Those evil naked short sellers! We hateses them.

Naked short selling is the practice of selling stocks short without borrowing them. That leads to failures to deliver shares, although there is no agreement on just how bad a problem that is.

Wall Street firms tend to see it as a minor ill, and point out that naked short sellers will still have to pay up if the stock price rises. They also say that not all failures to deliver are caused by short selling, although no one seems to have any data on just how many failures come from other causes.
The S.E.C. adopted a rule — called Regulation SHO, for short — in 2004. It led to the release of lists each day of stocks with a large number of failures to deliver shares. Earlier this year, the commission proposed amendments that would toughen the rules, making it harder to execute naked short sales or to keep the positions open. Wall Street has protested that the changes could go too far, while some companies call them inadequate.

“We believe that some of the volatility in our stock may result from manipulative short-selling practices,” Barry McCarthy, the chief financial officer of Netflix, a DVD-rental firm, told the S.E.C.

An analysis he submitted indicated that the highest volume of naked shorting in his stock tended to be at the highest prices, which would seem to be an indication that the short sellers knew what they were doing. The company dropped off the failures list in late September, a few weeks before the stock shot up on good earnings.

McCarthy ’75 is one of the more prominent Ephs in corporate America. Anyone who thinks that naked shorting is an important issue in the US equity markets is an idiot. It isn’t clear from this brief article exactly what McCarthy thinks. After all, his job is to be a great CFO, not to regulate the financial markets.

But, even if you believe his analysis, it sure looks like the short sellers were doing exactly what they were supposed to do. When the stock price was unsustainably high, they sold it short, thereby preventing the price from getting even more out of whack. When the price was too low, they bought (thereby covering their shorts) and keeping the stock price nearer to where it ought to be then would have happened had they not acted.

Side note: I drafted this post 2+ years ago. (I have several hundred (!) unfinished posts in the queue.) Since then, the article was updated with this correction:

The High & Low Finance column in Business Day yesterday misstated the pattern of trading in Netflix, a DVD rental company. Data submitted by the company to the Securities and Exchange Commission indicated that the highest volume of short selling appeared to be at relatively low prices, not relatively high prices.

Maybe. But common sense suggests that this is just bunk, at least on average. If the shorts sold at low prices, then they would lose money and go out of business. They can only earn a living if, they sell high and then buy low. That someone at NetFlix spent time gathering this data and then submitting it to the SEC is not a good sign for the health of the company.

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