To those who don't know better, "naked short selling" might conjure the image of an online day trader, tapping away on his keyboard in the nude. Many who do know better wish they didn't, since the reality of the illegal practice is much less amusing - especially for companies on the wrong end of the deals, such as smaller-cap biotechnology firms.
Short selling, of course, is perfectly legal, though regarded as somewhat shady by many investors (not to mention quite risky for practitioners). It involves selling shares borrowed from a broker, in hopes that the price falls and the shares then can be bought back at the lower amount, thus taking a profit and returning the borrowed stock. There's no formal certificate and the lender is not disclosed.
In naked short selling, the seller has not determined the stock can be borrowed, so the buyer never gets the phantom securities he or she thinks they have bought. More shares are traded than actually exist and the stock's value is diluted, sometimes to a degree that smaller companies can ill afford. And it's typically the small-cap and micro-cap firms trading "over the counter" that are targeted.
In certain instances, naked short selling also can be legal - that is, if it's done by a market-making entity and only for a few days, with the shares truly bought later. But that's not what investors are most concerned about.
The SEC in June voted to adopt what it calls Regulation SHO, which brought rule changes regarding short selling, but has delayed implementing SHO - which critics say is hardly enough anyway - until January. The National Association of Securities Dealers has taken steps, too, with its Short Sale Act Reporting Requirements for the OTC BB and Pink Sheet securities, but those rules also have been held up and won't take effect until late September (the previous date had been July 26).
So bad has the situation become that crusaders for more serious laws have used the term "StockGate" to describe the secret operations of short sellers, which are becoming less and less secret, if still feebly regulated. The SEC is alleged not only to drag its feet, but to have a prejudiced reason for adopting rules too weak to help small companies - rules that some say are only reiterations of what already exists.
One private investor commenting on SHO as proposed, for example, cited the requirement that broker-dealers "locate" and "annotate" trade certificates in writing before going ahead with any short sale. "The rule has merit and should be implemented," she wrote to the SEC. "However, history warns us that without an officer of the SEC standing over the shoulder of every broker-dealer's trader, this rule will be ignored, just like current rules have been ignored."
There's even an online organization gathering steam called www.investigatethesec.com.
"Naked shorting creates an imbalance between normal supply and demand and will depress any security being abused by the overselling of its stock," the website declares, adding that the practice "steals some of the greatest ideas, products and services in America. Small micro-cap companies are driven out of business by this abuse and we are left with the unknowns of what these companies and their employees had to offer our futures. The opportunities for the next Microsoft may never be felt as naked shorting snuffed out that creativity before it was ever brought to fruition. Ultimately, naked shorting steals from the very foundation of our nation as it steals the American dream of opportunity."
A Canadian firm, RGM Communications Inc., is toiling to get the word out regarding naked short selling, and is asking companies and individuals to sign the online organization's website. "Since the mid 1990's, the SEC has been aware of naked short selling and has failed to adequately respond to investor and company complaints alike," RGM's own website charges, adding that the FBI and SEC "have conducted numerous investigations into naked short selling and have followed these illegal stock sales through to money laundering and other illegal schemes. By [its] lack of enforcement and passive neglect, the SEC is therefore guilty of aiding and abetting criminal activities."
Naked short selling seems to have spread overseas in a big way, at least in Germany. To be listed there, a firm need not request it. In fact, companies might find themselves listed unawares, simply because a broker "sponsored" the company on the exchange. It happened. A lot.
Introgen Therapeutics Inc. in July saw its shares jump 32 percent after asking the Berlin-Bremen Stock Exchange to halt trading of its stock - which the exchange apparently was trading without Introgen's knowledge or consent. David Nance, Introgen's CEO, said such unauthorized listings might be part of an effort to avoid the SEC rules (such as they are) against naked short selling. Many observers had no doubt about it.
Nance's company hardly was alone. An avalanche of biotechnology firms have asked to be taken off the exchange this summer, including Commonwealth Biotechnologies Inc., Cell Genesys Inc., OxiGene Inc., Avant Immunotherapeutics Inc., Molecular Imaging Corp. and Genetronics Biomedical Inc. A handful more asked for Berlin-Bremen delisting just this month: Insmed Inc., V.I. Technologies Inc., CytRx Corp. and Mediscience Technology Corp.
But the situation is severe in the U.S., too, said Russell Godwin, RGM's president, who was a broker for 10 years.
"The proposed [SEC] rule changes aren't going to do a damned thing," Godwin told BioWorld Financial Watch, alleging that "the police aren't policing" because they want to protect the brokerage firms for which many SEC employees end up working after their stints with the commission, much the way military people work for contractors following their service and lawyers eventually become judges.
"It's a matter of time before this breaks open," he said. Although "people smarter than I am" are getting involved in the fight for reform, he added, the most likely scenario for eye-opening scandal will be a situation in which a larger firm takes over a smaller firm - and finds out shares of the smaller firm, outstanding on paper, don't exist.
"This hasn't happened yet but it will occur, most likely with a mining company or a biotech company," Godwin said, blaming electronic trading for much of the sham exchanges that take place.
"If they ever go to all electronic trading, you might as well hand the keys to the crooks," he said. n