IRVINE, Calif. — Critics of short-selling practices they deem abusive are up in arms over what they say is continued inaction by the Securities and Exchange Commission.
They say that the SEC delayed long-overdue reforms last month when it asked for more comments on proposals to tighten up exemptions to a rule intended to curb illegal “naked” short selling.
Naked shorting occurs when someone sells securities they don’t own and intentionally fails to deliver the shares to the buyer. Short sellers hope to profit by buying the sold securities at a lower price — and returning them to the lender — sometime in the future.
The reforms were originally proposed last summer and are pending final approval. They are meant to close loopholes in SEC Regulation SHO, which was implemented in January 2005 and requires market participants to close out trades in stocks that have met a threshold for delivery failure at settlement.
But the rule has several loopholes: Existing delivery failures were grandfathered, and options market makers were largely exempted.
“The comment period [on the amendments] was reopened to give the public the opportunity to comment on [new delivery failure] data,” said SEC spokesman John Nester, who declined comment on other aspects of the issue.
Critics think that the SEC is reluctant to take on hedge funds and their prime brokers, who they suspect are behind the naked-shorting problem.
“Enforcement of delivery of shares ... is not being done,” Kevin Dalton, a certified financial planner and vice president of Dalton Education LLC, said in a comment letter this month. Dalton is a Cumming, Ga., training firm for the
financial planning industry.
The exemptions “tilt the playing field in favor of the ... big money players in the market,” Mr. Dalton said.
Naked-short-sellers are “destroying companies before they have a chance to survive,” Joseph H. Kennedy Jr., a Bradenton, Fla.-based broker with A.G. Edwards & Sons Inc. of St. Louis, said in another comment letter to the SEC this month.
Nonsense, said Samuel Lek, chief executive at New York’s Lek Securities Corp.
“There’s not a shred of evidence that ... there’s any type of widespread manipulative abuse,” he said in an interview.
But the anti-naked-shorting crowd, after years of being condemned as conspiracy theorists, has gained at least a bit of traction.
In one of his clearest statements yet acknowledging that naked shorting hurts investors, SEC Chairman Christopher Cox last month said, “People victimized by it have a great deal of right on their side to complain about it.”
“Victims [of naked shorting] continue to suffer, and yet the [SEC] is dragging their feet,” said David Patch, an investor in Topsfield, Mass.
Mr. Patch, an engineer and critic of naked shorts, runs the website InvestigateTheSec.com.
Debate continues
The SEC says that Reg SHO has cut delivery failures, with an average of 271 companies on the list as of the end of February.
But Mr. Patch said that averaging the numbers is misleading, because there was a drop immediately after the rule went into effect, but failures have been increasing since late 2005.
The main concern now is persistent delivery failures on certain stocks, said Peter Chepucavage, general counsel at the Plexus Consulting Group LLC in Washington and a former SEC staff member who was involved in developing Reg SHO.
Mr. Patch pointed to two recent examples, subprime-mortgage lenders New Century Financial Corp. of Irvine, Calif., and Accredited Home Lenders Inc. of San Diego.
During price declines last month, a growing number of shares of the two companies went undelivered — a sign of possible abusive naked shorting.
On March 9, Accredited’s stock hit Reg SHO’s “threshold list” for stocks with delivery failures. New Century’s stock went on the list March 27, about a week before it filed for bankruptcy protection.
To reach the threshold, at least 10,000 shares representing at least 0.5% of a company’s outstanding shares must experience delivery failures for five consecutive trading days.
Mr. Lek said that the problems faced by subprime lenders, like many other companies on the threshold list, are of their own doing.
But “Netflix [Inc. of Los Gatos, Calif.] is a pretty successful company, and it’s [long been] on the threshold list,” Mr. Chepucavage said.
“When it’s deliberate, the ability to short without borrowing [the shares] has an unnatural impact on the stock.”
Another catastrophic event like 9/11 could induce naked shorters to take advantage of a panicked market — if they felt they could get away with it, Mr. Chepucavage said.
“That’s one scenario where investors could feel it big-time,” he said.
Finding violators
Mr. Chepucavage said that a system is needed to improve the identification and investigation of participants responsible for concentrated failures in particular issues, but he said regulators have been told there’s no easy way to get that information.
Stuart Goldstein, spokesman for the Depository Trust and Clearing Corp. in New York, an industry-owned utility that runs the industry’s settlement system, said that the SEC “certainly has access to the information” to identify any violators.
The DTCC doesn’t know the reasons for the underlying failures, which can occur for a variety of reasons, he said. “All we know is that a security is not delivered,” Mr. Goldstein said. “The reason is only known by the broker.”
Tom Ronk, owner of Buyins.net LLC, a Corona Del Mar, Calif., advisory service critical of naked shorts, said that abusive short-sellers could be identified if regulators cross-referenced “blue sheet” data they have from individual account trades with the SHO threshold list, and also through time and sale data.
“It’s a software-programming project” that could be easily done, he said.
