August 23, 2009
In the naked short-selling blame game, investors and
hedge funds sue the brokerages, the brokerages point to the
DTCC, the DTCC hides behind the skirts of the SEC, and in
full circle, the SEC investigates the hedge funds, all while skeptics
question the existence and the extent of the naked short selling
problem. Plaintiffs lawyers claim that naked short
selling is the Holy Grail and could be bigger than tobacco
in terms of damage awards if ever proved. But, so far, litigation
has been unproductive, and even occasionally wasteful, in curtailing
or catching alleged naked short sellers, despite an
overall post-Enron, pro-plaintiff trend. Meanwhile, overregulation
can do more harm than good in that it can reduce liquidity
and efficiency, but the under-regulation to date has hurt
vulnerable businesses, including some former Wall Street
mainstays.
In the naked short-selling debate, two uniquely American
value systems collide: the value of an efficient, liquid, open,
nationwide market versus the values of entrepreneurship and
the opportunity for young, struggling companies to have a fair
shot at success. How to balance those values? One solution
rests with the judiciary, who could declare all naked short-selling
market manipulation as a matter of law, but then set a high
bar for damages assessments by requiring proof of real economic
harm. If companies can prove that but for naked shortselling,
their stock price would not have declined to the extent
it did—a test that requires them to affirmatively prove their
business model, management practices, and/or products were
not to blame—they deserve a remedy. If they cannot, they do
not. The problem with that open-door approach is that while
the court system sorts out deserving plaintiffs from frivolous
ones, the defendant brokerages, hedge funds, and the DTCC
incur legal expenses, discovery burdens, and perhaps undeserved
negative publicity.
Another option is to place the burden with the regulators.
Rule 10b-21, the recent amendments to Regulation SHO, and
movement toward publicly releasing timely information on delivery
failures are all good steps for the SEC, but they are reactionary
in approach. Thus, long-term, the SEC should consider
an overhaul of DTCC systems, including greater transparency,
to better curb naked shorting abuses and rebut the
DTCCs persistent refrain of Its not our job to regulate or
enforce, therefore naked short selling is not our fault. Further,
the SEC must back up rule 10b-21 with more aggressive
enforcement measures. FINRA, too, must proactively enforce
its affirmative determination rule and consider ways it might
better cooperate with the SEC in releasing accurate information
about delivery failures and their causes.
Wrongs, no matter how small or infrequent, must be
checked with remedies. But until a court declares naked short
selling as market manipulation as a matter of law and clarifies
the issuers and investors burdens in proving the occurrence
of naked short selling, the practice will continue without a
check from the judiciary. And until the executive or legislative
branches effect better regulation and accountability, that
means there is no real check at all.
http://www3.law.nyu.edu/journals/lawbusiness/issues/uploads/5-1/NYB103.pdf