Enforcement News: Naked Short Selling, Reg. SHO and Securities Fraud
Print Article- Posted on: Jun 21 2023
By: Jeffrey M. Haber
A “short sale” is the sale of a security that the seller does not own or any sale that is consummated by the delivery of a security borrowed by, or for the account of, the seller. In order to deliver the security to the purchaser, the short seller will borrow the security, typically from a broker-dealer or an institutional investor. The short seller later closes out the position by purchasing equivalent securities on the open market, or by using an equivalent security it already owned, and returning the security to the lender.
In general, short selling is used to profit from an expected downward price movement, to provide liquidity in response to unanticipated demand, or to hedge the risk of a long position in the same security or in a related security.
Although the vast majority of short sales are legal, abusive short sale practices are illegal. For example, it is prohibited for any person to engage in a series of transactions to create actual or apparent active trading in a security or to depress the price of a security for the purpose of inducing the purchase or sale of the security by others. Thus, short sales effected to manipulate the price of a stock are prohibited.
In a “naked” short sale, a seller does not borrow or arrange to borrow securities in time to make delivery to the buyer within the standard settlement period.1 As a result, the seller fails to deliver securities to the buyer when delivery is due (known as a “failure to deliver” or “fail”).
Failures to deliver may result from either a short or a long sale. There may be legitimate reasons for a failure to deliver. For example, human or mechanical errors or processing delays can result from transferring securities in physical certificate rather than book-entry form, thus causing a failure to deliver on a long sale within the standard settlement period. A fail may also result from “naked” short selling. For example, market makers who sell short thinly traded, illiquid stock in response to customer demand may encounter difficulty in obtaining securities when the time for delivery arrives.
“Naked” short selling is not necessarily a violation of the federal securities laws or the rules of the Securities and Exchange Commission (“SEC” or the”Commission”). In certain circumstances, “naked” short selling contributes to market liquidity. For example, broker-dealers that make a market in a security generally stand ready to buy and sell the security on a regular and continuous basis at a publicly quoted price, even when there are no other buyers or sellers. Thus, market makers must sell a security to a buyer even when there are temporary shortages of that security available in the market. This may occur, for example, if there is a sudden surge in buying interest in that security, or if few investors are selling the security at that time. Because it may take a market maker considerable time to purchase or arrange to borrow the security, a market maker engaged in bona fide market making, particularly in a fast-moving market, may need to sell the security short without having arranged to borrow shares. This is especially true for market makers in thinly traded, illiquid stocks as there may be few shares available to purchase or borrow at a given time.
The opposite of short selling is “long selling”. Long selling occurs when the seller owns the security being sold and has a reasonable expectation that he/she/it can deliver the security in time for settlement.
The Commission promulgated regulations that govern the short selling of equity securities.2 In that regard, as discussed below, the Commission adopted Regulation SHO to address persistent fails to deliver securities within the standard settlement period and potentially abusive “naked” short selling. The Commission was concerned that large and persistent fails to deliver could deprive shareholders of the benefits of ownership, such as voting and lending, and enable sellers that fail to deliver securities on the settlement date to use the additional freedom to engage in trading activities that could improperly depress the price of a security.
Regulation SHO
Compliance with Regulation SHO began on January 3, 2005. Regulation SHO was adopted to update short sale regulation in light of numerous market developments since short sale regulation was first adopted in 1938 and to address concerns regarding persistent failures to deliver and potentially abusive “naked” short selling.
The Commission amended Regulation SHO several times since 2005 to eliminate certain exceptions, strengthen certain requirements and reintroduce the price test restriction.
Regulation SHO has four general requirements. Relevant to today’s article is Rule 200(g).
Under Rule 200(g), broker-dealers are required to mark all sale orders of equity securities as “long,” “short,” or “short exempt.”3 An order can be marked “long” when, as discussed, the seller owns the security being sold and the security either is in the physical possession or control of the broker-dealer, or it is reasonably expected that the security will be in the physical possession or control of the broker or dealer no later than settlement. However, if a person does not own the security, or owns the security sold but it is not reasonably expected that the security will be in the possession or control of the broker-dealer prior to settlement, the sale should be marked “short.” The sale could be marked “short exempt” if the seller is entitled to rely on an exception from the short sale price test circuit breaker.4
The Locate Requirement
Before accepting a short sale order or effecting a short sale for its own account, a broker-dealer must locate the securities being sold; i.e., the broker-dealer must: (i) borrow the securities; (ii) enter into a bona fide arrangement to borrow the securities; or (iii) have reasonable grounds to believe that the securities can be borrowed so that they can be delivered on the date delivery is due.5 This requirement is generally referred to as the “locate” requirement under Regulation SHO. The source of the locate must be documented. Broker-dealers usually charge customers a fee for borrowing securities.
Deemed to Own
An investor with a net long position in a security is “deemed to own” the security under Regulation SHO.6
A seller may be deemed to own a security if, for example, (i) the person purchased, or has entered into an unconditional contract, binding on both parties thereto, to purchase it, but has not yet received the security; or (ii) the person owns a security convertible into or exchangeable for it and has tendered such security for conversion or exchange.
For purposes of order marking rules under Regulation SHO, a seller of convertible securities (i.e., other securities that are convertible into the underlying stock being sold) is not “deemed to own” the underlying common stock until the seller has tendered such convertible security for conversion or exchange.
Long Selling
Under Regulation SHO, an order to sell may be marked “long” only if two conditions are met. First, the seller must be “deemed to own” the security pursuant to Rule 200(a) through (f) of Regulation SHO.7 Second, to mark a sale long, the broker-dealer must either: (i) have possession or control of the security to be delivered; or (ii) reasonably expect that the security will be in its physical possession or control no later than the settlement of the transaction.8 If a seller does not deliver the security in time for settlement, a buyer may not get what it purchased in a timely manner, eroding trust and confidence in the markets, and potentially depriving market participants of the benefits of their bargain.
Failure to Deliver
Regulation SHO was designed, in part, to reduce “failures to deliver,” which occur when a seller fails to deliver securities that it has sold by the settlement date. According to the SEC, failures to deliver may negatively impact the market and shareholders.9 Additionally, sellers that fail to deliver securities on the settlement date may attempt to use this additional freedom to engage in trading activities to improperly depress the price of a security.10 Moreover, by not borrowing securities and, therefore, risking that it will not be able to make delivery within the standard settlement period, the seller benefits by not incurring the costs of borrowing shares.
[Eds. Note: the discussion above comes from the SEC’s website and various SEC bulletins. E.g., Investor.gov, “Short sales” (here); Investor Bulletin: “An Introduction to Short Sales” (Oct. 29, 2015) (here); Investor.gov, “Settling Securities Transactions, T+2” (here); and U.S. Securities and Exchange Commission, “Key Points About Regulation SHO” (here).]
The foregoing rules were at the center of the SEC’s enforcement action against Sabby Management LLC (“Sabby”) and its principal, Hal D. Mintz (“Mintz” and together with Sabby, the “Defendants”). SEC v. Mintz, et al., 2:23-CV-3201 (D.N.J.) (here).
SEC v. Mintz
Mintz arose from an alleged fraudulent scheme involving abusive naked short selling, order mismarking, and other violative trading practices, orchestrated by Sabby, a registered investment adviser and recidivist,11 and Mintz. As discussed below, the alleged scheme generated more than $2 million in ill-gotten gains.
According to the SEC, from at least March 2017 through May 2019, Mintz used his knowledge and experience as a trader, to game the markets and carry out the alleged fraudulent scheme by repeatedly circumventing trading rules involving at least 10 issuers on behalf of two private funds managed by Defendants (“the Private Funds”).
As alleged by the SEC, Defendants’ fraudulent scheme involved at least two forms of abusive trading.
First, Defendants allegedly mismarked sales of securities as “long” even though the sales did not qualify as long sales because the Private Funds did not own and were not deemed to own the securities being sold and did not have a net long position in the securities being sold. As a result, said the SEC, Defendants should have marked those sales as “short.” Failing to mark the sales correctly, noted the SEC, was a violation of applicable order marking rules. The SEC contended that because the sales were actually short sales that Defendants allegedly tried to disguise as long sales, and Defendants had not “located” (i.e., borrowed, arranged to borrow, or had reasonable grounds to believe that the securities could be borrowed) the shares that they sold, the sales failed to comply with the locate requirements of Regulation SHO (i.e., 17 C.F.R. § 242.200 – § 204.204).
Second, Defendants allegedly marked and sold shares “short” when they knew or recklessly disregarded that they had not borrowed or located the shares. These trades, said the SEC, also failed to comply with the locate requirements of Regulation SHO. The SEC further alleged that in each instance in which Defendants failed to make timely delivery of shares, their trading constituted “naked” short selling, which was also a violation of Regulation SHO.
According to the SEC, Defendants engaged in this fraudulent trading scheme because it was more profitable than following the order marking and locate rules. As explained in the SEC’s complaint, Defendants would not have been able to carry out their short sales, and therefore could not have profited as they did, if they had followed the rules governing long and short sales. As a result of their alleged misconduct, said the SEC, Defendants obtained at least $2 million in ill-gotten trading profits for themselves and the Private Funds.
The SEC also alleged that on occasion, Defendants used their improper sales to artificially deflate the price at which Defendants were able to convert their securities into stock. Through these abusive sales, said the SEC, Defendants acquired more stock at a cheaper price.
According to the SEC, Defendants took multiple steps to conceal their fraudulent scheme and misconduct. Defendants allegedly made false statements to the brokers executing their trades, including falsely representing that they had locates for their short sales when, in fact, they did not. In addition, Defendants allegedly submitted fraudulent order instructions to the brokers, identifying their sales as “long” in an attempt to disguise their naked short sales and their short sales for which they had not obtained locates, when they allegedly knew that they were required to identify these orders as “short” sales. But for these misrepresentations, claimed the SEC, the brokers would not have executed these trades since the trades failed to comply with Regulation SHO.
Moreover, in an attempt to hide their failure to obtain locates for their short sales and satisfy their settlement obligations, Defendants allegedly acquired the required stock after their short sales, typically by purchasing the stock from the issuer or otherwise acquiring it through conversion of other securities. The SEC claimed that Defendants knew or recklessly disregarded that these practices failed to comply with applicable trading rules that require, with very narrow exceptions not applicable in Mintz, a short seller to locate the stock prior to the short sale.
While Defendants were often able to conceal from the market their fraudulent trading scheme, on some occasions, said the SEC, Defendants were unable to deliver securities in time to cover their short sales, causing “fails-to-deliver.” Each instance in which Defendants mismarked long sales and shorts sales without locates, noted the SEC, resulted in fails-to-deliver, and therefore also constituted naked short selling.
The SEC’s complaint (here), filed in the U.S. District Court for the District of New Jersey, charged Sabby and Mintz with violations of Section 10(b) of the Exchange Act and Rules 10b-5 and 10b-21 thereunder.12 The SEC also charged Sabby with violations of Sections 204 and 206(4) of the Investment Advisers Act of 1940 and Rules 204-2 and 206(4)-7 thereunder and charged Mintz with aiding and abetting those violations. The SEC seeks permanent injunctive relief, disgorgement of ill-gotten gains plus prejudgment interest, and civil penalties.
Commenting on the complaint, Carolyn Welshhans, Associate Director of the SEC’s Division of Enforcement, stated: “The SEC alleges that Sabby and Mintz attempted to game the system and make an illegal profit. When someone uses naked shorts or other manipulative practices to cheat the market and investors, the SEC will ensure that they are held accountable.”
A copy of the press release announcing the action can be found here.
Footnotes
- The standard settlement period is two (2) business days. This settlement cycle is known as “T+2,” shorthand for “trade date plus two days.” T+2 means that when a person buys a security, payment must be received by the brokerage firm no later than two business days after the trade is executed. When a person sells a security, the person must deliver to the brokerage firm his/her/its securities certificate no later than two business days after the sale. The two-day settlement date applies to most security transactions, including stocks, bonds, municipal securities, mutual funds traded through a brokerage firm, and limited partnerships that trade on an exchange. Government securities and stock options settle on the next business day following the trade. See Investor.gov, “Settling Securities Transactions, T+2” (here).
- 17 C.F.R. § 242.200 – § 204.204.
- 17 C.F.R. § 242.200(g).
- Rule 201 of Regulation SHO generally requires trading centers to establish, maintain, and enforce written policies and procedures that are reasonably designed to prevent the execution or display of a short sale at an impermissible price when a stock has triggered a circuit breaker by experiencing a price decline of at least 10 percent in one day. Once the circuit breaker in Rule 201 has been triggered, the price test restriction will apply to short sale orders in that security for the remainder of the day and the following day, unless an exception applies.
- Rule 203(b)(1) of Regulation SHO.
- 17 C.F.R. § 242.200(c).
- 17 C.F.R. § 242.200.
- 17 C.F.R. § 242.200(g).
- See Amendments to Regulation SHO, Exch. Act Rel. No. 34-60388 (July 27, 2009).
- See id. at 6-7.
- Sabby was previously sanctioned by the Commission in connection with alleged improper short sales. On October 14, 2015, the Commissioned instituted a settled cease-and-desist proceeding, finding that Sabby violated Rule 105 of Regulation M of the Securities Exchange Act of 1934 (the “Exchange Act”) on two occasions. The Commission imposed a cease-and-desist order, disgorgement of $184,747.10 plus prejudgment interest, and a civil penalty of $91,669.95 (here).
- 17 C.F.R. § 240.10b-5 and 17 C.F.R. § 240.10b-21.
Jeffrey M. Haber is a partner and co-founder of Freiberger Haber LLP.
This article is for informational purposes and is not intended to be and should not be taken as legal advice.
