In a "naked" short sale, the seller does not borrow or arrange to borrow the securities in time to make delivery to the buyer within the standard three-day settlement period.
As a result, the seller fails to deliver securities to the buyer when delivery is due (known as a "failure to deliver" or "fail").
Failures to deliver may result from either a short or a long sale. There may be legitimate reasons for a failure to deliver. For example, human or mechanical errors or processing delays can result
from transferring securities in physical certificate rather than book-entry form, thus causing a failure to deliver on a long sale within the normal three-day settlement period. A fail may also
result from naked short selling. For example, market makers who sell short thinly traded, illiquid stock in response to customer demand may encounter difficulty in obtaining securities when the time
for delivery arrives.
Naked short selling is not necessarily a violation of the federal securities laws or the Commission's rules. Indeed, in certain circumstances, naked short selling contributes to market liquidity. For
example, broker-dealers that make a market in a security generally stand ready to buy and sell the security on a regular and continuous basis at a publicly quoted price, even when there are no other
buyers or sellers. Thus, market makers must sell a security to a buyer even when there are temporary shortages of that security available in the market. This may occur, for example, if there is a
sudden surge in buying interest in that security, or if few investors are selling the security at that time. Because it may take a market maker considerable time to purchase or arrange to borrow the
security, a market maker engaged in bona fide market making, particularly in a fast-moving market, may need to sell the security short without having arranged to borrow shares. This is especially
true for market makers in thinly traded, illiquid stocks such as securities quoted on the OTC Bulletin Board, as there may be few shares available to purchase or borrow at a given time.
Answers to Frequently-Asked Questions from Investors
Is all naked short selling abusive or illegal?
a) When considering naked short selling, it is important to know which activity is the focus of discussion.
b) Selling stock short without having located stock for delivery at settlement. This activity would violate Regulation SHO, except for short sales by market makers engaged in bona
fide market making. Market makers do not have to locate stock before selling short, because they need to be able to provide liquidity. However, market makers are not excepted from Regulation SHO's
close-out and pre-borrow requirements.
c) Selling stock short and failing to deliver shares at the time of settlement. This activity doesn't necessarily violate any rules. There are legitimate reasons why a seller may
fail to deliver on the scheduled settlement date.
d) Selling stock short and failing to deliver shares at the time of settlement with the purpose of driving down the security's price. This manipulative activity, in general, would
violate various securities laws, including Rule 10b-5 under the Exchange Act. Regulation SHO does not address this issue.
Is naked short selling the reason my stock has lost value?
Investors should always use caution before investing in high-risk, speculative stocks, especially with regard to their retirement portfolios, because all stocks may decline in value. There are many
reasons why a stock may decline in value. The value of a stock is determined by the basic relationship between supply and demand. If many people want a stock (demand is high), then the price will
rise. If a few people want a stock (demand is low), then the price will fall. The main factor determining the demand for a stock is the quality of the company itself. If the company is fundamentally
strong, that is, if it is generating positive income, its stock is less likely to lose value.
Speculative stocks, such as microcap stocks, often have a high probability of declining in value and a low probability of experiencing above average gains. For example, investors should take extra
care to thoroughly research any company quoted exclusively in the Pink Sheets. With the exception of a few foreign issuers, the companies quoted in the Pink Sheets tend to be closely held, extremely
small or thinly traded. Most do not meet the minimum listing requirements for trading on a national securities exchange, such as the New York Stock Exchange or the Nasdaq Stock Market. Many of these
companies do not file periodic reports or audited financial statements with the SEC, making it very difficult for investors to find reliable, unbiased information about those companies.
There also may be instances where a company insider or paid promoter provides false and misleading excuses for why a company's stock price has recently decreased. For instance, these individuals may
claim that the price decrease is a temporary condition resulting from the activities of naked short sellers. The insiders or promoters may hope to use this misinformation to move the price back up so
they can dump their own stock at higher prices. Often, the price decrease is a result of the company's poor financial situation rather than the reasons provided by the insiders or promoters.
Naked short selling, however, can have negative effects on the market. Fraudsters may use naked short selling as a tool to manipulate the market. Market manipulation is illegal. The SEC has toughened
its rules and is vigilant about taking actions against wrongdoers. Fails to deliver that persist for an extended period of time may result in a significantly large unfulfilled delivery obligation at
the clearing agency where trades are settled. Regulation SHO is intended to address these effects by reducing the number of potential failures to deliver, and by limiting the time in which a broker
can permit a fail to deliver to persist. For instance, as explained above, Regulation SHO requires brokers and dealers to close-out the open fail-to-deliver positions in "threshold securities" (i.e.,
securities that have experienced a substantial number of extended delivery failures) that have persisted for 13 consecutive settlement days.