Order Code RS22099
March 30, 2005
CRS Report for Congress
Received through the CRS Web
Regulation of Naked Short Selling
Mark Jickling
Specialist in Public Finance
Government and Finance Division
Summary
Short sellers borrow stock, sell it, and hope to profit if they can buy back the same
number of shares later at a lower price. In effect, a short sale is a bet that a stock’s price
will fall. A short sale is said to be “naked” if the broker does not in fact borrow shares
to deliver to the buyer. When executed on a large scale, naked short sales can equal a
large portion of total shares outstanding, and can put serious downward pressure on a
stock’s price. Critics of the practice characterize it as a form of illegal price
manipulation. The Securities and Exchange Commission (SEC) recently adopted rules
designed to control short selling abuses, but calls for further restrictions on the practice
continue. This report describes the mechanics of short selling, summarizes the new SEC
rule, and analyzes the impact of short selling in the marketplace. It will be updated if
events warrant.
Short selling was best described by Daniel Drew, the Gilded Age speculator and
robber baron: “He that sells what isn’t his’n, must buy it back or go to prison.” Short
sellers borrow shares from a broker, sell them, and make a profit if the share price
subsequently drops, allowing them to buy back the same number of shares for less. In
other words, short selling is a bet that the price of a stock will fall.
Short sellers have always been unpopular on Wall Street. Like skeletons at the feast,
they seem to oppose rising values, increasing wealth, and general prosperity. However,
most market participants recognize that they provide a valuable service to the extent that
they identify companies and industries that are overvalued by investors in the grip of
irrational exuberance. By bringing such valuations down to earth, short selling can
prevent economically wasteful over-allocation of resources to those firms and sectors.
Manipulation by Short Sellers
Another persistent complaint against short sellers is that they cause artificial price
volatility. A form of manipulation common in the 19th century was the “bear raid” — a
gang of speculators would sell a stock short, causing the price to drop. They would
follow with another wave of short sales, depressing the price still further, and so on, until
the stock’s price was driven to the floor.
Congressional Research Service ˜ The Library of Congress

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In the 1930s, the Securities and Exchange Commission (SEC) adopted a regulation
to prevent bear raiding. The “uptick rule”1 states that a short sale may occur only if the
last price movement in a stock’s price was upward. This prevents short sellers from
piling onto a falling stock and setting off a downward price spiral. In the words of a
standard securities law textbook, the tick test (and related rules) “seem pretty well to have
taken the caffeine out of the short sale.”2
However, in recent years, complaints about manipulative short selling have
reappeared. Many shareholders and officers of smaller firms have identified “naked”
short selling as a source of price manipulation and have criticized the SEC’s enforcement
record.
Naked Shorting
A short sale always involves the sale of shares that the seller does not own. The
buyer, however, expects to receive real shares. Where do those shares come from?
Normally, they are borrowed by the broker from another investor or from a brokerage’s
own account. This is not difficult to do if the shares are issued by a large company, where
millions of shares change hands daily and where many shares are not registered to the
actual owners, but are held in “street name,” that is, in the broker’s account. With smaller
corporations, however, the number of shares in circulation may be limited, and brokers
may find it difficult to locate shares to deliver to the buyer in a short sale transaction.
When shares are not located to “cover” a short sale, the short position is said to be
naked. If shares are not found by the time the transaction must be settled, there is a
“failure to deliver” shares to the buyer. If it occurs sporadically and on a small scale,
naked short selling does not raise serious manipulation concerns. However, when the
number of shares sold short represents a significant fraction of all shares outstanding,
there may be a strong impact on the share price. In such cases, when naked short selling
creates a virtually unlimited quantity of shares, a market based on supply and demand can
be seriously distorted. The SEC notes that “naked short sellers enjoy greater leverage
than if they were required to borrow securities and deliver within a reasonable time
period, and they may use this additional leverage to engage in trading activities that
deliberately depress the price of a security.”3
The case against naked short selling has been that by permitting short sales to occur
when there is no possibility of actually delivering shares to the buyers, brokers and dealers
accommodate manipulation. When naked short selling drives prices down, holders of the
stock understandably feel cheated. They don’t believe the stock is overvalued; they are
not selling; but the price drops anyway.
1 Rule 10a-1(a). The rule technically applies only to exchange-listed stocks, but a comparable
rule was extended to Nasdaq National Market System stocks in 1994.
2 Louis Loss, Fundamentals of Securities Regulation (Boston: Little Brown, 1983), p. 717.
3 Release No. 34-48709, “Short Sales: Proposed Rule,” Oct. 28, 2003.

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It is important to note that naked short selling is not always evidence of intent to
manipulate prices. Under certain circumstances, a market maker4 may engage in naked
short selling to stabilize the market. For example, assume that there is a sudden flurry of
buy orders for a stock. The market maker may judge the buying interest to be temporary
and not justified by any real news about the company’s prospects. It may be the result of
a questionable press release or a rumor in an Internet chat room. The market maker may
choose to sell short to avoid what in its view would be an unjustified run-up in the stock’s
price. In this situation, naked short selling by the market maker may protect investors
against manipulation.
The problem of naked shorting is largely confined to smaller firms, and is
particularly acute in small-capitalization “penny” stocks listed on the Nasdaq bulletin
board market (OTCBB).5 In these companies, the bulk of outstanding shares may be
owned by corporate insiders or by securities dealers who act as market makers, so that
relatively few shares are generally available for purchase on the open market. This means
that transactions have a proportionately greater impact on the stock price than do trades
of the same size in the shares of a larger company, making manipulation easier. In
addition to OTCBB stocks, however, smaller companies listed on the exchanges or the
Nasdaq national market may also be vulnerable to short selling abuse.
Regulation SHO
After several years of deliberation, the SEC in 2004 adopted rules designed to
control abusive naked short selling. Regulation SHO6 took effect on January 3, 2005.
The new regulation replaces existing exchange and Nasdaq rules with a uniform national
standard. Under Regulation SHO, a broker may not accept a short sale order from a
customer, or effect a short sale for its own account, unless it
! has either borrowed the security, or made a bona fide arrangement to
borrow it; or
! has reasonable grounds to believe that it can locate the security, borrow
it, and deliver it to the buyer by the date delivery is due; and
! has documented compliance with the above.
The appearance of a stock on an exchange’s “easy to borrow” list constitutes
reasonable grounds for believing that the stock can be located. Stocks on such lists tend
to be highly capitalized, with large numbers of shares in circulation.
4 Market makers are dealers who stand ready to buy or sell a stock at any time and who publish
the prices at which they are willing to trade. They are the key intermediaries on the Nasdaq; on
the New York Stock Exchange, they are called specialists.
5 The uptick rule does not apply to OTCBB stocks.
6 Release No. 34-50103, “Short Sales: Final Rule,” July 28, 2004. Available online at
[http://www.sec.gov/rules/final/34-50103.htm].

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If a broker executes a short sale, and then fails to deliver shares to the purchaser,
further restrictions on short selling may come into force. If the “fail to deliver” position
is 10,000 shares or more, for five consecutive trading days, and the position amounts to
at least 0.5% of total shares outstanding, the stock becomes a threshold security. The
exchanges and Nasdaq are now required to publish daily lists of threshold securities.
Regulation SHO specifies that if a fail to deliver position in a threshold security persists
for 13 trading days, the broker (or the broker’s clearing house) must close the short
position by purchasing securities of like kind and quantity. After the 13 days have
elapsed, the broker may not accept any more short sale orders until the fail to deliver
position is closed by purchasing securities.
The rules include exemptions for market makers engaged in bona fide market-
making activities, and for certain transactions between brokers.
Effects of Regulation SHO
The adoption of Regulation SHO has not put an end to investor complaints about
naked short selling. Complaints are heard that the SEC is not enforcing the rules
vigorously enough, that short selling continues, and that some brokers evade the 13-day
requirement by passing fail to deliver positions from one to another.7
There is anecdotal evidence that Regulation SHO has unintentionally created
opportunities for a new type of manipulation, known as the short squeeze. The threshold
securities list identifies stocks where short sellers are active. Certain traders have
reportedly made large purchases of stocks listed as threshold securities.8 When these
purchases drive the price up, pressure increases on short sellers as their positions lose
money. (If prices rise, a short seller must pay more than the proceeds of the short sale to
replace the borrowed shares.) Brokers issue margin calls to ask for more collateral to
protect themselves against default. If the short sellers cannot meet those demands, they
must close out their positions, which requires the purchase of shares, driving the price still
higher.
Is Further Action Needed?
Since it has been in effect only a few months, many observers would think it
premature to pass judgement on the effectiveness of Regulation SHO in curtailing abuses.
Critics of short selling, however, are likely to continue to press for more stringent
restrictions or even abolition of the practice. There would be several costs to such
actions.
First, as noted above, short selling can improve the functioning of the market’s price
setting mechanism. Unless they engage in illegal manipulation, short sellers can stay in
business only if they successfully identify overvalued stocks. Without the information
provided by short sellers, the market might allocate capital less efficiently.
7 “Of Stocks and Socks: Senator Bennett Bores In On SECs Dismal Naked Short Sales Record,”
FinancialWire, Mar. 14, 2005, p. 1
8 Dean Foust, “Why the Shorts Have Long Faces,” Business Week, Feb. 28, 2005, p. 86.

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Second, while restrictions on short selling discourage certain forms of manipulation,
they may encourage or facilitate others. Manipulations that involve artificially inflating
stock prices are probably more common than techniques (like naked shorting) that seek
to depress them. Rumors, false press releases, and unexpected purchases may all cause
sudden run-ups of stock prices, which may be followed (in the classic “pump-and-dump”
fraud) by sudden collapse, as the manipulators sell their shares to the unwary. Without
short selling as a counterweight, the magnitude and duration of such fraudulent run-ups
are likely to be greater.
Finally, it should be noted that the SEC has full authority to pursue securities fraud
of any type, regardless of the mechanism employed. The SEC’s enforcement record in
the recent past is open to question, but this does not necessarily indicate that the existing
statutes and regulations are overly permissive regarding manipulation of securities prices.

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