WikiLeaks Document Release http://wikileaks.org/wiki/CRS-RS22099 February 2, 2009

Congressional Research Service Report RS22099 Regulation of Naked Selling Mark Jickling, Government and Finance Division

October 30, 2008

Abstract. When executed on a large scale, naked short sales can equal a large portion of total , and can put serious downward pressure on a ’s price. Critics of the practice characterize it as a form of illegal price manipulation. The Securities and Exchange Commission (SEC) in 2004 adopted Regulation SHO, a set of rules designed to control short selling abuses, focusing on small-capitalization where the number of shares held by the public was relatively small. Until the current financial crisis, the SEC did not view short selling of large, blue-chip stocks as a problem. In July 2008, however, the SEC temporarily banned naked short sales of the stock of Fannie Mae, Freddie Mac, and 17 other large financial institutions. On September 18, 2008, the SEC banned all short selling of the shares of more than 700 financial companies in an emergency action that expired on October 8, 2008. On October 1, the SEC adopted a rule requiring short sellers’ brokers to actually borrow shares to deliver to buyers, within the normal three-day settlement time frame. http://wikileaks.org/wiki/CRS-RS22099 Summary prevent economicallyprevent wasteful grip of irrational exuberance. By bringing such valuations down to earth, short selling can that extent they identify companiesand industr However, mostmarket participants recognizethey that valuablea provide service tothe they against stand to rising seem share valu In other words,shortselling isa bet that the price ofa stock willfall. subsequently drops,allowing themto buy b sell th broker, a from sellers borrowshares isn’this’ what sells robber baron:“Hethat report willbeupdated shares todeliver tobuyers, withinthe normal three-day settlement time frame. This requiring rule a October 1,theSECadopted inanemergency financial companies 18,2008,theSECbannedallshortse September stock ofFannie institutions.On Mae, Freddiefinancial Mac, and 17other large problem. In July 2008,however,theSECtem notview shortselling of large,did blue-chipfinancial stocks as a crisis, the SEC where the number ofshares held by the public was relatively small. Until the current rules designed tocontrol shortselling abuses, focusing onsmall-capitalization stocks Securities andExchange Commission(SEC) it as a Critics ofthepracticecharacterize of totalsharesoutstanding, andcanput se alarge canequal sales portion short naked scale, large a buyer. on the to executed When A shortsale issaid tobe “naked” ifthe broker does notinfact borrow shares todeliver sharesfall. of laterwill pricenumber at stock’s a lowera price. that Ashortsalebet isa Short selling was best described Drew, the byDaniel Gilded Age speculator and Short sellershavealways b Short sellersborrowstock,se Regulation ofNakedShortSelling Government andFinanceDivision as eventswarrant. Specialist inPublicFinance over-allocationofresources een unpopular on Wall Street.Lion Wall unpopular een ll it,andhopetoprofitifthey canbuy backthesame Mark Jickling action that expired on October8,2008.On action thatexpired ack thesamenumberofsharesforlessmoney. rious downward pressure onastock’sprice. es, wealth,a expanding n, mustbuy itbackorgo toprison.”Short form ofillegal pricemanipulation.The em, andmakeaprofit shortsellers’brokerstoactually borrow in 2004adoptedRegulation SHO, a set of ies thatareovervaluedby inthe porarily bannednaked lling of the shares of more than 700 lling ofthesharesmorethan to thosefirmsandsectors. ke skeletonsatthefeast, nd general prosperity. if the shareprice the if short salesofthe Updated October 30,2008 Order Code RS22099 http://wikileaks.org/wiki/CRS-RS22099 rule wasextendedtoNasdaq NationalMarket System stocks in1994. to prevent bear raiding. The “uptick rule” the stock’spricewasdriventofloor. market made the rule unnece textbook, standard securitieslaw piling ontofa a last pricemovementinastock’swa follow withanotherwaveofs gang ofspeculatorswouldsellastockshor taken thecaffeineout Naked Shorting .form ofmanipulation commonA inthe 19 by Sellers Short Manipulation 3 2 1 there maystrongimpacta onthe be share price. In such cases, when naked shortselling number ofsharessoldshortrepresentsasi However, when the naked shortsellingconcerns. does notraise serious manipulation buyer. the sharesto deliver” If to “failure naked. If sharesarenotfoundby thetime sale transaction. limited, and brokers may finditdifficult to locate shares todeliver tothe buyer ina short smallercorpora account. With broker’s the in is, that name,” “street in areheld but owners, actual the to registered where millionsofsharescompany, change hands daily and where many shares are not own account.Thisisusually notdifficultto Normally, theybybroker areborrowed the from? sharescome those do Where shares. buyer, real receive to however,expects the casewithBear StearnsinMarch2008. and of cut the potentially destruction firm, off the as credit, to leading access to was its spreading rumorsasanabusethatmay raise record. Atthesametime,SEChas short selling as a sourcemanipulati ofprice reappeared. Many shareholdersandofficer RL34519, Release No.34-55970, “RegulationRule SHOand LouisLoss, Rule 10a-1(a). Theruletechnically applies In the 1930s, theSecuritiesandExchange Another persistent shortsellers complaint isthat against they cause artificial price A shortsalealways involves However, inrecentyears, complaints When shares are not located to “cover”a to located sharesarenot When The Uptick Rule: TheSEC Removes aLimit onShortSelling Fundamentals ofSecuritiesRegulation lling stockand of theshortsale.” ssary, anditwasrepealed. hort sales,depressing tions, however, the number of sh however, thenumberof tions, setting off a downward price spiral. In the words of a the tick test (andrelatedrule tick the the saleofsharesthat 2 In 2007,theSECconcludedthat growth in the CRS-2 1 only toexchange-listed stocks, butacomparable on and haveand criticized on the SEC’senforcement it occurs sporadically and on a small scale, onasmall and occurssporadically it stated that a shortsale mayonly occur the if s upward. This prevents shortsellersfrom This s upward. identified short sellin identified short from anotherinvestoror from a brokerage’s gnificant fraction of all sharesoutstanding, gnificant fractionofall s ofsmaller firmshave identified “naked” t, causing the price todrop.They would the causing t, the transaction mustbesettled,thereisa the transaction fears aboutthesolvency ofthetarget firm about manipulative short selling have selling aboutmanipulativeshort Commission(SEC)adopteda regulation short sale, theshortpositionissaidtobe 10a-1,” 28,2007.SeealsoCRSReport June do if the shares areissuedbyshares alarge the if do (Boston: LittleBrown, 1983),p.717. the price stillfurther,andsoon,until the th century —a was “bearraid” the 3 the sellerdoesnotown.The s) “seempretty welltohave ares incirculationmay be g inconnectionwith , by Gary Shorter. http://wikileaks.org/wiki/CRS-RS22099 national market may also be vulnerable toshortselling abuse. however, smaller companies listedstocks, onthe exchangesOTCBB or the same size inthe shares of a larger company, making manipulation easier. In addition to transactions haveaproportionate that means This openmarket. forpurchaseonthe sharesareavailable few relatively be owned by corporate insiders orby securities dealers whoact as market makers, so that bulletin board market (OTCBB). to smaller firms,particularly onthe Nasdaq small-capitalization “penny”listed stocks such fraudulentrun-upsarelikely tobegreater to theunwary.a as selling Withoutshort classic “pump-and-dump”fraud) purchases may allcausesudden them. depress naked shorting)to thatseek involve artificially infl forms ofmanipulation,theyencouragemay against manipulation. price. In thissituation,nakedshortse choose tosellshortavoidwhatinitsview orarumor in pressrelease an a questionable Internet may maker chat Themarket room. and notjustifiedby any realnews aboutthe buy ordersforastock. The ma short selling tostabilizethemarket. For exampl manipulate prices. Under certain circumstances, maker Undercertain a market circumstances, prices. manipulate not selling; butthe price dropsanyway. stock understandably feelcheated.They donot accommodate manipulation.When when there isnopossibility ofactually delivering shares tothe buyers, brokers and dealers ofasecurity.”deliberately price depressthe period, andthey mayleve usethisadditional than ifthey withina reasonable were required time toborrowsecuritiesdeliver and be seriously distorted.TheSECnotesthat creates avirtually unlimitedquantity ofshar 6 5 4 the New York , they arecalledspecialists. at which theyprices the arewilling totrade. The uptick rule does not apply to OTCBB stocks. OTCBB apply to not does rule uptick The Market makers aredealerswho standready to ReleaseNo.34-48709, “ShortSales: Until July 2008,theSECviewedproblem It isalso worthnoting that while restrictions onshortselling discourage certain It is important tonote that naked shortselling isnotalways evidenceimportant ofintent to is It The case against naked shortselling has been that by permitting short sales to occur ating stock pricesareprobably mo 6 run-ups of stock prices, wh prices, run-ups ofstock ly greater impactonthestockprice thandotrades of the In these companies, the bulk of outstanding shares may outstanding In of bulk thesecompanies,the by suddencollapse,asthemanipulatorsselltheirshares nakedshortselling drives ProposedRule,”October 28, 2003. llingby the market maker may protect investors CRS-3 They are the key intermediaries ontheNasdaq; on counterweight, themagn Rumors, false press releases, andunexpected pressreleases, false Rumors, wouldbeanunjustifie es, a market basedonsupplycan a demand es, and company’s prospects.It may betheresultof buy orsellastock at any time and whopublish 4 “naked short sellers enjoy greater leverage sellers “naked short y judge the buying interest tobe temporary or facilitateothers. rage toengage intrading activitiesthat e, assume thatthereisasuddenflurry of believe thestockisovervalued; they are of nakedshorting aslargelyconfined re common thantechniques(like re ich may befollowed(inthe prices down,holdersofthe 5 d run-upinthestock’s may engage innaked itude anddurationof Manipulationsthat http://wikileaks.org/wiki/CRS-RS22099 [http://www.sec.gov/rules/final/34-50103.htm]. by purchasing secur broke the for 13trading days, thebroker(or Regulation SHOspecifies that ifa fail todeliver positionina threshold security persists exchanges and Nasdaq are nowrequired topublishdaily listsofthreshold securities. thestockbecomesa outstanding, at least0.5%oftotalshares consecu is 10,000sharesormore,forfive further restrictions onshortselling may come intoforce. If the “fail todeliver” position to be highly capitalized, withlarge reasonable groundsstock forbelieving thatthe customer, oreffectashortsa a orderfrom sale may ashort accept not abroker SHO, UnderRegulation standard. andNasdaqrules exchange with a The uniform new national existing replaced regulation of Regulation SHO,and,inJuly 2006,Chairm making activities, and forcertain transactions between brokers. position isclosed by purchasing securities. elapsed, thebrokermay notacceptany mores control abusive naked shortselling. Regulation SHO SHO Regulation 8 7 requirement by passing failtode vigorouslyenough, thatshortselling continue not enforcing the rules is naked shortselling. ComplaintsSEC are heard that the SHO Effects ofRegulation FinancialWire “Of Stocks andSocks: SenatorBennettBores ReleaseNo.34-50103, “ShortSales:Fina If a broker executes a short sale, and then fails to deliver shares to the purchaser, the sharesto deliver to fails then If and sale, ashort abrokerexecutes The appearanceofastockonanexchan The SEC staff has monitored the incidence offail todelivers after the effective date The rules include exemptions for market makers engagedfidebona in market- ! After severalyears ofde The adoptionofRegulation SHOhasnotput ! ! has documentedcompliancewiththeabove. it, anddeliverittothebuyer by has reasonablegrounds tobelievethat borrow it;or or has eitherborrowedthesecurity, , March14,2005, p.1. le foritsownaccount,unlessit ities of likeities kind a liberation, theSECin2004adoptedrulesdesigned to liberation, liver positionsfromonetoanother. numbers ofsharesincirculation. the date delivery isdue; and CRS-4 tive trading days, andthe position amounts to In OnSECsDismal Naked ShortSalesRecord,” made abonafidearrangement to s, and that somebrokersevadethe13-day it can locatethesecurity, borrow r’s clearing house)mustclosetheshort an Cox reportedthattherule“appearsto an Cox can be located. Stocksonsuchliststend be can hort sale orders until the fail to deliver to fail hort saleordersuntilthe l Rule,” July 28, 2004, available28, at l Rule,”July ge’s listconstituted “easyborrow” to nd quantity. After the 13 days have an end to complaintsabout investor anendto 7 tookeffect threshold security on January 8

3, 2005. 3, . The http://wikileaks.org/wiki/CRS-RS22099 were foreign firms. July 15, 2008.AvailableJuly at[h delivers the stock tothe buyer onthe regular settlement date. may occur unless the seller has actually borrowe The 2008Emergency Orders relating tooptionsmarket makers. be subject tothe 13-day close-out require provision. Whenastockgoes ontothethreshol consecutive trading days —wouldbe eliminated. securities listfromthe requirement that outafter fail todeliver 13 positionsbe closed established hadbeen that positions short restricted. Second,a“grandf thecurrentexem rules, Under theproposed which itcalledresponsibleforth Nevertheless, somefurthe reducing failstodeliv significantly be 10 9 Freddie, and 17other large financial institutions. banning anemergency issued SEC the order assets, plunged, andfearsarosethatthey might giant government-sponsored enterprisesth new funds.Inprovide July 2008,shareprices runs” —they cannotsurvivelong ifmark must becontinually refinan Bear StearnsonconditionthattheFed purch arrange to ahastyacquired Morgan which Chase, JP merger with forced was Reserve the firm might notbe able tomeet itsobligations,credit. extend refused The Federal to destroyedMarch 2008by in thee adequate capitala and leading liquidityhad investment bank, reserves, the firmwas firms’ creditworthinessliquidity. and Despite regulators’ assurances that Bear Stearns, and 2008,concernsemerged a 2006. Chairman ChristopherCox,“Ope “SEC EnhancesInvestor Protections Agai The SEC explained therationa The SECexplained 2007,theSECadoptedproposed August In SHO, Regulation InSEC proposedrulestoclosetwo“loopholes”in the July2006, Under the terms of theorder, the Under As financialcompaniescameunderpressure All large financial firmsfinancetheiropera All large r amendments toRegulati ttp:// ced, or rolled over.Thus,th rolled ced, or ather” provision in the original rule —whichexempted rule ather” provisionintheoriginal bout manipulative short sellers spreading rumorsabout bout manipulativeshortsellers www.sec.gov/ru e persistenceoffailtodeliver quivalent ofabankrun:mark ning Statement atthe Commission OpenMeeting,” July 12, noshortsaleofthestock le foritsunusualaction: CRS-5 nst Naked ShortSelling,” Press Release 2008-143, at holdabout$1.5 trillion in mortgage-backed ets lose confidence ets loseconfidence ment. The SEC did before a stock was placed on the threshold onthe wasplaced before astock er withoutdisruptiontothemarkets.” ption foroptionsmarketmakerswouldbe ase $29billionofrisky mortgage assets. naked shortsalesofthesharesFannie, of Fannie Mae andFreddie Mac,thetwo les/other/2008/34-58166.pdf]. ofthe17 Ten go the way go the ofBear Stearns.OnJuly 15, d list,allshortpositionsinthestockwill d (orarranged toborrow)thestockand tions by issuing short-termdebt,which 10 fromtight creditmarketsinlate 2007 on SHOwereconsidered. ruleabolishing thegrandfather ey arevulnerableto“nonbank of any of the 19 listed firms of anylisted 19 ofthe positions in certain stocks. positionsincertain et participants,fearing that and becomeunwilling to not adopt adopt not the proposal the 9 http://wikileaks.org/wiki/CRS-RS22099 such personsareviolating the or abilityintention todeliver securities intime forsettlement.clearmakes The rulethat short sellerswhodeceivebrok shares arenot the unless customers, means that the broker cannot sell that stoc than the beginning oftradinglater business onthe day. next byno Failure tocomply must immediatelysecuritiesand purchase closeborrow outthe fail or todeliver position shares withinthedeliver normal three-day settlement period occurs, the seller’s broker 34-58773], Oct.1,2008.See[http://www. 13 12 11 in September 18,theSECadoptedarulethat firms weresweptaway by panic.Th by thepossibledamage to the outweighed shortselling mightbenefits provide whatever than 700financialfirmswasba sweepingmoreemergency Allshort sellingorder. (naked ornot)ofthemore shares of manipulation. view isthatthe SEC’s objectiveofraising financial weakness.view, issimplythis Short selling,in market discipline at work.One have beenbatterednotby falserumors,but stocks. SecuritiesandExchange Commission, [Release No. “AmendmentsSHO,” toRegulation Lawrence Summers, “How to Build a U.S. Recovery,” Ibid. The SECalsoadoptedRule10b-21,anake The SEC’s original order,issuedonJu The SEC’sintervention has been criticized by some whobelieve that financial stocks On October 1,2008,inaddition toexte On September18,2008,asfina Stearns, theFederalReserve took emergency action. customaryterms. In light ofthepotentially Stearns were unwilling tomake securedfunding available toBear Stearns on the in crisis ofconfidenceoccurredlate firm. As BearStearns’stock pricefell, about liquidity problems atBearStearns, the market impact ofrumors. During theweek ofMarch10, eventsThe Companies precedingStearns Bear thesaleofThe Inc. areillustrative of threaten disruptionofourmarkets. process. If significant financialinstituti normalbelow thepricelevel pricediscovery thatwouldhavethe resultedfrom ma As aresult,thepricesofsecurities can leadtopanicselling, which may befu False rumors canleadtoalossofconfiden 13 Thisorder, inthe formofan interim final rule, requires that when a failure to 12 law when they fail todeliver. nned. Therationalewasthesa er-dealers orany othermarket ncial stocksplunged, the only locatedbutalsopre-borrowed. e emergency October8,2008. orderexpired sec.gov/rules/final/2008/34-58773.pdf]. CRS-6 y artificially andunnecessarily declinewell financial stockpricesitselfamountstomarket its counterpartiesbecame anda concerned, ons are involved, this chain of events can events of ons areinvolved, thischain ly through August 15,wasextended 12,2008. week. In particular,counterpartiestoBear rther exacerbatedbyselling. “naked”short by realistic assessments ce inourmarkets. Suchlossofconfidence financial system and systemic consequences of afailureBear which erodedinvestor confidenceinthe k short either for its effectbannednaked nding the short sa interms ofprice efficiency were far d shortselling anti-fraud rule, covering Financial Times 11 me asfortheearlier action: SEC issued another, much participantsabouttheir 2008, rumors spread le banannouncedle on the economy ifmajor own account or own for offirms’underlying , August 7,2007,p.5. short selling inall