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Naked short-selling: A not-so-short story

Geschrieben von hkarner - 12. Januar 2012

Date: 12-01-2012
Source: The Economist: Schumpeter

PATRICK BYRNE (pictured) is the chief executive of Overstock, a Utah-based online retailer. But he is better known—indeed, notorious in some circles—for his campaign against Wall Street over what he has long portrayed as an unholy alliance of brokers and hedge funds bent on profiting from the illegal (or “naked”) short-selling of shares, not least those of his own firm.

Five years ago, Overstock filed a naked-shorting case in California against a bunch of Wall Street firms. The gist of the accusation was that they had conspired with clients to manipulate short sales of the company’s shares in order to allow more shorting (and thus generate bigger brokerage fees) than would otherwise have been possible. The effect, Overstock alleges, was to depress its share price.  Most of the defendants settled for undisclosed sums, leaving just Goldman Sachs and Merrill Lynch (now part of Bank of America) in the cross-hairs. Four years of discovery produced vast piles of documentation, much of it still sealed at the request of the defendants, despite efforts by several media outlets (including The Economist) to have them made public. The case was due to go to trial in March, but this week the defendants persuaded Judge John Munter to throw out the complaint. This is a blow for Mr Byrne, but he has vowed to fight on.

His opponents will be cock-a-hoop. They have long portrayed him as a nutcase who invented the naked-shorting problem to distract attention from Overstock’s chronic underperformance. Mr Byrne is as quirky as he is brainy, and prone to the occasional batty outburst. (He didn’t help his cause by suggesting that a cabal of short-sellers was led by an unidentified “Sith Lord”.) But his belief that naked shorting happens and hurts companies is genuine, and backed by lots of research. He has always defended legitimate short-selling. He insists this is a battle he did not choose, but was forced to fight because of bear raids on Overstock. He is not alone in taking aim at perceived abuses of short-selling. Last year, for instance, a number of brokers, including Goldman, BofA and Morgan Stanley, settled a case with Taser for an undisclosed sum.

Overstock will appeal the ruling. It might take solace from the fact that the court’s conclusions were based not so much on the substance of the complaint but on the narrower issue of whether the alleged crimes took place in California and thus whether it has jurisdiction over the case. An appeal court might disagree, given that a large percentage of the trades in question were transacted on the Pacific Coast Stock Exchange in San Francisco. Overstock also plans to file a new racketeering suit, on the same charges, in New Jersey, where both sides accept some the relevant trades took place, even if they disagree over their legality.

More than a plumbing problem

There is much more at stake than the amount of damages Overstock was claiming, thought to be $55m. If the case ever does get to trial, it would shed light on the huge but still opaque businesses of prime brokerage (services for hedge funds) and securities lending (the loaning, for a fee, of the shares that short-sellers are supposed to borrow before selling). Regulators have struggled to grasp the inner workings of these markets. The unredacted court documents have provided a tantalising glimpse into the complex transactions, legal or otherwise, employed by prime brokers and their clients, such as options trades that allow unsettled short positions to be rolled over regularly, keeping them under the regulatory radar.

The failure to deliver shares (and thus to settle trades) that goes hand-in-hand with naked shorting is more than just a plumbing problem: a buyer who does not receive his share cannot technically vote it. And the case has relevance far beyond smaller companies like Overstock. The huge spike in settlement failures in the shares of Lehman Brothers and other large financial groups in the turmoil of late 2008 suggests, to some, that they were subjected to sustained raids by bears that were not bothering to properly locate and borrow stock before selling it short. Lehman’s problems were so acute that it would have almost certainly collapsed anyway, but its demise may have been accelerated by naked shorting.

Furthermore, settlement failures are still a problem. It is true that there have been fewer fails in single-company stocks since the SEC further tightened up its rules on shorting (known as RegSHO) in 2008. But there are still some loopholes. The SEC has conspicuously intensified its policing of the issue over the past year. Moreover, the problem seems to have migrated. Settlement failures have increased in exchange-traded funds, or ETFs, and in mortgage-backed securities. Fails have also been an issue in the Treasury-bond market, where new penalties have been introduced for dealers who do not conduct and settle trades properly.

Goldman and Merrill have always vigorously denied they were involved in any kind of manipulative scheme. Their supporters argue that the fall in Overstock’s share price in the period in question, 2005-07, was primarily down to poor management and products, not pressure from shorts. The two brokers won a key legal victory this week. But Mr Byrne seems determined to engage on another front. “Until at least twelve Americans have had a chance to issue their own ruling on these facts, we will carry on,” he said after the ruling. Regardless of whether he begins to score victories of his own or merely goes down fighting, this saga has some way to run.

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