Should naked short selling be illegal

The bad guys on Wall Street

Pegasus Wireless shares have been hit hard. Since the company from Fremont, California, was listed on the renowned US technology exchange Nasdaq for $ 13 in April, the share price has plummeted by a whopping 95 percent. It had started so well. The stocks were included in the index of the 2000 largest US companies and bought by good names such as Goldman Sachs, Vanguard and the Ohio Public Employees Pension Fund.

But then everything got out of control: the share price, which was quoted at almost $ 19 at the end of May, plummeted, stock market turnover rose to one million shares a day - a high turnover for a company with 65 million tradable shares. Although Pegasus increased its profits and announced an exciting technology with which videos can be transferred wirelessly from the home PC to TV sets in the household.

What happened? Pegasus was a victim of "naked short selling", in English: "naked short selling". Short sellers are investors who bet on falling share prices. They borrow shares from a broker for a fee and sell them on the stock exchange. If the rate falls, they cover up again cheaper and collect the profit.

So-called "naked" short sellers do not even try to borrow the papers they are selling beforehand. According to the stock exchange supervisory authority, the broker is obliged to check whether there are enough lendable stocks before a short sale, but he does not have to check whether the short seller actually lends these stocks. Anyone who buys such a non-existent share receives a promissory note upon settlement. Only later, when the short seller has covered up, is the promissory note exchanged for the share.

Naked short selling opens the door to price manipulation: Because you can throw any number of shares on the market, you are tempted to consciously depress prices. Anonymous smear campaigns by email often do their part. "These people lie, cheat, and steal," said Wes Christian, a Houston attorney who represents the Internet department store Overstock.com and more than a dozen other affected public companies. "This is the largest commercial scam in US history."

Naked short selling is not illegal unless there is evidence of deliberate price manipulation. This is usually problematic. Small, listed companies are often affected, which could be driven into ruin by falling prices. If the share price is once in the cent range, customers and suppliers are concerned about the continued existence of the company and may withdraw. Mere speculation becomes a self-fulfilling prophecy. "Many on Wall Street think that naked short sellers are often used as scapegoats for boards of directors of poorly managed companies," says corporation lawyer Peter Chepucavage. "They are simply regarded as whimpers."

But Philip Marcum, head of Metretek Technologies in Denver, doesn't really need any excuses for his performance: "We're a real company with real investors and real sales," says the 62-year-old, whose company sells meters for gas pumps. By the end of March, the share price had quintupled.

But on March 30, stocks fell seven percent in one day as the number of stocks traded soared from an average of 11,000 to 169,000. "You can't punish anyone for speculating against a share," says Marcum. "But short sellers also have to obey rules. I think there should be very serious penalties for people selling a stock without even borrowing it."

The US Securities and Exchange Commission has recognized the problem, but the measures are not effective. Since January 2005, the stock exchanges have been obliged to keep a list of all companies that have at least 10,000 undelivered shares or 0.5 percent of the tradable paper on five days in a row.

If a stock appears on the list, all new deals must be completed within two and a half weeks, demands the SEC. When the requirement came into effect in January 2005, the number of undelivered shares briefly decreased. But then it shot up again - the flood of data is almost impossible to get under control. The list of all stock exchanges is around 450 companies long.

"Naked" short sellers are rarely caught manipulating prices. One of the exceptions: the Edwin Buckey-managed, $ 310 million hedge fund Gryphon Partners. Securities fraud is accused in 35 cases. Only small companies whose prices are easy to manipulate are affected: Medis Technology, Generex Biotech, Immune Response or PhotoMedex are among them. Buckey is said to have stolen $ 6.5 million and is being taken to court.

As recently as September, hedge fund manager Hilary Shane was accused of fraud, insider trading and "naked" short selling in five cases. She pleaded not guilty, but paid a $ 1.4 million fine in a civil law settlement. From 2002 to 2005, the SEC collected a total of just $ 24 million in fines on five "naked" short-selling cases. For comparison: In 2006 alone, all violations of the securities law were punished with fines amounting to 1.2 billion dollars.

Jasper Knabb, CEO of Pegasus Wireless, therefore resorted to a kind of vigilante justice when, in his opinion, the Nasdaq reacted inadequately to his complaints: He offered his shareholders, who had remained loyal to the company during the price decline, a special dividend. The catch: if you wanted to collect it, you had to register your share by name. After that, it can no longer be lent to short sellers. If enough ordinary shareholders request registration, brokers are forced to reclaim borrowed shares from short sellers. They then have to buy into the market.

Knabb initially achieved its goal: The price of Pegasus rose by a whopping 30 percent to $ 7.60. However, it is still unclear whether he will be able to keep his company alive. His new video streaming product, which is supposed to be on the market before competing offers from Apple or Cisco Systems, has to find buyers first. The rate today is $ 1.50. However, Knabb is optimistic - he has five more products in the pipeline and is considering a license agreement with Microsoft. "We will survive."