The naked truth

In a new attempt by the SEC to clamp down on excessive short selling, Regulation Sho has been implemented. It’s aimed at slowing the growth of what the stock market calls a ‘naked short’. I thought that if someone had his shorts on, he couldn’t possibly be naked. But as with the emperor’s new clothes, life in financial markets isn’t always what you imagine. 

Short sales have serious implications for governance, ones the SEC chose not to cover, at least for now. The new rule does, however, expose dark corners of the financial markets to the light of day. 

Regulation Sho is aimed at traders. Before conducting a short sale – whether for a client or on its own account – a broker-dealer should ‘locate’ enough shares to cover the open position. It’s a small step toward controlling what many corporate officers see as a growing menace to orderly markets: the attempt by scurrilous investors to profit by damaging a company’s share price. The culprits? Hedge funds, of course, and the trading desks of the big investment banks. 

Short selling has been around – and allowed – for many years, and it has always been controversial. It usually takes the form of borrowing stock from another investor, selling it, and then buying it back at a lower price when the loan is due. 

Not all short sales happen that way, though. Sometimes, by accident, the short seller doesn’t actually get the stock he arranged to borrow. The result is an unsettled trade a few days later. But the volume of such transactions is now far too high to be purely accidental. Couple that with some injudicious gossip, a false rumor or a nod and a wink, and presto: market manipulation.
 
Moreover, the new owner – the ‘share-non-holder’ – has a legitimate contract to own the stock and might even sell it on. Then who owns the stock? At some companies, we’ve seen the stock owned by these non-holders exceed the number of shares in issue. 

Supporters argue that short selling makes markets more efficient, helping would-be buyers find willing sellers. Douglas Creutz of the Leonard N Stern School of Business at New York University finds evidence that short sellers sometimes pick up hints of corporate malfeasance before the fraud becomes known, helping the market achieve the ‘right’ price. ‘In fact, the markets may be better off in terms of efficiency if existing restrictions were loosened or lifted, and short sellers were allowed to ply their trade more reely,’ he says.

Naked shorts have fewer fans, not least for the ambiguity they foster, which Regulation Sho doesn’t address. Who should be a director? What direction should the company take? When it’s time for a shareholders’ meeting, who votes? Not the lender, in the case of a covered short. He or she has loaned the right to vote, too. But what happens with a naked short? There’s no lender to give away the rights, but there’s a new owner who thinks, quitelegitimately, that he or she has the right to vote. Indeed, the broker might well record the transaction as complete, and the non-holder of these phantom shares might well get proxy materials. And vote. 

And, by its lack of serious action, the SEC might well just Sho him or her the way to the ballot box.