Naked Shorts by munificent Blog entry

Blog: Spirit of Money, Financial Fluidity
by munificent

Naked Shorts

How does one short a stock that is not currently in their portfolio- and close out the position? Huh? I guess one doesn't anymore! So why would one short a stock? Perhaps one may see a trend or oscillation of trading pattern that shorting will bring profits without holding positions -how does that happen...Perhaps, some traders want to "create" the trend or oscillation of trading range?

Date: 8/8/2005 8:30:31 AM ( 19 y ) ... viewed 1244 times

Naked Shorts Enjoying Long Shelf Life

By Kevin Kelleher
TheStreet.com Senior Writer
8/8/2005 7:35 AM EDT
Click here for more stories by Kevin Kelleher

What if they passed a law and no one followed it?

Not one of those bizarre, outdated laws you hear about -- like in Maine, where people are required to bring shotguns to church -- but a brand new law with an entirely sensible goal, like keeping people from selling equities that don't exist.

Since January, Regulation SHO has required self-regulatory organizations like the NYSE or the NASD to keep a "threshold list" of securities that have a sizable failure-to-deliver position. That is, they must disclose daily the stocks that someone sold without either owning them or borrowing them.

Selling stocks that nobody owns, called naked short-selling, isn't necessarily illegal. Broker-dealers may sell imaginary shares to maintain liquidity in a stock that sees a sudden surge in demand. So the Securities and Exchange Commission gives broker-dealers a 13-day grace period before they are required to close out those naked-short positions. After 13 days, it's safer to assume there must be at least some abusive shorting going on.

Last month, TheStreet.com noticed that Internet Initiative Japan (IIJI:Nasdaq - news - research), a Nasdaq-traded ADS that had seen some spectacular and mysterious volatility coinciding with its aborted plans to issue new shares in Tokyo, had been on the NASD's threshold list for 17 days.

That seemed like an unusually long time back then. But IIJI has now been on the list for 39 straight days, according to Buyins.net, a site that compiles threshold-list data.

And that's just the tip of the iceberg. Buyins.net lists 59 other securities that have been on threshold lists for longer than IIJI has -- some of them for as long as 134 days. Of course, most are micro-cap stocks that are so illiquid it's not surprising broker-dealers find shares scarce.

But there are also 10 other companies, all traded on the Nasdaq, that have substantial daily volume and market caps between $150 million and $1.1 billion that have been on its threshold list for more than 26 days -- twice the allotted grace period after which the positions must be cleared out. They include well-known names like Netflix (NFLX:Nasdaq - news - research), Taser International (TASR:Nasdaq - news - research) and Overstock.com (OSTK:Nasdaq - news - research) -- hardly illiquid, yet they've been on the threshold list for months.

Overstaying Their Welcome?
It's not just micro-caps that languish on NASD's threshold list
Ticker Name Days on List Market Cap (millions) Short Ratio Shares Short as % of Float*
1 NFLX NETFLIX 134 $1,100 15.5 30.4%
2 GIVN GIVEN IMAGING 134 $637 17.9 13.5%
3 TASR TASER INTERNATIONAL 134 $567 5.8 31.6%
4 GLBC GLOBAL CROSSING 134 $397 22.3 47.7%
5 CALM CAL-MAINE FOODS 134 $149 10.8 11.8%
6 NAVR NAVARRE CORP 74 $247 30.4 35.3%
7 OSTK OVERSTOCK.COM 72 $858 14.0 51.7%
8 ENWV ENDWAVE CORP 45 $328 11.0 26.1%
9 IIJI INTERNET INITIATIVE JAPAN 39 $777 0.2 N/A
10 AGEN ANTIGENICS 33 $257 27.7 27.4%
11 OVEN TURBOCHEF TECHNOLOGIES 30 $481 7.7 40.5%
Source: buyins.net, yahoo finance
*as of 7/12/05.
So what gives? Or rather, what doesn't give? Why aren't broker-dealers cleaning out these naked-short positions? Asking the watchdogs doesn't offer much insight. John Heine, a spokesman for the Securities and Exchange Commission, says that body doesn't comment on the activities of its enforcement office, which oversees broker-dealer activity.

"There hasn't been a case yet where we've brought enforcement action" regarding Regulation SHO, Heine says. "We're always interested when people have any information about violations of SEC laws."

NASD, which is supported by 5,200 member brokerage firms, is required to gather data on naked short-selling, so it's in the best position to understand why so many stocks are stuck on its threshold list. Yet it seems oddly indifferent.

"Isn't that the business of the SEC?" snapped NASD spokesperson Nancy Condon when asked about the lingerers on its threshold list. A second spokesperson called back to point out the SEC's Web page explaining Regulation SHO, but didn't comment any further.

On that Web page, the SEC notes that a stock's longtime threshold status may be due to new failure-to-deliver positions opening up before the old ones can be closed out, or from positions that were grandfathered in before Regulation SHO took effect. But neither exception fully explains why so many liquid stocks are spending such long stretches with positions that could be closed out in a matter of days.

Why, for example, has it taken more than six months to clear out grandfathered short positions in Taser or Netflix?

Or take Overstock, which was on the threshold list from the beginning but fell off in March, suggesting any grandfathered short positions had been cleared out. But it appeared on the list again a few weeks later and has been there for 72 straight days.
Overstock's Patrick Byrne, an outspoken CEO who has dared hedge fund managers to confront him on earnings calls, has another explanation. "Regulation SHO is toothless," says Byrne. "The regulators have decided to give free passes to criminals."

That's a pretty blunt assessment, but it finds a little support in the interesting coincidence that many of the longtimers on the threshold list are the same stocks favored by short-sellers. The short interest of Overstock (i.e., the number of shares legitimately borrowed and sold short) is 6.5 million shares, or 52% of its float. The short interest in Netflix, Taser and Global Crossing (GLBC:Nasdaq - news - research) are, respectively, at 30%, 31% and 48% of their floats.

Data on naked short-selling isn't as transparent as it is on plain old-fashioned short-selling. The SEC doesn't require disclosure of how many shares have failed to deliver, which is too bad, because there's a good deal of disagreement on how widespread naked short-selling is. Some people, including investors at hedge funds, maintain it's all a tempest in a teapot. Others, like Byrne, suggest it's become too big a problem for regulators to rein in.

Regulatory agencies like the SEC often face tough choices in deploying scarce resources to fight an ever-shifting menace of investment fraud. But the SEC could make enforcement of Regulation SHO a lot easier by enlisting the help of the market itself: Why not simply disclose the size of the naked-short position in each stock as well as the broker-dealer responsible for clearing out the position?

If the naked-short positions are disarmingly small, investors will know that it is indeed a tempest in a teapot. And if the positions are large, they'll know who to call.