The Naked Truth: Examining Prevailing Practices in Short Sales and the Resultant Voter Disenfranchisement ROBE R T BR OOKS AND CLAY M. MOFFETT FORMAT ANY ROBE R T BR OOKS iterature on short-selling activity due to the costs associated with shorting is Wallace D. Malone, Jr. is a common topic for financial, stocks, thusIN leaving only optimistic investors Endowed Chair of Finan- economic, accounting, and legal and the resulting inflated asset prices; and cial Management in the Department of Finance, 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 shareholder short sellers. These constraints include: [email protected] sells a share of stock he does not own (by bor-ARTICLE rowing shares), and only later acquires them, • Borrowing costs. The shorter has to be CLAY M. MOFFETT 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 pension IS properly close out the transaction. This event is fund and mutual fund 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 46 THE NAKED TRU T H SUMMER 2008 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 margin require- • Using the proceeds from the short sale as collateral ments, with some requiring at least 30 percent equity until the position 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 investor purchases a “bona-fide market making activities in the security 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 market maker, who may find it rights and privileges thereof, including future dividends 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. SUMMER 2008 THE JOUR N AL OF TRADI N G 47 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 Corporation (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 hedge fund 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.