Naked Short Selling: Not as fun as it sounds

   The GameStop drama has brought new attention to an old practice. Short selling is an investment strategy where an investor sells shares that they do not own, believing that the stock price will decline. When the investor sells short, the sale is then completed by the delivery of a stock borrowed by, or for the account of, the investor. If the investor was correct and the stock price declines, the investor is eventually able to purchase the shares on the open market at a lower price and close out the position by returning the borrowed security to the stock lender. With this type of trading scenario the short seller will make a profit. If, however, the price of the stock increases, the short seller will have to buy it on the open market at the higher price and will incur a loss on the trade. Short selling is not only used by individual investors who believe that a stock price will decline but it is also used by market professionals to provide liquidity in a particular investment, or to hedge the risk of an economic long position in the same security or in a related security. For example, an investor could sell short a company within a certain industry to hedge a long position in another company within that same industry. This can be a very effective investing strategy and is used quite often. For these short sale events to occur, it is the respective brokerage firm which typically lends stock to its customers to engage in short sales. They do this by using the firm’s own inventory, the margin account of another of the firm’s customers, or another lending source to obtain the underlying security.

    A short sale becomes a "naked" short sale when a sale is made without the delivery of the underlying security. In a naked short sale, the seller does not actually borrow the shares or arrange to borrow the shares in the appropriate time needed to make delivery to the buyer. The appropriate length of time is designated by regulation to be required within the standard three-day settlement period for all stock sales and purchases. As a result of the failure or inability to actually borrow the same number of shares that were sold short, the seller fails to deliver securities to the buyer when delivery is due within the three-day time limit and this becomes a "failure-to-deliver” situation.

    While short sales are not illegal, and certainly help to provide liquidity to the overall market, naked short selling can become an illegal stock trading practice depending on the facts surrounding the sale. In an illegal naked short selling, sellers do not borrow stocks and do not intend to borrow the shares to make the delivery within the required three-day time period. The sellers fail to deliver the particular stock which they are supposed to deliver, resulting in the aforementioned failure-to-deliver violation.

    Granted, there may be legitimate reasons for a failure-to-deliver. In certain situations, human or mechanical errors may result in processing delays leading to a failure to deliver within the given three-day settlement period. In some other situations, market makers who sell short thinly traded stock due to customer demand may encounter difficulty in obtaining securities when the time for delivery arrives. There are also times when sudden surges in trading activity for a particular stock may make it impossible to purchase or arrange to borrow the shares within the given time period. Therefore, not every case of naked short selling becomes a violation of federal law or regulation. Still, it is widely believed that some professional investors and hedge funds are involved in naked short selling by using loop holes in the stock trading system and have implemented naked short selling as an ongoing part of the firm’s strategy.