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Home , Issued shares, Naked short selling, Securities lending

The Naked Truth: Examining Prevailing Practices in Sales and the Resultant Voter Disenfranchisement

Ro b e r t Br o o k s a n d Cl a y M. Mo f f e t t FORMAT ANY Ro b e r t Br o o k s iterature on short-selling activity due to the costs associated with shorting is Wallace D. Malone, Jr. is a common topic for financial, , thusIN leaving only optimistic Endowed Chair of Finan- economic, accounting, and legal and the resulting inflated asset prices; and cial Management in the Department of , authors and has been since the very second, that there are a number of short sales Lfirst journals were established (De la Vega constraints that reduce or limit the number of University of Alabama in Tuscaloosa, AL. [1688]). Short sales occur when a short sellers. These constraints include: [email protected] sells a of he does not own (by bor-ARTICLE rowing shares), and only later acquires them, • Borrowing costs. The shorter has to be Cl a y M. Mo f f e t t which then closes out the transaction. In so able to borrow and provide securities to is an assistant professor in the Department of doing, there may be various borrowingTHIS costs the purchaser of shares. The proceeds Finance, University of associated with the transaction. The short are then retained by the broker serving North Carolina, seller profits from the transaction if the share as collateral for the securities lender. Wilmington, NC. price declines more than the all-in costs of The interest that is paid is theoreti- [email protected] the transaction by the time he closes out the cally paid to the lender, who then must transaction. pay a portion stipulated by contract to Attention Members of the Press: In this oft-studied sequence of events, the borrower, referred to as the rebate Please cite The Journal of Trading there is one aspectREPRODUCE or stage of the process, which rate. This rate is generally lower than when referring to this article. has to date received scant attention, but which the interest rate paid by the borrower may well TOhave the most significant impact. This on the collateral but can be negative, For more information visit is the period between when the stock is bor- on restricted supply shares, so that the www.iijot.com or call 212-224-3570. rowed and sold and when it is subsequently pur- short-seller pays additional fees to the chased to end the transaction. There is also the lending broker. case when the stock is sold but shares are never • Shortages of certificates available for ILLEGALborrowed and never purchased in the market to borrowing; in addition many IS properly close out the transaction. This event is fund and managers are called a naked short. barred by prospectus from engaging in IT There is substantial literature that con- short sales. siders the effect of short sales restrictions on • The risk of a forced cover. stock prices in an environment of heteroge- • Short sellers are prohibited from short neous investors (Zhang [1997]; Bai, Chang, selling after a down-tick in the securi- and Wang [2006]). These papers are generally ties price or after a zero-minus tick.1 united on two issues: first, that short sellers • The risk of a stock price jump that may are generally underrepresented in the market, force the short seller to cover earlier than

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Copyright © 2008 he desires or if the broker can no longer borrow imposed by Reg T is 25 percent. Broker-dealers also the shares. have the flexibility to establish higher require- • Using the proceeds from the short sale as collateral ments, with some requiring at least 30 percent until the is closed. in the account.4 If the seller does not purchase or borrow the securi- With naked shorting these constraints no longer ties for delivery within the normal T+3 (sale date plus apply. three days), he has “failed to deliver” (FTD). This is what is known as a naked short. This singular event and The Mechanics of a Short Sale, its consequences have received scant attention and are or How to Naked Short the focus of this article. Interestingly, the ability to sell a stock and then FTD The process of settling securities involved in is completely legal for a certain type of investors: market shorting a stock is actually rather complicated. While the makers (including broker-dealers registered as market general details are rather well understood, the difficulties makers). According to SEC Rule 203(b)(2)(iii), market lie in the details. Conceptually, it is rather simple. makers do not have to deliver shares on short sales for In a normal transaction, an purchases a “bona-fide market making activities in the for stock anticipating a price increase, on which he may then which this exception is claimed.” And who determines realize on the future sale of the stock. Having purchased what are “bona-fide market making activities”? It is left the stock, the investor believes he is entitled to all the to the discretion of the , who may find it rights and privileges thereof, including future necessary to short the security for liquidity or market and voting rights. The short seller takes a contrary posi- stabilization reasons or perhaps other uncertain reasons. tion, first selling the stock, then expecting a price decline, There have been no mentions in the literature that we at which time he may purchase the stock and pocket the have found of market makers having to defend their use difference between the sale price and his purchase price. of this exemption. It is also commonly understood that the seller of an issue Other unique characteristics of this exemption for has three days to deliver the stock. Note that the payment the market makers are that there are no borrowing or and delivery are at different times. The U.S. markets are transaction costs. Not having to borrow or actually go among the few that have discordant timing of buying out in the market and buy the security, as well as not (the purchaser’s cash account is debited immediately) and having to pay the bid-ask spread, effectively eliminates delivery (not required for three days).2 some of the greatest constraints for short selling. In The short sale is commonly facilitated by the addition, the market makers have no margin require- borrowing of shares.3 When borrowing a security, the ment, are not subject to Reg T, and are not required short seller deposits collateral (normally the sales pro- to post collateral. They have full use of the proceeds— ceeds from the initial sale) as security for the borrowed immediately—to “hedge” the transaction. stock, and thus is deprived of the use of the sales pro- This raises the question of what then happens to ceeds to hedge his short position. The broker receives the buyer’s account, with the buyer having unknowingly the interest generated off of this collateral (rebate rate) purchased these naked short shares. He doesn’t receive with the difference between the market and rebate rates any security, either bought or borrowed, so what does (rebate spread) going to compensate the original owner he receive? In this case, the brokers will place a marker of the securities. In addition, the short seller may be or a pledge to deliver the shares, which are made by required to increase the amount of collateral held in the seller’s clearing firm. To the buyer, he is unaware the margin account when a shorted stock’s value rises this has occurred. On his statement, it appears as if the significantly. securities were acquired and made “good delivery.” The The requirements are delineated by Federal buyer is oblivious to the fact that there are no shares in Reserve Regulation T (Reg T). This regulation requires his account. He sees the debit in his account and has a an initial margin of 50 percent of the initial market statement reflecting the securities purchase. There is value of the shorted shares, which increases as the share absolutely no way for the purchaser to know or deter- price increases. The maintenance margin requirement mine if he has a real share or a marker.

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Copyright © 2008 There are no hard and fast numbers publicly outside observes and will depend on market available on the number of FTDs; the Securities and customs and private incentives. Exchange Commission (SEC) and the Depository Trust and Clearing (DTCC) as well as the bro- Hu and Black argue that buying shorted securities kers have usually refused to release the information, even affords additional voting power, at little cost or risk. to the issuers, but there are some clues. In a study of They show how this phenomenon has affected proxy options market makers, Evans, Geczy, Musto, and Reed voting and its use by large fund or managers [2003] noted that one of the top five market makers to increase their leverage and expand beneficial owner- failed to deliver in 52 percent of the positions requiring ship. We suggest the concept be expanded by including delivery. They found the risk of being forced to actually naked shorts in the realm of hidden ownership and vote have to deliver the shares was also small, with forced buying. Naked short shares represent true empty shares, buy-ins occurring only 0.12 percent of the time. They created by fiat but possessing the rights of ownership, also noted that put prices remained high, though the or so the purchaser believes, which the brokers and the options market makers could “collect rents on their clearing firms accommodate through various machina- unique ability to hedge put options without borrowing tions that serve to obscure from the purchaser his true a stock.”5 position in the stock. Boni [2006], with data gathered while she was The act of shorting, or naked shorting, creates a at the SEC, documented the widespread prevalence of share which is not an actual share. They are not issued naked shorting across all markets and affecting all indus- nor authorized by the company. These shares are not tries, including stocks with no listed options. She offered registered with the Securities and Exchange Commis- evidence that market makers strategically fail to deliver sion nor are they beneficial to the company or its legiti- when the borrowing costs are high. In this way, they mate owners. The short sellers are denied the use of their can avoid paying the rebate spread, and they know they funds, the purchaser accounts are debited by the brokers, have low risk of a forced buy-in (Evans, Geczy, Musto, no delivery of the securities has taken place, and none and Reed [2003]). may never take place. So how does this situation arise, Clark, Russell, and Bachrodt [2007] find evidence and who actually owns the properly issued shares? that stocks with listed options have stronger persistence for the continuation of the naked short position, lending The Clearing Process and Custody Practices support to the market maker exemption as a source for a significant level of naked shorting. The clearing and settlement process is illustrated in Exhibit 1. This schematic shows the ordinary clearing, Expansion of Beneficial Ownership failing, and buying-in process over a timeline for an investor who has purchased shares that were sold short. It Hu and Black—Empty Voting does not reflect whether the shares were cleared through and Morphable Ownership the DTC system or in an ex-clearing (intra-broker) pro- cess. The clearing broker is responsible to ensure the Hu and Black [2006] examined the decoupling shares are settled with “good delivery.” of the voting rights from the economic ownership of These processes are known as “back room” and are shares. Voting rights can be used to one’s advantage in largely hidden from view from the investor, who isn’t proxy contests and on governance issues. They define burdened with the matters of the delivery and settlement hidden (morphable) ownership as: process. When there is an FTD, with the forced- buy-in, the shareholder receives by day T+5 good delivery on … indirect economic ownership that disclosure shares issued by the company. If good delivery is not rules do not cover (or are reasonably interpreted made, a marker is placed in the shareholder accounts by the person as not covering), coupled with likely and a confirmation statement is issued. The purchaser possession of informal voting rights. These informal remains unaware that his securities have not delivered, voting rights will generally not be verifiable by having received the same confirmation statement.

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Copyright © 2008 E x h i b i t 1 The Clearing Process This schematic shows the clearing, failing, and buying-in process over a timeline for an investor who has purchased shares that were sold short. It does not reflect whether the shares were cleared through the DTC system or in an ex-clearing process. The clearing broker is responsible for ensuring the shares are settled with “good delivery.” T is the initial date of purchase, with T+3 the conventional settlement date.

The records and data collected by the SEC and sale it was usually necessary to first identify and obtain DTC on FTDs are not readily available, and there is a certif icate to borrow. The lender with certif icates reg- little transparency in the process. So the exact details istered in their names would have to endorse the stock and numbers of FTDs in any specific issue are somewhat over to the borrower, to enable the short seller to sell opaque. But there is much that is known. the certificate. One contributor to FTDs is the implementation of This practice of physical transfer of certificates was a new custody system in 1973. Prior to 1974, settlements a significant constraint to the marketplace. With the were conducted by the actual delivery of physical certif i- increasing volume of securities being issued and sold, cates. The legal power to transfer the certificate would the NYSE would often close one or two days a week be executed on the back of the certificate, endorsed in to allow the brokers to get caught up on their paper- the favor of the purchaser. Each time a trade was con- work. Obviously the system bottleneck was becoming cluded, a physical share certif icate was delivered by run- a breakpoint. ners who then literally collected a physical check from What changed were the custody rules. Starting in the purchaser’s broker to return to the selling broker 1973, the practice began of holding securities in nominee for crediting to the seller’s account. To execute a short name (or street name) through varying intermediaries,

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Copyright © 2008 including investment banks, broker-dealers, and deposi- member firms. The NSCC acts as a clearinghouse with tory trusts.6 The Depository Trust Company (DTC) was the responsibility of ensuring all transactions of members created as a subsidiary of the Depository Trust Clearing are properly cleared and the obligations discharged. Corporation (DTCC) and privately owned by its member The NSCC continuously updates trades during institutions, the brokerage firms. It operated as a clear- the day for each member in each security. In addition, inghouse for the brokerage firms. Its commission and it assists in processing transactions, referred to as “ex- design was to promote the efficient, secure, and accurate clearing,” for share transfer handled outside the DTC custody in a central location and to expedite post-trade system. These transactions are settled through the Con- processing services for both stocks and bonds. The DTC tinuous Net Settlement (CNS) system (Exhibit 2). In is charged with retaining physical custody of all stock essence, the NSCC nets buy and sell transactions in an certificates in trust on behalf of its members. Its com- effort to cut down the number of stock transactions that puters and vaults contained approximately $31 trillion in would require transfer of securities positions held by the securities as of 2005.7 DTC. During an average trading day, the CNS nets all The DTC operates a computerized book-entry the buys and sells in the various securities. At the end accounting system, which serves to replace physical of the day, the member’s net or short position in certificates for those stock and bond holders who do each stock is passed to the DTC, and the appropriate not wish to hold physical certificates. The certificates securities are transferred and member accounts adjusted. for all of the securities are held in what are known as An FTD occurs when an NSCC member fails to deliver fungible bulk.8 That is, the aggregate amount of each the stock at the T+3 settlement date. In these cases, the security held by each participating brokerage firm is NSCC looks to a member’s account to see if there are held in one certificate by the DTC. The DTC has no enough shares to cover the outstanding transactions. If record of individual ownership, only the gross amount the member is short of shares, the long member may held by the different brokerages, and it is considered the request a buy-in. If it doesn’t request a buy-in, the shares nominal holder of the certificate. All customer transac- remain in a persistent failure state. tions and record keeping are the responsibility of the Another way for the NSCC to resolve open posi- brokerage firm. tions created by FTDs is through the Stock Borrow Pro- This means the investor, despite the language or gram (SBP). In this program, members may opt to “lend terminology used by brokers and most other investors, NSCC available” securities from their DTC accounts. owns something other than a security. The investor At the close of trading, NSCC members identify which owns a right, or a “security entitlement,” as detailed stocks they have available and notify the NSCC. During in the Uniform Commercial Code, Article 8. This the CNS processing run that evening, open positions are “entitlement” or claim is held against the broker for the compared to this list of available securities to borrow, account, which in turn holds a claim against the DTC. and if shares are available, they are used to make delivery The ownership of the accounts is recorded in broker to members with open positions. accounts at the DTC. It is important to note that in this system, for all its All agree the DTC system provides a valuable safe- complexity, there is no ability to identify which sellers keeping service, as well as economies of scale to the have failed or which buyers have acquired such shares. market by permitting low-cost processing and speed. The DTCC admits such, in a reply to Finnerty’s [2005] The DTCC, in 2007, processed approximately $1.86 article:10 quadrillion of securities trades a year, of which approx- imately $3.9 trillion a month were equities trades.9 Because of the CNS netting process, it is not fea- These are amounts that would be virtually impossible sible to trace any particular delivery or fail to to accomplish if physical certificates were the norm. deliver by a seller to any particular receive or fail There are also ways to transfer security owner- to receive by a buyer. The system, in that sense, ship without having to go through the DTC transfer is entirely anonymous. process. The National Securities Clearing Corpora- tion (NSCC), another subsidiary of the DTCC, exists As an example using the schematic in Exhibit 2, if to offer clearing, netting, and settlement services for Broker 1’s customers sell to Broker 2’s customers 1,000

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Copyright © 2008 E x h i b i t 2 The CNS System This exhibit illustrates two ways in which the clearing of stock sales is handled in the ex-clearing system. Participating members (in the DTC/NSCC clearing systems) are identified by circular organizations. These can either be intra-broker, inter-broker (ex-clearing), or processed through the DTC transactions. The CNS (for ex-clearing transactions) system will net out buys and sells between brokers, with the net differences in each issue reported to the DTC so the bulk certificate can be adjusted. If the net transactions conducted intra-broker equal zero, then zero transfers are reported to the DTC.

shares of Gonzo stock, and Broker 2’s customers sell to would report zero transactions to the DTC for adjustment Broker 1’s customers 1,000 shares and to Broker 3’s cus- on their books. The sale of Broker 2’s 500 shares to a cus- tomers 500 shares of Gonzo in unrelated transactions, then tomer of Broker 3 would be processed through the DTC netting out the sales between Brokers 1 and 2, the NSCC system, and each broker’s certificate amount of Gonzo

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Copyright © 2008 stock held at the DTC would be changed at the end of issuing firm with three , each holding 100 the day. Each firm, Broker 1, 2 and 3, would be required shares of the 300 authorized and outstanding. There to adjust its books reflecting the customer changes in the is then a progression of a normal short sale: the use of ownership of the Gonzo stock. However, the fungible the market maker exemption to naked short shares, and certificates (book or physical) at the DTC for Brokers 1 multiplicity, or the use of the same shares to satisfy the and 2 would remain the same and unadjusted, based on locate rule in short selling. These latter two examples of these netted transactions. in effect give rise to multiple forward In the absence of physical transfer of certificates, contracts, undated and unhedged, which are tantamount the only evidence individual customers have of any to phantom shares. transactions in their accounts are the brokerage and This complexity in tracking the transactions is fur- trade confirmation statements they receive. It should ther compounded by the fact that the typical customer be noted also that the brokerages do not track indi- margin account agreement allows the broker to hypoth- vidual certificate numbers, but rely on the same fungible ecate (lend) the securities without notice. In addition, bulk system to accurately reflect the net shares held by the agreements stipulate that the broker receives all their customers. They account for each individual cli- interest on the loan of the securities, and not the lending ent’s number of shares, not as an individual certificate, shareholder. This is for the benefit of the broker eco- but as a part of the bulk—client A owns 1,000 out of nomically and is a practical result of the broker’s inability 1,000,000 shares of Gonzo Company, for example, with to determine which shareholder owns which certificate the one bulk certificate held by the DTC. or shares in any specific company. The broker simply The system of resolving shorts is in theory very has no idea which customer’s stock has been lent because straightforward. Each of the short positions passed of the aggregation of certificates in a fungible pool that through the ex-clearing system is then compared to the serves as the source for loans. If a customer owns stock number of aggregate shares in a member’s DTC account. held by the broker in street name, there is no specific If there are sufficient shares at the DTC to effect settle- certificate that can be linked to that customer. ment, the DTC will transfer an amount equal to the number of shares shorted to the NSCC, and the shares The Mystery of Ownership are considered to have been borrowed. If a member institution holding a short position does not have suf- If there is no certificate that the individual can f icient shares to borrow in order to cover the short posi- identify as his in a particular company, how does he tion, then the NSCC/DTC can either borrow shares claim the benefits of ownership? We know the cus- from another account and, if shares are not available to tomer in margin accounts legally waives his right to the borrow, then demand a dealer buy in; buy the shares voting rights of the lent, but has he done so practically? itself in the open market; or break the trade. Remember, before 1973, when a stock was shorted, the lender of the stock surrendered his voting rights while Systemic Presentations of Opportunity the short seller guaranteed to reimburse the lender for any dividends received while the stock was borrowed. The simplicity is masking a deeper complexity. This waiver of the voting right was essential to the trans- The stock borrowing (lending) program actually facili- action. This waiver, which was attached to a specific tates or presents the opportunity for naked shorting in security, no longer exists with dematerialized securities. several ways. The NSCC can usually borrow shares cov- This is critical to understanding the influence or impact ering the position, allowing the sellers to fail to deliver. of naked shorts on matters of corporate control. If the NSCC borrows the shares, this removes from This problem most clearly manifests itself in cor- the seller the burden to buy in the stock at the market. porate governance or proxy votes by creating a form of Interestingly, this process potentially allows for the Hu and Black’s [2006] “empty shares.” Prior to a vote of reuse of the same shares, allowing a single share to be shares, the company will announce a date of record, which relent several times, an effect referred to by regulators identifies those entitled to vote. For most public compa- as multiplicity. In Exhibit 3, the process of naked short nies, their largest shareholder is “Cede & Company”—the selling and multiplicity is illustrated. We begin with an nominee name of the DTC. The issuing company

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Copyright © 2008 E x h i b i t 3 Short Sale Illustration A. No short sales outstanding. All shares can be certificated and enjoy full voting rights.

B. Short sales outstanding. While the shares are borrowed, before settlement, the short seller is the beneficial owner, entitled to all rights of share ownership. He owes the lender any distributions (cash or shares) received during this time. After settlement, at some future time the borrower closes the position by buying shares and returning them to the lender (shareholder with margin account). The broker keeps all lending fees.

requests from the DTC a list of the participants (bro- that have on deposit their customer’s stock at the kers) for whom the DTC is holding the shares of record. DTC. In this process, the broker is assigned a number There is nothing in this exchange of information that of voting rights equivalent to the amount of shares identifies individual owners or identifies the shares as deposited with the DTC as of the company’s record having been loaned or shorted. date. The brokerages, not the issuing company, are Since the DTC cannot vote the shares, but is responsible for distributing proxy materials to their the nominal owner of the shares deposited, it assigns shareholding customers. Not only do the brokers its right to vote to the brokers or investment banks mail out the proxy statements, they often receive

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Copyright © 2008 E x h i b i t 3 (Continued) C. Naked Short Sale—Market Maker Exemption. This presents a simple schematic of a typical naked short utilizing the market maker exemption from borrowing shares sold short. All proceeds of the sale are available to the market maker immediately; there is no collateral requirement or transaction costs for the market maker.

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Copyright © 2008 E x h i b i t 3 (Continued) D. Naked Short Sale—Multiplicity. This presents a simple schematic of the form of naked shorting known as multiplicity. Here the market maker satisfies the requirement to locate shares and may then borrow them (borrowing is not required, just locating). This technique offers the opportunity to shift voting control, at little risk, with virtually no transaction or lending cost. All buyers believe they have good delivery and are entitled to all benefits of owning the shares, including voting. All proceeds of the sale are available to the selling broker or market maker immediately; there is no collateral requirement..

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Copyright © 2008 the instructions back from the customers on how to We do know, by the DTC’s own admission13 that vote the affected shares. FTDs (as of 2004) constitute about $6 billion of dollar When the broker has loaned shares, or when the volume per day.14 With an average of 220 trading days market maker has shorted shares and failed to deliver and per year, this translates to $1.32 trillion per year. We the broker has placed a marker in the client’s account, also know that the value of equity trades processed by the number of exceeds the recorded the DTC/NSCC is approximately $130 billion to $150 number of shares according to the company’s records. billion per day. This produces a fail-to-deliver rate of at The increase in the number of shares available to vote in least 4 percent of all equity trades. many cases has been most impressive, often exceeding It is also known that the DTC claims, through its the float or even the total authorized. According to a Continuous Net Settlement system (CNS), that it has Bloomberg News article: “In one measure of potential “eliminated the need to settle 96 percent of total obli- overvoting, 15.2 billion New York , gations.” If this ratio applies to the equities settlements, and American Stock Exchange then a minimum of $130 billion out of the maximum shares were loaned out to short sellers as of Jan. 13, an $150 billion per day doesn’t require any delivery of secu- 81 percent increase from 8.4 billion shares five years rities, leaving only a maximum of $25 billion that does earlier.”11 require settlement. Dividing this into the $6 billion of In the same article, a trade group, the Securities daily fails raises the settlement fail rate to at least 24 Transfer Association, reviewed 341 proxy contests in percent.15 2005. It found that there was evidence of overvoting in These numbers most likely would increase sig- all 341 of the cases. nificantly if the ex-clearing failures were also included. In those cases where the brokers receive the infor- Since they constitute 96 percent of all trades, should the mation on how to vote the shares from the shareholders, fail rate remain the same, then the dollar volume would they usually do not to turn in more votes than they have be at least $31 billion a day in fail-to-delivers. Due to shares. Firms have procedures in place to adjust the votes the potential of shares being lent more than once in an in this instance. According to the Securities Industry ex-clearing account, the rate is likely higher. There are Association, in an April 2005 letter to the NYSE, they numerous examples of this, such as the rather striking detailed the system of pro rating the votes based on the example of Global Links, Inc., which under an FOIA number received according to the number eligible.12 If a request determined there were 27,000,000 delivery fail- broker receives 20 percent more votes than it has aggre- ures outstanding for company shares.16 This while Global gated shares for, then it simply reduces the vote totals in Links authorized and issued shares stood at 1,100,000, or each category by 20 percent. It is a simple system, but an amount of fails nearly 26 times the maximum float. one that offers the potential of throwing out legitimate The cause or history of naked shorting is unclear. votes while retaining illegitimate votes. It also offers Some theorize it was tied to the decimalization of the the potential for allowing the same share to be voted markets. As several studies have detailed, this resulted in multiple times. a tightening of the spreads, encouraging market makers and brokers to look elsewhere to recover lost revenue Scope of the Presented (Harris [1999], Gibson, Singh, and Yerramilli [2002]). by Naked Shorting Obviously, selling shares with a zero cost basis would have its advantages. Since naked shorting and ex-clearing has recently In addition, the dematerialization of securities has come to light, how pervasive is it? It is known that under likely contributed to the ease of naked short selling. While conventional short-selling theory, “the quantity of stock the benefits in facilitating settlements have been a main sold short is typically very small, usually less than 1%, contributor to the growth of the markets, it also has made and so allowing for realistic quantities of short selling the multiplicity possible. Since there are no longer cer- does not change the conclusion that prices are set by the tificates requiring transfer, the backroom processes have optimists” (Miller [2004]). Does naked shorting main- become more complex and opaque, further contributing tain these “realistic quantities”? to the ease of failing without consequence. Simply put,

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Copyright © 2008 the most excessive examples of naked short abuse could Almost every calculation performed for the market using not have occurred without dematerialization. the number of outstanding or tradable shares will need An example of this is the Continuous Net Settle- to be recalculated. What is the impact if there are truly ment (CNS) system, which conceals and thus facilitates no shorting constraints and the outstanding shares of a naked short selling. In this system, a broker’s buy and sell company are 25 times the authorized and outstanding orders are netted and offset before being presented to the shares? What is the impact on corporate governance if DTCC for settlement. Here the short seller’s fails of a cer- legitimate shareholders represent but a minority in the tain security can be concealed by the existence of offsetting vote? There remains interesting research to be done. long transactions at the same broker. The broker may have Naked shorting is a phenomenon unknown two a number of short orders which it then nets out against years ago, but it now offers the prospect of being the the longs. If it doesn’t borrow the securities from margin most volatile and significant market activity of the past accounts, it has fails in its system, but the net orders may several decades. It appears, from the evidence gathered, cancel each other out. The fails are never reported to the that it is pervasive throughout all markets and all indus- DTCC or SEC, and no one but the brokers are aware of tries. Evidence from the sec shows the outstanding the true number of issues that have failed to deliver and the delivery failures can surpass 100 percent of the average naked short position will remain concealed. daily trading volume. The average for the OTC is In addition to the creation of these phantom shares, approximately 28 percent of the average daily volume. there is also the potential that the broker may actu- This does not include the ex-clearing fails, which are ally borrow shares from a margin account and lend to not reported. Even some NYSE firms experience an another margin account, from which it then borrows abnormal number of fails. NovaStar claims to have the shares again. Because the broker (or the NSCC) FOIA documents showing on some days 40 percent of borrows the shares, without buying in, the number of its daily trading volume fails to deliver. Again, this does outstanding shares still increases. So there are a number not include ex-clearing trades. of ways in which the multiplicity can occur. It is interesting to note that no brokerage firm In summary, the problems caused investors and the has admitted the existence of or participation in naked markets by these shares are: shorting. However, since SHO’s implementation in January of 2005, firms such as , Citi- • Loss of shareholder rights—by overvoting and the group, JP Morgan, Wachovia, First Clearing, Daiwa, resultant “throwing-out” of votes, many of which and Credit Suisse have been censured and/or fined for may be legitimate for non-registered shares. violations of Regulation SHO.17 For years the market as a • Multiplicity—the actual shares traded may be whole, regulators, and finance professionals have denied many times the authorized and outstanding. the existence of naked shorting,18 but now numerous • Informed consent—customers are not informed, efforts are under way to find ways to eliminate or simply nor are they aware of the extent to which their control it. It will be of great interest to see how successful shares are lent out or if they even actually own these efforts are and how the current naked positions legal shares. Most are unaware that by opening a are rectified. margin account, they would lose voting rights if and when the security is lent. Endnotes • Market analysis—analyst recommendations are often based on determinations involving a com- 1SEC Rule 10a-1(a)(1) provides that a listed security pany’s legitimate and stated float or outstanding may be sold short either at a price above the price at which shares. With the prevalence of naked shorting, the immediately preceding sale was effected (plus tick) or at both may be significantly understated. the last sale price if it is higher than the last different price (zero-plus tick). Short sales are not permitted on minus ticks or zero-minus ticks, subject to several exemptions. Rule 10a-1 Conclusion and Implications applies only to hypothecable securities listed on the NYSE or AMEX. NASD Rule 3350, which governs short sales on If naked shorting exists and is pervasive, then much NASDAQ, generally prohibits member firms from effecting of the analysis performed recently needs to be revisited.

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Copyright © 2008 short sales in listed securities at or below the current inside 10http://www.dtcc.com/ThoughtLeadership/keyissues/ bid whenever that bid is lower than the previous inside bid. finnerty.htm Since NASDAQ became a stock exchange in August 2006, 11Bob Drummond, March 1, 2006, “One Share, One the rule effectively became NASDAQ Rule 3350. We refer Vote: Short Selling Short-Circuits System,” Bloomberg to both rules as the “up-tick rule” in general. News. 2Japan and Canada, for example, net the buying and 12Ibid. selling of securities and cash on the same day. Europe nor- 13http://www.dtcc.com/Publications/dtcc/mar05/ mally has overnight settlement between nations, and funds are naked_short_selling.html kept with a custodian, not the broker as in the U.S. system. 14There is anecdotal evidence that the level of fails may 3The terms “securities borrowing” and “securities be higher currently. In a Dow Newswire article on January 19, lending” are misnomers. According to Fabozzi and Mann 2006, Carol Redmond quoted an unnamed SEC staffer as stating [2005]: “Under English law… ‘’ is in fact… that only 1 percent of all trades fail. With the NSCC and DTCC clearing $2 trillion in trades a day, the 1 percent figure translates A disposal (or sale) of securities linked to the into $20 billion in fails. 15 subsequent reacquisition of equivalent securities The original formulation for this calculation was Dr. by means of an agreement. Such transactions are Shapiro’s letter to the DTCC in response to an internet post collateralized and the ‘rental fee’ charged…. on the DTCC website by General Counsel Larry Thompson (copies are available from author). The figures have been adjusted. The DTCC challenged in general Dr. Shapiro’s and There are some consequences arising from this Dr. Finnerty’s conclusions, but it has offered no contrasting clarification: information or calculations. 16Copies of the FOIA documents are available at: http:// 1. Absolute title over both the securities on loan and the www.thesanitycheck.com/Portals/0/GL.pdf collateral received passes between the parties. 17The SEC recently fined Daiwa Securities, Goldman 2. The economic benefits associated with owner- Sachs, and Citigroup $1 million each for failing to mark cor- ship—e.g., dividends, coupons, etc.—are ‘manufac- rectly orders as long and short and not accurately reporting tured’ back to the lender, meaning that the borrower is total fails. The regulatory arm of the NYSE fined Daiwa entitled to these benefits as owner of the securities but Securities America, Goldman Sachs, Credit Suisse, and Citi- is under a contractual obligation to make equivalent group $1.25 million for violations of Regulation SHO—Liz payments to the lender. Moyer, Forbes, July 26, 2006. 3. A lender of equities surrenders the rights of ownership, 18See Weiss, Gary, commentary: “Don’t Force the Shorts e.g., voting. Should the lender wish to vote on securi- To Get Dressed,” Business Week, December 8, 2003; edito- ties on loan, it has the contractual right to recall such rial, “Do Nudists Run Wall Street?” , securities from the borrower. April 12, 2006; Nocera, Joseph, “New Crusade for Master of Overstock,” The New York Times, June 10, 2006; NASAA 4Section 220.12(c) of Regulation T: Margin Conference on Short-Selling (November 30, 2005). Requirements. 5Evans, Geczy, Musto, and Reed [2003], p. 3. 6http://www.dtcc.com/AboutUs/history.htm References 7 DTCC Annual Report, 2005, p. 3, Asset Services. Bai, Yang, Eric C. Chang, and Jiang Wang. “Asset Prices 8Federal Register, June 10, 2004 (Vol. 69, No. 112), Under Short-Sale Constraints.” Working paper, Univer- Section B. The Role of Securities Intermediaries, pp. 32786– sity of Hong Kong and Sloan School of Management, MIT, 32787. One excerpt describes the DTC’s holding of certifi- November 12, 2006. cates: “Fungible bulk means that no participant or customer of a participant has any claim or ownership rights to any Boni, Leslie. “Strategic Delivery Failures in U.S. Equity particular certificate held by DTC. Rather, participants have Markets.” Journal of Financial Markets, Vol. 9, No. 1 (2006), a securities entitlement to obtain a certificate representing pp. 1–26. securities held in their DTC accounts.” 9Taken from an address by Jill M. Considine, Chair and Clark, Steven P., Judson Russell, and Bill Bachrodt. “Delivery CEO, The DTCC, at the 8th Asia-Pacific CSD Group annual Failures Post SEC Regulation SHO.” Working paper, Uni- meeting, Taipei, Taiwan, November 1, 2004. versity of North Carolina, 2007.

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Copyright © 2008 De la Vega, J. Confusion de Confusiones (1688). Portions Harris, Lawrence. “Trading in Pennies: A Survey of the Descriptive of the Amsterdam Stock Exchange, edited and Issues.” Working paper, University of Southern California, translated by H. Kellenbenz, Kress Library of Business and presented at NYSE Conference, December 10, 1999. Economics series no. 13. Cambridge: Harvard University Press, 1957. Hu, Henry T.C., and Bernard Black. “Hedge Funds, Insiders, and the Decoupling of Economic and Voting Ownership; Evans, Richard B., Christopher C. Geczy, David K. Musto, Empty Voting and Hidden (Morphable Ownership).” As and Adam V. Reed. “Failure Is an Option: Impediments to submitted to Journal of , Draft, December Short Selling and Options Prices.” Unpublished Working 2006. paper, 2003. Miller, Edward M. “Restrictions on Short Selling and Exploit- Fabozzi, Frank J., and Steven V. Mann. “An Introduction to able Opportunities for Investors.” In ed. Frank J. Fabrozzi, Securities Lending.” In Securities Finance: Securities Lending and Short Selling Strategies, Risks and Rewards, p. 85. John Wiley Repurchase Agreements, p. 4. John Wiley and Sons, 2005. and Sons, 2004.

Finnerty, John D. “Short Selling, Death Spiral Convertibles, Zhang, Harold H. “Endogenous Short-Sale Constraint, Stock and the Profitability of Stock Manipulation.” Unpublished Prices and Output Cycles.” Macroeconomic Dynamics, 1 (1997), Working Paper, Fordham University, 2005. pp. 228–254.

Gibson, Scott, Rajdeep Singh, and Vijay Yerramilli. “The Effect of Decimalization on the Components of the Bid-Ask To order reprints of this article, please contact Dewey Palmieri Spread.” EFMA 2002 London Meetings. Available at SSRN: at [email protected] or 212-224-3675 http://ssrn.com/abstract=314271.

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