The Emperor’s New Shorts

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A number of readers wrote us after last month’s quick look at the naked short scare, unhappy with our treatment of the subject. Perhaps we would have given it more ink had we known the level of concern among subscribers about the issue. You spoke, we listened, and we’ve re-checked our premises… and we have to say that we’ve come to the same conclusion; this is a tempest in a teapot. At least for our stocks.

A number of readers wrote us after last month’s quick look at the naked short scare, unhappy with our treatment of the subject. Perhaps we would have given it more ink had we known the level of concern among subscribers about the issue. You spoke, we listened, and we’ve re-checked our premises… and we have to say that we’ve come to the same conclusion; this is a tempest in a teapot. At least for our stocks. There is potential for harm to some of the big, lumbering dinosaurs on Wall Street – but we have no objection to the tempest of evolution taking its toll there.

What tempest? There’s more than one version, but they all go something like this:

A small group of well-funded people [insert names that begin with “Sir” or “legendary”] with good connections in the financial news industry [loudest cheerleader channel goes here] are using naked short-selling to manipulate the prices of [insert latest portfolio casualty] downward. When their naked shorting has pushed prices down to giveaway levels, they buy back and make a killing. Everyone else gets hurt.

If that doesn’t quite ring a bell, trying inserting an industry that interests you, e.g., junior mining companies, and the name of a financial television personality with a gymnastic delivery… hurry, this is the speed round.

While there may be dishonest shenanigans in the financial markets… no, that’s not right. It’s not a maybe. There are fraudulent schemes afoot in every market. But the stories of excessive greed manifesting itself in naked shorting just don’t add up. Whatever misdeeds, if any, may have hurt investors lately, it’s unlikely that naked short selling has been the primary cause of hurt.

Most people, of course, have no clue what naked short selling is, but it sounds to them like something a nice person wouldn't do. Which makes it perfect fodder for a scare that will sell a lot of news (and newsletters).

So, let’s go back to the basics. What exactly is naked short selling? And is it really something you wouldn’t want the neighbors to know you’ve been up to?

In The Beginning…

If you have a brokerage account, it’s probably a cash account. You buy stocks or bonds, pay in full, and hold each security until you think it’s time to sell. Life is simple.

But if you plan to do things that are a little trickier, more ambitious and probably riskier, you’ll need a margin account. That’s where your securities go if you want to borrow against them (perhaps to leverage your position) or write put or call options. If your investing involves taking on liabilities of any kind, your broker will wrap the business in a margin account. Almost universally, the agreement governing a margin account (but not a cash account) gives the brokerage a free hand to borrow your securities and use them for its own purposes.

A margin account requires more attention than a cash account. The broker must monitor it continuously, ensuring your liabilities as a percentage of your equity meets the minimums established by the National Association of Securities Dealers (NASD) at all times. This is a very important point, and a regulatory constant in the brokerage business that imposes very real limits on what you can and can’t do – we’ll come back to this.

Selling

Plain-vanilla sale. When you sell stock, you are given three business days to settle the transaction. If you sell on Monday, for example, on Thursday your broker (i) delivers the stock to the clearinghouse that transfers it to the buyer’s broker, (ii) collects the cash proceeds, and (iii) credits the cash to your account less transaction fees.

In a typical plain-vanilla sale, the stock is already in the seller’s account, so the broker knows where to find it when settlement day comes. But if you hold the stock somewhere else, perhaps in the form of a certificate, your broker still may be willing to execute your sell order and rely on you to deposit the shares into your account within three business days – if the broker knows you well, and if the sale isn’t too large.

Conventional short sale. If you have a strong bearish opinion about a stock you don’t own, you nonetheless can sell it, by opening a margin account and depositing enough cash or securities. The broker will borrow shares from someone who does own the stock, to be ready to make delivery when settlement day comes. The borrowed shares may come from another customer with a margin account, or they may get borrowed from another broker. Either way, your brokerage ordinarily will want to have the shares in hand, or at least in clear sight, before it executes your short sale. Later, if your opinion about the stock turns out to be correct, you can buy the stock, return the shares you owe, and pocket the difference between the price at which you sold and the price at which you eventually bought.

A short sale generates more revenue for your broker than a plain-vanilla sale. The broker will charge for lending you the shares, perhaps by imposing an explicit rental fee or perhaps by sequestering the cash proceeds of your sale and earning interest on the money.

In the U.S., in order to short a stock, regulations require that the securities be “marginable,” and they must be trading over $5. This basically rules it out for OTC shares and penny stocks. As per our interview with Seth Allen last month, you can short in Canada, but that gets reported and you can get “bought in,” making it exceptionally dangerous to short a good company.

Naked short sale. A broker may execute a sale of stock you don’t own, even though neither you, the broker, nor anyone else knows for sure where the shares that will be needed to make delivery on settlement day are going to come from. Then the broker will scramble to find shares to borrow, and if it’s the stock of a small company, the scramble can get intense.

The SEC implemented regulation SHO in 2005 to prevent this, but there are market-maker exemptions (which are indefinite) and other bona-fide reasons for some wiggle-room in the system. For example, sometimes an honest investor thinks he or she knows where the shares are but is wrong. If brokers had to take physical possession of every single stock certificate they trade before entering a short sale, the whole system would slow to a crawl. The need for this wiggle-room is what allows a naked short sale to happen at all.

If the broker fails to deliver (FTD) the shares, it will fall into default with the clearinghouse where it settles trades with other brokers. In the U.S., the broker has ten days to clear this up or face hefty fines. And if that’s not bad enough, get too many FTDs and you lose your license. We’ve had detailed conversations with several brokers we deal with in the U.S., and they assure us that while there are theoretically 13 days before fines are levied and licenses are threatened, things get “very uncomfortable” if an FTD persists over three days. You can think of FTDs as Financially Transmitted Diseases – nobody wants ‘em.

Inadvertent short sale. As noted earlier, a broker may execute a sale for a cash account in anticipation that the account owner will promptly deliver the stock. In that case, it’s possible, for a number of honest, if not laudable, reasons, that the account owner will fail to hand over the stock on time – possibly because the custodian that’s holding the shares (perhaps another broker) doesn’t move quickly enough to transfer them, or the shares weren’t in the safe deposit box where the owner was sure he’d put them, or the dog didn’t eat his homework but did chow down on a stock certificate.

When that happens, what was intended to be a plain-vanilla sale turns out to be a naked short sale. And the consequences are the same as with any other naked short sale – the broker scrambles to borrow the shares. And if it is unable to do so by settlement day, the clearinghouse cleans things up and sends the bill to the broker, who passes it on to the account owner. In addition, the broker sends the account owner a message to the effect of “Congratulations! You now have a margin account.” The broker also will make a note that the account owner is a flake.

Effects Of Selling

“Short sale” is a term our language has given us, but in some ways the expression is unhelpful. Even though it seems to do so, the word “short” doesn’t refer to a type of sale. It refers instead to the obligation the seller assumes. So a short sale, whether naked or fully clothed, will have the same effect on a stock’s price as any other sale: it tends to lower the price of the stock, especially if the stock in question is thinly traded or has a small market cap.

This fact is where suspicions and cries of “Foul!” about naked short selling begin. A short sale that’s big enough can hurt the stock’s price, so the suspicion runs, and allow the short seller to buy the shares back on the cheap. And because a naked short sale can be executed without first rounding up the shares that will be needed on settlement day, a naked short sale can be big, big, big – which would be just the ticket for slamming a stock’s price.

This line of thinking fails to hold together for two basic reasons:

One. Even though a naked short sale bypasses the need to find the shares before the sale is executed, the seller doesn’t have a blank check to sell as many shares as he or she pleases. The regulators monitor these things and question unusual trades. The broker will accept a sell order only for shares representing some fraction of the value of the seller’s margin account. As one of our brokers put it:

"If I buy a million dollars worth of Moosepasture Inc. and don’t get the shares [if a permitted short becomes a naked short], I become an unsecured creditor to my clients. I’m liable for a million dollars for a $10K commission – it's not worth it. And I have to file monthly accounting reports. An unsecured receivable from another brokerage firm is not allowed as an asset, so we take a million-dollar hit to net assets. Most brokerages are only worth a few hundred thousand – a single million-dollar liability like this could invert their balance sheet, and the SEC would shut them down.

“In terms of settlements between firms, firms might have treaties… but it only works if there’s enough slack on the buyer’s balance sheet that they can cover the unsecured liability of the absent shares with other assets. And the receiver would have to trust the other firm, which just doesn't happen very often.”

Another of our brokers told us the regulators are prompt in taking action: “If you go over 13 days, you get fined, and if you do that a lot, you get your license yanked. If they catch you doing anything deliberate, they’ll yank your license.” He also told us the SEC checks their financials every month. If they see anything unusual, they call the broker. They don’t just check to make sure the brokers are not doing anything wrong; they want to make sure they are financially viable. “If you’re not, they’re all over you.” Which is why brokers are so reluctant to become the unsecured creditors of clients – which is what happens when a client naked shorts. They simply can’t tolerate large FTDs resulting from naked shorts showing up as liabilities on their balance sheets.

In short (no pun intended), only the really big players can risk trying to profit from the loopholes – and those types of funds don’t generally even notice, let alone invest in, the types of small companies we follow. Yes, some people have very big accounts, but that doesn’t free them from the reality that…

Two. All short sales must eventually be covered. If a short sale is big enough to move the price down, the subsequent buy order to acquire the shares that will need to be returned will be big enough to push the price back up. In effect, the would-be manipulator will be creating a large bid-ask spread and forcing himself to eat it. Not a winning strategy. And this difficulty would be present even if the short seller were a broker or a huge hedge fund. To “get away with it,” the naked shorter would have to induce such a scare that it sparked a wave of real plain-vanilla selling. If enough shareholders decide to bail on a company, the shorters may be able to buy back without sending the price soaring again…

But why would a sudden, unexplained drop in share price make droves of investors decide to sell? If a company has solid fundamentals, representing real value, a sudden chance to buy on the cheap could easily just bring more buyers into the market, making it that much harder for the shorter to cover.

On the other hand, if the scare hits an overvalued company… Well, it will teach management and unwary investors a lesson – this is the self-policing role short selling plays in the marketplace.

Requirements For Manipulation

A fellow newsletter writer we respect has pointed out that the market-maker exemptions and other loopholes can be used to extend FTDs way beyond the 13-day limit. There is something called a “security entitlement” a clearinghouse can create when it doesn’t have the shares to deliver. This can, in effect, “inflate” the number of shares apparently in circulation. But only a clearinghouse can do this, and it’s the clearinghouse’s obligation, and in their best interest, to clear up such entitlements ASAP.

Ask yourself when the last time was that you heard of more votes being cast in a corporate election than there were shares issued and outstanding. We’re not talking about duplicate proxies, but shares people actually think they have, but don’t, and try to vote with. This just doesn’t happen very often.

In order for there to be a large-scale and systematic abuse of this system, there would have to be a conspiracy between the large brokerages (who would bother conspiring with a little one?) and the clearinghouses. That’s exactly the sort of thing the SEC keeps a very close eye on. We just don’t buy it.

A large hedge fund could short and lie about having the borrowed shares in hand, and that might take a long time to work its way through the system. But it would take a very large and trusted player to get away with it – again, not the sort of institution that bothers with Canadian juniors.

It’s worth noting that the SEC’s recent tightening of the regs only applied to a few companies – Freddie and Fannie, first and foremost – they wanted to protect. The SEC clearly does not see the threat of a systemic abuse – they were just trying to prevent a Bear Stearns fiasco from hitting their pals.

But what if a large fund did hit a good company hard with naked short selling? Well, other aggressive shorters could see the carnage and pile on, and the first might get out intact, but the last will have to cover when there are no more shorters, driving the price right back up again. We’re sure this does happen to large, liquid companies at times – you could see evidence of naked short selling when the SEC changed the rules, and those who shorted Freddie and Fannie had to scramble to cover. This sort of thing increases the volatility of the shares involved, potentially burning many day traders and whoever jumps on the band wagon last, but would have little consequence for those who buy value and hold on for the right exit point.

So is it just an urban myth that naked short selling is a tool for market manipulation? Almost, but not quite.

There is a situation in which a short sale, naked or otherwise, can be used to profitably move a stock’s price without need for a conspiracy with a clearinghouse: when other investors have placed an abundance of stop-loss orders… and the short seller knows it.

A stop-loss is the inverse of a limit order. It tells the broker to sell if the price declines to a certain point. In such a situation, a sufficiently knowledgeable and sufficiently capitalized short seller could push the price low enough to trigger the stop-loss orders others have placed, which would further depress the price – at which point the short seller would buy back.

Such a thing is possible – but only if the stars are very delicately aligned.

What To Do

If you’ve been troubled by the stories about naked short price manipulation, especially when they center on junior resource stocks, here is a three-step program for recovering from the fear of naked short selling.

1. Worry about something else. We are going to keep hearing about naked short selling for a while. Get used to it. Unless you are invested in large companies in trouble, it should not affect you. If you are making decisions based on fundamentals and on real prospects realistically appraised, the stocks you’ll buy aren’t likely targets for such manipulation. And if the unlikely should occur, it would give you an opportunity to back up the truck at the shorter’s expense.

2. Don’t use stop-loss orders. Yes, we know you’ve read a hundred times about how smart stop-loss orders are. We’ve used them in the past – but advised against them when we entered the Wall of Worry phase of this bull market and the market got extremely volatile. This advice may seem like a warning never to pick up the small fork first, but don’t use them. They are a direct violation of the “buy low, sell high” maxim. If you’re not sufficiently confident in a stock’s fundamentals to buy it without placing a stop-loss order, don’t buy it. If you are considering placing a stop-loss on a stock you already own, think instead about selling now.

3. Turn up your noise filters. You already know that when you receive emails from strangers about buying a stock with grand but uncritically evaluated prospects, it’s time to hit the Delete key. Now you have one more reason. Unless you want to build a list of overpromoted stocks to consider shorting.

Protecting your assets is imperative in these times of fiscal insecurity. The card house called “the United States economy” will collapse sooner or later, and you’ll be glad to have taken some precautions.

One of the easiest ways to accumulate a nest egg for rougher times is to invest in precious metals—physical gold and silver—and precious metals stocks. For decades, Doug has proven that it is possible to make a double- or triple-return (and sometimes much more than that) within 12 months or less.

You don’t want to be unprepared when the walls come crashing down around you. To learn what you can do to survive financially and turn a major crisis to your advantage, click here.

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