Ask Securities Lawyer 101 l Short Sale Q & A

Short selling can be a legitimate trading strategy.  It is often endorsed for its beneficial effects on the securities markets, which include increasing liquidity.  It is also criticized.  Short sellers profit by identifying companies that are weak or overvalued, and companies whose shares have been manipulated to rise to artificially high share prices.  The most widely misunderstood aspect of a short sale is under what circumstances it becomes illegal.  Over the past few weeks we have been bombarded with questions concerning the activities of various short sellers and their broker-dealers and created this blog post to address some of those questions.

Question: What is a Short Sale?

A: A short sale is the sale of a security that the seller does not own but has borrowed for delivery to the purchaser of the security.  In a short sale, the short seller speculates that the price of a particular company’s shares will decrease.

The person involved in the short sale borrows shares to sell in the open market at the stock’s then trading price.  The loan of shares is arranged by his brokerage firm.  The stock may come from the firm’s own inventory, the accounts of other clients on margin, or from another lender.  Eventually, the Short Seller will repay the borrowed shares by purchasing the shares in the open market.  If the stock price decreases as the Short Seller expected, he can buy to cover at a lower price, and keep the difference as profit.  If the price increases, the Short Seller must pay the difference and so will take a loss.

Q. What is a naked short sale?

A. A naked short sale occurs the short seller does not borrow or arrange to borrow the securities in time to make delivery to the buyer within the standard three-day settlement period.  As a result, the short seller fails to deliver securities when delivery is due.  This is known as a “failure to deliver”.

Q: Did Regulation SHO make naked short selling illegal?

A: In January 2005, the Securities and Exchange Commission (“SEC”) launched Regulation SHO, which was intended to reduce persistent failures to deliver.  Fails to deliver are sometimes, though not always, associated with short selling.  The new rules have been largely successful.

Q. What is the Alternative Uptick Rule?

A. In February of 2010, the SEC adopted Rule 201 under Reg SHO; it is also known as the Alternative Uptick Rule.  The Alternative Uptick Rule restricts short selling when the price of a security drops at least 10% in the course of one session.  At that point, short selling is permitted only if the price of the security is above the current highest bid price.  The rule remains in effect for that security for the rest of the session, and for the following day.  The Alternative Uptick Rule also requires that brokers establish, maintain, and enforce written policies and procedures that are reasonably designed to prevent the execution or display of a prohibited short sale.  Short selling is not illegal in these circumstances; it is merely regulated.

Q. A broker-dealer shorted my company’s stock and failed to cover. Is this legal?

A: Broker-dealers who make a market in a security must be ready to buy and sell the security on a regular and continuous basis at the publicly quoted price, even if there are no other buyers or sellers.  This results in market makers selling the security to a buyer even when no stock is available.  Because it may take the market maker considerable time to purchase or arrange to borrow the security, he may need to sell the security short without having the immediate ability to borrow shares.  This is most common for market makers in thinly traded, illiquid stocks such as securities quoted on the OTCMarkets.  This activity is legal.

Question: What is T + 3?

A. Rule 204T requires that the short seller’s broker-dealer, as opposed to the short seller, locate an entity that the broker reasonably believes can deliver the shares within three days after the trade (“T+3”).  If reasonable, the broker-dealer may rely on the short seller’s assurance that he or she has located a lender who can deliver the security in time for settlement.  Rule 204T made it a violation of Regulation SHO if a clearing firm fails to purchase or borrow shares to close out a failure to deliver that results from a short sale in any equity security by no later than the beginning of trading on the day after the fail first occurs (T+4).  Beyond that point, penalties will be imposed.

Q. I think a broker shorted my Company’s stock and failed to cover.  Is this illegal?

A. If a broker accepts a short sale for a large percentage of an issuer’s float without having the ability to cover, it may have an extremely difficult time demonstrating it acted reasonably.  Selling stock short and failing to deliver shares at the time of settlement doesn’t necessarily violate any rules unless it was done for the purpose of driving down the security’s price.  The latter is considered to be manipulative activity and violates the securities laws, including Rule 10b-5 under the Securities Exchange Act of 1934.

Q. What is a manipulative short sale?

A Market manipulation is intentional or willful conduct designed to deceive or defraud investors by controlling or artificially affecting the price of a security.  Market manipulation can cause a stock’s price to increase or, in a short sale, can cause to decrease.

Q: Can short sellers release information about my company to drive the stock price down?

A: Short sellers engage in manipulative conduct when they attempt to drive down a stock’s trading price by spreading false and/or misleading information.  This practice is manipulative if short sellers trade in collusion, because as the group’s sell orders hit the market, the stock price declines while the short sellers profit.  The more precipitous the drop, the more profit the short sellers make, and the more devastating it is to the security.

Q. What are some examples of manipulative short selling?

A. One example of a manipulative practice would include announcements of negative information concerning an issuer, such as false statements about SEC investigations and/or trading suspensions or DTC chills.  Other examples include false or misleading statements indicating a company has engaged in fraudulent activity when it has not.  A common example that has come up recently involves an alleged fraudster who files frivolous litigation accusing public companies of spam or other illegal activity while at the same time his cohorts engage in short sales of the same company.  This is clearly illegal.

Another form of manipulation can occur when the Short Seller shorts a large percentage of the public float of the security he’s trading.  Under these circumstances, it may be difficult for the Short Seller to establish that he intended to cover.  His broker may also have difficulty showing that he acted reasonably in accepting the Short Seller’s order.

Q. Where do I report an illegal short sale?

A. If you believe your company has been the victim of illegal short selling then you should report the activity to:

FINRA – Regulatory Tips
1735 K Street, NW
Washington, DC 20006-1500
Fax: (866) 397-3290

Office of the Whistleblower
Securities & Exchange Commission
100 F Street, NE, Mail Stop 5971
Washington, DC 20549
Fax (703) 813-9322

For further information about this securities law blog post, please contact Brenda Hamilton, Securities Attorney at 101 Plaza Real S, Suite 202 N, Boca Raton, Florida, (561) 416-8956, by email at [email protected] or visit www.securitieslawyer101.com.  This securities law blog post is provided as a general informational service to clients and friends of Hamilton & Associates Law Group and should not be construed as, and does not constitute, legal and compliance advice on any specific matter, nor does this message create an attorney-client relationship.  For more information about going public and the rules and regulations affecting the use of Rule 144, Form 8K, crowdfunding, FINRA Rule 6490, Rule 506 private placement offerings and memorandums, Regulation A, Rule 504 offerings, SEC reporting requirements, SEC registration statements on Form S-1 , IPO’s, OTC Pink Sheet listings, Form 10 OTCBB and OTC Markets disclosure requirements, DTC Chills, Global Locks, reverse mergers, public shells, direct public offerings and direct public offerings please contact Hamilton and Associates at (561) 416-8956 or [email protected].  Please note that the prior results discussed herein do not guarantee similar outcomes.

Hamilton & Associates | Securities Lawyers
Brenda Hamilton, Securities Attorney
101 Plaza Real South, Suite 202 North
Boca Raton, Florida 33432
Telephone: (561) 416-8956
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www.SecuritiesLawyer101.com