[SSRN] Naked Shorting

자료: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=982898

By:

Christopher L. Culp (University of Chicago - Booth School of Business; Compass Lexecon)

J. B. Heaton (Bartlit Beck Herman Palenchar & Scott LLP)

April 26, 2007

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A “naked short sale” is a short sale of stock in which the seller does not own the shares and essentially has no plans to locate and borrow the stock by the settlement date. Naked shorting has been the focus of an increasing number of lawsuits.1 One plaintiffs’ lawyer bringing these lawsuits argues that naked shorting is “the largest commercial fraud in U.S. history involving hundreds of billions of dollars.”2 Outside the legal community, those decrying the practice of naked shorting range from fervently opinionated individual investors to the U.S. Chamber of Commerce, which asked the Securities and Exchange Commission (“SEC”) on January 23, 2007, to take additional steps to stop naked shorting.3 Regulators and exchanges have shown a willingness to crack down on alleged violations of prohibitions on naked shorting.4

Equity short sellers of all kinds have long been unpopular with securities issuers, investors, and, to some extent, the SEC.5 Notwithstanding popular sentiment, however, speculative short selling is legal in U.S. securities markets as long as the short seller or his broker has located shares from existing owners that are willing to lend their shares for delivery on the short sale’s settlement date.6 The proceeds of the short sale remain with the security lender7 who must deliver the proceeds to the short selling “borrower” when the short seller delivers equivalent shares to the security lender.

January 23, 2007, to take additional steps to stop naked shorting.3 Regulators and exchanges have shown a willingness to crack down on alleged violations of prohibitions on naked shorting.4 Equity short sellers of all kinds have long been unpopular with securities issuers, investors, and, to some extent, the SEC.5 Notwithstanding popular sentiment, however, speculative short selling is legal in U.S. securities markets as long as the short seller or his broker has located shares from existing owners that are willing to lend their shares for delivery on the short sale’s settlement date.6 The proceeds of the short sale remain with the security lender7 who must deliver the proceeds to the short selling “borrower” when the short seller delivers equivalent shares to the security lender.

Despite the recent spate of lawsuits and media attention, however, the existing literature on naked shorting consists mostly of self-confessed advocacy pieces by lawyers and consultants already directly involved in naked shorting cases,10 or parties who are defendants in such lawsuits.11 Our article takes a more balanced look at the issue.

We begin in Part I by reviewing the standard economic arguments for and against the speculative short sale of equities. Part II then describes the mechanics of naked shorting and the strong economic similarities between permissible short selling and impermissible naked short selling. Despite the legal prohibitions on the latter, the analysis suggests that economically, naked shorting is not fundamentally different from traditional short selling and is unlikely to have serious detrimental effects on capital markets. Finally, Part III explains how naked shorting may provide the basis for securities manipulation lawsuits under the federal securities laws for long sellers and, in some circumstances, for issuers. (중략/abbr.)

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III. The Economic Near-Equivalence of Traditional and Naked Shorting

A. Clearance and Settlement

To better understand the naked shorting debate, it is necessary to understand something about the securities clearing and settlement process in the United States. Indeed, some part of the widespread concern with the practice of naked shorting may stem from at least a partial misunderstanding of what it means to buy and sell securities.

Despite the language that nearly everyone but the most knowledgeable insider uses, the investors we think of (and speak of in Section II) as buying and selling securities usually own something different than a security. They own a “security entitlement,” as defined in Article 8 of the Uniform Commercial Code. This entitlement is usually against their broker, which in turn owns a security entitlement against The Depository Trust Company (“DTC”). The DTC is a subsidiary of The Depository Trust & Clearing Corporation (“DTCC”). In the United States, trades in registered securities are cleared and settled through the National Securities Clearing Corporation (“NSCC”), another subsidiary of DTCC, while “ownership” of securities is recorded in participant accounts at DTC. Security “ownership” means having securities entitlements against and among the participants in DTC. Understanding the naked shorting debate requires some understanding of the DTCC system. All major broker-dealers are members of this system.

Customers of the broker-dealer deal with the broker-dealer. The broker-dealer deals with the NSCC as a member of NSCC. NSCC acts as a clearinghouse with a commitment to ensure that all stock and funds obligations of its long and short members are eventually discharged. Long members are the buyers, and short members are the sellers, to which we refer hereafter as selling members to prevent confusion with the short-sellers of which we speak in this article).

The NSCC updates trades through the trading day for each member in each security. Starting at T+1, the first day after the trade, the NSCC nets trades in a process known as “continuous net settlement” or “CNS.” The NSCC communicates the net long and short positions of its members in each security to DTC. Most shares listed on major U.S. exchanges are dematerialized, immobilized, and held in custody accounts at DTC. When it comes time for NSCC to settle the netted positions at T+3, the selling member’s stock account at DTC is debited and a corresponding credit is issued to in the purchasing member’s stock account at DTC. No physical shares actually are exchanged.

B. Failure to Deliver

A failure to deliver occurs when an NSCC member fails to deliver stock at T+3. NSCC has an automatic process for resolving failures to deliver.25 The NSCC system first looks at the selling member’s stock account at DTC. If the member does not have enough shares in its account already to cover the position, the long member (the purchaser who is owed the stock) may initiate a “buy-in” against the CNS system. The member then has another two days to

satisfy its delivery obligation, and, if it does not, NSCC at that time can buy the shares itself and charge the account of the member that failed to deliver.26 If the long member does initiate a buyin, the member effectively postpones delivery of the stock until the NSCC receives shares to

deliver. “Persistent” failures to deliver or receive are stock trades that remain unsettled in this

manner for more than a week.

C. Stock Borrow Program (중략/abbr.)

D. Traditional Short Selling

In any sale of securities, the seller and buyer consummate a transaction on the trade date that obligates the seller to deliver shares of stock for the agreed-upon trade price on the settlement date, which is three days after the trade date, or T+3. In a short sale, the seller does not own the stock he is selling on the trade date. In a traditional short sale, the seller (or, more likely, his prime broker) tries to locate and borrow the security from a security lender. The short seller then borrows the shares and delivers them by settlement date T+3.

In a traditional short sale, the short seller enters into an agreement with a current owner of the security to acquire the current owner’s shares in return for an obligation to deliver shares back to the short seller whenever the current owner demands. The short seller can then deliver the acquired shares to the NSCC at T+3 in satisfaction of its delivery requirements after selling the shares to a new buyer. The short seller generates little or no cash income on the short sale at

T+3 because he posts 102% of the market price as collateral.28 The short seller may receive a

“rebate” from the former security owner in the form of some or all of the interest earned on the

cash collateral. The collateral is marked to market, with the short seller obligated to fund any

shortfalls and allowed to withdraw excess collateral. The short seller has the right to receive the

return of all collateral on returning the stock acquired from the former owner.

At the end of the settlement day for this transaction, the former owner thus is owed back shares of the stock, the new owner holds the new stock for which it has paid cash to the NSCC (which cash is paid by the NSCC to the short seller and which, along with an additional 2% is then held by the former owner as collateral), and the short seller is entitled to the return of the collateral when he returns the stock to the former owner.

E. Naked Short Selling

A naked short occurs when the short seller does not intend to (and actually does not) locate and borrow shares for delivery to the NSCC at settlement. This results in a failure to deliver by the selling member (i.e., the short seller’s broker). Any selling member that fails to deliver at T+3 and has an open unsatisfied obligation to NSCC must post some fraction of the stock’s current market value in cash as collateral with the NSCC. If the stock price declines after settlement date T+3, some or all of this collateral may be returned to the short seller. If the stock subsequently rises in value, NSCC may debit the seller’s funds account at NSCC for additional “margin.” Provided NSCC receives adequate collateral from stock sellers that have failed to deliver, this marking to market of the obligation eliminates most of the risk the NSCC faces. Specifically, in the event of a later default by the selling member on its open obligation (arising if, say, the selling member becomes insolvent), NSCC will have to make the stock purchaser whole by purchasing the stock at the new price. In principle, however, NSCC will have collected a sufficient amount of collateral – the original purchase price paid by the stock buyer plus the marked-to-market margin from the seller – to cover any resulting loss.

If the shares are available in SBP – unlikely for the most difficult to borrow securities that are most popular with naked short sellers – the long member can be satisfied using that program. Otherwise, the long member will remain undelivered-to until the shares become available. The selling member continues to have an open delivery obligation to NSCC, and that selling member does not receive funds until the shares are delivered. In turn, the long member’s funds remain with the buyer until delivery. As we explain below, this is largely what leads to the near-economic equivalence of traditional shorting and naked shorting.

F. Similarities and Differences Between Traditional and Naked Shorting

Armed with some institutional details, we turn now to illustrate the economic nearequivalence

of permissible short selling and impermissible naked short selling. Recall that with a

traditional short sale there is [:]

(1) a party owed shares (the former security owner that lent shares to the short seller) that retains the purchase price of the shares as collateral;

(2) a party that owes shares (the short seller) who will receive proceeds on delivery of the shares; and

(3) a new owner of the shares.

A naked short leads to an almost identical situation. There is [:]

(1) a party owed shares, now the NSCC and ultimately the undelivered-to buyer who retains the purchase price of the shares as collateral;

(2) a party that owes shares (the short seller) who will receive proceeds on delivery of the shares; and

(3) an owner of the shares, now simply the former would-be security owner.

There is nothing economically important about the ultimate identities of the parties who hold otherwise-equivalent economic receivables and obligations. Despite the contentious rhetoric that sustains public debate over naked shorting, there are no especially meaningful economic differences between the two.29

From an economic perspective, naked shorting combined with a failure to receive alleviates the security borrowing problem by allowing the short seller to borrow shares de facto from the stock buyer rather than the current share owner.30 In a naked short sale, the short seller agrees to sell a share to the current buyer at the spot price (the price currently prevailing in the market) but then fails to deliver the shares to the buyer on settlement day T+3. In this scenario, the short seller has been able to transact a sale at the spot price, as in a typical short sale. Also as

before, one party remains a current owner of the security, while another party is owed delivery of the security by the short seller. Rather than the security lender being obliged to pay the proceeds over to the short seller in return for the delivered shares, it is the buyer who is owed delivery of shares by the short seller and holds the amount of the sales price as collateral.

Although some minor technical differences distinguish the two forms of short selling,31 we can identify only two potentially significant differences between traditional and naked shorting. First, unlike the security lender in a traditional short sale, the buyer did not voluntarily enter into the security lending relationship. Second, the undelivered-to buyer may remain undelivered-to for a relatively long period of time even if he initiates a buy-in. That buy-in, after all, may itself result in another fail to deliver, and this process could in principle (and sometimes in practice) continue for a while.

The first difference is not as objectionable as it sounds. The buyer, now in the position of the security lender, has a very solvent counterparty in the NSCC and may be enjoying an opportunity to lend that facilitated its transaction, a transaction that might not otherwise have occurred. The second difference is related to the first. Although it is true that the undelivered-to buyer may remain undelivered-to for some time, it is not true that the alternative is necessarily delivery. If naked shorting were not allowed and short selling was possible only by locating and borrowing shares, it is by no means clear that any sale (and delivery) would have occurred at the transacted price. Holding a delivery obligation from the NSCC at the price of the naked short may be more valuable to the buyer than no interest in the security at all.

G. Why Engage in Naked Shorting?

According to recent empirical research, options market makers begin naked shorting when the rebate rate paid to them starts to fall, and especially when they would otherwise have to pay interest to the lender.32 This provides a hint at what is really going on in a naked short. Specifically, naked short selling seems primarily a manifestation of the fragmentation of and competition in the market for securities lending. (중략/abbr.)