Will the amended rule 204T once and for all kill the nefarious practice of naked short-selling? Well.. at least the SEC admits there is a huge problem, that’s a start. The jury is out whether the new “interim final temporary rule” will work and the persistent problem of large quantities of undelivered shares will be resolved.

Last week, the SEC introduced an amended temporary rule 204T, which could provide the best bet yet to deal with the nefarious naked short-selling practices, but the jury is still out. First, some definitions

• Short selling involves a sale of a security that the seller does not own or a sale which is consummated by the delivery of a security borrowed by, or for the account of, the seller. Short sales normally are settled by the delivery of a security borrowed by or on behalf of the seller.
• In a “naked” short sale, however, the short seller does not borrow securities in time to make delivery to the buyer within the standard three-day settlement period. As a result, the seller fails to deliver securities to the buyer when delivery is due (known as a “fail” or “fail to deliver”). Sellers sometimes intentionally fail to deliver securities as part of a scheme to manipulate the price of a security, or possibly to avoid borrowing costs associated with short sales, especially when the costs of borrowing stock are high.

The first effort of the SEC to deal with this was Regulation SHO (July 2004):

• It required broker-dealers to “locate” securities that the broker-dealer reasonably believes can be delivered within the standard three-day settlement period (T+3), failure of which was routinely extended for another 10 days (T+13)
• The SEC did have the option of a mandatory close out when the shares have not been delivered within the 3 day requirement (T+3 although, more likely, T+13), basically meaning the party in violation (usually the broker-dealer) should buy the undelivered security at once.
• Instigated a list of securities with large fails to deliver (the reg SHO threshold list)
• Option market makers were exempt
• A “grandfather”provision existed that provided that fails to deliver established prior to a security becoming a threshold security did not have to be closed out in accordance with Regulation SHO’s thirteen consecutive settlement day close-out requirement.

The simple truth is, these rules were never really used, so they didn’t have any bite, witness that there are numerous securities who linger on the reg. SHO list for weeks, months, or, as in the case of InterOil, even years, and with millions of undelivered shares, hardly the sign of garden variety administrative hick-ups in the settlement procedures.

Here is some stuff we published earlier:

• Regulation SHO did not force short sellers to borrow real shares before they sold them. They were given three days to produce stock before it was declared a “failure to deliver.” If they missed the three-day deadline, they were given another ten days, after which they were supposed to buy (not borrow) real shares and deliver them, or face penalties. (the forced close out)
• In practice, many hedge funds and brokers ignored the deadlines without repercussions. But even traders who met the deadlines were able to churn the markets. Since they were not required to possess real shares before they hit the sell button, they could offload a large block of phantom stock and let it dilute supply for three to 13 days. When the deadline arrived, they might borrow real shares and deliver them, and then sell another block of phantom stock, which would hammer prices for another three to thirteen days.
• Or, rather than borrow real shares, the hedge fund might buy stock (the price having been knocked down during 13 days of diluted supply) from a friendly broker. Often, the brokers did not have any stock to sell the hedge fund, but they pushed the sale button anyway. The hedge funds then used the broker’s phantom stock to settle its initial sale of phantom stock, and when the broker’s deadline came, he bought an equal quantity of phantom stock from another broker, and so on.
• A lot of journalists have portrayed this naked short selling as “legal.” In fact, it is grossly illegal assuming the goal is to manipulate markets. But the SEC until recently shied away from making that assumption. So long as the hedge funds met the delivery deadlines, they could distort and destroy at will.
• Another result of the short-seller lobby’s intervention is that a company does not appear on the SEC’s “threshold” list unless there are failures to deliver of more than 10,000 of the company’s shares (and at least 0.5% of its total shares outstanding) for five consecutive days. So long as there are no failures on day six, there are no flashing red lights at the SEC. That is, threshold (excessive) levels of phantom shares can float around the system for a total of eight days (three days before they are registered as “failures to deliver,” plus five more) without a company being designated a victim of naked short selling.
• An eight-day blast (or even just a one day blast) of, say, a couple-hundred thousand phantom shares can knock down a stock’s price very nicely. Blasts of a million-plus shares, which are common, can do even more damage.
• If a company has weaknesses that can be blown out of proportion with help from the media, and if hedge funds blast the company with phantom stock, then pause, then blast again, then pause, then blast again — over and over — for a couple of months, then the company’s share price can soon be in the single digits. – without ever having appeared on the SEC’s threshold list.

Things got a little bit better this year, when the SEC came under much pressure and instigated one rule after the other. For instance, the grandfather provision and the exception for option market makers have been eliminated, which is not unimportant.

And now the SEC comes with a mea culpa of sorts:

• Given the importance of confidence in our financial markets as a whole, we have become concerned about sudden and unexplained declines in the prices of equity securities generally.  Such price declines can give rise to questions about the underlying financial condition of an institution, which in turn can create a crisis of confidence even without a fundamental underlying basis.  This crisis of confidence can impair the liquidity and ultimate viability of an institution, with potentially broad market consequences.  These concerns resulted in our issuance on September 17 of this year of an emergency order under Section 12(k) of the Exchange Act (the “September Emergency Order”). Pursuant to that emergency order we imposed enhanced delivery requirements on sales of all equity securities by adding and making immediately effective a temporary rule to Regulation SHO, Rule 204T.

That last sentence is the important one. This new “interim final temporary rule” (bureaucratic language can be hilarious at times):

• To further our goal of preventing substantial disruption in the securities markets, we areadopting Rule 204T as an interim final temporary rule, with some modifications to address operational and technical concerns resulting from the requirements of the temporary rule as adopted in the September emergency Order. We intend that the temporary rule will address potentially abusive “naked” short selling by requiring that securities be purchased or borrowed to close out any fail to deliver position in an equity security by no later than the beginning of regular trading hours on the settlement day following the date on which the fail to deliver position occurred.  This temporary rule should provide a powerful disincentive to those who might otherwise engage in potentially abusive “naked” short selling.

So, on paper at least, forced close outs on positions which have not been delivered is now the rule. What effect this will have in practice remains to be seen, we notice that this could in fact have happened under the 2004 rules (with the two exceptions).