Sources: San Antonio Express News, March 2, 2005, Title: “Naked Short Selling Is A Plague For Businesses And Investors,” Author: David Hendricks; TheMotleyFool.com, March 30, 2005, Title: “Who’s Behind Naked Shorting?,” Author: Karl Thiel; Financial Wire, Stockgate Today Series, Title: “SEC’s Donaldson Addresses Liquidity Fraud,” September 20, 2004; “Dateline NBC Cancelled and Attorney Accuses DTCC of Cheap Thuggery,” April 7, 2005, Author: Dave Patch
Faculty Evaluator: Wingham Liddell, Ph.D.
Student Researcher: David Stolowitz
The negligence of government regulatory agencies and the media is becoming worrisome as a major scandal, unknown outside the financial community, is bankrupting small businesses and investors and having a negative effect on the economy.
While the balance of supply and demand is a fairly well known principle of economic health, a related and similar relationship exists between liquidity-the availability of liquid, spendable assets such as cash, stocks and bonds-and security-the stability, endurance and trustworthiness of more long-term financial mechanisms.
A healthy economy requires both enough access to liquid assets to ensure a smooth and flexible flow of money and a system that guarantees enough stability, protection and security for investors to take a reasonable measure of risk without having excessive fears of losing their money. Unreasonable emphasis on the first requirement and not enough attention to the second is a trend that has developed in the last decade and may have more to do with ideology than sound economic policy. Liquidity fraud and naked shorting abuses as described in this article are a symptom of a greater problem within our economic culture. This lopsided philosophy of economic regulation is a significant factor in creating the kind of climate that has produced company scandals like Enron and WorldCom, as well as a careless attitude towards free trade and globalization that may create more costs than benefits in the name of “economic growth.”
The scandal coined “Stockgate” by the Financial Wire involves the abuse of a practice called “short selling.” As opposed to a traditional approach to investing in which stocks are researched and bought on the hope they will rise over the “long” term, going “short” involves a bet that a stock is about to go down in value. In a short sale, an investor sells stock that he or she technically doesn’t own. The investor borrows these shares of stock from their broker, who in turn may likely borrow the shares himself from a financial clearinghouse like a brokerage firm or hedge fund. Hoping that the price of the stock will drop, the investor is obligated to eventually “close” the short by buying back the sold shares at a hopefully lower price, thus making a profit from the fall of the stock. When the time runs out for “covering” the short and the price hasn’t dropped, the investor is forced to buy back the shares at a loss and take a financial hit. The short sale of stocks is a risky bet, usually not recommended except for speculation or hedging-to protect long-term financial positions with short-term offsets. As short-selling is a sale of stocks not owned, but loaned, it is an example of buying on margin-a category of practices whose abuses stand out clearly in many people’s minds as a significant factor in the Stock Market Crash of 1929 which ushered in the Great Depression.
Naked shorting is an illegal abuse of short selling in which investors short-sell stock that they have no intention or ability to ever cover. When allowed to occur, naked shorting drives the stock value of a company down by creating more stock shares flowing around the market than actual shares of stock that the company can back with their current earnings. Companies, their shareholders, and indeed the entire economy are hurt financially by naked shorting, as it reduces the money available to support economic growth. According to activist Dave Patch, “Naked shorting steals some of the greatest ideas, products, and services in America. Small micro-cap companies are driven out of business by this abuse and we are left with the unknowns of what these companies and their employees had to offer our futures. The opportunities for the next Microsoft may never be felt as naked shorting snuffed out that creativity before it was ever brought to fruition. Ultimately, naked shorting steals from the very foundation of our nation as it steals the American dream of opportunity.”
Patch and other investors hurt by or concerned about the consequences of naked shorting organized, petitioned and investigated the background surrounding the Stockgate scandal. What they found was not merely a series of noteworthy cases of extravagant abuse by individual investors and professionals, but a systemic pattern of negligence by regulators that allowed the abuse to go by largely unchecked. A whole series of checks and balances was originally designed to prevent abuses like naked shorting. Yet, as their research has shown, every regulator along the way has failed its duty and led to both widespread and high-figure abuse. While investors have lost hundreds of billions of dollars in savings, the Wall Street Firms responsible for the abuse saw negligible fines that had no appreciable impact on their stock values. Some executives were even given raises in the midst of their negligence and fraud!
As more pressure has been brought against regulatory agencies to stop the fraud and enforce rules, an opposition has come forth that actually favors allowing the illegal practice to continue unchecked. These critics argue that all short sales, including illegal naked shorts, help bust the hype that can surround micro-cap companies. Excitement over new but untried ideas can artificially inflate stock prices, causing eventual losses to companies and investors when the bubble bursts, as in the case of the dot-com boom of the ‘90s.
While it is true, as the critics argue, that removing naked shorting could in some cases allow hyped prices to climb further, such an effect is vastly overrated. The argument does not take many other financial factors into account, such as the increased efficiency in the flow of information and shares that eliminating naked shorting would create or the fact that legal short selling could provide the same protections. Many securities analysts say it is fallacious to assert that the only recourse to the adjustment in hype and price securities is to allow an illegal practice to continue.
The same enforcement of already existing rules by regulators could curb hype just as much as it curbs naked shorts. A proactive stance by the financial community in informing and educating the public could also prevent the pump and dump schemes that such critics say would be the consequence of ending naked shorting.
Often it is the very organizations that did little to stop the dot-com problem from getting out of hand while it was occurring that now cry out at the prospect of the SEC stepping up to protect small investors from naked shorting. Of particular interest is the fact that much of this criticism comes out of the Depository Trust Commission (DTCC), which takes a share of profits from every short sale and is currently fighting off lawsuits accusing it of impropriety in a number of areas. The DTCC is also alleged to have brought pressure to bear on media corporations such as General Electric to suppress the story from being reported. GE’s NBC Dateline program obtained an exclusivity contract to cover the Stockgate scandal over a year ago, and then postponed the episode indefinitely. Officially, Dateline claims that a slew of more important stories than this widespread financial scandal have caused the delay. At the time of this writing, however, they are preparing to air an Al Roker interview with an American Idol finalist.
David Sedore, “Hedge Fund Assets Frozen”: March 4, 2005; “Hedge Fund Virtually Bare”: March 12, 2005; etc. The Palm Beach Post-KL Financial fraud series.
PrimeZone Media Network, “First American Scientific Corp. Takes Counter Measures to Stop ‘Naked Shorting’ of its Stock”-December 17, 2004.