US equity market – Short selling: The naked truth

Up to that point in 2008, cumulative fails to deliver of Bear Stearns’ stock were only between 10,000 and 200,000 on any given day. On March 14, more than 2 million Bear Stearns shares went undelivered, and from then until the end of March, failures increased, peaking one day at more than 13.78 million shares. At the same time, from March 12 to the announcement on Friday March 14, Bear Stearns’ share price crashed from $61.68 to $30, dropping to $4.81 the following Monday.

That the precipitous drop in Bear Stearns’ share price coincided with fails to deliver has forced the market to properly address a long-standing question: are fails to deliver responsible for rapid share price deterioration? Had those failures been averted through better regulation would Bear Stearns have had a slower downfall, or even avoided outright collapse? And what of Lehman Brothers, Fannie Mae and Freddie Mac? Indeed, would all financial companies have enjoyed more resilient share prices, instead of seeing sudden, sharp price declines that were the final nudge to creditors and counterparties abandoning firms and driving them into bankruptcy?

The SEC has since attempted to bring a halt to naked short-selling, which gives rise to fails to deliver, but are its efforts sufficient?

Formal investigations are taking place to look into abusive short-selling of the stocks of both Bear Stearns and Lehman Brothers.

Robert Shapiro, former economic adviser to Bill Clinton, chairman of Sonecon and an adviser to the presidential transition team of Barack Obama, believes there is sufficient evidence that naked shorting accelerated the collapse of Bear Stearns. He says: "Bear Stearns failed because it went bankrupt. However, the pace of the collapse of the stock price was clearly accelerated by the enormous naked short-sale activity. There perhaps could have been a more orderly bankruptcy which would have preserved more of the assets."

John Welborn, an economist with investment firm the Haverford Group, agrees. "Fails to deliver added to the downfall of Lehman Brothers and Bear Stearns but were not, obviously, the whole story. Fails in Lehman Brothers were never significant enough to drastically alter the tradable float. In Bear Stearns, however, a torrent of fails began on March 12, before the public knew most of the bad news. The important thing to note here is that T+3 settlement essentially allows people to sell an infinite amount of any stock either to precipitate a bear raid or to capitalize on one already in progress."

Welborn continues: "A bear raid encourages panic selling by long holders. Once enough long holders are induced to sell, then there are plenty of shares available to cover any naked positions ex post. When the long holders have sold their positions and the naked short sellers have covered at a lower price, then the issuer faces a dramatically depressed market. That may make it difficult (or impossible) to recapitalize, especially if that issuer is in the financial sector."

Naked short-selling can be a confusing topic. A short-seller can only sell short if it can locate a source from which to borrow that security and therefore ensure delivery to the buyer – within the T+3 requirement. In most circumstances it is up to the prime broker to confirm whether it is possible to locate the stock and agree the transaction. If it is not possible to locate a stock, which can happen when certain stocks become illiquid, the trade is not allowed to take place. Market makers are an exception to this rule, and are able to lend stock without having located a source from which to borrow, in order to keep the markets liquid. This type of "naked shorting" is legal. If the source of stock is not a market maker, selling of a stock without having located a stock to deliver is illegal. Illegal, however, means very little when no enforcement penalties are in place.

Up until the end of this summer – not till September did the SEC enforce a crackdown – shorting without locating a source from which to borrow has suffered no penalty in the US, and brokers’ statements about efforts to locate them might be rather vague. "A broker can say he has located a stock, but that’s it," says a hedge fund manager. "What if five other brokers are looking at that same stock and telling their clients they have located it. Who will get it?"

And if there is no penalty for failing to locate and failing to deliver, then why not just fail to deliver? In equity markets if a short-seller does not deliver, he can simply wait until the stock price deteriorates sufficiently so that he will never have to deliver, and therefore is able to keep the money from his sale. Do short sellers, be they hedge funds or proprietary trading desks, do this often? No. But can they do it? Yes. And were some doing this during the peak of the financial crisis? Absolutely.

One former employee of regulator NASD says he knows of a hedge fund that was shorting Freddie Mac and Fannie Mae on a "massive scale", with no intention of ever locating stock. "His prime broker let the trade go through regardless as he was a large client of theirs," he says.

Illegal naked shorting, at its worst, can be implemented to bring a company down. In the present crisis of confidence among financial institutions, it can also simply be a means of jumping on a losing target. If a financial institution’s stock looked as if it was falling, why not short-sell without promising a buy-in within three days and hope that the fall is sufficiently large beyond three days to make an even bigger profit?

A glance at the fails to deliver in the financials market indicates that some investors applied this strategy. A comparison of the average daily reported shares failing to deliver between the first quarter of 2007 and the first quarter of 2008 for the US’s top financial firms showed a clear increase over the period. The data, compiled by Washington publication IA Watch, showed a 335% increase for Freddie Mac, a 226% increase for Citigroup, a 133% increase for Goldman Sachs, a 632% increase for Morgan Stanley and a 1,123% increase for Bear Stearns. One source even suggests that some market participants never intended to buy-in and simply marked their tickets "long" selling shares that they did not even own as they knew they would never have to make delivery.

Fails to deliver: Unheard voices

For years, small companies affected, and larger companies such as Overstock.com (which has market capitalization of $500 million) have appealed to the SEC to prevent fails to deliver, claiming that their stock prices have suffered as a result of the practice. In April 2005, in a series of articles, Euromoneywarned about the implications for larger household names if fails to deliver were not properly addressed. Shapiro agrees that larger companies are now being targeted. He says: "Ordinarily this doesn’t happen to large institutions with large stock floats but in a panic situation they become vulnerable along with those companies that are always vulnerable – smaller companies that are without large public floats. In a time of panic, mechanisms that allow the markets to overshoot (naked shorts) mean you can drive a stock into the ground."

Patrick Byrne, chief executive of Overstock.com, continues to lobby against fails but insists it is not a matter of self-interest. "The argument gets reduced to me being upset that stock in my firm might be being shorted. That was never the argument. Shorting has its place, I know. This has always been about why the government is ignoring the loopholes within the settlement system that are allowing for fails to deliver to occur."

He is certain, as are several other long-standing lobbyists, that the recorded number of fails to deliver is only a fraction of the true amount. "If two broker/dealers clear through the DTCC, and one fails, then the two brokers can turn that failure into a private contract to be dealt with outside the DTCC and it becomes ‘ex-clearing’. After that there is no register of that fail," says Byrne.

If failures are as frequent as suggested, the idea of broker/dealers preferring to cancel out each other’s fails on a private basis is not beyond the realms of possibility.

Wes Christian is partner in a law firm representing 15 companies that allege that their stock price has been driven down by illegal naked shorting and fails to deliver. "We are aware of these deals being ex-cleared and of the failings of Reg SHO. Allowing failures to deliver creates artificial supply and that drives down prices," he says. The defendants in Christian’s clients’ cases are the majority of broker/dealers on Wall Street.

Fails to deliver in the equity markets are seen to create artificial supply. If a stock can be sold without having to be borrowed, there is a strong possibility that stocks in excess of those issued are being sold. Indeed, several companies, Overstock.com included, have reported instances of more owners of stock than is possible. On March 14 128% of Bear Stearns stock outstanding was traded. These "phantom shares" can be on-lent without delivery again and again, further diluting the stock.

"The pace of collapse of the Bear Stearns stock price was clearly accelerated by the enormous naked short-sale activity" Robert Shapiro

However, settlement is faster in Europe than in the US. It is surprising that the US still operates a T+3 system. Robert Greifeld, chef executive of Nasdaq, questioned the system in March this year at a conference when, in reference to fails to deliver, he said it was hard to believe that in 2008 the market still required three days to settle, and that a T+1 system should be part of a discussion about fails.

The SEC has pussyfooted around enforcing delivery in the US equity market over the past 10 years or so, but the collapse of financials stocks has pushed it to be stricter. On September 17, SEC chairman Christopher Cox announced several actions to "make it crystal clear that the SEC has zero tolerance for abusive naked short-selling." From that date, fails to deliver beyond T+3 have been subject to a hard close-out. If stocks fail to deliver beyond T+3, the broker/dealers acting on the short-seller’s behalf are prohibited from further short sales in that security unless stocks are pre-borrowed.

This change of tack upsets those such as Byrne who have been fighting to have their voices heard for years. "When companies that had access to the Fed window became victims of fails to deliver, the SEC then had to sit up and take notice," says Byrne.

Actions taken against naked shorting: Small steps

Since August, the number of companies with stock on the Reg SHO list has fallen from an all-time high of 650 to an all-time low of 90, although this does not take into account ex-clearing data.

Shapiro says it is a step in the right direction. "The actions taken are an acknowledgement of the issues regarding naked shorting and fails to deliver at least. Progress is under way. Given there are many issues facing the SEC at the moment, this is encouraging."

Others, however, are disappointed that more has not been done. Byrne says: "A hard close-out is not nearly enough. To truly stop failures to deliver, the SEC must enforce a pre-borrow where parties have to guarantee that a locate has been found through a contract." At present, broker/dealers and short-sellers can say they have located a source of stock when several other parties might have also identified the same source. Peter Chepucavage of the International Association of Small Broker/Dealers and Advisers agrees that an initial pre-borrow rule is crucial in preventing fails to deliver. "The industry is resisting an initial pre-borrow rule but it is essential," he says. "Without it the stock market is like the airline industry. You’re overselling the airplane seats knowing that someone will not be able to board even though they reserved/located, to avoid decrementing their inventory."

Bringing down bear

Bear Stearns stock price falls in line with FTDs, March 2008

Source: Haverford Group

Welborn says the SEC knows it has to introduce the pre-borrow rule if it wants to eliminate fails to deliver for good. "As long as there are companies on the Reg SHO list, then the problem has not been solved," he says. "The only sustainable solution to naked short-selling is a rule requiring both a pre-borrow and a hard delivery. With only one of these pieces in place, the system is still open to abuse. For example, a hard-delivery requirement by itself would not have made an iota of difference for Bear Stearns; only a pre-borrow could have put a brake on the naked short-selling."

Welborn points out that the SEC did precisely this in July when it ordered emergency pre-borrows for Fannie Mae, Freddie Mac and the 17 primary dealers. "The SEC knows what must be done to fix this problem once and for all," he says.