What practices are absolutely illegal in short selling?

[davidmich]

What practices are absolutely illegal in short selling? I find various books and articles vague on the matter. When is naked short selling illegal in the US? Are Canadian and US laws in agreement as to what constitutes illegal practices in shorting?
I look forward to your feedback
davidmich

[robert_columbia]

I think a few apparel vendors have been arrested at the beach for indecent exposure and were later found to have committed fraud by mislabeling skirts as short shorts.

[amorali]

Are you talking about real estate?

[Heracles]

All right, I don’t have an answer, but in the spirit of GQ I will at least provide a short definition of short selling:

@Wikipedia

In finance short selling (also known as shorting or going short) is the practice of selling securities or other financial instruments that are not currently owned, and subsequently repurchasing them (“covering”). In the event of an interim price decline, the short seller will profit, since the cost of (re)purchase will be less than the proceeds which were received upon the initial (short) sale.

and of naked short selling:

@Wikipedia

Naked short selling, or naked shorting, is the practice of short-selling a tradable asset of any kind without first borrowing the security or ensuring that the security can be borrowed, as is conventionally done in a short sale. When the seller does not obtain the shares within the required time frame, the result is known as a “failure to deliver”. The transaction generally remains open until the shares are acquired by the seller, or the seller’s broker settles the trade.

[Jonathan_Chance]

In terms of absolutely illegality on short selling, I don’t recall any coverage of it in my certification nor in my continuing education. Instead, the focus is on ‘hell no, don’t naked short!’

The reasoning behind such is because the potential loss in a naked short is essentially unlimited. Thus:

I sell a stock short at $10/share
I don’t have the stock in hand
My time is up and I’m required to deliver the shares.
I’ve guessed wrong and the shares are now valued at $infinite.
I’m screwed

Now, as mentioned above, I could fail to deliver, but that leaves the contract open and eventually I could get hammered by various peoples - the purchaser, the regulator, etc for my trifling ways.

Bloomberg does have an article about a specific kind of shorting that is illegal. Curiously, though, the piece makes the case that such might improve the market for certain securities.

Investopedia does mention that naked shorting is illegal. However, it also goes on to say that loopholes and such are available in sufficient quantity to allow it to go on.

[septimus]

There are several movies (mostly, but not all, comedies) about naked short selling. During America’s First Great Robber Baron Era, Daniel Drew was one of several famous short-sellers, winning and losing huge sums, though at the height of his famous “Erie War”, he’d changed his tactic to have the company he was shorting secretly issue shares to cover his sales. :smack: (Drew ultimately lost his “Erie War”, as shown by the fact that Commodore Vanderbilt is considered the 2nd richest American ever, while Drew doesn’t even make the Top 100 list.)

In the present climate, naked short-selling is one of those ploys “big boys” are allowed to do but the hoi polloi is not. (Even if covered, “big boys” get interest paid on their short sale proceeds, the hoi polloi does not.)

The SEC has cracked down on naked sales, though as usual I imagine the “big boys” are largely unaffected. “Shorting against the box” (where you’re not only not naked, but borrow the stock from yourself) is legal, but the IRS has cracked down on some of its tax advantages.

[Tom_Tildrum]

Under US law, insider trading is illegal in connection with short sales just as it is in connection with long transactions. Also, it is fraud to “short and distort”, spreading false rumors to drive the price down.

[Trom]

Registered market makers can execute naked short sales in the interest of maintaining a “fair and orderly” market. However, they are expected to cover their shorts as soon as possible or secure a locate for their shares sold short.

The Reg SHO Threshold Security List shows companies that have at least 0.5% of the companies’ stock sold short currently failing to deliver. List here.

You can check out historical short interest for individual stocks here.

[ethelbert]

@Jonathan_Chance

The reasoning behind such is because the potential loss in a naked short is essentially unlimited. Thus:

I sell a stock short at $10/share
I don’t have the stock in hand
My time is up and I’m required to deliver the shares.
I’ve guessed wrong and the shares are now valued at $infinite.
I’m screwed

The potential loss in any short selling is unlimited. In the case you describe if the sale had not been naked (i.e. you had actually borrowed the shares in question), your loss would have been $infinite - $10 per share.
I seem to recall that at certain times (not recently), restrictions have been placed on short selling because some people believe that it is often used as a tool to bring companies down, but I have no cites on that.

[davidmich]

Thank you all. Very helpful.
davidmich