We Told You So: “Naked Shorting” Unveiled!

Street Gears Up for Short Changes Brokerages Parse New Rules’ Details; The ‘Naked’ No-No

The Federal crackdown on short selling is causing a scramble on Wall Street, with brokerage firms racing to implement new controls before the rules take effect on Monday. The unprecedented get-tough action by the Securities and Exchange Commission means that securities firms will have to fine-tune their back-office operations to comply with the requirements.

The biggest potential headache: Existing rules allow brokers to sell stock short as long as they reasonably believe they can locate the shares and deliver them on time [emphasis added]. —The Wall Street Journal

Well, we told you so.

Thanks to the SEC’s move to restrict “naked short-selling” in a handful of financial stocks, we now know that the problem is not that hedge funds deliberately short stocks without properly borrowing them—the main charge of at least one CEO looking for a scapegoat to draw investor attention away from his own performance.

It resides with the brokers themselves. Let’s re-read that last sentence from the excerpt quoted above:

The biggest potential headache: Existing rules allow brokers to sell stock short as long as they reasonably believe they can locate the shares and deliver them on time.

Now, several years ago we here at NotMakingThisUp laid out how every hedge fund we’ve ever known goes about shorting a stock: they ask their broker for a “locate.” If the broker says the shares are located, the hedge fund borrows the shares and shorts them. If shares can’t be located, the hedge fund doesn’t sell them.

No borrow, no short-sale.

We described the process in response to a bizarre earnings call in which the CEO of the company hosting the call pretended not to know one of the questioners. The CEO did this in order to allow the questioner to describe a supposedly vast conspiracy against the company on the part of hedge funds selling the company’s stock without borrowing it.

For our efforts to set the record straight, we received a number of vituperative comments from fans of the CEO, nearly all overwhelmingly irrational, paranoid and ignorant of the facts of the case.

It was as if we had suggested that Area 51 was not the underground meeting place of government officials and extra-terrestrials, or a lab for time-travel experiments, or the headquarters of the One-World organization known as the Majestic Twelve, but merely a top-secret military base.

Thanks to the SEC’s move to limit the so-called “naked no-no,” however, we now know that the brokers themselves have been giving “locates” without always actually locating the stock.

Looks like we weren’t making it up after all.

Oh, and Area 51 really is just a top-secret military base. Sorry about that.

Jeff Matthews I Am Not Making This Up

© 2008 NotMakingThisUp, LLC

The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews’ recommendations. This commentary in no way constitutes investment advice. It should never be relied on in making an investment decision, ever. Nor are these comments meant to be a solicitation of business in any way: such inquiries will not be responded to. This content is intended solely for the entertainment of the reader, and the author.