Naked Before Byrne

The SEC, wanting to avoid short-squeezes in dozens of stocks caused by the closing out of naked short positions, opted to "grandfather in" any failed deliveries before Jan. 3. But that opened the door to another problem: In the four months between the date Regulation SHO went into effect and the date it took effect, the grandfather provision gave anyone who was so inclined a generous period of time to build up naked short positions in any stock he liked.

Or, to use the counterfeit analogy, imagine outlawing the printing of funny money, but giving everyone four months to print up as much as they'd like. Only then would counterfeit dollars be illegal -- but only to print, not to use.

And it wasn't as if regulators weren't expecting this. The NASD, in a 2004 proposal to tighten rules on naked short-selling, wrote, "Naked short-selling ... can result in long-term failures to deliver, including aggregate failures to deliver that exceed the total float of a security. NASD believes that such extended failures to deliver can have a negative effect on the market."

"Among other things, by not having to deliver securities, naked short-sellers can take on larger short positions than would otherwise be permissible, which can facilitate manipulative activity," the proposal read. "Further, significant failures to deliver can impact certain rights of buyers, such as the right to vote shares or the treatment of dividends."

So the hedge funds may be right in that many of the companies suffering from short-selling are badly run or on the path to insolvency anyway. And it may be that none of them are engaging in naked shorting in the era of Regulation SHO.

But if they are, it raises a serious question: Isn't there a better way to pursue their noble ends?