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Naked Shorts (Naked Shortselling)
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In its simplest terms, naked shorting involves selling shares of stock that don’t exist. It’s performed routinely by market-makers to keep an orderly market, but it is illegal when done to manipulate a company’s stock price. Only when someone intends to drive down the stock price is naked shorting breaking the law. Throughout the rest of this overview, any reference to naked shorting will refer to the illegal variety.
It’s also worth noting the important distinction between shorting and naked shorting. The former is perfectly legal and occurs extensively as either a way for an investor to mitigate risk or as a bet that a company’s share price will decrease (i.e. the short-seller or “short” believes the company is overvalued). Despite the wary glances often cast upon them, shorts are an essential part of a robust market and are often the first to discover financial fraud, as in the case of Enron.
A short will sell borrowed shares as a bet against a company because he believes the price will eventually drop. These borrowed shares come from his broker, which loans the short a certain number of shares (not dollars). As soon as the short receives the borrowed shares in his account, he sells them immediately for cash, which goes to his brokerage account. The short still has that pesky loan to pay back, though, and does so by waiting for the price of the stock to drop. Then he buys some cheaper shares using money from the same pool of cash he received after the original sale, gives the broker his shares back, and keeps whatever cash is left in his account.
Naked shorts, in contrast, are much more manipulative – they sell short shares that don’t exist and then attempt to actively lower the company’s share price through constant short-selling pressure. By using pretend shares, of which there is an unlimited supply, naked shorts can effectively control the share price through this constant pressure, eventually driving the price of a company’s shares into the basement.
Where do these fake shares come from? Naked shorts can create them out of thin air, depending on your point of view, due to either (a) glaring inefficiencies in the back-office world of certificate transfers, or (b) institutionalized fraud on a massive scale. Either way, the effects can be disastrous for companies who are victimized.
On Oct 29, 2003, the SEC implemented a new rule to ban naked shorting in order to protect thinly traded stocks that are vulnerable to aggressive short-selling which would cause the stock price to fall. Critics of the new rule argue that if naked-shorting had not taken place during the micro-cap crime wave of the 1990s, such stocks would have climbed even higher before they crashed. Thus, the SEC's action to ban naked-shorting eliminated the only market force against over-hyped, or even fraudulent, small-cap and micro-cap stocks.
Source: American Micro Cap Institute and Investopedia.com
See also:
The National Coalition Against Naked Shorting - http://www.ncans.net/
Faulkingtruth article about Stockgate - the naked shorting scandal - http://www.faulkingtruth.com/Articles/Investing101/1011.html
Eat my shorts! A Naked Shorting Primer for CEOs - http://www.americanmicrocaps.com/featuredcolumn2.htm
Online petition against naked shorting - http://www.investigatethesec.com/
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