Naked Short Selling -- Illegal but Hard to Prove

NEW YORK (TheStreet) -- The Securities and Exchange Commission Chairman Christopher Cox on Tuesday said the regulator planned to crack down on naked short-selling of Fannie Mae (FNM) and Freddie Mac. Cox said in a testimony to the Senate Banking Committee on Tuesday that the agency will require short-sellers to borrow shares of the two government-sponsored mortgage giants and broker dealers including Lehman Brothers (LEH), Goldman Sachs (GS), Merrill Lynch (MER) and Morgan Stanley (MS) before selling them. The new restrictions are called for under a temporary emergency order that expires in 30 days.

For a refresher on why this is a big deal, here you go.

The traditional method for making money in the stock market is to "buy low and sell high." But there is another way to profit called "shorting," where the trick is to "sell high and buy low." There are strict rules when it comes to shorting stocks, however. One way they are broken is via naked shorting.

But first, let's discuss the right, as in legal, way to profit from a declining stock.

Investors short stocks that they believe are going to fall in price in the near future. To sell a stock short, you borrow the shares from your broker, then sell the shares and hold the money and wait for the stock to fall. If it does fall, you buy the shares at the lower price and give them back to your broker, who gets a commission and interest for his troubles.

If you short a stock whose price rises, things can get hairy. You can wait to see if the stock will decline, or you buy the stock back at a higher price than you sold them and give them back to your broker (along with the other fees), and take the loss. You can learn more about the short selling process here.

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Regulators have no problem with conventional short-sellers if the practice is done according to the rules. In fact, regulators are among the first to say that short selling provides a necessary check-and-balance on the market. Short-sellers, for instance, are particularly good at smoking out companies that are either engaged in fraud or misleading investors.

It's naked shorting, a manipulative practice that enables traders to defy the laws of supply and demand, that regulators are trying to stop.

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, the traders 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 irregular situation in which the total number of shares sold short on a stock exceeds its float, or the number of shares available for trading.

The issue of just how widespread naked shorting is on Wall Street is a matter of considerable dispute, despite the regulatory crackdown. Some contend the unsavory practice has all but disappeared since the National Association of Securities Dealers and the Securities and Exchange Commission instituted new rules in early 2005 making it more difficult to engage in naked shorting. The rules, commonly referred to as Regulation SHO, prohibit brokers from letting traders short a stock unless there are "reasonable grounds" for believing there are shares available to borrow.

The most outspoken critics of naked shorting say it remains a rampant practice among a group of nefarious short-sellers and brokers.

Short-sellers point out, however, that many of the companies often cited as victims of naked shorting are businesses that were either losing money or had failed business strategies.

Also, naked shorting can be difficult to prove because trades settle in three days. So technically, short-sellers have three days to locate the shares before the trade is overdue. And even under the new rules, the regulators won't really start digging too deeply until five days after the initial sale.

Finally, it's hard to prove naked short selling in some cases because it's not always done with illegal intent. Occasionally, there are legitimate reasons why shares are not delivered in time. Sometimes there are mistakes in transferring physical certificates, and those cases are usually resolved in a week or two. And sometimes traders just make mistakes by selling stocks that they think they have in their portfolio, but really don't, thus causing an imbalance.

-- Written by Gregg Greenberg in New York City

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