SEC Taking Aim at Naked-Shorting Brokerage Clients
March 31, 2008
Seeking to bolster short-selling regulations, the Securities and Exchange Commission has proposed getting tough on customers who falsely tell their brokers they've located securities to borrow.
The proposed Rule 10b-21 addresses so-called naked shorts, in which parties selling securities short do not secure the stock for delivery. In a typical short-sale transaction, the seller borrows a security and then sells it, with the goal of purchasing it at a lower price in the future and pocketing the difference. Critics say those pursuing naked shorts are essentially creating phantom shares to sell and drive down a stock's price.
To satisfy the locate requirements of the SEC's Regulation SHO, which went into effect in 2005, broker-dealers must borrow the security, have entered a bona fide arrangement to do so, or have reasonable grounds to believe the stock can be obtained before settlement.
Under Reg SHO, broker-dealers are permitted to accept customer assurances that they have identified a source of borrowable securities. "We are concerned, however, that some short sellers may have been deliberately misrepresenting to broker-dealers that they have obtained a legitimate locate source," said the SEC in its proposal, published in the Federal Register on March 21.
However, Reg SHO requirements do not apply directly to brokers' customers, noted Michael Trocchio, senior associate attorney at Bingham McCutchen in Washington, D.C. who worked on the concept release leading up to SHO.
"Regulation SHO puts no obligations on customers," said Trocchio, adding that broker-dealers should sever relationships with repeat offenders. Brokers can find themselves in a quandary, however, when a valuable client appears to be engaging in occasional naked shorting.
The SEC is hoping to squelch such behavior with Rule 10b-21. Though Trocchio said that there are antifraud provisions that already apply to such transactions, the SEC noted that the proposed rule "would highlight the specific liability of persons that deceive about their intention or ability to deliver securities in time for settlement."
According to Trocchio, under the new rule the SEC would have to prove the seller knew or should have known he didn't own the stock and had not made arrangements to borrow it. Under existing fraud provisions, the SEC must demonstrate that a client's misrepresentation was part of a deceptive or manipulative scheme. "The current standard requires a lot more legal work and is tougher to prove factually," Trocchio said.
Rule 10b-21 is "going to discourage customers from lying to brokers," he added. "It's going to help, but it's not going to make it any easier for the regulators to detect fails."
The proposal--comments are due May 20--clarifies that the rule would also apply to broker-dealers shorting stock for their own accounts. Perpetrators would face fines and other penalties.
The SEC said that recent enforcement actions "have contributed to our concerns about the extent of misrepresentation." The agency cited its settlement in October, for more than $8 million, with hedge fund adviser Sandell Asset Management Corp., whose employees allegedly improperly marked some short sale orders "long" when they hadn't located sufficient stock to borrow.
Josh Galper, principal of Vodia Group, said the rule is likely to have limited effect on reducing fails-to-deliver.
Studying delivery failure data from Aug. 15--released by the SEC in December--the Concord, Mass.-based research firm found most fails are not "systematic," which would indicate an intention to mislead in terms of borrows or locates (Securities Industry News, March 10). "The proposed regulation targets hedge funds who tell their brokers that they have an away locate but do not deliver," Galper said. "Anecdotally, this represents a very small fraction of the fails-to-deliver that occur, making the current SEC action something of a footnote for solving ongoing naked short-selling issues."
