Even With New Rules, Naked-Short Violations Hard To Enforce

By Joseph Checkler
DOW JONES NEWSWIRES
AUGUST 3, 2009, 12:48 P.M. ET

NEW YORK (Dow Jones)--Recent experience suggests the Securities and Exchange Commission's new short-selling rules will do little to punish violators of the "naked-short selling" provisions.

In a short sale, an investor seeks to profit from a decline in the price of a stock by borrowing shares, selling them and then buying them back later, hopefully at a lower price. During the market rout last autumn, short sellers came under criticism, and short sales of some financial institutions were temporarily halted at one point.

The rules, which are considered by the industry to be a "middle ground" between defenders and critics of short selling, make permanent a temporary rule that traders must close a short sale within four days. In other words, a short-selling trader who performs a "naked" sale - or borrows a stock without physically locating shares within four days - will have violated the rule.

Before last September, a trader had 13 days to locate shares. While naked-short selling has been lowered dramatically since the temporary rule was put in place, there is still a lot of it going on and few, if any, cases of penalties for offenders. Most short-selling is done by hedge funds.

If the history of enforcing naked-shorting rules is any indication, there is little deterrent in the new rules for violations by brokers who clear the trades for short-selling hedge-fund managers or other investors.

While SEC data have shown that the temporary version of the four-day rule has dramatically curbed the practice of not physically locating borrowed shares, actual sanctions of violators who have done so are still extremely rare. In fact, the SEC doesn't spell out exactly what the penalties are for naked shorting.

An SEC spokesman said the commission has no cases against naked short-sellers on file, but that self-regulatory organizations such as the Financial Industry Regulatory Authority would also be responsible for bringing such cases. A spokesman for Finra, which regulates the broker-dealers responsible for clearing traders' short sales, told Dow Jones Newswires that, in the 10 months of the temporary four-day rule, there have been no naked-shorting cases.

Besides the naked-short provision, the SEC's new rules mandate reporting of daily short volume for individual stocks, as well as time and price data for all short sales.

Proponents of short selling say too much regulation or disclosure of short positions is unfair to hedge-fund managers, as it makes public their proprietary trading strategies. A lawyer who works closely with the hedge-fund industry said he has no problem with rules against naked shorting, but does have a problem with providing information that would identify exactly which stocks individual hedge-fund managers were shorting.

Those who think the naked-shorting rules should go further say there are still loopholes, even with the four-day rule.

"There is still room for powerful short sellers to 'game' the system and short uncontrollably for three trading days and then cover before the close on the third day," said Tom Ronk, chief executive of Newport Beach, Calif.-based short-sales tracker Buyins.net.

Ronk formed Buyins.net in 2005 as a company to track stocks that are on a list of stocks subject to naked shorting, compiled by the SEC. Buyins.net also provides data about whether short-sellers are making or losing money in their positions. Ronk said he was a victim of naked shorts in a previous business.

In the 1990s and early 2000s, he was an executive at several companies, including chief executive at HealthStar Corp., a health-care management company that itself was heavily shorted by traders who didn't locate their borrowed shares. In 2001, HealthStar's stock quickly fell from the $20s to less than $1, and the company eventually merged with another company.

Ronk said the four-day rule has helped cut back on naked-short selling, even if there haven't been penalties for violators. SEC data back up that assertion. After Sept. 18, 2008, when the temporary four-day rule was implemented, the number of stocks borrowed but not located dropped 56.6% for all securities, and 73.5% for stocks already on the naked-short list. The number of shares on the naked-short list dropped more than 75%, but still stands at more than 100 stocks. The data suggest that, even as penalties for naked shorting haven't increased, broker-dealers have preemptively been stingier on the practice.

Some lawmakers wanted the short-selling rules to go further, particularly the ones regarding naked shorting. Sen. Ted Kaufman, D.-Del., was one of seven senators who wanted to identify hard-to-find stocks and prohibit traders from shorting them.

According to Ronk, such a requirement would help.

"Establishing a pre-borrow rule for any stock that has been on the [naked-short] list would be great way for the industry to self-enforce," Ronk said.

-By Joseph Checkler, Dow Jones Newswires; 212-416-2152; joseph.checkler@dowjones.com

http://online.wsj.com/article/BT-CO-20090803-711044.html