Naked short selling occurs when shares that have not yet been determined to exist are shorted.1 The issue is that an investor is selling shares that they do not yet possess, nor have they confirmed these shares even exist.2 Thus, naked short selling offers an avenue for an individual to still participate in that security without any borrowing prior to shorting.3 Although naked short selling was banned in 2008, it is still widely practiced and was responsible for the latest market frenzy regarding GameStop.4 The GameStop incident occurred because hedge funds were naked short selling GameStop and, because of disclosure requirements, a Reddit feed was able to see this happening, which prompted a call for everyday people to buy GameStop so that the hedge funds would suffer financial losses.
This situation prompts two questions: first, should naked short selling be allowed and second, how can disclosure requirements be reformed to disincentivize naked short selling? In regard to the first question, I argue that naked short selling should not be allowed, and its illegality should be more rigidly enforced. As to the second question, I argue that the current disclosure regime should be reformed in two ways to further curb naked short selling.
- Should Naked Short Selling Be Allowed?
The mechanics of naked short selling are relevant to understanding why it should not be allowed. When a share is bought and sold on the market, within four days (the transaction day plus three business days), the shares must be legally delivered.5 This cycle is called the T+3.6 When naked short selling takes place, no shares are actually delivered. Instead, there will be a “failure to deliver” and the buyer will be given an electronic credit for the stock.7 The result is the buyer can then take their electronic credit and sell the security to someone else, resulting in illusory shares being bought and sold.8
The Depository Trust & Clearing Corporation (DTCC), responsible for ensuring the delivery of shares and receipt of money in exchange for shares, is not taking adequate measures to prevent naked short selling.9 However, DTCC claims the real responsibility for this problem lies with the brokerage firms because they are the actors who know for sure whether or not a client failed to deliver their stock.10 The DTCC has limited ability to administratively oversee and stop naked short selling, and naked short selling accounts for such a minuscule portion of trades that it doesn’t seem to be worth the administrative costs (despite its immense potential impact on the market).11 On the other hand, brokerage firms have absolutely no incentive to try to stop naked short selling because of the commissions they make on each sale.12 Therefore, this explains the crack in the regulatory framework in which the abuse of naked short selling continues.
In response to these issues, the SEC implemented Regulation SHO in 2004 to curb naked short selling.13 The regulation instituted four main requirements: 1) marking requirements, 2) short sale price test circuit breakers, 3) locate requirements, and 4) close-out requirements.14 Most notably, the third prong requires that the broker have “reasonable grounds” to believe that the security can be borrowed.15 However, market makers engaged in bone fide market making are exempt from this requirement.16 In addition to this regulation, in 2008, the SEC adopted Rule 10b-21, the naked short selling antifraud rule, which specifies it is unlawful to “sell a security if that person deceives a broker-dealer, participant of a registered clearing agency, or purchaser regarding his/her intention, or ability, to deliver the security by settlement date and that person fails to deliver the security by settlement date.”17 Although the SEC has taken legal action against parties under Rule 10b-21, it has not eradicated the problem and there are complaints that the SEC is not strongly enforcing it.18 As demonstrated by the GameStop incident, the naked short selling scheme is still alive and well.
Based on the mechanics of naked short selling, it should not be allowed because of the effect it has on the market. It is commonly referred to as creating “phantom” shares because they don’t exist but are still influencing the market. Pure short selling has purported benefits such adding liquidity to the market and reducing overvaluation of shares.19 However, both naked short selling and pure short selling are criticized for incentivizing unethical activity, increasing the volatility of the market, and depressing prices.20 Additionally, it can scare off investors if they see that a potential investment is being naked short sold by others. These results alone can give rise to material market manipulation. Therefore, naked short selling should not be allowed and more should be done to enforce its illegality.
- Reforming Disclosure Requirements to Disincentivize Naked Short Selling
An issue directly related to naked short selling surrounds the disclosure requirements of hedge funds/asset management companies because disclosure is one way the public can become aware that naked short selling is occurring. This was the case in the GameStop short squeeze. When a big hedge fund is shorting a company, the only way that the public becomes aware is because the fund must file 13Fs with the SEC. A 13F is a required disclosure report that investment managers file every three months, and it details all their equity holdings.21 If these disclosure requirements did not exist, then the GameStop incident arguably would not have occurred because no one would have known that these investment managers were shorting GameStop stock.
From the hedge fund’s perspective, there are several downsides to disclosure. First, hedge funds and investment managers conduct proprietary research to determine which trades will create the most value for their clients. Although they do not have to disclose this research in the 13F reports, it does signal to others which trades may be the most advantageous. Therefore, it could directly cause someone to make a trade that they otherwise would not had made just by looking at what the major players are doing. Second, knowing that third parties are looking at their disclosures, it is common for investment managers to prepare for 13F reporting by making red herring trades in an effort to disguise their true strategy. The reason for this is because disclosure is only required every three months—therefore, a hedge fund’s equity holdings on March 31st could vary significantly from their equity holdings on April 1st. The result is that they could intentionally lead the market astray and misguide outsiders. Therefore, 13F disclosures can be used to both a third party’s advantage and disadvantage. At large, however, 13F disclosures are generally not in the hedge fund’s interests. That being said, if the SEC and DTCC are not taking sufficient steps to stop naked short selling, disclosure is the public’s best option. Additionally, disclosure reform would disincentive brokers from engaging in naked short selling, despite its benefits to them.
I argue that 13F disclosures should be reformed in two ways. First, it should be on a continuous basis for changes in equity holdings above a certain threshold. Therefore, instead of disclosing only every three months, continuous disclosure of material equity changes would mitigate investment manager’s efforts to hide their strategy or present a façade of equity holdings that they promptly change following disclosure. Although this would create administrative burdens on the investment companies, this burden would be lessened by the fact that continuous disclosure would only be triggered if equity holdings changed above a certain threshold over a certain period of time. Adding in time as a factor would prevent companies from slowly changing their equity holdings and not triggering disclosure by increasing/decreasing their holdings in intervals rather than all at once. Note that this continuous disclosure for certain equity holdings would be in addition to the mandatory quarterly disclosure.
Second, the quarterly disclosure reporting should require the investment firms to confirm the existence of the securities related to their equity holdings. Currently, SEC Regulation SHO merely requires brokers have “reasonable grounds” to believe that the security can be borrowed. By increasing this threshold, it puts more pressure on the investment firms to engage in due diligence and ensure that the securities they are buying or selling in fact exist. By implementing this requirement, the naked short selling of counterfeit shares will be minimized to some degree. By requiring this reporting only for quarterly reports, it reduces what would otherwise be an immense administrative burden on the investment firms. Further, it balances the need to curb naked short selling with the fact that, although it is happening and can greatly impact the market, the majority of security buying/selling does not engage in naked short selling. Implementing these two proposals into the current disclosure regime offers a way to appropriately respond to the ways in which SEC Regulation SHO and the DTCC are failing to address this issue without creating an immense burden for investment firms.
Although GameStop was an extreme incident of naked short selling, other big companies like Delta Airlines, Netflix, and Overstock.com have also reported more than 10% of shares outstanding (evidence of “failures to deliver”) at various points in time.22 Naked short selling is something to be concerned about because of the impact it can have on market manipulation. Based on the current lack of action by the SEC and DTCC, more should be done to curb naked short selling. Specifically, the 13F disclosure regime should be reformed in an effort to minimize naked short selling.
Adam Hayes, Naked Shorting, Investopedia: Stock Trading Strategy & Education (March 13, 2021), https://www.investopedia.com/terms/n/nakedshorting.asp. ↩
Press Release, SEC, SEC Issues New Rules to Protect Investors Against Naked Short Selling Abuses (Sept. 17, 2008), https://www.sec.gov/news/press/2008/2008-204.htm (last visited March 12, 2021). ↩
About Settling Trades In Three Days: Introducing T+3, SEC: Investor Publications (May 12, 2004) https://www.sec.gov/reportspubs/investor-publications/investorpubstplus3htm.html. ↩
John R. Emshwiller & Kara Scannel, Blame the ‘Stock Vault’?, Wall St. J. (July 5, 2007), https://www.wsj.com/articles/SB118359867562957720. ↩
Why is Naked Short Selling Both Illegal and Common Practice?, The First Am. Stock Transfer Co., http://www.firstamericanstock.com/index.php/articles/why-is-naked-short-selling-both-illegal-and-common-practice/ (last visited March 13, 2021). ↩
Emshwiller, supra note 7. ↩
First Am. Stock Transfer Co., supra note 8. ↩
Key Points About Regulation SHO, SEC (last updated April 8, 2015) https://www.sec.gov/investor/pubs/regsho.htm. ↩
Adoption of “Naked” Short Selling Antifraud Rule, Exchange Act Rule 10b-21 — A Small Entity Compliance Guide, SEC (October 17, 2008) https://www.sec.gov/divisions/marketreg/tmcompliance/rule10b21-secg.htm. ↩
Mark Jickling, CRS Report for Congress: Regulation of Naked Short Selling 4 (2008). ↩
James J. Angel & Douglas M. McCabe, The Business Ethics of Short Selling and Naked Short Selling, 85 J. of Bus. Ethics 239, 241 (2009). ↩
Id. at 243 ↩
Will Kenton, What is the SEC Form 13F?, Investopedia (April 9, 2020) https://www.investopedia.com/terms/f/form-13f.asp. ↩
Angel, supra note 19, at 243. ↩