Short selling has always been a despised but accepted fact of life for public companies. More recently, though, an increase in naked short-selling — that is, when traders sell stock short without borrowing it first to cover the position — has wreaked havoc on some companies. Vonage's recent IPO disaster, for example, is thought to be the work of naked short-selling by hedge funds. The attacks, often accompanied by vicious rumor campaigns, have been so bad that one company was forced to change its name after being targeted.
As naked short-selling becomes more widespread, regulators are looking at ways to combat the practice. In May, Utah adopted a law that fines brokers that facilitate naked short-selling. The amount can range from $10,000 a day to millions of dollars to cover all unsettled trades. Other states could soon follow Utah's lead.
Naked short-selling occurs when brokers fail to deliver securities to the buyer within the typical three-day period after "selling" shares by sending IOUs through a stock clearinghouse. The increase in selling volume, unhindered by shares available to borrow, can send the stock price into a tailspin. The practice is usually considered illegal, but not always: a loophole in federal securities laws gives market makers that sell short "thinly traded, illiquid stock" extra time to obtain the securities for delivery, according to the Securities and Exchange Commission.
In January 2005, the SEC enacted a new rule, known as Regulation SHO, to guard against naked short-selling. The rule requires all exchanges to provide a list of stocks that have been shorted and not delivered to a buyer for 5 consecutive trading days. After 13 trading days, the broker or dealer must settle the trade by buying securities "of like kind and quantity." So far, Reg SHO has not always been effective at discouraging naked shorting, says Tom Ronk, chief executive of Buyins.net, a Website that tracks short selling. He thinks the Utah law will help. "It's getting too expensive to not properly borrow stock," he explains.
It could be too late to help some companies. Shares of Nanopierce Technologies tumbled in 2001 when it became the target of naked short-sellers. The organic-feed company survived by restructuring and changing its name to VytaCorp. But CEO Paul Metzinger says other companies suffer a far worse fate: "Naked short-selling leads to the demise of a lot of small companies."