By: Sam Kwan
To short a stock, the seller borrows shares of the stock, hoping that the price will go down, sells the stock, and then buys the stock at a lower price to return to the lender, but pockets the difference. Shorting stocks is a completely legal practice, naked shorting on the other hand, where one sells a stock they never possessed, is illegal.[1] The Securities and Exchange Commission (SEC) banned naked short selling after the 2008 financial crisis.[2] The practice has been back in the news within the last year, after allegations of hedge fund naked shorting surrounding “meme trading.”[3] At a House Financial Services Committee hearing in February 2021, Congresspeople asked whether GameStop’s enormous price spike and volatility was related to naked short selling.[4] The Congress members and some commentators on social media seemed to think so, while others, such as some finance writers, didn’t think naked short selling was rampant.[5]
On May 19, 2021, the Securities and Exchange Commission charged a stock brokerage firm, BTIG, LLC, for “repeatedly violating the order-marking and locate provisions of Regulation SHO, which regulates the short-selling of securities.”[6] In its complaint, the SEC alleges that BTIG mismarked sale orders from a hedge fund as “long” or “short except” that should have been marked as short sales.[7] BTIG was also alleged to not have owned nor borrowed the shares that it sold for the hedge fund, thereby committing illegal naked selling.[8] The SEC seeks from the court, among other relief, a finding that BTIG violated federal securities laws and regulations, and an order for BTIG to pay civil penalties.[9]
Returning to the GameStop example, if there truly was naked short selling going on (again, no evidence has been revealed one way or the other), then brokerages, as well as retail traders, could theoretically make even greater profits by “borrowing” more (non-existent) shares and trading them as soon as there was a price drop, without worrying about actually locating real shares.[10] If the SEC’s complaint is dismissed, or ultimately goes to trial and the court finds in favor of the defendant, other brokerages could take the same approach to short selling. As it stands, even if a trader is caught and fined, which is rare, the penalties are relatively small compared to the profits.[11]
If the SEC eventually wins its case, it could put brokerage firms on higher notice that the government regulator isn’t going to turn a blind eye. Future House Financial Services Committee hearings on the topic of naked short selling is likely to include testimony from the SEC, so there would be additional pressure on the agency to investigate allegations.[12] Any brokerages rumored of participating in GameStop naked shorting might be especially nervous. Further, a favorable ruling for the SEC would likely encourage lawsuits from individual citizens or classes against brokerages. In the competitive market of securities trading, litigation and the associated negative press could be more damaging than any SEC-levied fine.
[1] See Adam Hayes, Naked Shorting, Investopedia (Sept. 9, 2021), https://www.investopedia.com/terms/n/nakedshorting.asp.
[2] Id.
[3] See William White, Meme Stocks Mania: What Is ‘Naked Shorting’ and Why Is It Trending on Twitter?, Markets Insider (June 7, 2021 10:33 AM), https://markets.businessinsider.com/news/stocks/meme-stocks-mania-what-is-naked-shorting-and-why-is-it-trending-on-twitter-1030500804.
[4] Lucy Komisar, The GameStop Mess Exposes the Naked Short Selling Scam, The American Prospect (February 25, 2021), https://prospect.org/power/gamestop-mess-exposes-the-naked-short-selling-scam/.
[5] Wayne Duggan, Why Naked Short Selling Is Not As Prevalent As You Think, Benzinga (June 07, 2021 3:35 PM), https://www.benzinga.com/general/education/21/06/21457803/why-naked-short-selling-is-not-as-prevalent-as-you-think.
[6] SEC Charges Broker-Dealer with Order Execution Violations, Litigation Release No. 25092, SEC (May 20, 2021), https://www.sec.gov/litigation/litreleases/2021/lr25092.htm.
[7] Complaint at 2-3, Sec. and Exch. Comm’n v. BTIG, L.L.C., No. 21-civ-4521, (S.D.N.Y. filed May 19, 2021).
[8] Id. at 3.
[9] Id. at 32-33.
[10] See Josh Enomoto, Why Naked-Short Selling Accusations May Not Help GameStop Stock Bulls, InvestorPlace (July 29, 2021 6:00AM), https://investorplace.com/2021/07/why-gme-stock-naked-short-selling-accusations-not-helping/.
[11] See Lucy Komisar, The GameStop Mess Exposes the Naked Short Selling Scam, The American Prospect (February 25, 2021), https://prospect.org/power/gamestop-mess-exposes-the-naked-short-selling-scam/.
[12] Id.
