Hedge Fund Shells Out in Shorting Probe

The SEC contends Thorp carried out the naked-shorting scheme with the assistance of an unidentified Canadian broker. Over the years, critics of the PIPEs market often have alleged that U.S. hedge funds were carrying out abusive trading strategies in Canada, where the rules against naked shorting were less stringent.

A year ago, U.S. securities regulators, in part because of the PIPEs investigation, took steps to make it more difficult for traders to engage in naked shorting in this country. Friestad says he believes Canada has taken a similar action.

Regulators say the naked shorting scheme was critical to Thorp's strategy because it enabled him to make short bets on the shares of companies doing PIPE deals, even when no shares were available for him to borrow from a broker in the U.S. The naked shorting, according the complaint, enabled Thorp to "earn larger profits'' when a stock declined in price because he "had no borrowing limitations.''

In other words, the illegal strategy gave Thorp a big advantage over other investors in these PIPE deals who used legal means to short shares as a hedge against a decline in the price.

In a typical short sale, a trader borrows shares from a broker, sells them, and then hopes the stock falls so he can replace his borrowed stock at a lower price. The short-seller makes money by pocketing the difference between the borrowed shares he sold and the ones he purchased.

But in a naked short sale, a trader places short bets without actually borrowing the stock first, or even determining that any shares are available to borrow. This way, naked short-sellers are freed from a key check of the short-sale process -- the need to find willing stock lenders. Critics claim such operations create excessive downward pressure on certain stocks and can create chaos as buyers await undeliverable shares.

Left unchecked, naked shorting can lead to an anomalous situation in which the total number of shares sold short on a stock exceeds its float, or the number of shares available for trading.