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Naked Short Selling – Failure To Deliver

naked shorting

Naked Short Selling – Failure To Deliver

When we first started investing in penny stocks there weren’t many options to find additional information about those penny stocks.  The main message boards for penny stocks back then was www.RagingBull.com.  During those times the filing requirements for micro cap stocks were much less stringent.  This was about the time the SEC placed restrictions on Blank Check Companies.   This made it harder for those shell factory guys to pump out companies for the sole purpose of selling stock.  When our investment in a particular penny stock company wasn’t going the way we had hoped, we headed on over to the message boards to see what other people were saying.

Normally, what we witnessed on these message boards was an age old battle between the Bull and the Bears.  Only it wasn’t your traditional stock market animal battle.  Of course, it was between long and shorts, but the amount of misinformation, while subtle, was rampant.

As we poured through the comments to glean a hint of why our stock was tanking, in time we were able to notice some patterns in the comments.  There were the longs of course, telling everyone why this company was so great and why the 3 cent company would hit a buck some time in the near future.  The problem was they had been repeating this variations of this same message for quite some time now.  Then you had the good Samaritans warning everyone not to invest in this particular company because it was a scam of some sort.

We also noticed some variations of these groups, the longs that kept telling you why the stock was down and to keep holding because when the shorts break this stock would have a huge short squeeze and everyone would make out like bandits.

Then the debate came about whether you could actually short penny stocks.  The reply was that the Market Makers were Naked Shorting the stock.  First, let’s clarify a big myth about shorting penny stocks.  It is legal to short a penny stock.  However, you must find a broker that allows you to do this, and the account requirements are much greater than with normal brokerage accounts.  Not to mention that there must be a supply of stock that can be borrowed against.  Just like regular shorting rules.  What is illegal is Naked Shorting a stock.

Naked short selling is when someone, market maker, trader… whomever, short sells a stock with out regard for a supply to borrow against.  This means they are basically selling phantom stock, stock that didn’t exist and never would, creating an artificial supply of stock.  This was our first exposure to the naked shorting theory.   The theory basically went along the lines of…naked short sellers keep selling down the stock with the hopes that the company goes out of business and the naked short seller can cover their positions at an extremely reduced price.  The turn about on this is, if the company actually turned out to be successful, and the stock price started climbing it would force these naked shorters to cover before they had to cover their stock at increasingly premium prices.  This would in turn create a short squeeze of epic proportion…something along those lines.

So the myth of Naked Short Selling was born!  At least it was our first exposure to the concept. So is naked shorting real?  And what is it really?  Can people really naked short sell stocks?

First lets look at some of the definitions of Naked Short Selling.

The SEC defines Naked Short Selling as:

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. As a result, the seller fails to deliver securities to the buyer when delivery is due; this is known as a “failure to deliver” or “fail.”

Investopedia has this to say about Naked Shorting:

The illegal practice of short selling shares that have not been affirmatively determined to exist. Ordinarily, traders must borrow a stock, or determine that it can be borrowed, before they sell it short. But due to various loopholes in the rules and discrepancies between paper and electronic trading systems, naked shorting continues to happen.

While no exact system of measurement exists, most point to the level of trades that fail to deliver from the seller to the buyer within the mandatory three-day stock settlement period as evidence of naked shorting. Naked shorts may represent a major portion of these failed trades.

Read more: http://www.investopedia.com/terms/n/nakedshorting.asp

Well now, if it is defined by the ultimate authority on the stock market The SEC (insert dramatic music) then it must be real.

It is our understanding that some or all market maker firms are afforded a small cushion with their ability to naked short sell a stock.  This was meant to be on a very small scale in order to fill orders and keep trading in the markets running smoothly.  As long as they can recover and deliver the sold stock within the 3 day requirement afforded by the law.  If they can not deliver the stock within that time period there is what is called a Failure To Deliver.  Which means exactly that.  They can’t deliver the stock and the short position remains open well past the 3 day period.  How long that position remains open or allowed to remain open is the real question.  And what is being done to prevent and enforce this activity?

Due to recent market crash of 2008 and the ensuing economic impairment that followed, the fingers were pointed at the big banks and the gladiators of Wall Street.  The outcry from Main Street forced law makers to place yet even more regulations on potentially dangerous investing activities of the big financial firms.  Normally, the great minds within the government are no match for the cunning minds of the Major Banking and Investment firms.  In the end it was Main Street (us little guys) that ended up paying for these consequences and actions that resulted in near global economic devastation.  This was in the form of tax payer bail outs of the big banks.  But this is the fodder of another article.

It does, however, bring up a big question.  Can we trust the “gatekeepers” of the stock market to follow the rules?  The answer may surprise you.

Naked Short Selling can be done by a market maker, or on behalf of a client of the market maker, depending on their influence.  Does this provide an unfair advantage in the stock market?  Sure it does. A big one.  It gives certain individuals and entities access to specific advantages that the majority of the stock market can not access.  Is it fair?  Not in any definition of the word we can find.

For the longest time naked short selling was called a myth or considered to be made up by unscrupulous stock promoters and longs as an excuse to why a stock was going down.  Now that doesn’t mean we are suggesting all penny stocks go down because of naked short selling or short selling, its a combination of many factors.  The Naked short and shorts were or are taking advantage of the fact that most small start up companies must sell stock in order to gain operating capital for growth.  This is called dilution.  (There are the exceptions of course, where a public company was created with the intent to sell stock. These are a flash in the pan, and those behind the deals make millions, and normal market players can take advantage of this themselves by buying and selling the stock at the right time, again, food for another article.  There are also plenty of real companies out there that can go on a tear too.  Learn more about finding profitable penny stocks here: Penny Stock Egghead.)

Myths are stories and legends that tend to come from some sort of fact.  Over the past several years the myth of  Naked Short Selling has become more and more exposed.

In 2005 the SEC created what is known to day as Regulation SHO.  It is basically a guideline or rule that governs short selling activity.  It states that, “Although the vast majority of short sales are legal, abusive short sale practices are illegal. For example, it is prohibited for any person to engage in a series of transactions in order to create actual or apparent active trading in a security or to depress the price of a security for the purpose of inducing the purchase or sale of the security by others. Thus, short sales effected to manipulate the price of a stock are prohibited.” Read more here: http://www.sec.gov/spotlight/keyregshoissues.htm

It almost seemed that for the longest time regulators were ignoring the issue or were keeping it under wraps for whatever reason.  When a short sale goes beyond the 3 day period and receives a Failure To Deliver it now makes a list called the Regulation SHO Threshold list which can be found here http://www.nasdaqtrader.com/Trader.aspx?id=RegSHOThreshold

Sometimes people like to track this list in hopes of discovering the next big short squeeze.

But does this system really work? And how are these firms forced into reporting Failure To Deliver notices?

Going back to the question, can we trust the big Wall Street firms and the “gateway keepers” of the stock market to do the right thing?  To err and the side of caution, it may be best to keep your financial guards up involving this matter.  When it comes to financial authority concerning yours and your family’s financial future, trust should be earned and not so freely given.

For example, in a recent article put out by Reuters featuring Credit Suisse Securities (USA) LLC, “The Financial Industry Regulatory Authority (FINRA) said it was fining the American brokerage unit of Swiss banking giant Credit Suisse $1.75 million for violating rules regarding the controversial market-making practice known as Naked Short Selling”

“In Credit Suise’s case, the FINRA statement noted, the broker “entered millions of short sale orders without reasonable grounds to believe that the securities could be borrowed,” which resulted in an elevated number of cases where Credit Suisse executed a securities short-sale but then suffered a “failure to deliver” the borrowed securities. The violations noted occurred between June 2006 and December 2010.”

The full article can be read here http://www.ibtimes.com/articles/273140/20111227/naked-credit-suisse-short-selling-finra.htm

One company, that fell victim to the illegal practice of Naked Short Selling is Overstock.com trading under the ticker symbol (NASDAQ: OSTK).  The company in a nutshell is a major online retailer of just about everything.   OSTK in its heyday traded as high as $60, now its almost considered a penny stock, pricewise that is at about $6 bucks a share.  Whether or not naked short selling, the economy, bad management or maybe all 3, played a part in the depressed stock price remains to be seen.   But Patrick Byrne CEO of Overstock.com would say otherwise.

Patrick Byrne was so convinced that something nefarious was going on with the trading of his beloved Overstock stock, that he set out on a relentless crusade to unmask these unethical activities not only for his benefit but the benefit of others.  He started a website that tracks issues related to Naked Short Selling in an attempt to open people’s eyes to what is happening.  Its called Deep Capture and you can visit it here http://www.deepcapture.com/.  Here he attempts to expose the “foxes” that guard the “Wall Street Hen House”.

But this isn’t a story about Overstock or Patrick Byrne, even though they play a pivotal part of exposing the illegal practices of Naked Short Selling.  If it wasn’t for Patrick Byrne’s persistence into pursuing this matter we wouldn’t have this smoking gun evidence discussed in an article by Rolling Stone magazine.

In the article titled ” Accidentally Released – and Incredibly Embarrassing – Documents Show How Goldman et al Engaged in ‘Naked Short Selling‘ by Matt Taibbi, he details how the lawyers of the big Wall Street firms accidentally exposed the “privates” of their charges such as Goldman Sachs and others.

” The lawyers for Goldman and Bank of America/Merrill Lynch have been involved in a legal battle for some time – primarily with the retail giant Overstock.com, but also with Rolling Stone, the Economist, Bloomberg, and the New York Times. The banks have been fighting us to keep sealed certain documents that surfaced in the discovery process of an ultimately unsuccessful lawsuit filed by Overstock against the banks.”

What are these firms trying to hide from the public?  After all, don’t they control a great deal of the money that pours through Wall Street?  And if they are a publicly traded entity, shouldn’t they be more transparent?

Apparently what the big firms were trying to hide was their rampant disdain for the integrity of the stock market and their greedy attitudes toward the regulations that control it. And their ability to identify and extort questionable loopholes that allowed them to refrain from reporting Failed To Delivers.  Maybe we aren’t so crazy after all?

If that weren’t enough, you get some insight into what some of the managers at these big firms thick of their clients.  It just so happens that these big bankers of Wall Street managed not only to sink their hooks into Main Street, but now they are dragging Sesame Street into it?  That’s going a bit too far.  Hey leave Sesame Street alone!

In March of 2012, in a whopper of a resignation announcement, disillusioned  Goldman executive Greg Smith cited one of many reasons he was quitting the business.  ” It makes me ill how callously people talk about ripping their clients off. Over the last 12 months I have seen five different managing directors refer to their own clients as “muppets,” sometimes over internal e-mail.”

Read the whole resignation letter here its a doozy: Why I Am Leaving Goldman Sachs.

While some will say that Smith was just a disgruntled employee, what he is stating in his resignation parallels the mistakenly released “secret” documents discussed in the Rolling Stone article.

With all that being said, does Naked Shorting really exist?  It most certainly does!

And… people are becoming more and more aware of the not so ethical practices of Wall Street greed.  Take a look at the Occupy Wall Street movement for instance.  Of course this is just an opinion piece and many people have their own opinions on the matter.  This also brings about the message of “Moral Hazard” as expressed in the sequel movie Wall Street: Money Never Sleeps.  Basically, “Moral Hazard”, as it relates to Wall Street, is when someone takes a risk with OPM (Other People’s Money) but has no risk themselves.  If they win, they profit, if they lose…well they don’t lose that’s that problem. Only the person who gave them the money loses.

Does all this mean you shouldn’t engage in stock market investing? No.  It just means that there are many things that go on behind the ticker tapes that you should be aware of as an investor.  Contrary to popular belief, the stock markets are not owned by Wall Street, they are owned by the investors who put their money at risk.

So what do the rich guys do to make money in the stock market? Besides becoming an investment banker for a large firm?  Maybe they go with hedge funds.  These private funds are notorious for raking in profits even in the worst times of the stock market.  Hedge funds are private funds traded by an expert or a group of experts with, sometimes, the uncanny ability to sniff out profit in areas most people don’t even know to look.  Most of these are off limits to the likes of Main Street investing folks.  However, there is one way to access the knowledge of a hedge fund manager.

Further reading on Naked Shorting and references:

Goldman, Merrill E-Mails Show Naked Shorting, Filing Says

Do Nudists Run Wall Street?

Deep Capture

Accidentally Released – and Incredibly Embarrassing – Documents Show How Goldman et al Engaged in ‘Naked Short Selling’

Here is a Youtube video of the Majority.FM show featuring Matt Taibbi discussing JP Morgan’s $2 Billion trading loss.  It could be viewed as a recent example of Moral Hazard.  It goes over issues like Federally Insured banking institutions making these kinds of bets.  Keep in mind that JP Morgan received over  $25 Billion during the “too big to fail” bail out.  Interesting indeed.

As always, do your own research.  Be responsible with your money.  Trust no one with your money that has not earned your trust. Stay informed.  And remember, if you do not have your own plan, chances are you’re part of someone else’s.

 

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Written by John Thomas

I began my investing career back in 1998. I quickly discovered day trading, small cap and penny stocks. I was the editor of my own investment newsletter, stock promoter, investor relations, public relations and have witnessed the back-end process of taking a private company public through reverse merger and registration. That is roughly over a decade in a nutshell. During this time I learned how to identify the rats, sharks and people who truly want to help you learn about investing. Now I do research and write.
My hope is to pass along nuggets of information that could help or the very least entertain you on your way to financial success.