Is it time to regulate short selling?

A few short months ago, The Securities and Exchange Commission (SEC) issued an emergency order to “enhance investor protections against ‘naked’ short selling in the securities of Fannie Mae, Freddie Mac, and primary dealers at commercial and investment banks.”

The order required anyone effecting a short sale in these securities to arrange beforehand to borrow the securities and deliver them at settlement. This unprecedented action against short sellers was in response to concern that “negative bets” against bank and brokerage stocks may have been worsening the crisis in the financial sector.

SEC chairman Christopher Cox said the temporary action was aimed “to stop unlawful manipulation through ‘naked’ short selling that threatens the stability of financial institutions.”

While there was talk by the SEC about extending the order to all stocks traded in the US, no such action has been taken, and the temporary order protecting the specified banks has also since ceased.

The breakdown of short selling

Short selling is a legal trading strategy in which traders aim to profit from falling stock prices. Shorting can act as a corrective force at times of rampant bullishness in markets, but it has long been controversial because it pits investors (often hedge funds) against companies that are eager to see their share prices rise.

Bob Thomae, vice president of capital markets and corporate secretary at TXCO Resources Inc. worries about the practice. “It’s amazing to me that there hasn’t been a lot more regulatory scrutiny on this practice. The insidious reality is that there is no way for the investing public or targeted companies to know who might be trying to drive their stock prices down. It is a glaring hole in the reporting system. There is something ominous about the practice. It’s certainly seems to be a threat to the concept of an orderly marketplace,” he said.

But there is always a flip side.

Adam Newar, portfolio manager and analyst for Eden Capital Management Inc. said “A lot of people like to demonize short-selling, and it’s actually an important discipline in financial markets. Sometimes the shorts do better work on a situation and sometimes the longs do better. Demonizing one side or the other isn’t in the best interests of anybody, but that does presume that people operating in the markets are operating in accordance with rules of the regulating bodies.”

Al Reese, CFO of ATP Oil & Gas Corp. emphasized the importance or recognizing the difference. “To throw the baby out with the bathwater and say that all short selling is bad is just not appropriate.” There are various types to consider.

“When you’re naked shorting a stock, you create artificial supply. When demand can not keep up with supply, the price goes down. They rig the system.”— Wes Christian of Christian Smith and Jewell LLP.

Puts and Calls

A put or call option is backed by the shares underlying the option. If you have a convertible instrument at a set price, you have the right to buy at that price. With a covered option one may have the right to buy 100 shares, but technically he or she is selling 100 shares short in the market because he or she doesn’t have the shares to sell – only the right to sell. “That’s perfectly legal; it’s something that everybody truly understands. From that standpoint, short selling of that type is good,” said Reese.

Covered short

Another type of stock shorting is the covered short. You can go to the broker dealer and borrow shares of a company that you don’t own because you believe the price is going down and you want to sell them. While Reese says he does not embrace the strategy, he understands its role. “It’s not impacting the number of shares outstanding by a company because the shares that are borrowed must be returned,” he said.

Naked shorting

In “naked shorting”, a trader shorts a stock without first making necessary arrangements to borrow shares. There are times when the seller then fails to deliver the stock to the buyer, leaving the trade unsettled.

This is the particular shorting that many of the people I spoke with took issue with. “The thing that hurts companies is when you have truly naked short selling,” said Reese. “There are puts and calls in markets that you can use and achieve affectively the same thing. It doesn’t impact the number of shares that are “short” that stock. It’s when you go in and you actually sell shares that you don’t own and you don’t borrow that can create an artificial selling pressure on a company,” he continued.

If there are other ways to achieve the same outcome, why naked short?

In theory, naked short selling lets you make money through volatility and through impacting stock prices without having to report it. “Whether you own it or not, shorts are not reported to the SEC in a manner in which the parties can be identified by the investing public,” noted Thomae.

What makes this practice even more ominous is the idea of the “heard mentality.” If you sense any weakness in a company because of news, headlines, commodity volatility, whatever the motivation…you start shorting it. As soon as the price starts moving down, other institutions with the same strategy follow suit. “To say that they don’t talk and aren’t in communications is naïve, but to prove that is nearly impossible,” said Thomae.

Wes Christian, of law firm Christian Smith and Jewell LLP, paints a similar picture. “Lets say ABC oil company is $100. I sell it today at $100, but the rules say I don’t have to deliver it for three trading days…if it’s the weekend I don’t have to deliver for five days. Imagine that…on Friday, Monday, and Tuesday I naked shorted with a bunch of my buddies…five million shares of the stock. The normal volume is only a million a day. Guess what happens to the price of the stock? It goes down. When you’re naked shorting a stock, you create artificial supply. When demand can not keep up with supply, the price goes down. They rig the system.”

The theory goes, that while multiple reporting institutions working together to own or control a stock is a reportable event in the market; it assumes they’re being honest. If they can hide the collaboration factor, essentially guys can move 5% of the stock and in fact, move 25% of the stock volume by splitting it up amongst themselves as a profit.

“If I never deliver the buyer the shares, I basically just stole the money from the buyer,” Christian continued.

This “sideswiping” of securities laws is the type of shorting that companies take issue with. “At the base root of the problem is that the SEC is not enforcing the laws that are on the books,” said the outspoken Christian.

So what are the rules? And who enforces them?

Rules, regulations, and governing bodies

No question, the markets are regulated entities. There are rules, regulations, and governing bodies that are in place to, hopefully, ensure best practices all around.

Securities and Exchange Commission

The organization now finds itself in the position of deflecting blame for alleged malicious short selling. The SEC has vehemently rejected the argument that rampant or malicious market manipulation is taking place. It also rejects the claim that ‘phantom shares’ of stock float around the markets in quantities capable of adverse affect.

Moreover, the commission finds itself reminding folks that it is not an ‘enforcer’ of the securities laws; that is a matter for the governmental regulators and the Self-Regulating Organizations.

One of the biggest problems may, in fact, be the SEC rule requiring sellers make “best faith efforts” to locate the stocks sold. How does one prove it put forth “best” effort? “Clearly there are rules that say you have to deliver that you’ve sold. Otherwise the SEC would be aiding and abetting,” quipped Christian.

Uptick rule

The now defunct uptick rule was adopted in 1938 after the SEC conducted an inquiry into the effects of concentrated short selling during the market break of 1937. Subject to certain exceptions, you could not sell shares short on a down tick price. If the last trade was in at a $1.01 you could put in at $1.02. You could place your short betting that it’s going down, but by itself it wouldn’t force the price down.

The SEC eliminated the uptick rule in July 2007 as part of a planned action set into motion in 2004 to study the effectiveness of the rule. The SEC officials and researchers concluded that the rule only modestly reduced liquidity and didn’t appear necessary to prevent manipulation.

Despite this explanation, there are still critics questioning the rule’s removal. There are theories regarding pressure applied from the market side, from the trading side, and from Wall Street. Adding to that is speculation about the influence of US Treasury Secretary Henry Paulson Jr., who previously served as the chairman and CEO of Goldman Sachs. The thought is that he brings with him a parallel mentality that manifests into a ‘basket of assistance’ to the large financial institutions. An immediate counter to that is that Paulson was appointed in 2006, well after the SEC initially put out the order to test the rule’s elimination.

“To throw the baby out with the bathwater and say that all short selling is bad is just not appropriate.”— Al Reese, CFO of ATP Oil & Gas Corp.

Another criticism is regarding the research results themselves. Critics say the SEC eliminated the rule during a bull market, when liquidity was not a problem.

Wild swings in the market are now being attributed to the fact that the uptick rule was eliminated. In July, Wachtell, Lipton, Rosen & Katz, an adviser on mergers and acquisitions, asked the SEC to reinstate the 70-year-old rule, citing record level short selling.

“When the downtick rule changed you could see a marked change (60-90 days) in the volume of volatility in various sectors. Several hundred point swing days, as opposed to once or twice a year, were happening many times in a two- to three-month period. It exacerbates any market instability or nervousness and you’re able to push it even further,” warned Thomae.

One particular case that comes to mind is that of Bear Stearns. It’s been theorized that the rapid decline was due to a herd of shorters. “If the downtick rule had not been removed, they likely wouldn’t have been impacted nearly as hard as they were,” speculated Thomae.

Reg SHO

Regulation SHO took effect January 3, 2005, and provides a regulatory framework governing short selling of securities. After stocks have been sold, but not delivered for 13 consecutive settlement days, the companies that are “owed” are publicly listed for all to see. “Unfortunately the perpetrators that committed the crimes do not go on the list, just the companies that got robbed. It’s a consistent theme on Wall Street…the SEC protects Wall Street, not investors,” stated Christian.

The Depositary Trust & Clearing Corp.

The DTCC processes the trading volume from all equity markets in the US, which on a peak trading day can represent over 6 billion shares and $1.5 trillion.

Fingers are often pointed to at the DTCC because of the nature of the business. Electronic trading is harder, in essence, to keep track of than a paper stock. Not surprisingly, more than 95% of people trading stock don’t want paper certificates - they want electronic.

In that regard, the DTCC attests it would be impossible with the high volume of trading (over 5 billion shares daily) across equity markets to force all trades to complete in three days.

The organization states it has no regulatory authority over trading activity or to release information related to trading activity.

What happens to a “failed short”?

It is important to note that a ‘failed trade’ does not automatically mean there is naked short selling. Oftentimes, trade failures occur due to administrative reasons.

The National Securities Clearing Corp., a subsidiary of the DTCC, reports that failed transactions represent less than one-tenth of 1% of the more than 26 million average daily transactions handled by DTCC. It also states that 80% of the total failed positions (which may include a number of trades) are resolved in two business weeks.

The broker for the buyer does not pay the contractual value for the trade to the clearing system until the stock is delivered. However, the broker’s customer may be given a security entitlement immediately to ensure he or she can buy and sell securities freely throughout the day or over several days.

Imagine buying a stock in the morning, then hearing market information that would have a certain adverse affect on that company’s stock. Now imagine you’re told you had to wait to sell out your position to minimize the potential loss.

All that being said, a seller’s obligation to deliver securities does not go away. The broker/dealer who acts as a buyer has a regulatory entitlement and the power - and, in many cases, an affirmative obligation after a period of time – to execute a buy-in on a failed delivery to force the seller to fulfill its obligations.

Spillover into energy

In off-the-record conversations with various E&P company spokespeople, it was clear that many companies are concerned about short-selling and its potential detriment to the company and undervaluation of its stock.

“We’ve had an increased level of shorting, but so have a lot of other companies. I feel that its [naked shorting] impacting our company, but I can’t prove it,” said ATP’s Reese.

TXCO Resources Inc., a company with a less than half a billion dollar market cap, noted that short selling of its stock has gone from “negligible three years ago, roughly 5%, in the last year to 12%. We clearly saw more short selling overhang on our stock as a company,” confirmed Thomae.

“It’s amazing to me that there hasn’t been a lot more regulatory scrutiny on this practice. The insidious reality is that there is no way for the investing public or targeted companies to know who might be trying to drive their stock prices down. It is a glaring hole in the reporting system.”— Bob Thomae, VP of capital markets, corporate secretary of TXCO Resources Inc.

In the weeks leading up to press time, some exploration and production companies have been on the NASDAQ, AMEX, and NYSE naked short threshold list for many consecutive trading days. One in particular, is Houston-based BPZ Energy Inc. The $1.33 billion market cap company had 76.64 million shares outstanding and 7.45 million shares declared short as of July 2008. At press time, the failure to deliver in shares of BZP has not been resolved.

Targeting volatility?

General consensus seems to be that small- to mid-cap companies (those with market caps of roughly $5 million or less) were the most likely to be affected by stock shorting. These companies tend to be a lot more volatile than others - and in the eyes of those demonizing short-selling, volatility appears to be a target.

“If you’re a hedge fund that’s into short-term profits, which is a very significant component of the market as opposed to long-term investors, growth investors, etc., you have an opportunity to make money by trading into that volatility. Somewhere that advantage can change from just good timing to what appears to many to be outright market manipulation, and that is where more regulatory scrutiny could better protect the investing public,” explained Thomae.

Commodities have been historically much more volatile than equities. The oil and gas industry is predicated on high oil and gas prices. Company stock prices tend to move as oil and gas prices go up as a result of perceived valuation. But then again, it’s a “perceived valuation.” Is there an argument that the shorts are reverting prices to a more suitable level for a company that was perceived incorrectly and overinflated?

That being said, volatility could, in effect, take the opposite course. The trade is risky for the shorter as well. If price for a company’s stock turned the corner and ran up, there’s a chance the shorter may not be able to cover. As mentioned above, the broker dealer must go in to the market and close and buy the account – in reality, the broker dealer is the one that gets stuck with it. He has to pay more to balance that account out.

A simple solution?

Despite the complexities of the system, one common solution came to the minds of many of those weary of certain types of short selling. The thought is that companies that fit certain criteria (investment companies) should have to report their holdings in a company at of the end of each calendar quarter so that the companies know who the shareholders are.

The plumbing is seemingly already in place; it wouldn’t be a new realm of reporting.

“Instead of just reporting your ownership positions you report your short positions at the same time. There’s absolutely no reason why that can’t be done,” Reese stated.

The counter

As this article showcases throughout, there are always two sides to every story. The flip side of this entire issue is that it may not even be an issue. Theorists on the other side of the fence feel that the issue isn’t a regulatory one, but a scandal propagated by stock promoters and CEOs of companies looking to point the finger elsewhere for poor performance – essentially exploiting the immense complexity of the stock-clearing system.

Conclusion

One thing that seems to be agreed upon is that shorting, whether naked or not, is prevalent across many sectors. What isn’t agreed upon is whether abuses are taking place.

It seems the SEC recognized a potential problem in the complexity of the system and took action. It provided shelter to the problem du jour, the financial institutions hit hard by the credit crisis. If the problem of tomorrow should be the E&P sector, perhaps some similar order will come its way. What then? Would abusive naked shorting simply shift focus to another volatile sector?

Ultimately, no claims articulated in lawsuits regarding unlawful “naked” short selling have been successful, and no new case has been filed in more than two years.

The emergency order put out by the SEC has come and gone with no tangible benefit to the institutions it sought to protect. Either the shield didn’t work, or the threat wasn’t as real as perceived. Therefore, the notion that this protection would be blanketed across all industries now seems like wishful thinking to those who hoped for it.