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When the market surged 6% last Tuesday, it was allegedly due to the rumor that the SEC would bring back the “uptick” rule (on Friday, the SEC announced it will hold an April 8th Commission meeting to propose a new uptick rule). The use of short selling by hedgies to move markets for their own gain was discussed during the conversation between Jon Stewart and Jim Cramer on Thursday. Add us to the chorus that something has to be done about short-selling. And something different than the SEC’s emergency short-selling restrictions implemented last Fall, which some argue had no impact.

We’ve always believed that naked short selling is a form of manipulation, particularly when it occurs near the market’s opening and close (even if it’s part of a hedging strategy, it’s often still manipulative). There now have been a number of stories revealing what short sellers have been doing over the past few years and it’s clear that this is destructive behavior.

It’s time that the SEC and other regulators step up. Otherwise, this is one more aspect of “deregulation” that will continue to allow some to artificially manipulate stock prices – and feed the widespread belief that the markets aren’t safe.

How to Fix It: Totally Eliminate Naked Short Selling

Many thanks to Carl Hagberg, for allowing us to reproduce his fine article below from the most recent issue of his “Shareholder Service Optimizer“:

Here’s the simple fix: We still can’t figure why smart people haven’t been able to understand exactly how naked short sales cheat investors – and how they can and do create cascades of sales to spook legitimate investors into panic selling – so the shorts can lock-in their profits, guaranteed – AND how simple the “fix” to the naked short-selling scandal really is:

Every single trade must be settled on T+3, or a mandatory buy-in must be executed by the seller’s agent…no excuses or exceptions allowed. Something the SEC is still – shockingly and wrongly allowing.

We’ve been equally surprised by the large number of very smart people who think that restoring the “uptick rule” is the solution to the problem. It isn’t – especially since with trades now moving in one-cent increments, any crook in town can create an uptick to sell on – but still fail to deliver, sale after sale, after sale, etc.

How the markets are supposed to work: Let’s patiently review what should really be simple logic, about the way securities markets are supposed to work – and also about the inexorable, but basically simple law of supply and demand:

– First, let’s remember that one of the main reasons the SEC was formed in the first place – and the main reason that SEC registration of all publicly tradable shares was (and is) required – is to prevent fraudulent “over-issuances” of securities. In other words, if 100 shares of Company-A are registered, and I own 10 of them, the SEC rules and regs are meant to assure that I own one-tenth of the company, regardless of whether the shares are $1 each or $10 each.

– Second, let’s note than when shares are “sold short” there is always, by definition, a buyer. That buyer is entitled to have possession of his shares, and all the rights pertaining thereto, on T+3. And, under the present system, the buyer’s agent automatically credits the buyer with the ownership.

– But thus, please note, it is not enough for a seller to simply “locate shares” or to simply “ascertain that shares are available for lending” as current SEC rules seem to say is sufficient: the “short seller” must literally “borrow” the shares – and literally deliver them to the buyer for cancellation and re-registration; otherwise the issuer is “over-issued.”

Let’s review: For every single day a short-seller is allowed to go “naked” – i.e., the seller or his agent has failed to deliver the shares sold for cancellation – the issue is literally “over-issued” by that number of shares.

– In other words, if I sell 10 shares and the buyer has taken ownership of ten shares … but I haven’t delivered 10 shares for cancellation… there are now 110 shares “floating” out there in our little example. And, most important to note, in economic terms, this represents a 10% dilution of the SEC-registered shares.

– Theoretically, the 10% dilution – and the accompanying economic distortion of the true “equilibrium price” of the stock – is supposed to be immediately corrected by a forced “buy-in” of the undelivered shares, which will automatically bring the price back to a market-based “equilibrium” price.

– But when the buy-in rule is not strictly enforced, as is presently the case, “smart” naked-short-sellers will make as many more naked-short-sales as they possibly can – since allowing shorters to go naked almost guarantees that the shares will continue to fall – which will allow them to “cover” at even lower market prices than if they’d been covered on time.

– Please note carefully that allowing “naked shorts” to go uncovered by T+3 creates a “double whammy” in terms of market dynamics and in terms of the economics: Not only is there a frightening drumbeat or repeated sales – that tends to encourage a barrage of covered-sales too – each “naked sale” dilutes the number of shares they’ve bought, but no shares have been presented for cancellation.

– Please note too, that if a mandatory buy-in takes place, the “outstanding shares” are immediately brought back to the registered number of shares – and the market purchase automatically assures that the price is brought to a market-based “equilibrium number”…which, of course, is the correct number from a market-based perspective.

Let’s review the math again: If I make a short sale of 10 shares of the 100 shares outstanding on Monday, and don’t deliver on Thursday – and I am not automatically bought-in – as theoretically required, Company-A is over-issued by 10%. If I decide to make another naked short sale of 10 shares – and once again fail to deliver and fail to get bought-in, Company-A is now over-issued by 20%. Make no mistake about it: the SEC is allowing this to happen every single day!

Let’s review the consequences again: The market – and the market price of the stock – are being inexorably distorted…because in reality, sellers are being allowed to sell something they do not have…or ever plan to have and for every day they are allowed to go naked they have been allowed to sell shares that should no longer truly exist under the charter and bylaws of the company – or under SEC rules.

So let’s sum up: There is absolutely nothing wrong with short selling…as long as one ponies-up the shares on settlement date…regardless of whether one owns them outright or borrows them. (If one bets the wrong way, as very often happens, and the shares go up – and pass the point where the seller “sold short” legitimate short sellers will, of course, have to “cover their bet” at some point and repay the borrowed shares – either by delivering shares they may now own or buying them at the market price, which keeps the price of said shares at the market-based “equilibrium price”).

But note: There is something that is both immoral and illegal about selling something you don’t own – or where you haven’t actually borrowed the goods to make delivery…and made delivery, pursuant to the normal terms of the sale. (And if you sold short with no intention of ever delivering the goods…that’s fraud.)

If one allows the supply of shares to multiply by 5% or 10% or more – as naked short sellers actually have done…while the “demand” to buy shares is constant, other things being equal, the price of said shares will definitely fall. (This is the first law of economics by the way). And if one adds to the normal desire to sell – by initiating a panic, fueled by sales of shares that one doesn’t own, and doesn’t intend to lay claim to and deliver try the agreed upon date…(i.e. an artificially induced ‘disequilibrium’ between real supply and real demand)…the price will fall even more!

– Broc Romanek