Naked Truth Dressed to Baffle

Brent Baker, who went into private practice at Woodbury and Kesler this spring after 14 years at the SEC, says naked short-selling "is a very large problem."

Baker is representing Overstock in a lawsuit alleging hedge fund Rocker Partners and research firm Gradient Analysis engaged in unfair business practices designed to "denigrate" Overstock. Rocker has countersued, alleging Overstock launched a "smear campaign."

Baker says many regulators regard short-selling as a useful tool that brings suspicious business and accounting practices to the light of day. "They see short-selling as a beneficial market force -- and it is. It's when it becomes a procedure to game the system that it becomes illegal."

"Everyone at the SEC has good intentions," he adds. "The problem is they don't realize short-selling has grown up. You now have sophisticated hedge funds that have short-selling as part of their business model."

Letting hedge funds weed out the weaker companies is kind of like hiring the Hell's Angels to handle security at your free rock concert -- you may solve lots of little problems, but you also run the risk of creating a few, much bigger ones.

The only clear-cut information on naked short-selling as an abusive practice has come from trials where such evidence was made public -- but often years after the fact. Ken Breen, an attorney in the Justice Department during the Anthony Elgindy case, says the prosecution presented evidence that naked short-selling was active in stocks between late 2000 and early 2002.

"There was a significant amount of naked short-selling in the Elgindy case," says Breen, now a partner at Fulbright and Jaworsky. "We presented evidence on nearly 40 stocks where there was manipulative short-selling, and in nearly all of those cases, there was naked short-selling."

But in the era of Regulation SHO, which took effect last January in an effort to curtail naked short-selling, it's harder to show such activity. So, while some investors describe an elaborate method of listing stocks on foreign exchanges so that short-sellers can claim to U.S. brokers that they have shares available to borrow, others are more skeptical.