Short Selling - A Primer

by

John R. Fahy

Short sellers are a standard part of the investing landscape and will continue to significantly impact targeted stocks. Securities issuers must concern themselves as much with investors who want the stock price to decline as they would with investors who want the stock price to rise.

What Is Short Selling?
Short sellers sell stock today with the hope of buying the stock back later at a lower price. Basically, short sellers sell stock that they borrowed, and do not own. Short sellers borrow stock from a securities broker-dealer, who has borrowed the stock from another customer or another securities broker-dealer. SEC Regulations obligate broker-dealers who conduct short sales for customers to locate the stock for good delivery to the purchaser.

Grain silos and securities broker-dealers act similarly for their customers. Both grain and stock are fungible. This means that when a customer deposits a bushel of wheat or a share of stock and later withdraw it, the customer will not necessarily receive exactly the same wheat grains or shares of stock. Instead the customer receives the same amount of wheat or stock, generally from the easiest location for delivery. One bushel of wheat or share of stock is as good as another.

The borrowed stock used by short sellers may come from other broker-dealer customers. Broker-dealer customers sign “hypothecation agreements” to allow the broker-dealer to lend their shares. Shares authorized to lend are deposited into the “silo” of securities authorized for lending and the broker-dealer uses them as needed for short sales. Sometimes, broker-dealers lend their customer shares to other broker-dealers so that those customers can sell the shares short.

Second, shares may come from non-liquid shares that the customer has for delivery. This includes convertible debt that have met conditions for conversion into stock and restricted stock that has met its holding period. SEC rules allow for 35 days to deliver these type of shares to allow for converting the convertible debt or restricted stock to saleable stock.

Why would a broker-dealer let someone borrow their customers’ stock? Short sales are margin transactions, so broker-dealers charge interest on the value of the stock borrowed. The broker-dealer gets all the interest even though the broker-dealer’s customer actually owns the stock.

Why Sell Short?
Short sellers sell for two reasons. First, they make directional bets on stock and profit from declines in stock price. In 2005, the CSFB Tremont Dedicated Short Bias Index was up 9.93%, beating the 4.91% gained by the S & P 500 Index. Second, short sellers may seek to hedge certain related long positions. Short selling is an available investment strategy for many of the 8,000 hedge funds currently operating. Hedge funds may use data from third party analysts such as the Center for Financial Research and Analysis and Behind the Numbers to decide whether to short sell a stock.

Short Seller Tactics – the Bear Rush
Once short sellers obtained a short position, they often seek to publicize their doubts about the issuer’s business model and financial statements. Among other things, short sellers tell their story to the business press and the SEC’s Enforcement Division. Indeed, this author received many such telephone calls while working as a SEC Enforcement Attorney.

Investment analyst reports may also be a target. Recently, Overstock.com sued Gradient Analytics, an analyst firm, and Rocker Partners, a short-selling firm, for allegedly allowing Rocker Partners to “preview, edit, and control” and otherwise “alter” Gradient's stock research relating to Overstock.com. No court has made any determination of wrongdoing in that litigation.

Naked Short Selling – Failure To Deliver
SEC Regulations require that broker-dealers be able to “locate” the stock to be delivered in a short sale on behalf of customers. Purchasers trust that located shares will actually be delivered to settle a trade. Securities regulations except market-making trades, that is, broker-dealers trades for their own proprietary accounts for the purpose of maintaining an orderly market. Typically short market-making sales net out on the buy side long before share delivery must be made to settle the trade.

“Naked" short selling occurs when a broker-dealer sells shares for a short-selling customer without locating the shares for delivery. For U.S. brokerages, naked short selling is typically not a profitable enterprise. For the broker-dealers, naked short selling lowers the short-term cost of servicing short-selling customers, but these broker-dealers will be required to settle the trades in the long run, whether or not their customers have paid them. These broker-dealers also face huge regulatory risks for illegal actions. For example, in June 2005, the NASD charged a broker-dealer and its manager for falsely marking naked short trades on behalf of hedge fund customers as market-making trades and not locating the shares for delivery. In Re: Scott W. Ryan and Ryan & Company, LP. Also, in April 2006, the NASD sanctioned a broker who allegedly made almost $300,000 by marking short sales as “long” when he was unable to locate shares for delivery. In Re: Steven W. Norin. Most naked short selling comes from offshore venues which have fewer regulations than the U.S. securities firms, including fewer restrictions on leverage. Treasury Department regulations on margin levels do not apply offshore.

Regulation SHO
The SEC targeted Naked Short Selling with Regulation SHO, effective January 5, 2005. The SEC requires that:

• Broker-dealers cannot lend shares on trades marked “Long,” except:
• if the NASD or a stock exchange finds that the trade was wrongly marked in good faith with reasonable due diligence or;
• if the broker-dealer reasonably believed that the customer owned and could deliver the shares
• Before completing a short-sale transaction, the broker-dealer must locate securities to deliver on the settlement date.

Regulation SHO also requires that the NASD and exchanges receive information on delivery failures for issuers traded on their platforms. If an issuer's delivery failures meet or exceed .5% of all the shares outstanding for five consecutive business days, then that issuer is added to a published list, called the “Threshold Securities List.” Regulation SHO requires that if a broker-dealer fails to deliver a stock on the “Threshold Securities List” for 13 consecutive business days, it must close out the position.

Regulation SHO, however, does not necessarily require a buy-in. There is no requirement for guaranteed delivery of the shares. If the customer account and attaching liability is moved to another broker-dealer, the 13 days start re-counting.

The SEC claims that Regulation SHO has been a success. It claims that from January through September 2005, the average daily aggregate failures to deliver declined by 35.2%, the average daily number of threshold securities has declined by 32.1%, and the average daily failure to deliver threshold securities has declined by 22.7%. But, naked short-selling continues to receive extensive regulatory attention. Recently the North American Securities Administrators Association (NASAA), the national association for state securities administrators, held a hearing on naked short-selling issues.

SEC Actions Against Short Sellers
In 2005, the SEC filed actions against Hilary Shane, a hedge fund manager, and Guillame Pollet, a former managing director at an investment bank, alleging insider trading for selling short in advance of the disclosure of news that could negatively impact the stock price. Shane settled with the SEC and the NASD, paying more than $1.45 million. The Pollet case is still pending.

More Information
This primer provides only a surface-level explanation of short selling issues and omits many details.

For more information, call John Fahy at (817) 878-0547 or e-mail him at jfahy@whitakerchalk.com. Mr. Fahy is available for presentations on short-selling.