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The Impact of Naked Short Selling

Posted August 23, 2008

Laura Cadden

The practice of naked short selling has been blamed for the failure of hundreds of small companies – and the loss of billions of dollars for individual investors. If the SEC puts an end to it (and it looks like they will) the impact will be felt by the practitioners – the institutions themselves. Rick Pendergraft reveals the strategies individual investors should take.

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Baltimore (TFN):

Laura Cadden: Accusations abound that naked short selling is being illegally practiced. That institutions are in fact driving down share prices to profit at the expense of shareholders.

It’s been estimated that such practices have cost investors billions of dollars and driven hundreds of small and mid-cap companies out of business.

The impact seemed evident when the SEC implemented a temporary band on the naked shorting of 19 companies, including Freddie Mac and Fannie Mae, and the shares for those firms stabilized during that period.

Further action on the part of the SEC is anticipated. What will be the effect of such regulation? I’ve invited Rick Pendergraft, managing editor of Investors’ Daily Edge to provide insight.

So Rick, first let’s make a distinction between short selling and naked short selling or naked shorting.

Rick Pendergraft: When you short sell a stock, you’re borrowing it from somebody else because you’re selling something that you don’t own. So if I go out and do a short sale, I have to borrow those shares from someone in order to deliver them to the buyer.

With a naked short sell, that three day window – the delivery never happens. The shares are never delivered. They’re basically counterfeiting shares when they do a naked short sale. So it’s a very distinct line, the three day rule of delivering the equities. It comes into play when you short sell. A naked short sale is never delivered.

Laura Cadden: Phantom shares…

Rick Pendergraft: Exactly.

Laura Cadden: Now how did this practice become legitimate? It seems questionable.

Rick Pendergraft: There’s still questions on whether or not it is legitimate. Technically it is illegal for retail investors to do. You and I could not go out and do naked short selling, but institutions… the rule states that if it’s not hurting the company that they can do it and it’s technicalities that they’re getting away with it on. So whether it’s legitimate or not I think is still up in the air.

Laura Cadden: So you believe that abuses are widespread.

Rick Pendergraft: Absolutely. Well, I wouldn’t say widespread among the number of stocks. I think they target particular stocks. Ones that are more vulnerable, smaller stocks. You can’t go out and do this with a Coca-Cola or a GM or a GE – well, maybe you could with GM with their market cap these days. But you couldn’t take an Exxon-Mobile or GE, some of the larger cap stocks and do that with them. But some of the smaller stocks that have been the targets – Overstock was one that we were discussing beforehand.

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Laura Cadden: Do you think they actually were a victim of naked shorting?

Rick Pendergraft: I wouldn’t doubt it.

Laura Cadden: Patrick Byrne thinks so.

Rick Pendergraft: Absolutely. He’s very vocal about what has happened with his own company’s stock and I think that certainly there’s a case to be made there that his company may have been targeted.

I think it’s more widespread. That is, the brokerages, the hedge funds, the institutions are practicing it on a pretty widespread basis. I don’t think it’s widespread amongst the stocks themselves. I think that they’ve picked on a few.

There is a list that you can go to nasdaqtrader.com has a list of companies that meet the Regulation SHO requirements where there’s 2% of the float or more undelivered. The trade isn’t settled without the delivery of those shares.

So that’s one way that you can find out the number of stocks that meet that requirement and there’s probably a couple hundred on there each day.

Laura Cadden: Amazing. So do you think the SEC will implement stricter measures? This practice is illegal in Canada, India, a bunch of other countries.

Rick Pendergraft: I do think that they will. They have to crack down in some way. When they stepped in and protected the financials, Fannie and Freddie and 17 other financial institutions, it really did, like you said, stabilize the entire financial sector. But it also caused a lift in the dollar.

This one move by the SEC had so many ripple effects with gold and oil falling, the financials jumped sharply, airlines jumped sharply. It was a ripple effect with this implementation, this directive of “stay away from the financials right now,” basically, by the SEC.

That just proves that how widespread this practice is. How they are targeting certain sectors and certain stocks.

Laura Cadden: So you think if they do pass this legislation – if they do make it illegal, it will have a beneficial effect across the board.

Rick Pendergraft Watch this video

Rick Pendergraft: My concern would be this is if they act too quickly… if they came out tomorrow and said “Okay, naked short selling’s illegal across the board,” it would cause certain stocks with big institutional sponsorship to fall .

Take a Coca-Cola or a GM that has a huge number of institutions that own it. These institutions might have to do some selling of their actual holdings to cover the naked short sales that they’ve done.

So it could have an adverse effect on the big blue chip companies. But the companies on the Reg SHO list would benefit sharply because they would see all this buying pressure come in as everybody scrambled to try and buy shares.

So I think that they’ve got to be careful about how they implement a change it and make it totally illegal.

Laura Cadden: What do you think a retail investor should do right now? Should they keep their eye on specific things like the blue chips and keep their ear to the ground to see what’s going to happen?

Rick Pendergraft: Yes, if you hear more ramblings about the SEC cracking down on this practice, you can check the Reg SHO list for companies that could potentially bounce if they totally do away with naked short selling.

Some of the bigger blue chip companies that have 75% or higher institutional ownership could indeed get hurt by the new implementation of these laws.

So I think the retail investor has to be careful about what they own currently, if they own blue chips. Check the institutional ownership and you might want to back off a little bit on them — take some profits if you have them and so forth.

If you’re looking for some new ideas, that Reg SHO list could be a potential – we should see some big jumps in some smaller companies there.

Rick Pendergraft is managing editor of Investor’s Daily Edge.

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