulation SHO specifies that if a fail to deliver position in a threshold security persists
for 13 trading days, the broker (or the broker’s clearing house) must close the short
position by purchasing securities of like kind and quantity. After the 13 days have
elapsed, the broker may not accept any more short sale orders until the fail to deliver
position is closed by purchasing securities.
The rules include exemptions for market makers engaged in bona fide market-
making activities, and for certain transactions between brokers.
Effects of Regulation SHO
The adoption of Regulation SHO has not put an end to investor complaints about
naked short selling. Complaints are heard that the SEC is not enforcing the rules
vigorously enough, that short selling continues, and that some brokers evade the 13-day8
requirement by passing fail to deliver positions from one to another.
The SEC staff has monitored the incidence of fail to delivers after the effective date
of Regulation SHO, and, in July 2006, Chairman Cox reported that the rule “appears to
7 Release No. 34-50103, “Short Sales: Final Rule,” July 28, 2004, available at
[ h t t p : / / www.sec.go v/ r u l e s/ f i nal / 34-50103.ht m] .
8 “Of Stocks and Socks: Senator Bennett Bores In On SECs Dismal Naked Short Sales Record,”
FinancialWire, March 14, 2005, p. 1.
be significantly reducing fails to deliver without disruption to the markets.”9
Nevertheless, some further amendments to Regulation SHO were considered.
In July 2006, the SEC proposed rules to close two “loopholes” in Regulation SHO,
which it called responsible for the persistence of fail to deliver positions in certain stocks.
Under the proposed rules, the current exemption for options market makers would be
restricted. Second, a “grandfather” provision in the original rule — which exempted
short positions that had been established before a stock was placed on the threshold
securities list from the requirement that fail to deliver positions be closed out after 13
consecutive trading days — would be eliminated.
In August 2007, the SEC adopted the proposed rule abolishing the grandfather
provision. When a stock goes onto the threshold list, all short positions in the stock will
be subject to the 13-day close-out requirement. The SEC did not adopt the proposal
relating to options market makers.
The 2008 Emergency Orders
As financial companies came under pressure from tight credit markets in late 2007
and 2008, concerns emerged about manipulative short sellers spreading rumors about
firms’ creditworthiness and liquidity. Despite regulators’ assurances that Bear Stearns,
a leading investment bank, had adequate capital and liquidity reserves, the firm was
destroyed in March 2008 by the equivalent of a bank run: market participants, fearing that
the firm might not be able to meet its obligations, refused to extend credit. The Federal
Reserve was forced to arrange a hasty merger with JP Morgan Chase, which acquired
Bear Stearns on condition that the Fed purchase $29 billion of risky mortgage assets.
All large financial firms finance their operations by issuing short-term debt, which
must be continually refinanced, or rolled over. Thus, they are vulnerable to “nonbank
runs” — they cannot survive long if markets lose confidence and become unwilling to
provide new funds. In July 2008, share prices of Fannie Mae and Freddie Mac, the two
giant government-sponsored enterprises that hold about $1.5 trillion in mortgage-backed
assets, plunged, and fears arose that they might go the way of Bear Stearns. On July 15,
the SEC issued an emergency order banning naked short sales of the shares of Fannie,
Freddie, and 17 other large financial institutions.10
Under the terms of the order, no short sale of the stock of any of the 19 listed firms
may occur unless the seller has actually borrowed (or arranged to borrow) the stock and
delivers the stock to the buyer on the regular settlement date.
The SEC explained the rationale for its unusual action:
9 Chairman Christopher Cox, “Opening Statement at the Commission Open Meeting,” July 12,
10 “SEC Enhances Investor Protections Against Naked Short Selling,” Press Release 2008-143,
July 15, 2008. Available at [http://www.sec.gov/rules/other/2008/34-58166.pdf]. Ten of the 17
were foreign firms.
False rumors can lead to a loss of confidence in our markets. Such loss of confidence
can lead to panic selling, which may be further exacerbated by “naked” short selling.
As a result, the prices of securities may artificially and unnecessarily decline well
below the price level that would have resulted from the normal price discovery
process. If significant financial institutions are involved, this chain of events can
threaten disruption of our markets.
The events preceding the sale of The Bear Stearns Companies Inc. are illustrative of
the market impact of rumors. During the week of March 10, 2008, rumors spread
about liquidity problems at Bear Stearns, which eroded investor confidence in the
firm. As Bear Stearns’ stock price fell, its counterparties became concerned, and a
crisis of confidence occurred late in the week. In particular, counterparties to Bear
Stearns were unwilling to make secured funding available to Bear Stearns on
customary terms. In light of the potentially systemic consequences of a failure of Bear11
Stearns, the Federal Reserve took emergency action.
The SEC’s intervention has been criticized by some who believe that financial stocks
have been battered not by false rumors, but by realistic assessments of firms’ underlying
financial weakness. Short selling, in this view, is simply market discipline at work. One
view is that the SEC’s objective of raising financial stock prices itself amounts to market12
manipulation.
The SEC’s original order, issued on July 15, was extended through August 12, 2008.
On September 18, 2008, as financial stocks plunged, the SEC issued another, much
more sweeping emergency order. All short selling (naked or not) of the shares of more
than 700 financial firms was banned. The rationale was the same as for the earlier action:
whatever benefits short selling might provide in terms of price efficiency were far
outweighed by the possible damage to the financial system and the economy if major
firms were swept away by panic. The emergency order expired October 8, 2008.
On October 1, 2008, in addition to extending the short sale ban announced on
September 18, the SEC adopted a rule that in effect banned naked short selling in all
stocks.13 This order, in the form of an interim final rule, requires that when a failure to
deliver shares within the normal three-day settlement period occurs, the seller’s broker
must immediately purchase or borrow securities and close out the fail to deliver position
by no later than the beginning of trading on the next business day. Failure to comply
means that the broker cannot sell that stock short either for its own account or for
customers, unless the shares are not only located but also pre-borrowed.
The SEC also adopted Rule 10b-21, a naked short selling anti-fraud rule, covering
short sellers who deceive broker-dealers or any other market participants about their
intention or ability to deliver securities in time for settlement. The rule makes clear that
such persons are violating the law when they fail to deliver.
11 Ibid.
12 Lawrence Summers, “How to Build a U.S. Recovery,” Financial Times, August 7, 2007, p. 5.
13 Securities and Exchange Commission, “Amendments to Regulation SHO,” [Release No.