Short-Selling: Should It Be Illegal?

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Interesting debate over at Point of Law between Moin Yahya and Larry Ribstein on whether selling stocks short should be illegal.

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  1. Clarification Nick.

    The article is about whether plaitiffs suing a given company should be able to short that company. It is not about short selling in general.

  2. One is saying that all insider trading should be legal. the other is saying that insider trading should be illegal only if the person with insider info chooses to do an affirmative act that makes the insider knowledge valuable.

    It would be a lot more interesting if they instead debated why we have the pretense of insider trading laws at all. All they do is ensnare an occasional talkshow host.

  3. Gotta agree with Ribstein – the last thing we need to do is bring back (although I’m not sure it’s entirely gone) the idea that having superior information regarding a transaction is a crime. There are already laws regulating fraud, we don’t need more.

    And since when has more regulation by the SEC been good for business?

  4. Actually, Dave, it seem Ribstein would agree with you. I’ll have to track down his blog and read more, but his arguments would lend themselves to that conclusion.

    In essence, he’s arguing that fraud and manipulation are covered by the criminal law already. No need to make special rules that apply only to stocks. Insider trading laws already go far beyond fraud and manipulation.

  5. qb,

    what is the difference between fraud and insider trading? I think it is that fraud means that you lie and insider trading means that you simply don’t say what you know. Is that roughly it?

  6. What is illegal, but not really enforced, is prohibition of naked short selling, which is rampant against small and medium sized companies. Naked short selling in its modern form is electronic counterfeiting of shares, and is used by crooks to push down the price of targeted stocks by flooding the market with an oversupply of fake shares. This is the kernel of the scandal surrounding Overstock.com and many other companies. The SEC recognized the problem when it implemented Regulation SHO, but unfortunately grandfathered in previous large naked short positions, probably to avoid a scandal which would cause the public to lose confidence in US equities markets. And rightly so, unfortunately.

  7. Has anybody else followed the SEC’s investigation of business reporters in which Chairman Cox recently provided some much needed adult supervision? When a vetran of the CA GOP delegation looks like the smartest guy in the room, you have to worry about the room. The enforcement guys in the SF office have gone completely bonkers.

  8. “He who sells what isn’t his’n
    must buy it back
    or go to pris’n.”

  9. Dave,

    It’s very technical, and I haven’t looked into the details in years, but that’s the essence. The problem is that the regulations presume guilt if you are an agent of the company. Furthermore, there’s always a question of whether you had information that was truly only available to insiders, or even if it was, did you really think it was material looking forward (and not monday morning QBing). Finally, there is the question that even if you knew inside info, but you needed to sell for other reasons (a sudden need for liquidity, or a planned sell after a certain time) do you need to always tell your transaction partner everything you know about the stock? Do you do that in everyday life when you sell things?

    As a purely jurisprudential argument, it seems the better thing to do is to not have fraud in that form in stock transactions. Save it for the really blatant stuff where the seller or buyer actively mislead the other party. People should always be circumspect when buying from an insider.

    Although, there would be nothing wrong with a private exchange enforcing stricter fraud laws with the penalty of losing the ability to trade in that exchange in the future (with other exchanges able to take note).

  10. As a victim of a naked shortselling attack 5 years ago (my wife held restricted stock in a medium-sized company traded on NASDAQ), I make a strong second to markv’s comment. It is stimply stealing by another name. Had we known that such a thing was even possible back then, we would have made considerably different financial decisions than we did. Strangely enough, I still invest in the market through my 401(k), although you would think I would have learned my lesson by now. Where the markets are concerned, the emperor really is wearing no clothes. People would be amazed at how fraudulent the system is.

  11. thanks, qb. What you (& Ribstein) say makes sense to me as both law and policy. I just don’t like the situation where I learned one set of insider trading laws in law school, and seem to observe something very different in the modern world. If they have gotten rid of insider trading law in substance, then they ought to get rid of it in name as well.

  12. I think there is nothing wrong with a lawyer who is suing a company that deserves to be sued from also short selling. How can this be bad? It brings the stock price closer to where it “belongs”, and that is precisely what we want market participants to be doing.

    If we can find a way to penalize lawyers enough who engage in frivolous lawsuits, then we ought to be covered by any abuse.

    By the way, it is not only short selling by lawyers that ought to be covered if you believe the premise of the person arguing for such a ban. You’d also need to ban buying put options and shorting call options, both of which would gain far more than a short sale in this instance.

  13. Thanks for mentioning Overstock markv.

    I’m probably not the only one here who likes to watch public psychotic breakdowns of the rich and powerful. The 2005 Kim Jon Il award for public lunacy goes to CEO Patrick Byrne.

    Back in the 90’s, if a company’s stock fell there were a few well worn excuses to work through including Y2K, global warming, accounting rules changes, … and short sellers. But in the last few years it’s become popular to blame “naked short sellers” and “paid bashers” for *everything*. Lost $2.5 million on something nobody can explain, blame naked short sellers. Had to restate earnings back to 2000 because of accounting errors, it’s the naked short sellers. Hired an ugly spokesmodel, had to eat some inventory, missed earnings, tied up all your cash in some asian currency instrument, … all coordinated by a Sith Lord selling shares short naked.

  14. This seems to be a reverse “pump and dump” scheme. I can’t think of a cute name for it offhand but it can easily be seen as fraud. Any suggestions for what to call it?

  15. “Tort and short” there’s the name!

  16. Eryk:

    Chris Moltisante did something like that on the Sopranos. Got people to buy his fake stock, then sold high.

  17. That’s very good Eryk, but you just want to reverse them. 🙂

  18. Eryk,

    superficially, they look the same, but they’re not, at least to me. In “pump and dump,” you are making affirmative statements regarding your holdings. If you outright lie about a material fact, that’s fraud, plain and simple. On the other hand, if you fail to disclose what becomes a material fact, it is not always fraudulent. Maybe you didn’t know the fact either. Maybe you didn’t understand the signifigance of the fact. Maybe you didn’t think it was material. Or maybe it just slipped your mind.

    Again, when you sell your car, do you give the buyer a complete rundown of everything you’ve ever done with the car? Some of it might be material with respect to future performance of the car. Caveat emptor tends to be a pretty good rule, because then the buyer will ask the questions that he thinks are important and material. And if you lie in an answer, that is fraud.

  19. Quasi…If you sell a car with a bad brakeline (as I did recently) you have an obligation to say so. Likewise, when selling short, the fact that you will be filing major litigation against the affected company soon is also material.

    To be fair, the party loaning the stock should have the sense to ask such questions even if disclosure isn’t legaly required.

    BTW, “pump and dump” doesn’t always involve fraudulent statements. Simply buying a large number of shares for no good reason may artificially inflate the price.

  20. Wow, johl, I’m sorry I pressed your buttons. If you have a thing about Overstock, just Google “naked shorting” and explore the resulting links. Something about correlation between smoke and fire…..

    Ron, what I’ve found is that there is no open, objective way to check the tally of the total number of outstanding shares of any publicly traded company. This being the case, there is no way to control the number of those shares on the open market.

    When you go to your broker and place an order to buy X number of shares of ABC company, the broker places the order for the trade and after it goes through you have to pay him within 3 days. Supposedly, within that same 3 day period, your newly purchased shares leave the account of your (unknown) selling counterpart, and land in your account. The money you paid your broker is forwarded to the seller, and the shares you purchased are forwarded to you within the allowed 3 day settling period (less broker’s commissions etc. on both sides). That’s the way it’s supposed to work.

    The proof you see that you own X shares of ABC Corp. is the stock certificate you receive in the mail a week or so later. You can also verify you own the shares by calling ABC Corp. and asking them if you are listed as a shareholder of record owning X shares. They will say yes. You can also of course phone your bank, and verify that the check you sent your broker for the purchase cleared. Money gone, shares received — all is good.

    What if you don’t take delivery of the stock in certificate form? Here’s where the system gets a bit loose. If you just rely on your broker’s monthly statement to you, showing you own X shares of ABC, you are holding the X shares of ABC “in street name”, which means your name does not appear as a shareholder of record on the books of ABC Company. If you call ABC up and ask them to verify that you own X shares, they will not see your position on their shareholder list as owning X shares. In this case, you are completely trusting your broker to have “taken delivery” of X shares of ABC and to be holding X shares in their name for you. If for some reason your broker didn’t actually go to the trouble of acquiring the shares, then you only *think* you are an owner, and in effect X “new” shares were created by your “purchase”. In this case, you are not really an owner, and you in effect have made a side bet on the price of ABC stock. Certainly, if you later place a sell order, your broker will, after you “sell”, place a corresponding amount of money in your account and the entry showing “ownership” of X shares of ABC will be absent from your next monthly statement.

    So what’s wrong with that? Who cares if you “really” weren’t an owner (of record on ABC Company’s list) between the buy event and the sell event? After all, you did get paid the going price when you “sold” the shares you “owned”.

    The problem is twofold: First, if you pay real money for something, you should actually receive what you paid for — in this case, shares in ABC, not just a side bet on the price. Second, if you don’t actually receive shares from an actual seller, your purchase did not show up in the market as part of the aggregate demand for ABC stock, and so did not affect the price. This is not good for you as an ostensible owner of ABC, since you are counting on aggregate demand for your new shares to reflect the perceived value of ABC Company. You think there is a limited supply of shares, and that good news about ABC will drive up demand and as a result the price will rise. You are not assuming there is an unlimited supply of shares available to meet demand.

    But this is precisely why a naked short seller dumps counterfeit shares on the market: To overwhelm demand with arbitrarily large supply. And since almost no one nowadays takes delivery of their shares in certificate form, there is no way to know whether the accounting of shares is accurate.

    You can’t counterfeit US currency: the Secret Service will come after you. But, if you are well positioned in the brokerage/trading community, you *can* counterfeit the shares of a publicly traded company and sell the counterfeit shares for real money. And if the small publicly traded company you naked shorted subsequently goes out of business, no one will ever bother accounting for all of its shares.

  21. “What is illegal, but not really enforced, is prohibition of naked short selling, which is rampant against small and medium sized companies. Naked short selling in its modern form is electronic counterfeiting of shares, and is used by crooks to push down the price of targeted stocks by flooding the market with an oversupply of fake shares. This is the kernel of the scandal surrounding Overstock.com and many other companies. The SEC recognized the problem when it implemented Regulation SHO, but unfortunately grandfathered in previous large naked short positions, probably to avoid a scandal which would cause the public to lose confidence in US equities markets. And rightly so, unfortunately.”

    Amen brother, Amen. Selling short is a fine idea, and a good way to make a buck. Naked shorting is fraud with a capital fu%&ing F. Just as Markv says, naked shorting is a tactic that is widely employed to shake down the share holders of small companies, in particular.

  22. The logic behind making insider trading legal is that the buyer is going to get screwed either way. The insider is often barred from telling people what is wrong with the company through nondisclosure agreements and the like. So whoever buys the stock is going to do so anyway, for his own reasons and misconceptions. In fact, if the insiders are barred from selling their stock, the unknowing buyers will have to pay an even higher price for a stock that is about to tank, increasing their losses.

    On a stock exchange where the buyer and seller never meet misrepresenting the product can only be done through the media. An individual seller cannot defraud an individual buyer unless he’s using the media to pump up the value of the stock. Absent that activity, insiders who sell stock on the expectation it’s about to go down aren’t “hurting” anyone, for the excellent reason the buyers are going to get hurt anyway. If they’re determined to buy, they will bid up until they find a seller. The behavior of the insiders doesn’t affect their purchasing decision…unless they make the rational decision not to buy stock that is being dumped by insiders. In this case insider trading is to their benefit.

  23. “To be fair, the party loaning the stock should have the sense to ask such questions even if disclosure isn’t legaly required.”

    If you have a margin account with a brokerage then you have given explicit permission to loan any shares you own to anybody who wants to borrow them. A short seller asks the owner of the shares nothing, he just places a short sell order and the brokerage fills his order with shares borrowed from margin accounts.

  24. I heard a story about a guy who literally bought every share of a company with a market cap of about $100,000.

    The company shares proceeded to trade with relatively normal volume. It was all naked shorting. Fraud. If you stick up a 7-11, you go to jail for armed robbery. If you naked short a company out of business, you get rich.

  25. Markv I wanted a 500 word essay arguing there is no way to telltherefore what’s happening is without traveling to the DU and voila, I found one mind weak enough to fall for my Jedi powers. You better go get your tinfoil hat reinforced.

  26. The real problem with short-selling has to do with voting. Not that the problem isn’t fixable, but the system as it stands laughs at any pretense that one has to actually hold shares of a company to vote shares.

  27. Johnl: You’re right, it’s just poorly-managed companies who just happened one day to find over 50% of their outstanding shares sold short by one or two identifiable individuals. No fraud here, just move along, folks.

  28. Anybody want some GM stock?

  29. “Johnl: You’re right, it’s just poorly-managed companies who just happened one day to find over 50% of their outstanding shares sold short by one or two identifiable individuals. No fraud here, just move along, folks.”

    I agree there is no fraud, provided those short sellers actually had shares to sell. If they were naked short, then there was indeed fraud.

  30. Insider trading and fraud are really two different things, although dumbass/greedy prosecutors have conflated the two.

    Insider trading, once upon a time, was applicable only to people who were actually insiders and owed a fiduciary duty to the shareholders of the company. Trading on information before it was public knowledge was a breach of that duty to the other shareholders.

    Say you are the President of a company, and you know ahead of time that a new product is going to have a great launch and push up your share price. You are an insider with a fiduciary duty to the shareholders, and you have that knowledge by virtue of your position.

    If you go out and buy a bunch of shares to get in on the big ride, you are buying them from people you owe a fiduciary duty to, and doing so without telling them about the big ride their stock is about to take. Very naughty, but only because you are their fiduciary.

    Sadly, this view of insider trading is lost in the mists of time.

  31. I think stock trading should be illegal! I’m so tired of losing!!! 🙁

  32. Douglas you better hang on to that GM stock you know the guvmt is going to bail them out, jest like Chrysler. Shoulda bought that stuff when if was 50 cents a share.

  33. Not to burst anyone’s bubble, but you can’t “naked short a company out of business”. A company has to lose REAL money to do that–market cap doesn’t count!

  34. Almost all companies spend some time losing money before they start making money. During this developmental stage, you certainly can naked short a company out of business. You do it by depressing the stock price so much that it is impossible to raise any money without giving away the company. Here is the strategy used by naked shorters to make money by destroying companies:
    1. Pick a company in the development stage.
    2. Hype it in the financial press and on the internet, so that people buy the stock at higher and higher prices.
    3. When the price gets pretty high, start selling naked short (nonexistent) shares into the market.
    4. Now bring on the bashers to turn the mood negative while dumping huge amounts of mostly nonexistent shares onto the market. This crashes the price. Keep up the negative PR.
    5. Hold the price low with plenty of naked shorting while the company runs out of money before it can complete its business plan and turn profitable.
    6. When the company goes bankrupt, the shares disappear and the naked shorter never has to buy back the shares and cover out.
    7. Repeat with the next target company.

    The entire scam is carried out without any help (indeed usually with the opposition of) the company’s management.

    Only with systemwide sloppy accounting of the number and location of the company’s shares can this kind of scam be pulled off. Regular shorting (where the shares shorted must first be borrowed by the short seller) can’t create enough shares to crash the price and hold it down indefinitely.

    Note that naked shorting is just an extension of the pump and dump technique.

    Your observation that it is hard to naked short a profitable company out of existence is disingenuous and beside the point. All companies must spend some time as unprofitable entities before they become profitable, and one of the prime functions of a public stock market shoud be to provide capital for startup ventures. The added risk of being victimized by naked short crooks increases the cost of capital and destroys the wealth creating potential of our economy, to the benefit of scam artists and white collar criminals.

    And of course pretending to sell someone shares that don’t exist (naked shorting) in exchange for real money is pure fraud in itself.

  35. Markv you forgot the part where the naked short sellers cause the company to file its financials late, fail to use GAAP methods, trash its systems so they can’t keep track of customer orders, waste company resources on CEO hobbies such as currency trading and frivolous lawsuits.

    And that’s Overstock, which, before Byrne put on the clown makeup, looked like a real company. NSS is a more typical complaint of pure scams, run by people who have never sold anything but stock.

  36. Some companies are poorly run, and some managements are crooked. We all know about Enron by now. OS.com may be one of them. So what? This doesn’t discount any of my points at all.

  37. Some companies are poorly run, and some managements are crooked. We all know about Enron by now. OS.com may be one of them. So what? This doesn’t discount any of my points at all.

  38. It looks like Patrick’s leveraged stock manipulation scheme is unraveling. Too bad I can’t borrow any shares to short. But i can load up on $17.50 April and June puts, which just might cause an MM to make some legal naked short sales, if the MM doesn’t have offsetting calls, to stay risk neutral. Of course people who then have no way of knowing the difference between legit market making and illegal naked shorting will claim that it was illegal because that’s what fits with their perpetual victimhood narrative.

  39. Why don’t you enlighten us as to “the difference between legit market making and illegal naked shorting”? You sound like someone who knows. Please explain…in 500 words or less. 🙂

  40. If I buy 4 contracts (woo!) and an MM then shorts 1000 shares (without borrowing them!) to maintain a risk neutral position that’s legal. If I sell 1000 shares (woo!) and tell by broker that I’ll FedEx them right away, that’s illegal. Now tell us how you know which has happened.

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