Naked shorting

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FACTUAL BACKGROUND

1. The regulatory history relevant to the current naked short selling of stock in public companies began in 1985 when the National Association of Securities Dealers, Inc. (“NASD”] commissioned Irving M. Pollack (“Pollack”][7] to conduct a study of short selling (“Pollack study”]. As stated in his report, Pollack concluded:  “The fail-to-deliver / fail-to-receive problem has the potential for causing serious difficulties in a lengthy bear market.”[8] Naked short sales routinely result in failures to deliver and failures to receiveunless they are concealed by the broker-dealers who execute them. Pollack’s report also noted that there was no inherent mechanism to constrain the buildup of failures to deliver and warned of the consequences: “[T]he fact that there is no automatic mechanism preventing the substantial buildup of short positions at the clearing corporation and of fails to receive in the brokerage firms carries the potential for serious problems, particularly in the event of crisis market conditions.”[9] Pollack’s warning would prove prophetic two decades later in 2008, when giant investment banks began to collapse due in part to naked short selling.
2. Based on the conclusions in the Pollack Study, the NASD proposed an amendment to Section 59 of the NASD Uniform Practice Code which amendment was designed to curb naked short selling. In approving the amendment, SEC Exchange Release No. 26694, issued on April 4, 1989, the SEC concluded, “the NASD is taking a reasonable approach to deal with the problems that the Pollack study revealed. While fails-to-deliver resulting from short sales may be relatively infrequent, we cannot say that the proposed mandatory buy-in rule for public customers is an unwarranted restriction on short selling.”[10] The same SEC release also recognized: “naked short selling potentially can present substantial manipulative concerns. …  The ability of naked short sellers to employ this leverage to effect ‘bear raids’ would appear to provide support for the NASD’s decision to impose additional discipline on naked short selling.” For the next 14 years, the SEC limited its role in relation to naked short selling to approving rules proposed by SROs relating to containing naked short selling. The constraints incorporated into the amendment to NASD Section 59 proved inadequate to stop or contain naked short selling.
3. On October 28, 2003, the SEC implemented its own rules to prohibit naked short selling when it issued Exchange Act Release No. 48709 (“Release 48709”] which included a preliminary version of Reg SHO.[11]
4. In Release 48709, the SEC explained the negative effects of naked short selling on the securities market:

Naked short selling can have a number of negative effects on the market, particularly when the fails to deliver persist for an extended period of time and result in a significantly large unfulfilled delivery obligation at the clearing agency where trades are settled. At times, the amount of fails to deliver may be greater than the total public float. In effect the naked short seller unilaterally converts a securities contract (which should settle in three days after the trade date) into an undated futures-type contract, which the buyer might not have agreed to or that would have been priced differently. The seller’s failure to deliver securities may also adversely affect certain rights of the buyer, such as the right to vote. More significantly, 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.

1. In Release No. 48709, the SEC also explained how the SEC believed Reg SHO “would address the problem of ‘naked’ short selling.” The SEC pointed to two principal mechanisms that were expected to contain naked short selling:

[1] Proposed Regulation SHO would, among other things, require short sellers in all equity securities to locate securities to borrow before selling, and [2] would also impose strict delivery requirements on securities where many sellers have failed to deliver the securities. In part, this action is designed to address the problem of “naked” short selling.[12]

As more particularly alleged below, the financial crisis demonstrated that neither mechanism curbed naked short selling

1. Reg SHO became operative on January 1, 2005. In the commentary accompanying the final rule, the SEC expressed its optimism that Reg SHO and, in particular, Rule 203 would contain naked short selling:

As adopted, Rule 203 creates a uniform Commission rule requiring broker-dealers, prior to effecting short sales in all equity securities, to “locate” securities available for borrowing, and imposes additional delivery requirements on broker-dealers for securities in which a substantial amount of failures to deliver have occurred (“threshold securities”]. We believe that strong and uniform requirements in this area will reduce short selling abuses. The locate and delivery requirements will act as a restriction on so-called “naked” short selling.[13]

1. From the date Reg SHO became operative, January 1, 2005, until the financial crisis struck in September 2008, the SEC’s enforcement of Reg SHO was almost nonexistent. Two SEC administrative decisions made passing reference to naked short selling and Reg SHO in 2006. In both cases, SEC administrative judges were dismissive of contentions that public companies were being ravaged by naked short selling.[14]
2. The SEC brought two administrative decisions to enforce Reg SHO in 2007.[15]  In both cases, the alleged Reg SHO violations were limited to allegations that the respondents had falsely characterized short sales as long sales. The SEC’s minimal enforcement of Reg SHO from 2005 through 2008 implies its belief that the mere issuance of Reg SHO had convinced broker-dealers, traders, and other market participants to suspend their practice of naked short selling. Those engaged in naked short selling were unimpressed by a new regulation which the SEC chose not to enforce. The SEC’s tough talk in Reg SHO, absent its enforcement, did not deter or frighten them.
3. The SEC’s tepid enforcement of Reg SHO from its operative date, January 1, 2005, until the financial crisis struck in 2008 gave no clue that naked short selling was festering in the shadows, invisible to public companies afflicted by it. Few saw naked short selling as a serious risk to public companies, and virtually none saw it as a systemic risk that could threaten the capital markets. Until the 2008 financial crisis, the common perception was that naked short selling, if it existed, afflicted only a few, relatively small public companies.
4. One industry group, the broker-dealers, knew before the 2008 financial crisis that naked short selling was rampant and also knew the supposed constraints of Reg SHO were easily circumvented.
5. The Securities Industry Group (“SIA”], which represents more than 600 broker-dealers, has been particularly effective in blocking legislative and rule-making efforts to contain naked short selling. The SIA and its members successfully lobbied the SEC to draft the language in Reg SHO and other rules so that broker-dealers could conceal their lucrative naked short selling practices within loopholes the SEC incorporated into Reg SHO.
6. The SEC dubbed one of the loopholes the “Madoff exemption,” since it was the brainchild of Bernard Madoff (“Madoff”]. Madoff was held in high esteem by the SEC in July 2004 when it issued the release accompanying the final version of Reg SHO. The “Madoff exemption” effectively allows a “bona fide” market-maker to engage in naked short selling briefly, supposedly as part of its role as a true market-maker.  The limitation (bona fide) generally requires the market participant to simultaneously place a buy order at or near the best bid and a sell order at or near the best ask.  As a practical matter, it is difficult  if not impossible for public companies and market participants, with exception of the broker-dealers, to determine whether a specific short sale is a naked short sale or a trade by a “bona fide market-maker,” because the data necessary to make the determination is generally unavailable.
7. As a consequence of the Madoff exemption, more accurately described as the Madoff loophole, and SEC’s inability to track compliance with Reg SHO as alleged herein, the SEC has brought only one proceeding for abusing the bona fide market maker exemption, a case against an individual who was an insignificant market participant.[16]  The SEC has never brought a case against a broker-dealer for abusing the bona fide market-maker exception.
8. The “Madoff exemption” was not the only loophole the SEC incorporated into Reg SHO at the behest of the SIA and its members. Market participants can also engage in short term naked short sales if they have “reasonable grounds to believe” they can borrow the stock before they have to deliver it to the buyer.[17]  This creates an even bigger loophole in Reg SHO.
9. The SEC has been and continues to be incapable of determining whether short sale trades by broker-dealers and other market participants are in compliance with Reg SHO, because it has lacked the market surveillance expertise and equipment to track the volume and speed of the securities trading since Reg SHO became operational in January 1, 2005. The discrepancy between trading activity, now at approximately 5 million messages per second, and the SEC’s capacity to track that trading activity has progressively widened since Reg SHO became operative. The decision by the SEC to create Reg SHO, which purports to contain naked short selling, when the SEC knew it lacked the capacity to monitor the securities markets for violations of Reg SHO leads to the inescapable conclusion that Reg SHO was a sham to appease the public companies, investors and traders who had been harmed by naked short selling, while not offending the broker-dealers, especially the mega broker-dealers owned by Wall Street investment banks, who engaged in naked short selling since Reg SHO was in fact unenforceable.
10. The SIA has also vigilantly monitored the state legislatures for possible legislation which could fill the glaring gaps in Reg SHO and thereby threaten the broker-dealers’ lucrative naked short selling practice. In July 2006, the SIA learned that Utah had enacted a statute designed to stop naked short selling. The SIA immediately filed a civil action for injunctive relief to stay the enforcement of the statute. Later, the SIA led the successful charge to repeal the statute. The SIA’s actions to block the enforcement and then repeal the Utah statute is exactly the type of “protection” the SIA promises its broker-dealer members on its website with this words: “The Security Industry Association (SIA) protects and advances our members’ interests by: advocating pro-industry policies and legislation on Capitol Hill and throughout the 50 states…”[18]
11. Despite the lax enforcement of Reg SHO, the tone of the SEC’s releases relating to Reg SHO began to change in August 2007 to reflect the growing and legitimate concern by public companies and their investors about the harmful effects of naked short selling. For the first time, the SEC releases relating to Reg SHO contained this language:

[M]any issuers and investors continue to express concerns about extended fails to deliver in connection with “naked” short selling. To the extent that large and persistent fails to deliver might be indicative of manipulative “naked” short selling, which could be used as a tool to drive down a company’s stock price, fails to deliver may undermine the confidence of investors. These investors, in turn, may be reluctant to commit capital to an issuer they believe to be subject to such manipulative conduct. In addition, issuers may believe that they have suffered unwarranted reputational damage due to investors’ negative perceptions regarding large and persistent fails to deliver. Any unwarranted reputational damage caused by large and persistent fails to deliver might have an adverse impact on the security’s price.[19]