The SEC just sued two brothers, Jeffrey A. Wolfson and Robert A. Wolfson, for violating Regulation SHO, which governs short sales.
All quotes below are from the SEC Complaint.
The allegations are rather complicated, but the essence is that they abused in multiple ways the market maker exception from the Reg SHO rule requiring locates of stock sold short:
The Respondents in this matter, who were not conducting bona-fide market making activities but were instead engaged in “naked” short sale transactions for their
personal investment purposes, improperly utilized the Market Maker Exception from Rule 203(b)(1) in order to avoid locating shares before effecting short sales as part of “reverse conversion” and “assist” transactions, as further described below. Because the Respondents failed to borrow or arrange to borrow securities to make delivery when delivery was due, the short sales as part of the reverse conversions and assists were “naked” short sales. These
same Respondents also violated Rule 203(b)(3) by repeatedly engaging in a series of sham transactions to ostensibly “reset” the thirteen-day clock for complying with the close-out requirement, but without actually purchasing shares in a bona fide transaction. These sham transactions enabled the Respondents to circumvent Reg. SHO, allowed them to generate millions of dollars in profits because they did not actually borrow or arrange to borrow the
securities they were selling short, and caused their clearing broker to have large persistent fail to deliver positions in these threshold securities, thus undermining one important
purpose of Reg. SHO.
One interesting thing is that these transactions were designed not to short stocks for the Wolfsons’ accounts but to enable them to essentially lend out hard to borrow stocks and profit from the fees:
9. Reverse conversions are executed to meet a one-sided market demand for hard-to-borrow threshold securities. The buyers of the threshold securities, in this case
large prime brokerage firms, engaged in the conversion transaction that allowed them to 4acquire a long stock position that is hedged by the synthetic short options position. The brokerage firm could then loan out the shares of the threshold securities and received fees from the borrowers. Those loan fees can be quite significant when the stock is a threshold security, because threshold securities are generally hard to borrow and therefore command
large fees in the stock loan market. Indeed, the borrow rate (referred to as a “negative rebate” because it is paid by the borrower to the lender) on a threshold security can be as
high as 50% of the stock’s market price (on an annualized basis), as compared to a small positive rebate that a financial institution borrowing securities would receive from the lender to compensate for cash collateral it posts to the lender when a security is easy to
borrow. In many cases, certain threshold securities could not be borrowed at all. Alternatively, if the shares could be borrowed, the price to borrow was often much higher
than the price at which the Respondents were willing and able to transact in reverse conversions because they did not have and did not intend to actually buy or borrow the
stock they were selling short.
10. As a result, the Respondents, who did not comply with the “locate” requirements of Rule 203(b)(1) before selling the stock and did not comply with the close out requirements of Rule 203(b)(3), were able to attract the business of prime brokerage firms seeking to create inventory for stock loans on hard to borrow securities.
A couple conclusions that I draw from this are that yes naked short selling is real, but it is not easy to do. Also, there is still no evidence of the ‘evil naked shorts’ who use their naked short selling to manipulate lower price of certain stocks.