April 4, 2008
Naked short selling creates shares of a company out of thin air. They are nothing more than "counterfeit" shares, sold as if they had value. If one were to create money out of thin air, and use it as if it had value, the penalties for such counterfeiting are steep. The same should exist for counterfeit shares.
I have personally owned shares of a company that recently came under a naked short attack (VCG Holdings, VCGH). that company is STILL on the Reg SHO list, and the share price has been driven from $15 to $5, all while earnings have increased dramatically. No matter how many buyers show up, there is an unlimited amount of shares ready to be sold into the bids.
Short sellers (and naked short sellers) are completely anonymous, yet they have massive influence over a company's share price. 5% and above "owners" are required to disclose their identity with SEC filings. That rule was put in place so other parties know who has majority interests, and can be asked about intentions. Short sellers on the other hand have NO such requirement. Short sellers have just as much influence over a company's share price, as do the owners, yet they remain anonymous. Short sellers should be subject to the same 5% reporting rule.
A 5% reporting rule for short sellers would solve two problems. First, the world will know the identity of the shorting party, and can ask about their intentions. Second, naked shorting allows one to short more shares than exist. How could a naked shorter effectively report they have shorted 300% of the float without admitting illegality?
Failures to Deliver, intentional or unintentional, should have very STEEP fines - based not on the occurance, but on the number shares that FTD'ed. There is no excuse for not delivering that which was contracted in the deal.
Another concern of mine is the settlement period for foreign-based short sales, which is 13 days, not 3. Most naked shorting occurs through foreign exchanges, particularly the Frankfurt and Berlin exchanges. A LOT can happen to a share price in 13 days A naked short position can remain open for 13 days, and yet not be in violation of any current rule. The foreign settlement period should be the same as the domestic period, 3 days max. Those countries have sophisticated computers just like the United States. There is no reason to need 13 days to settle a transaction.
All this brings up another issue. Why is the settlement period 3 days, in this modern world? With computer systems the way they are, there is no reason to not have instant settlement. When every broker is plugged into the same central system/s, there is no reason for the debits and the credits to not happen instantly - similar to the way an ATM deducts from your bank balance when you with draw cash - instantly. If that happened, naked shorting could not exist. Steep fines could be an interim solution, while instant settlement would be the longer term goal.
My biggest concern about naked short selling is the overall intent. Many may argue that it does not matter if a naked short seller sells, because they must cover the position eventually. Those people fail to understand the intent of a naked short seller. It is true they must cover the position. WHEN they do that, is the issue. A naked short seller's intent is to drive a stock below $1 and keep it there until it is de-listed from the exchange. Once it is on the pink sheets, the naked short seller can then cover their position without fear of the stock price increasing in a more liquid market like a major exchange. Further, once on the pink sheets, there are more than enough sellers from which the naked shorted can buy shares to cover. In fact, they are the ONLY party buying shares
One final issue has to do with psychology. Once a company is listed on the Reg SHO list, it becomes a warning flag for all buyers to stay away. The SHO list actually works FOR the naked short seller, helping them drive the price lower. Every broker knows that one can inspire fear 10-times easier than one can inspire confidence. when there is negative news (or rumors), investors sell first, then ask questions later. If there is positive news, investors ask questions as fast as they can, then buy. Hedge funds have increasing figured this out, and more often than not, will play the short side of stocks. They can plant rumors and achieve faster results. Once a stock is on the SHO list, one rumor and the mention of a ficticious negative fact, can drive a stock price down 50% in minutes. We saw this happen on March 17, 2008 with the shares of Lehman Brothers (LEH). While Lehman was not on the SHO list, we saw just how quickly a rumor can destroy a company, as their share price fell more than 50% on that day. Imagine how much more it would have fallen if they appeared on the SHO list as buyers were scared away
Naked shorting is a crime, and should be punished as a crime - perhaps with steep fines and jail time for multiple offenses. It is nothing more than counterfeiting. Steep fines and jail time are the norm for counterfeiting money. The same should be true of naked short selling.