The Securities and Exchange Commission today announced new and stringent rules against the practice of “naked short selling”, a stripped-down version of short selling that some would say is an issue to most investors on Wall Street.
Short selling, or “shorting”, is the selling of a security you do not own. The idea is to borrow a security, and then sell it, in anticipation that the price of the security will decrease. You can then later purchase the security at a lower price and return it. Instead of buying low and selling high, you are selling high and buying low. The result is the same; you make a profit based upon the difference between the high price and the low price.
In actual practice, you would normally borrow the securities from a broker, who, in turn, might borrow them from an investor who is holding the shares long (although brokers usually borrow from a custody bank or fund management company). At some point you will buy back the stock to cover the short.
Before you can borrow a security to sell, the broker is expected to confirm that it is able to actually make delivery of the shorted securities. This is called a “locate”. If you sell a security short without a locate, it is called a naked short sale, and that’s what the SEC is clamping down on. The concern is that such naked shorting allows market manipulators to force prices down much lower than would be possible through normal short selling.
The new SEC rules take effect on Thursday, and impose a firm close-out requirement on short sellers and their brokers, requiring delivery of securities borrowed for short sales on the trade settlement date, which is three days after the transaction date, with penalties for non-compliance. The SEC rules also target short sales where sellers misrepresent their ability to deliver borrowed shares, a rule that goes into effect immediately.
In a statement Wednesday, SEC Chairman Christopher Cox said “These several actions today make it crystal clear that the SEC has zero tolerance for abusive naked short selling.”
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