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					Version: April 26, 2007

Naked Shorting
Christopher L. Culp
Lexecon, Inc.

J.B. Heaton
Bartlit Beck Herman Palenchar & Scott LLP Abstract A “naked short sale” is a short sale of stock in which the seller does not own the shares and essentially has no plans to acquire the stock by the settlement date. We review the standard economic arguments for and against the speculative short sale of equities and explain the strong economic similarities between permissible short selling and impermissible naked short selling. Despite the legal prohibitions on the latter, we show that, from an economic perspective, naked shorting is not fundamentally different from traditional short selling and is unlikely to have detrimental effects on capital markets. Nevertheless, we explain how naked shorting can provide the basis for securities manipulation lawsuits under the federal securities laws for long sellers and, in some circumstances, for issuers.

We received helpful comments from several anonymous reviewers of a preliminary draft. Please address correspondence to Culp at Lexecon, 332 S. Michigan Ave., Chicago IL 60604, or Heaton at Bartlit Beck Herman Palenchar & Scott LLP, 54 West Hubbard Street, Chicago, Illinois 60610. Culp acknowledges that the opinions expressed here are his own, and do not reflect the position of Lexecon. Heaton acknowledges that the opinions expressed here are his own, and do not reflect the position of Bartlit Beck Herman Palenchar & Scott LLP or its attorneys.

Electronic copy of this paper is available at: http://ssrn.com/abstract=982898

Naked Shorting
We are particularly concerned about the potential negative effect that substantial and persistent fails to deliver may be having on the market in some securities. Specifically, these fails to deliver can deprive shareholders of the benefits of ownership - voting, lending, and dividends from issuers. Moreover, they can be indicative of abusive naked short selling, which could be used as a tool to drive down a company's stock price. They may also undermine the confidence of investors who may believe that the fails to deliver are evidence of manipulative naked short selling in the stock. In turn, issuers may be harmed, as investors may be reluctant to commit capital to a stock that they believe is subject to abusive naked short selling. –Christopher Cox, Chairman, Securities and Exchange Commission, July 2006 The court was not astonished to learn from counsel that the practice of selling short naked is rather less fun than might be imagined. –Miller v. Asensio, 101 F. Supp. 2d 395, 398 n3 (D.S.C. 2000) __________________________________________ A “naked short sale” is a short sale of stock in which the seller does not own the shares and essentially has no plans to locate and borrow the stock by the settlement date. Naked shorting has been the focus of an increasing number of lawsuits.1 One plaintiffs’ lawyer bringing these lawsuits argues that naked shorting is “the largest commercial fraud in U.S. history involving hundreds of billions of dollars.”2 Outside the legal community, those decrying the practice of naked shorting range from fervently opinionated individual investors to the U.S. Chamber of Commerce, which asked the Securities and Exchange Commission (“SEC”) on

1 Randall Smith, Suits Focus on Street’s Role in ‘Naked Shorting,” The Wall Street Journal, June 28, 2006, C1. Most such lawsuits have been dismissed. See, e.g., a list describing the status of various lawsuits against The Depository Trust & Clearing Corporation at http://www.dtcc.com/ThoughtLeadership/keyissues/naked_short_case.htm

James W. Christian, Robert Shapiro, and John-Paul Whelan, Naked Short Selling: How Exposed Are Investors?, 43 Houston L. Rev. 1033 (2006).

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Electronic copy of this paper is available at: http://ssrn.com/abstract=982898

January 23, 2007, to take additional steps to stop naked shorting.3 Regulators and exchanges have shown a willingness to crack down on alleged violations of prohibitions on naked shorting.4 Equity short sellers of all kinds have long been unpopular with securities issuers, investors, and, to some extent, the SEC.5 Notwithstanding popular sentiment, however, speculative short selling is legal in U.S. securities markets as long as the short seller or his broker has located shares from existing owners that are willing to lend their shares for delivery on the short sale’s settlement date.6 The proceeds of the short sale remain with the security lender7 who must deliver the proceeds to the short selling “borrower” when the short seller delivers equivalent shares to the security lender.

Letter from David Chavern, Chief Operating Officer & Senior Vice President, Chamber of Commerce of the United States of America, to The Honorable Christopher Cox, Chairman, U.S. Securities and Exchange Commission, January 23, 2007, available at http://www.uschamber.com/ncf/initiatives/investment.htm?n=tb (regulatory comment letters).
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See, e.g., “Goldman Snared in Naked Shorting Probe,” http://www.forbes.com/business/2007/03/14/goldmannaked-shorts-biz-cx_lm_0314naked.html?boxes=author See Provost v. United States, 269 U. S. 443, 450-51 (1926) (“As the phrase indicates, a short sale is a contract for the sale of shares which the seller does not own or the certificates for which are not within his control so as to be available for delivery at the time when, under the rules of the Exchange, delivery must be made.”); Regulation SHO, 17 C.F.R. § 200(a) (“The term “short sale” shall mean any sale of a security which the seller does not own or any sale which is consummated by the delivery of a security borrowed by, or for the account of, the seller.”).
6 See 17 C.F.R. § 240.10a-1 (2006) (providing rules governing short sales); GFL Advantage Fund, Ltd. v. Colkitt, 272 F.3d 189, 209 (3d Cir.2001) (“short selling, even in large volumes, is not in and of itself unlawful and therefore cannot be regarded as evidence of market manipulation. That short selling may depress share prices, which in turn may enable traders to acquire more shares for less cash (or in this case, for less debt), is not evidence of unlawful market manipulation, for they simply are natural consequences of a lawful and carefully regulated trading practice”); In re Olympia Brewing Co. Sec. Litig., 613 F.Supp. 1286, 1296 (N.D.Ill.1985) (“short selling is simply not unlawful, even in large numbers and even if the trading does negatively affect the purchase price”). 7 Securities “lending” is a misnomer; loaned shares are delivered free and clear of any other claims to the buyer on the other side of the short sale. See Robert C. Apfel, John E. Parsons, G. William Schwert, Geoffrey S. Stewart, Short Sales, Damages, and Class Certification in 10b-5 Actions, unpublished working paper, July 2001, available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=285768 (analyzing problems in distinguishing ownership interests created by short sales). 5

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Under SEC Regulation SHO8, it is illegal in some circumstances9 to sell a security short without having first located a security lender from among existing security owners. Regulation SHO requires that a broker cannot accept a short sale order from a customer, or effect a short sale for its own account, unless: (1) it has borrowed the security or made a good faith arrangement to borrow the security; (2) it reasonably believes it can locate and borrow the security by the settlement day; and (3) it has documented compliance with the above requirements. Despite the recent spate of lawsuits and media attention, however, the existing literature on naked shorting consists mostly of self-confessed advocacy pieces by lawyers and consultants already directly involved in naked shorting cases,10 or parties who are defendants in such lawsuits.11 Our article takes a more balanced look at the issue. We begin in Part I by reviewing the standard economic arguments for and against the speculative short sale of equities. Part II then describes the mechanics of naked shorting and the strong economic similarities between permissible short selling and impermissible naked short selling. Despite the legal prohibitions on the latter, the analysis suggests that economically, naked shorting is not fundamentally different from traditional short selling and is unlikely to have serious detrimental effects on capital markets. Finally, Part III explains how naked shorting

817 C.F.R. § 242.200-242.203. Regulation SHO became effective on September 7, 2004. (Securities Exchange Act Release No. 50103 (July 28, 2004), 69 FR 48008 (August 6, 2004)). The commencement date to comply with the provisions of Regulation SHO was January 3, 2005. Regulation SHO applies to short sales of equity securities. 9 Some forms of naked shorting are legal and permissible – especially naked shorting that is associated with genuine market making activities. 10 See, e.g., Christian, et al., supra note 6, at 1033 (“One of the Authors of this Article is plaintiff’s counsel in a series of litigation involving naked short selling. The Houston Law Review invited a response from defense counsel, who elected not to submit a response.”)

See, e.g., the discussion of naked shorting at a webpage of the Depositary Trust & Clearing Corporation: http://www.dtcc.com/Publications/dtcc/mar05/naked_short_selling.html.

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may provide the basis for securities manipulation lawsuits under the federal securities laws for long sellers and, in some circumstances, for issuers.

I.

Speculative Short Selling According to widespread conventional wisdom, short selling drives down the price of the

stock being sold. The SEC consistently receives excited opposition to the practice of short selling, much of which invokes accusations of conspiracy theory and nearly religious fervor against short selling in general and naked short selling in particular.12 At the same time, financial economists have long been skeptical of the value of regulations that constrain speculative short selling because of a conviction that short sale constraints may allow overpriced securities to remain overpriced.13

A. The Good Side of Short Selling Prices are socially valuable signals. Short selling can correct irrational overpricing when it occurs, and, for this reason, financial economists usually object to regulatory constraints on short selling.
12

http://www.sec.gov/rules/proposed/s72303.shtml; “SEC is urged to attack ‘naked’ short selling,” The Wall Street Journal, September 22, 2006, C3.

13 The classic explanation is put forth in Edward M. Miller, “Risk, Uncertainty, and Divergence of Opinion,” 32 J. Fin. 1151 (1977) (describing the role of short sale constraints in allowing prices to reflect the opinions of a badly informed minority); see also Michael Harrison and David Kreps, Speculative investor behavior in a stock market with heterogeneous expectations, 92 Quarterly J. Econ. 323 (1978).; Douglas W. Diamond and Robert E. Verrecchia, “Constraints on Short–selling and Asset Price Adjustment to Private Information,” 18 J. Fin. Econ. 277 (1987); Joseph Chen, Harrison Hong, and Jeremy Stein, “Breadth of ownership and stock returns,” 66 J. Fin. Econ. 171 (2002); Charles M. Jones and Owen A. Lamont, “Short-sale constraints and stock returns,” 66 J. Fin. Econ. 207 (2002) (finding that stocks that are expensive to short or which enter the borrowing market have high valuations and low subsequent returns); Harrison Hong and Jeremy Stein, “Differences of opinion, short-sales constraints and market crashes,” 16 Rev. Fin. Studies 487 (2003); José Scheinkman and Wei Xiong, “Overconfidence and speculative bubbles,” 111 J. Pol. Econ. 1183 (2003); Harrison Hong, José Scheinkman, and Wei Xiong, “Asset Float and Speculative Bubbles,” 61 J. Fin. 1073 (2006); Lauren Cohen, Karl B. Diether, and Christopher J. Malloy, “Supply and Demand Shifts in the Shorting Market,” unpublished working paper, May 9, 2006, available at fisher.osu.edu/~diether_1/papers/shifts.pdf.

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In Figure 1, the shares outstanding before any short selling are fixed at quantity QO. The curve labeled DO is our “excessively optimistic” demand curve. Before any short sales, the price that clears the market at the existing supply of shares is PO. A short sale can be viewed as a short-term increase in the supply of the stock – say, from QO to QO+S. The market clearing price at this “as if” 14 quantity is then PO+S, which is lower than PO. In this example, short selling depresses prices. But that alone cannot make short selling profitable and, therefore does not provide an incentive for speculative short selling. In particular, the price decrease is only temporary if demand does not shift because it will disappear when the short seller covers the short. If the demand curve remains fixed at DO, then the short’s effect on prices unravels when he covers, leaving the short with no profits. When the short seller buys back the shares to cover his short position, he decreases the apparent supply from QO+S back to QO and the price moves back to PO , wiping out the price decrease.

P PO PO+S Po-S DO

DO-S
Figure 1

QO

QO+S

Q

Artificial increase in quantity is shorthand for the fact that the sale is selling to marginal buyers beyond the existing supply.

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In order for short selling to be profitable, there must be a future downward shift in demand, as from DO to DO-S in Figure 1. If this downward shift occurs, then the short seller can profit when he covers his short sales. He sold short for proceeds of PO+S * (QO+S - QO) – i.e., the market clearing price for the short sale times the quantity of shares sold short. It will cost him less than that after the downward shift in demand to cover his short, PO-S * (QO+S - QO), leaving profit of the difference (PO+S - PO-S)* (QO+S - QO). But the short position is profitable only because the demand curve shifts down on its own, not because short selling alone forces it down. Speculative short selling is a bet on a downward shift in demand, but short selling, without more, does not cause that downward shift. The short seller cannot profit from the decrease in prices that his short selling causes unless this shift in demand occurs. The potential social benefit of short selling is that short selling forces prices today closer to the amount that reflects intersection of supply and demand later, if we assume that the current demand is excessively optimistic and will shift to a more rational level. Indeed, short sellers will have an incentive to pursue their short selling strategies until there is no more profit available from the strategy. This will force profits today to what they should be in the future. Figure 2 illustrates. If the short sellers forecast a fall in demand from DO to DO-S, they will continue short selling until the price at demand DO with short selling equals the price at demand DO-S once they have covered their shorts – i.e., without short selling. If the shorts are correct, unconstrained short selling thus will drive prices today to the levels that the prices will reach under the new demand DO-S. If we conceive of demand DO as excessively optimistic and demand DO-S as more rational, shorting allows the price at demand DO to be the same as it will be under demand DO-S.

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P PO

PO+S = Po-S

DO

DO-S
Figure 2

QO

QO+S

Q

B. The Bad Side of Short Selling It is easy to see why current security owners might object to short selling, however, and why such objections are not wholly without merit from their perspective. First, short selling impacts the price at which existing security owners can sell today. If demand curves for securities are downward sloping, then short selling generates prices that are lower than they would be if only the outstanding securities were available for trade in the market. So long as the current demand curve DO reflects existing demand for the security, the amount of the short selling will depress the price by virtue of the “as-if” increase in quantity. This price depression has a real impact on the ability of existing share owners to sell their shares because the short selling has already satisfied the latent demand of all the marginal buyers from PO to PO+S. The marginal seller among existing security owners is clearly worse off after the short sale than before. Before the short sale, the marginal owner seller would be able to sell at a bit

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below PO. After the short sale, the marginal owner seller would have to sell at a bit below PO+S, which is less than PO. Short selling allows a non-owner to satisfy demand from PO to PO+S. Second, short selling generates trading prices that do not reflect the willingness of any existing owner to sell at the prices generated by the short sales. In securities markets, a sale price conveys socially valuable information about the minimum value that the marginal buyer places on owning the security sold. If the seller is an existing security owner selling from his current holdings of the security, the sale also reveals that the new buyer values that security more than the selling owner (setting aside liquidity needs that may require a seller to sell despite his or her valuation). But if the seller is a speculative short seller, the sale reveals something different. In particular, a speculative short sale generates the minimum value that the marginal buyer places on the security, just as would be the case in a sale by an existing security owner. But although the speculative short sale allows us to conclude that the speculative short seller values the security less than the new buyer, we cannot conclude that any existing security owner values the security at less than the price struck in the short sale. Speculative short selling is risky for the speculative short seller, of course, for exactly this reason. The speculative short seller must, at some point, find a current owner willing to sell at below the price struck in the speculative short sale to cover his short. Otherwise, the speculative short seller will incur a loss. Third, and perhaps most relevant from a social cost-benefit perspective, short selling will generate price volatility even when short sellers are incorrect about future demand for the security. If demand stays fixed at demand curve DO, then short selling can generate price changes from PO to PO+S at the short sale, and then from PO+S back to PO when the short sale is unwound. In this manner, short sellers can bounce the price back and forth. Because they only lose transactions cost in the process, short sellers can – innocently or deliberately – induce

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heightened price volatility for long periods of time. Importantly, that volatility is unrelated to any changes in economic fundamentals of the economy at large or the security in isolation. Just as society benefits when short sellers generate prices better reflective of rational demand, some parts of society may lose when short sellers generate price volatility unrelated to fundamental valuation.
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C. Short Selling on Balance Do the social benefits of speculative short selling (primarily the possibility of generating discovery of more rational prices for overpriced securities) outweigh the costs (primarily the possibility that prices do not reflect the intersection of demand at the true supply of physical shares)? This remains an empirical question, and the evidence is mixed and consistent with both costs and benefits of short selling. It seems that short selling improves the pricing of some securities while simply making others more volatile.17 These effects are hard to disentangle. But substantial evidence shows that stocks with the highest idiosyncratic volatility (i.e., volatility unrelated to market-wide factors) are also those securities that appear to be most consistently overpriced using the best available financial economic tests.18

Short selling may also amplify the price volatility caused by economic shocks. See Tal Fishman, Harrison Hong, and Jeffrey D. Kubik, Do Arbitrageurs Amplify Economic Shocks, unpublished working paper, October 2006, available at finance.wharton.upenn.edu/department/Seminar/2006Fall/micro/hong-micro110206.pdf (finding that arbitrageurs amplify fundamental shocks in the context of short arbitrage in equity markets).
16 Certain parties may benefit from heightened market volatility even when it is unrelated to changes in economic fundamentals – e.g., long options holders. So it is not strictly accurate to say that “everyone benefits” from a reduction in volatility unrelated to changes in value. 17 See, e.g., Anchada Charoenrook and Hazem Daouk, “A Study of Market-Wide Short-Selling Restrictions,” unpublished manuscript available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=687562 (concluding that short selling improves market quality).

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See, e.g., Ang, Andrew, Robert Hodrick, Yuhang Xing, and Xiaoyan Zhang, 2006, “The Cross-Section of Volatility and Expected Returns,” 51 J. Fin. 259 (2006).

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Anecdotal evidence exists that the overpricing of individual stocks in some financial markets may be connected to constraints on short sales.19 But short selling may do little to correct mispricing in the overall stock market.20 Empirical evidence on the relation between short selling and overpricing is weak, but numerous problems complicate any clear determination of the effect short selling has on securities prices. Theoretically, firms whose stocks are easy to short should be better priced than firms with shares that are very difficult to short. And, unfortunately, short interest – the fraction of securities outstanding that are currently shorted – is a weak predictor of subsequent returns.21 Reliable proxies that measure the difficulty of shorting are hard to find. One such proxy is breadth of ownership. And evidence does suggest that stocks with narrow ownership – likely composed of the most optimistic investors – might be subject to binding short sale constraints. Such stocks perform poorly on average.22 Unfortunately, one great complication overwhelms all others in analyzing alleged market manipulation in terms of whether the activity pushes prices to an artificial level. Namely, it is exceedingly difficult to define an “artificial price.” For one thing, the tools of modern finance do not allow us to unequivocally define what the “true price” of an asset is.23 Additionally, there is a

See, e.g., Owen A. Lamont & Richard H. Thaler, 2003. "Can the Market Add and Subtract? Mispricing in Tech Stock Carve-outs," Journal of Political Economy, University of Chicago Press, vol. 111(2), pages 227-268, April. See Owen A. Lamont and Jeremy C. Stein, Aggregate Short Interest and Market Valuations, The American Economic Review, Vol. 94, No. 2, May 2004. See, e.g., S. Figlewski and G. Webb, “Options, short sales, and market completeness,” 48 J. Fin. 761 (1993) (short interest predicts stock returns in the 1973–1979 period but not in the 1979–1983 period.); Figlewski, S. (1981). The Informational Effects of Restrictions on Short Sales: Some Empirical Evidence, Journal of Financial and Quantitative Analysis 16, 463–476; Paul Asquith, Parag A. Pathak, and Jay R. Ritter, Short Interest, Institutional Ownership, and Stock Returns, Journal of Financial Economics 78 (2005) 243–276 (finding that short sale constrained stocks we find that constrained stocks underperform during 1988-2002 by a significant 215 basis points per month on an EW basis, although by only an insignificant 39 basis points per month on a VW basis.) Joseph Chen, Harrison Hong, and Jeremy Stein, Breadth of ownership and stock returns, 66 J. Fin. Econ. 171 (2002).
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19

See, e.g., Alon Brav and J.B. Heaton, Market Indeterminacy, 28 J. Corp. L. 517, 518-19 (2003)

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circularity problem with this whole line of arguing that has been noted in previous discussions of securities manipulations – viz., the only trades that are “bad” are the ones that generate artificial prices, but artificial prices are often defined to be prices that result from “bad” trading.24

III.

The Economic Near-Equivalence of Traditional and Naked Shorting A. Clearance and Settlement

To better understand the naked shorting debate, it is necessary to understand something about the securities clearing and settlement process in the United States. Indeed, some part of the widespread concern with the practice of naked shorting may stem from at least a partial misunderstanding of what it means to buy and sell securities. Despite the language that nearly everyone but the most knowledgeable insider uses, the investors we think of (and speak of in Section II) as buying and selling securities usually own something different than a security. They own a “security entitlement,” as defined in Article 8 of the Uniform Commercial Code. This entitlement is usually against their broker, which in turn owns a security entitlement against The Depository Trust Company (“DTC”). The DTC is a subsidiary of The Depository Trust & Clearing Corporation (“DTCC”). In the United States, trades in registered securities are cleared and settled through the National Securities Clearing Corporation (“NSCC”), another subsidiary of DTCC, while “ownership” of securities is recorded in participant accounts at DTC. Security “ownership” means having securities entitlements against and among the participants in DTC. Understanding the naked shorting debate requires some understanding of the DTCC system. All major broker-dealers are members of this system.

See, e.g., Daniel R. Fischel and David J. Ross, Should the Law Prohibit “Manipulation” in Financial Markets?, 105 Harv. L. Rev. 503 (1991).

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Customers of the broker-dealer deal with the broker-dealer. The broker-dealer deals with the NSCC as a member of NSCC. NSCC acts as a clearinghouse with a commitment to ensure that all stock and funds obligations of its long and short members are eventually discharged. Long members are the buyers, and short members are the sellers, to which we refer hereafter as selling members to prevent confusion with the short-sellers of which we speak in this article). The NSCC updates trades through the trading day for each member in each security. Starting at T+1, the first day after the trade, the NSCC nets trades in a process known as “continuous net settlement” or “CNS.” The NSCC communicates the net long and short positions of its members in each security to DTC. Most shares listed on major U.S. exchanges are dematerialized, immobilized, and held in custody accounts at DTC. When it comes time for NSCC to settle the netted positions at T+3, the selling member’s stock account at DTC is debited and a corresponding credit is issued to in the purchasing member’s stock account at DTC. No physical shares actually are exchanged.

B.

Failure to Deliver

A failure to deliver occurs when an NSCC member fails to deliver stock at T+3. NSCC has an automatic process for resolving failures to deliver.25 The NSCC system first looks at the selling member’s stock account at DTC. If the member does not have enough shares in its account already to cover the position, the long member (the purchaser who is owed the stock) may initiate a “buy-in” against the CNS system. The member then has another two days to satisfy its delivery obligation, and, if it does not, NSCC at that time can buy the shares itself and

25

This process is algorithmic and does not normally involve the exercise of any discretion by NSCC personnel.

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charge the account of the member that failed to deliver.26 If the long member does initiate a buyin, the member effectively postpones delivery of the stock until the NSCC receives shares to deliver. “Persistent” failures to deliver or receive are stock trades that remain unsettled in this manner for more than a week.

C.

Stock Borrow Program

One way that the NSCC resolves open positions created by fails to deliver is through its Stock Borrow Program (“SBP”). Under the SBP, NSCC members may opt to “lend NSCC available stocks and fixed income securities from their account at The Depository Trust Company (DTC), to cover temporary shortfalls in NSCC’s Continuous Net Settlement (CNS) System.”27 At the end of each business day, NSCC members notify NSCC of which stocks they own that are available for borrowing in the SBP. All listed CNS-eligible securities are eligible for this program, but it is not compulsory for stock owners to participate. During the CNS processing cycle each night, positions that remain open and unfilled in CNS are compared with stocks available in the SBP for borrowing by NSCC. Those shares are then used to make delivery to members with open positions. As with a securities lender that loans out stock to facilitate settlement at T+3 in a traditional short sale, the member lending under the SBP gives up title to the shares. Under the SBP, the stock lender also receives a cash deposit equal to the then-current T+3 market value of the securities in an interest bearing account. The NSCC systems select from which members to borrow. The buyer acquires all right, title, and interest in the borrowed shares – just as it would
26

In the worst case, the NSCC can break the trade and make the buyer whole in cash, but this has never occurred to our knowledge. See DTCC, “Stock Borrow Program,” http://www.dtcc.com/ProductsAndServices/clearing/stock.html.

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in any cash transaction that settles the regular way – including the right to vote the shares, receive dividends, resell them, or lend them (e.g., back to the NSCC through the stock borrow program). NSCC charges a fee to each member who forces the use of the SBP. The NSCC returns the shares to the SBP lender when it receives shares from the selling member (or when the shares otherwise become available). Upon receiving the shares back, the stock lender in the SBP returns the cash deposit but may keep the interest proceeds. In addition, lenders in the SBP can demand the shares back from NSCC at any time and can force or initiate a buy-in to get those shares. In any case, if a seller fails to deliver shares through NSCC on settlement date T+3, the stock seller’s obligation to deliver those shares remains an open, ongoing, enforceable obligation until the seller eventually discharges it by delivering the shares.

D.

Traditional Short Selling

In any sale of securities, the seller and buyer consummate a transaction on the trade date that obligates the seller to deliver shares of stock for the agreed-upon trade price on the settlement date, which is three days after the trade date, or T+3. In a short sale, the seller does not own the stock he is selling on the trade date. In a traditional short sale, the seller (or, more likely, his prime broker) tries to locate and borrow the security from a security lender. The short seller then borrows the shares and delivers them by settlement date T+3. In a traditional short sale, the short seller enters into an agreement with a current owner of the security to acquire the current owner’s shares in return for an obligation to deliver shares back to the short seller whenever the current owner demands. The short seller can then deliver the acquired shares to the NSCC at T+3 in satisfaction of its delivery requirements after selling

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the shares to a new buyer. The short seller generates little or no cash income on the short sale at T+3 because he posts 102% of the market price as collateral.28 The short seller may receive a “rebate” from the former security owner in the form of some or all of the interest earned on the cash collateral. The collateral is marked to market, with the short seller obligated to fund any shortfalls and allowed to withdraw excess collateral. The short seller has the right to receive the return of all collateral on returning the stock acquired from the former owner. At the end of the settlement day for this transaction, the former owner thus is owed back shares of the stock, the new owner holds the new stock for which it has paid cash to the NSCC (which cash is paid by the NSCC to the short seller and which, along with an additional 2% is then held by the former owner as collateral), and the short seller is entitled to the return of the collateral when he returns the stock to the former owner.

E.

Naked Short Selling

A naked short occurs when the short seller does not intend to (and actually does not) locate and borrow shares for delivery to the NSCC at settlement. This results in a failure to deliver by the selling member (i.e., the short seller’s broker). Any selling member that fails to deliver at T+3 and has an open unsatisfied obligation to NSCC must post some fraction of the stock’s current market value in cash as collateral with the NSCC. If the stock price declines after settlement date T+3, some or all of this collateral may be returned to the short seller. If the stock subsequently rises in value, NSCC may debit the seller’s funds account at NSCC for additional “margin.” Provided NSCC receives adequate collateral from stock sellers that have failed to deliver, this marking to market of the obligation eliminates most of the risk the NSCC faces.

See Jeff Cohen, David Haushalter, and Adam V. Reed, Mechanics of the Equity Lending Market,” in Frank J. Fabozzi, ed., Short Selling: Strategies, Risks and Rewards (2004).

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Specifically, in the event of a later default by the selling member on its open obligation (arising if, say, the selling member becomes insolvent), NSCC will have to make the stock purchaser whole by purchasing the stock at the new price. In principle, however, NSCC will have collected a sufficient amount of collateral – the original purchase price paid by the stock buyer plus the marked-to-market margin from the seller – to cover any resulting loss. If the shares are available in SBP – unlikely for the most difficult to borrow securities that are most popular with naked short sellers – the long member can be satisfied using that program. Otherwise, the long member will remain undelivered-to until the shares become available. The selling member continues to have an open delivery obligation to NSCC, and that selling member does not receive funds until the shares are delivered. In turn, the long member’s funds remain with the buyer until delivery. As we explain below, this is largely what leads to the near-economic equivalence of traditional shorting and naked shorting.

F.

Similarities and Differences Between Traditional and Naked Shorting

Armed with some institutional details, we turn now to illustrate the economic nearequivalence of permissible short selling and impermissible naked short selling. Recall that with a traditional short sale there is (1) a party owed shares (the former security owner that lent shares to the short seller) that retains the purchase price of the shares as collateral; (2) a party that owes shares (the short seller) who will receive proceeds on delivery of the shares; and (3) a new owner of the shares. A naked short leads to an almost identical situation. There is (1) a party owed shares, now the NSCC and ultimately the undelivered-to buyer who retains the purchase price of the shares as collateral; (2) a party that owes shares (the short seller) who will receive proceeds

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on delivery of the shares; and (3) an owner of the shares, now simply the former would-be security owner. There is nothing economically important about the ultimate identities of the parties who hold otherwise-equivalent economic receivables and obligations. Despite the contentious rhetoric that sustains public debate over naked shorting, there are no especially meaningful economic differences between the two.29 From an economic perspective, naked shorting combined with a failure to receive alleviates the security borrowing problem by allowing the short seller to borrow shares de facto from the stock buyer rather than the current share owner.30 In a naked short sale, the short seller agrees to sell a share to the current buyer at the spot price (the price currently prevailing in the market) but then fails to deliver the shares to the buyer on settlement day T+3. In this scenario, the short seller has been able to transact a sale at the spot price, as in a typical short sale. Also as before, one party remains a current owner of the security, while another party is owed delivery of the security by the short seller. Rather than the security lender being obliged to pay the proceeds over to the short seller in return for the delivered shares, it is the buyer who is owed delivery of shares by the short seller and holds the amount of the sales price as collateral. Although some minor technical differences distinguish the two forms of short selling,31 we can identify only two potentially significant differences between traditional and naked shorting. First, unlike the security lender in a traditional short sale, the buyer did not voluntarily
29

For a view that naked shorting can be harmful, see John D. Finnerty, Short Selling, Death Spiral Convertibles, and the Profitability of Stock Manipulations, unpublished working paper, March 2005, available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=687282 (presenting a theoretical model where naked shorting facilitates market manipulation, especially in combination with a certain type of convertible security). See also the DTC response to Finnerty’s paper at http://www.dtcc.com/ThoughtLeadership/keyissues/finnerty.htm. Remember the actual obligations on both sides are to NSCC, but ignoring credit risk our statement is accurate economically. For example, the selling member must post collateral to the NSCC.

30

31

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enter into the security lending relationship. Second, the undelivered-to buyer may remain undelivered-to for a relatively long period of time even if he initiates a buy-in. That buy-in, after all, may itself result in another fail to deliver, and this process could in principle (and sometimes in practice) continue for a while. The first difference is not as objectionable as it sounds. The buyer, now in the position of the security lender, has a very solvent counterparty in the NSCC and may be enjoying an opportunity to lend that facilitated its transaction, a transaction that might not otherwise have occurred. The second difference is related to the first. Although it is true that the undelivered-to buyer may remain undelivered-to for some time, it is not true that the alternative is necessarily delivery. If naked shorting were not allowed and short selling was possible only by locating and borrowing shares, it is by no means clear that any sale (and delivery) would have occurred at the transacted price. Holding a delivery obligation from the NSCC at the price of the naked short may be more valuable to the buyer than no interest in the security at all.

G. Why Engage in Naked Shorting? According to recent empirical research, options market makers begin naked shorting when the rebate rate paid to them starts to fall, and especially when they would otherwise have to pay interest to the lender.32 This provides a hint at what is really going on in a naked short. Specifically, naked short selling seems primarily a manifestation of the fragmentation of and competition in the market for securities lending.

32 See Richard B. Evans, Christopher C. Geczy, David K. Musto, and Adam V. Reed, “Failure is an Option,” unpublished working paper dated December 2006, forthcoming Rev. Fin. Studies (finding that half the time the market maker shorts a hard to borrow stock, it fails to deliver at least some of the shares. And it never accepts a negative rebate, always choosing to fail instead.)

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In particular, when shares are easy to borrow, a short seller simply finds a security lender, borrows the shares by the settlement date, and earns a rebate on the proceeds which remain deposited with the lender. For stocks that are easy to borrow, the rebate rate is very close to the overnight Federal Funds rate. Unlike the deep and centralized markets that exist for long positions in common stocks, however, no such deep and centralized markets exist to match those willing to lend their securities for short selling.33 Indeed, it is sometimes very difficult to locate shares to borrow, in which case the rebate rate paid to the short seller goes down, with the lender keeping more and more. For some stocks, the rebate rate can turn negative, in which case the lender is receiving all the interest on the proceeds and the short seller is actually paying the lender. Naked shorting is preferable for the short seller anytime the rebate rate (interest rate paid on the proceeds by the security lender in a typical short sale) falls below zero. At zero, the naked short seller is indifferent between getting nothing from (and paying nothing to) the security lender and getting nothing from the NSCC because of its failure to deliver. Below a zero rebate rate, when the short seller actually has to pay the security lender in a typical short sale, the short seller clearly prefers to fail to deliver at zero cost. When the naked short seller does deliver, he gets the proceeds from the original short sale but has not had to pay the negative rebate to any security lender. The undelivered-to buyer, while his position remains open, earns interest on the purchase price while retaining the upside of the security. This, in effect, allows the undelivered-to buyer to compete in the market for security lending even though he just acquired his interest in the
33 There are now numerous empirical studies on the costs of borrowing shares in the equity lending market. See, e.g., Gene D’Avolio, “The Market for Borrowing Stock,” 66 J. Fin. Econ. 271 (2002); Christopher C. Geczy, David K. Musto, and Adam V. Reed, “Stocks Are Special Too: An Analysis of the Equity Lending Market,” 66 J. Fin. Econ. 241 (2002); Eli Ofek and Matthew Richardson, “Dotcom mania: The rise and fall of internet stock prices,” 58 J. Fin. 1113 (2003).

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security. This may reflect a more important reason why buyers are willing to remain undelivered than more commonly asserted reasons.34

IV.

Is Naked Shorting Market Manipulation? Section 10(b) of the 1934 Act makes it “unlawful for any person . . . to use or employ in

connection with the purchase or sale of any security . . . any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe ….”35 Under Securities and Exchange Commission Rule 10b-5 (17 C.F.R. § 240.10b-5), it is illegal to employ manipulative devices in connection with the sale of a security. These rules apply to short selling. Rule 10b-5 provides:

Employment of manipulative and deceptive devices. It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange, (a) To employ any device, scheme, or artifice to defraud, *** [or] (c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.36

34 One recent study proposes four reasons for persistent fails to receive by NSCC members: (1) costs of failures are small because opportunities to lend are usually low; (2) members may be required to first call in stock loans they have made through the SBP before requesting buy-ins; (3) bought-in shares may themselves be subject to delivery failures; and (4) firms that fail to receive shares hope to bank good will with firms that fail to deliver. See Leslie Boni, Strategic Delivery Failures in U.S. equity markets, 9 J. Fin. Mkts. 1, 20 (2006). The last point may no longer be relevant since buy ins are now anonymous from the perspective of NSCC members. 35 36

15 U.S.C. § 78j. 17 C.F.R. § 240.10b-5.

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The Securities and Exchange Commission defines manipulation as “intentional interference with the forces of supply and demand.”37 For a plaintiff to state a claim of market manipulation under 17 C.F.R. § 240.10b-5(a) and (c) against those participating in illegal naked shorting under Rule 10b-5(a) and (c), the plaintiff must allege “that the defendant (1) committed a deceptive or manipulative act (2) with scienter, (3) that the act affected the market for securities or was otherwise in connection with their purchase or sale, and (4) that defendants’ actions caused the plaintiffs' injuries.”38 Actions brought under § 10(b) and Rule 10b-5 “must be commenced within one year after the discovery of the facts constituting the violation and within three years after such violation.”39

A. Is Impermissible Naked Short Selling a Manipulative Act? There is a strong argument that impermissible naked short selling constitutes a manipulative act because it is virtually defined as one. Naked shorting is, however, only malum prohibitum (wrong because prohibited) rather than malum in se (wrong in itself).

Brooklyn Capital & Securities Trading, Inc., 52 S.E.C. 1286 (1997) (quoting Pagel, Inc., 48 S.E.C. 223, 226 (1985), aff'd, 802 F.2d 942 (5th Cir. 1986)). In re Parmalat Sec. Litig., 414 F. Supp. 2d 428, 432 (S.D.N.Y. 2006) (citing Ganino v. Citizens Utils. Co., 228 F.3d 154, 161 (2d Cir. 2000); San Leandro Emergency Med. Group Profit Sharing Plan v. Philip Morris Cos., 75 F.3d 801, 808 (2d Cir. 1996)). Rules 10b-5(a) and (c) provide a cause of action against defendants who use any device, scheme, or artifice to defraud or the participation in any act, practice, or course of business that would perpetrate fraud on investors. See, e.g., In re Enron Corp. Sec., Deriv. & ERISA Litig., 235 F. Supp. 2d 549, 577 (S.D. Tex. 2002); see also In re Global Crossing Sec. Litig., 322 F. Supp. 2d 319, 335-36 (S.D.N.Y. 2004). A claim under Rules 10b-5(a) and (c) does not require the making of an untrue statement of material fact or omission to state a material fact as under Rule 10b-5(b). Enron, 235 F. Supp. 2d at 577; SEC v. Zandford, 535 U.S. 813, 820-22, 122 S. Ct. 1899, 153 L. Ed. 2d 1 (2002) (quoting Marine Bank v. Weaver, 455 U.S. 551, 556, 102 S. Ct. 1220, 71 L. Ed. 2d 409 (1982) (stating misrepresentation need not be involved and that suit could be based on Rules 10b-5(a) or (c)).
39 38

37

Lampf et al. v. Gilbertson, 501 U.S. 350, 364, (1991).

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Naked shorting is plainly not malum in se because it is permissible in numerous circumstances, such as naked shorting by market makers in bona fide market-making activities.40 Further, as we have already established, naked shorting and traditional shorting are economically quite similar. Naked shorting, then, has the same or similar economic effect of regular shorting discussed in Section II. Said differently, naked shorting may well depress prices for reasons we explored in the traditional short selling case in Section II. But because these same price effects of naked shorting are also possible with permissible short selling, naked shorting appears to cause no more harm than traditional short sale activities. Naked shorting is also malum prohibitum and not malum in se because it is not – despite commonly used rhetoric – inherently deceptive. The United States Supreme Court has said that manipulation is a “term of art … connot[ing] intentional or willful conduct designed to deceive or defraud investors by controlling or artificially affecting the price of securities.”41 Put still another way, “market manipulation occurs when a manipulator injects inaccurate information into a market or creates the false impression of market activity.”42 But naked shorting does not inject inaccurate information into the securities market. On the other side of each naked short is a real buyer. Naked shorting, without more, does not involve deception since it does no more or

The SEC writes: “Naked short selling is not necessarily a violation of the federal securities laws or the Commission's rules. Indeed, in certain circumstances, naked short selling contributes to market liquidity. For example, broker-dealers that make a market in a security4 generally stand ready to buy and sell the security on a regular and continuous basis at a publicly quoted price, even when there are no other buyers or sellers. Thus, market makers must sell a security to a buyer even when there are temporary shortages of that security available in the market. This may occur, for example, if there is a sudden surge in buying interest in that security, or if few investors are selling the security at that time. Because it may take a market maker considerable time to purchase or arrange to borrow the security, a market maker engaged in bona fide market making, particularly in a fast-moving market, may need to sell the security short without having arranged to borrow shares. This is especially true for market makers in thinly traded, illiquid stocks such as securities quoted on the OTC Bulletin Board,5 as there may be few shares available to purchase or borrow at a given time.” http://www.sec.gov/spotlight/keyregshoissues.htm.
41 42

40

Ernst & Ernst v. Hochfelder, 425 U.S. 185, 199, 47 L. Ed. 2d 668, 96 S. Ct. 1375 (1976). GFL Advantage Fund, Ltd. v. Colkitt, 272 F.3d 189, 205 (3d Cir. 2001).

22

less than is possible through permissible short selling.43 Nonetheless, it seems likely that impermissible naked shorting constitutes a manipulative act under existing regulations.

B. Is The Act of Impermissible Naked Short Selling Sufficient to Infer Scienter? The scienter element is a requirement that the naked short seller have the intent to commit a wrongful act. Because impermissible naked shorting is, per se, a prohibited activity, an allegation that the conduct was undertaken intentionally is probably sufficient to allege scienter and survive dismissal.44

C. Does Naked Short Selling Affect The Market For Securities or a Securities Purchaser or Seller? Naked short selling is likely to affect the market for securities and sellers of securities by lowering the market clearing price through an artificial increase in the quantity of shares. This occurs for the same reason that permissible short selling can lower the share price, as we explained in Section II.

Cf. Sullivan & Long, Inc. v. Scattered Corp., 47 F.3d 857, 864 (7th Cir. 1995) (As the plaintiffs themselves point out, the essence of the offense is creating "a false impression of supply or demand," for example through wash sales, where parties fictitiously trade the same shares back and forth at higher and higher prices to fool the market into thinking that there is a lot of buying interest in the stock. There was nothing like that here. On the other side of all of Scattered's transactions were real buyers, betting against Scattered, however foolishly, that the price of LTV stock would rise.”) (Internal quotations and citations omitted).
43

See In re IPO Sec. Litig., 241 F. Supp. 2d 281, 293 (S.D.N.Y. 2003) (scienter adequately pled where defendants engaged in deliberately unlawful conduct); In re Adler, Coleman Clearing Corp., 2006 U.S. Dist. LEXIS 95236, *34-35 (S.D.N.Y. January 8, 2007) (“[O]n this record the scienter requirement to establish a § 10(b) violation is satisfied. The Trustee has sufficiently demonstrated Gurian’s knowledge of or reckless participation in the manipulative scheme involving the concerted short selling of the Hanover House Stocks, and the extortion scheme intended to lower the price of the securities and ultimately to cause Hanover's collapse.”).

44

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D. Does Naked Short Selling Cause Injury? In general, courts have found that “[m]arket manipulation by means of concerted short selling calculated to artificially bring down the price of stocks constitutes harmful conduct sufficient to establish loss causation.45 Determining whether some parties have been harmed by impermissible naked short selling is no mean feat. If harm has been done, who has been harmed and by how much? We consider separately below several different possible parties that have the potential for being harmed by impermissible naked short sales.

(1) Brokers A few cases involving naked shorting selling have involved injuries to brokers and/or clearing firms that suffered losses when they were forced to cover as a result of their customers’ failures to cover their own short sales.46 In the extreme, customer failures to deliver on naked shorts that cannot cover their sale obligations can drive a broker out of business.47 These cases say more about customer credit risk than naked shorting. The risk of a customer defaulting on any kind of an obligation to its broker or clearing member is, after all, hardly unique to naked shorting. Brokers bear customer credit on numerous transactions in which they are guaranteeing their customers’ trades, including some trades very similar to naked

In re Adler, Coleman Clearing Corp., 2006 U.S. Dist. LEXIS 95236, *34-35 (S.D.N.Y. January 8, 2007) (citing Compudyne Corp. v. Shane, 453 F. Supp. 2d 807, 827 (S.D.N.Y. 2006)). 46 See United States v. Naftalin, 441 U.S. 768, 99 S. Ct. 2077 (1979) (affirming defendant’s criminal conviction under Section 17(a)(1) of the 1933 Act, where defendant, the president of a registered broker-dealer firm and a professional investor, engaged in a short selling scheme and falsely represented that he owned the shares that he directed five brokers to sell; defendant was unable to make covering purchases when stock price did not fall and brokers were forced to borrow stock to keep their delivery promises; brokers then had to purchase replacement shares on the open market at now higher prices and suffered substantial financial losses.)
47 See In re Adler, Coleman Clearing Corp., 2006 U.S. Dist. LEXIS 95236, *34-35 (S.D.N.Y. January 8, 2007) (granting summary judgment motion of Securities Investor Protection Act trustee for liquidation of business of securities clearing firm with respect to claims against controlling person of Bahamian companies that had engaged in, among other illegal activities, naked short selling of certain stocks traded by a securities firm that served as one of the clearing firm’s introducing brokers.”)

45

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shorting. A clearing member futures commission merchant guaranteeing customer trades on short single-stock futures contracts, for example, assumes essentially the same kind of delivery risk that the broker assumes on customers doing naked shorting.

(2) Other Short Sellers Just as some brokers and clearing members have blamed customers for losses arising from naked short selling, so, too, have some customer short sellers blamed their brokers for losses. Some have alleged, for example, that market makers and prime brokers have exercised market power over customers and at the expense of those customers by charging customers negative rebates to cover shorts that were in fact not covered but instead were fails to deliver on the part of the broker.48 One possible explanation for persistent fails to receive by stock buyers is that they want to bank goodwill capital so that they can in turn fail to deliver without the stock purchaser initiating a buy-in against them.49 If true, this plays into the hands of those who allege that brokers are colluding to keep rebates negative on short covering that in fact does not occur. The potential problem with these arguments is the lack of a mechanism to enforce the alleged collusion – the usual Prisoner’s Dilemma problem often encountered with alleged cartel behavior. The theory is that brokers are colluding to keep certain stocks on negative rebate in the cash securities lending market and then failing to deliver on those short sales after telling customers they have been covered. If the stock really is a hard-to-find negative rebate stock anyway, however, it is not clear that customers are suffering any real damages. And if the stock
48 See, e.g., Electronic Trading Group LLC, et. al., v. Banc of America Securities LLC, et. al., No. 06-Civ-2859 (S.D.N.Y) filed April 12, 2006 (maintaining that broker-dealer and prime broker defendants “effectively operated in a tag team fashion – rotating in the roles of prime broker, clearing agent or counterparty that enabled the short sale transaction to go forward without the expectation of delivery”).

See Boni, op. cit. (also noting that the firms that routine fail to receive are also those which routinely fail to deliver).

49

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otherwise would have a positive rebate, then the theory here only works if virtually no firms engage in stock lending at that positive rebate rate and no stock buyers initiate buy-ins. Possible, but not very likely. Contrary to popular belief, buy-ins are quite prevalent.

(3) Long Stock Sellers Naked shorting will cause at least a temporary decline in the value of the stock, all else equal. A seller who sells at a price that is lower than the price otherwise would have been might argue that it has been injured by the difference between what the price would have been absent the naked shorting less the price with naked shorting. Problems of proof here are likely to be substantial. Because permissible short selling (even permissible naked short selling) is a substitute for impermissible naked short selling, the activities are likely to occur at the same time. Nevertheless, long sellers may have a viable case for market manipulation based on impermissible naked short selling though establishing non-speculative damages presents a considerable hurdle.

(4) Issuers It is well established that a private right of action for market manipulation is available under Section 10(b) only to purchasers and sellers of securities allegedly defrauded by the manipulation.50 An issuer may not maintain a claim for damages under Section 10b-5 unless it is a purchaser or seller of securities.51 However, a corporation that issues its own stock in reliance

50 51

See Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723, 730-31, 44 L. Ed. 2d 539, 95 S. Ct. 1917 (1975). See Frankel v. Slotkin, 984 F.2d 1328, 1334 (2d Cir. 1993).

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on another’s deceptive or manipulative practice may be deemed a “seller” with standing to sue under §10(b) and Rule 10b-5.52 Where a corporation is fraudulently induced into issuing its own securities for less than their fair value, in particular, the corporation itself is injured.53 This issue arises when issuers want to issue additional shares, as in a seasoned equity offering. Such shares will be issued at discount to the current price if demand is downward sloping. For this reason, apparently, the SEC forbids short sellers from covering short sales “with offered securities purchased from an underwriter or broker or dealer participating in the offering, if such short sale occurred during the shorter of (1) The period beginning five business days before the pricing of the offered securities and ending with such pricing; or (2) The period beginning with the initial filing of such registration statement or notification on Form 1-A and ending with the pricing.”54 Otherwise, short sellers would have an incentive to short sell in advance of any offering in the amount of securities they expected to receive in any allocation.55

(5) Security Holders Consider finally security holders. The federal securities laws allow suits by purchasers and sellers of securities. Generally speaking, security holders who experience nothing more than a change in the value of their holdings do not have causes of action under the securities laws for

52 See Superintendent of Ins. of New York v. Bankers Life & Casualty Co., 404 U.S. 6, n4 (1971) (citing, inter alia, Ruckle v. Roto American Corp., 339 F.2d 24, 27-28 (2d Cir. 1964); Hooper v. Mountain States Securities Corp., 282 F.2d 195, 200-203 (5th Cir. 1960), cert. denied, 365 U.S. 814, 5 L. Ed. 2d 693, 81 S. Ct. 695 (1961)). Accord Schoenbaum v. Firstbrook, 405 F.2d 215 (2d Cir. 1968) (en banc), cert. denied, 395 U.S. 906, 89 S. Ct. 1747, 23 L. Ed. 2d 219 (1969), applied in Goldberg v. Meridor, 567 F.2d 209 (2d Cir. 1977). 53 54

Cf. Frankel v. Slotkin, 984 F.2d 1328, 1334 (2d Cir. 1993). 17 C.F.R. §242.105.

55 See, e.g., Assem Safieddine and William J. Wilhelm, Jr., “An empirical investigation of short-selling activity prior to seasoned equity offerings,” 51 J.Fin. 729 (1996) (finding that curbs on short-selling activity reduced new issue discounts)

27

market manipulation.56 So, although current holders of a security will see its price fall when naked shorting occurs – just the same as the price would fall when permissible short selling occurs – they likely have no cause of action related to naked shorting. Some lawsuits have sought to hold naked short sellers and their clearing firms responsible under state law theories directed at price declines resulting in adverse impacts to current security holders. But it is at least questionable whether such theories will ultimately succeed.57 As long as there is demand for shorting and the premium for shorting is positive to current stock holders, those who value legal ownership of their shares more than they value the returns from security lending will experience price declines from shorting. But these price declines do not result in any definite economic loss until some cash outflow occurs as a result of the lower market price.

IV.

Conclusion Despite the recent spate of lawsuits and media attention, the existing literature on naked

shorting consists almost entirely of self-confessed advocacy pieces by lawyers and consultants involved in naked shorting cases, or parties who are defendants in such lawsuits. Our Article
56 See, e.g., Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723 (1975) (“holders” of securities may not sue under Section 10(b) of the Securities Exchange Act). 57See, e.g., Overstock.com, Inc., et al. v. Morgan Stanley & Co., et al., Case No. CGC-07-460147, Superior Court of the State of California, County of San Francisco, filed February 2, 2007 (alleging causes of action for (1) Conversion; (2) Trespass to Chattels; (3) Intentional Interference with Prospective Economic Advantage; (4) Violations of California Corporations Code Sections 25400, et seq.; Unfair Business Practices (Cal. Bus. & Prof. Code Sections 17200, et. seq. and Sections 17500, et seq.); Avenius, et al. v. Banc of America Securities LLC, et al., Case No. CGC-06-453422, Superior Court of the State of California, County of San Francisco, filed June 22, 2006 (alleging causes of action for (1) Violations of California Corporations Code Sections 25400, et seq.; and (2) Unfair Business Practices (Cal. Bus. & Prof. Code Sections 17200, et. seq. and Sections 17500, et seq.); In re Short Sale Antitrust Litig., No. 06-Civ-2859 (S.D.N.Y), filed January 5, 2007 (suit by short sellers claiming that they paid high fees to borrow stocks to defendants who did not actually borrow the shares, but instead entered into naked shorting positions; alleging antitrust violations under Section 1 of the Sherman Act, and common law claims for breach of fiduciary duty, aiding and abetting breach of fiduciary duty, and common law unjust enrichment.).

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takes a more balanced look at naked shorting. We review the standard economic arguments for and against the speculative short sale of equities, describe the mechanics of naked shorting, and explain the strong economic similarities between permissible short selling and impermissible naked short selling. Despite the legal prohibitions on the latter, we show that, from an economic perspective, naked shorting is not fundamentally different from traditional short selling and is unlikely to have serious detrimental effects on capital markets. Nevertheless, some naked shorting remains illegal. We explain how naked shorting can provide the basis for securities manipulation lawsuits under the federal securities laws for long sellers and, in some circumstances, for issuers. As with other matters of financial economics and policy, the debate on naked shorting would benefit from additional empirical research.58

58 A recent positive step in this direction is Amy K. Edwards and Kathleen Weiss Hanley, 2007, Short Selling and Failures to Deliver in Initial Public Offerings, working paper, Office of Economic Analysis, Securities and Exchange Commission. Available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=981242.

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