The SEC is closing in on a profitable loophole for many a hedgefund..

Shorting shares involves borrowing them, selling them, and buying them back (preferably at a lower price) and deliver them to the lender (and pocketing the difference). There is nothing wrong with that.

Naked shorting is doing much of the same, without first borrowing the shares.This creates ‘failures to deliver’: from Investopedia:

• Failure to deliver is also important when discussing naked short selling. When naked short selling occurs an individual agrees to sell a stock that they neither own nor have borrowed. Subsequently, the failure to deliver creates what are called “phantom shares” in the market which may dilute the price of the underlying stock.

From the SEC:

• In a “naked” short sale, the seller does not borrow or arrange to borrow the securities in time to make delivery to the buyer within the standard three-day settlement period. 3 As a result, the seller fails to deliver securities to the buyer when delivery is due (known as a “failure to deliver” or “fail”).

Below we will go through some stuff explaining the mechanics a little more. Back to the SEC. What they issued is a requirement to pre-borrow shares before one starts to short:

• The emergency order, to be in effect for 30 days, will bar the practice called naked short selling, in which traders avoid the financial cost of borrowing shares when betting they’ll fall.

And even more interesting:

• Mr. Cox said the SEC will draft rules “to address these same issues across the entire market.”

Why hasn’t the SEC done so before?

• The SEC is reluctant to curb short sales “because it would require a major retooling of the plumbing of Wall Street,” a finance professor at Georgetown University studying short sales, James Angel, said. “It’s only when the big Wall Street firms are threatened that the SEC does something about it.”

And there is another, related problem involved:

• Short sellers, who borrow shares betting that they’ll decline, are spreading rumors about Lehman in an organized attempt to depress the stock, according to a bank analyst at Ladenburg Thalmann & Co. in Lutz, Fla., Richard Bove.

But this time, now it threatens the health of the whole financial system, authorities are reacting:

• U.S. regulators probing suspected stock price manipulation, several sources at hedge funds said. The U.S. Securities and Exchange Commission recently sent subpoenas to more than 50 firms concerning trading in investment banks Bear Stearns, which was rescued in March, and Lehman Brothers Holdings Inc, whose shares have been hurt badly by rumors about its financial health

Some of you will know that we post as STPIOC on the Yahoo message board for InterOil, it’s exactly for this reason, as the amount of nonsense spread there, often by people who do nothing all day than posting and thus wearing out those with good information and drowning out their messages. We might show you a few examples of that in the coming days (one poster even vehemently denies naked short-selling exists.. )

Some other reports on naked shorting:

From Time Magazine:

• naked short selling is illegal, barring certain exceptions for brokers trying to maintain an orderly market. In naked short selling, you execute the sale without borrowing the stock. The SEC noted in a report last year the “pervasiveness” of the practice.
• Naked short selling “has got to push the price down,” says James Angel, associate professor of finance at Georgetown University. He says the rate of short selling has nearly doubled in the past five years, to 36% of all trades.
• Illegal naked short selling, according to Robert Shapiro, a former Under Secretary of Commerce, has cost investors $100 billion and driven 1,000 companies into the ground.

From Mothley Fool

• On Feb. 3, a man named Robert Simpson filed a Schedule 13-D with the SEC describing his purchase of 1,158,209 shares of Global Links Corp. (OTCBB: GLKCE), “constituting 100 percent of the issued and outstanding common stock of the Issuer.” As described in a story that ran on FinancialWire on March 4, Simpson stuck every single share of the company in his sock drawer — and then watched as 60 million shares traded hands over the next two days. In other words, every single outstanding share of the company somehow changed hands nearly 60 times in the course of two days, despite the fact that the company’s entire float was located in Simpson’s sock drawer. In fact, even as recently as last Friday, 930,872 shares of Global Links still traded hands.
• But many companies linger on the Threshold Security List, experiencing impossible trading volumes. Many are penny stocks like Global Links, but others include well-known names like KrispyKreme Doughnuts (NYSE: KKD), Martha Stewart Living Omnimedia (NYSE: MSO), and Delta Airlines (NYSE: DAL).
• The way it works is that one brokerage house sells short, has 13 days under your rule under which to acquire the shares, and in that 13-day period hands the whole transaction off to another brokerage house. They just keep moving it around and nobody ever has to settle.
• Under the new rules, if shares haven’t been delivered for 13 days after the transaction, the broker must buy them back — with money it presumably would collect from the client who shorted the stock in the first place. So a bad actor can break the law a little bit, but if he breaks it a lot, he has to cover the short — which he was going to have to do anyway and, since he’s been manipulating the price by illegal activity, can probably be done at a bargain price. Now that’s showing the bad guys! Moreover, as Sen. Bennett noted, brokers working together could get around even this restriction by passing the transaction among each other, starting the 13-day clock over again.

Delivery problems can very well go beyond the garden variety hick-ups in the settlement process. These securities get on the threshold securities list. Threshold securities are equity securities that have an aggregate fail to deliver position for:

• five consecutive settlement days at a registered clearing agency (e.g., National Securities Clearing Corporation (NSCC))
• totaling 10,000 shares or more; and
• equal to at least 0.5% of the issuer’s total shares outstanding.

You can find the threshold list here for instance. It’s noteworthy that InterOil is on that list for 472 consecutive trading days (as of today). If you have problems with that, you can complain at regsho@amex.com.

Is it a serious problem? Well.. from James J. Angel, Ph.D. Associate Professor of Finance Georgetown University:

• Fails reduced but problem still remains. Over 20% of listed firms had failures serious enough to warrant inclusion on the SEC “Threshold list” with special buy in rules during first 18 months of Reg SHO.

From part II of that Mothley Fool article

• But can unsigned or lost certificates really explain why some companies have lingered on the list [the SHO failure to deliver list] for weeks, meaning that more than 10,000 shares per day or over 0.5% of the company’s entire float is subject to failed settlement on a daily basis? If that’s the root cause, it would certainly seem to point to some pretty shoddy settlement practices among broker-dealers.
• The potential problem is that unscrupulous folks could potentially register as market makers to take advantage of the exemptions. (Do you want to be a market maker? Go here for an application! It’s not a rubber-stamp process, but it’s not as hard as you might think.)
• And here is a final source of potential trouble I’ll suggest. Say the broker placing the order to short a stock is in an offshore location where naked short selling is legal. This would seem to open up the same opportunities purportedly exploited to naked short the stock of companies that have issued floorless convertible debt.

There are people starting actions against naked shorting, here is one, it also contains many useful other sources and articles on other types of stock scams.

For some scientific work, see that of John Finnerty, for instance

• I explain how naked short selling can routinely occur within the securities clearing system in the United States and characterize its potentially severe market impact. I show how a recent securities innovation called floating-price convertible securities can resolve the unraveling problem and enable manipulative short selling to intensify.