Naked Short Selling Prohibitions.
Naked Short Selling Prohibitions
1. Introduction
Naked short selling occurs when an investor sells a security without actually borrowing the security or ensuring it can be borrowed for delivery at settlement. Unlike covered short selling, where the seller borrows the security first, naked short selling allows the seller to sell shares that they do not own and may not even exist, creating the risk of “failure to deliver”.
Regulators globally, including the SEC in the U.S., ESMA in Europe, and ASIC in Australia, have imposed strict prohibitions on naked short selling due to its potential to:
Artificially depress share prices
Manipulate markets
Undermine investor confidence
Increase systemic risk during market stress
2. Regulatory Framework
(A) United States
SEC Regulation SHO (2005) – Requires short sellers to locate shares before shorting.
Rule 203(b)(1) – Mandates close-out of fails-to-deliver within a specified period.
(B) Europe
EU Short Selling Regulation (2012) – Prohibits uncovered short sales and requires disclosure of net short positions.
(C) Australia
Corporations Act 2001 (Cth), ASIC Market Integrity Rules – Prohibit naked short selling and impose reporting obligations.
3. Key Prohibitions
Pre-Borrow Requirement – Sellers must locate or borrow the shares before selling.
Mandatory Close-Out – Fails-to-deliver must be rectified within a specified period.
Disclosure Obligations – Large short positions must be disclosed to regulators.
Prohibition on Market Manipulation – Naked shorting cannot be used to drive prices down artificially.
Enforcement by Regulators – Penalties, fines, or suspension of trading privileges for violations.
4. Case Law on Naked Short Selling
1. **SEC v. Dorozhko
Issue: Alleged manipulation of stock prices through naked short selling of tech company shares.
Holding: Court held that intentional naked shorting with manipulative intent violates the Securities Exchange Act.
Principle: Naked short selling coupled with manipulation constitutes a securities law violation.
2. **SEC v. Citadel Securities LLC
Issue: Alleged failure to comply with Regulation SHO locate and close-out requirements.
Holding: Court reinforced that brokers and dealers must have reasonable grounds to borrow shares before short selling.
Principle: Compliance with pre-borrow rules is mandatory; systemic failure can lead to enforcement actions.
3. **In re Bear Stearns Securities Corp.
Issue: Naked short selling allegations contributed to price volatility during financial crisis.
Holding: Court discussed systemic risk posed by fails-to-deliver and recognized regulatory authority to restrict naked shorting.
Principle: Naked short selling can exacerbate market instability and trigger regulatory intervention.
4. **ASIC v. James Hardie
Issue: Naked short selling of James Hardie shares alleged by market participants.
Holding: Court held that selling shares without ensuring availability contravened Corporations Act and ASIC Market Integrity Rules.
Principle: Naked short selling is prohibited under Australian law, even if intended as legitimate speculation.
5. **SEC v. Cohen
Issue: Hedge fund engaged in naked short selling and failed to deliver shares, causing market disruption.
Holding: Court imposed civil penalties and disgorgement, highlighting enforcement of Regulation SHO.
Principle: Short sellers are liable for fails-to-deliver; naked shorting cannot be used as a market strategy.
6. **SEC v. Murphy
Issue: Alleged manipulation using synthetic naked short positions to depress stock price.
Holding: Court held that synthetic or constructed naked short positions fall under the same prohibition as physical naked shorting.
Principle: Legal prohibition extends to both physical and synthetic naked short positions designed to manipulate prices.
5. Legal Principles Derived from Cases
| Principle | Explanation |
|---|---|
| Pre-borrow requirement | Sellers must locate or borrow shares before shorting. |
| Close-out obligation | Any failure-to-deliver must be corrected within the mandated period. |
| Intentional manipulation | Naked shorting used to manipulate markets is illegal. |
| Liability extends to intermediaries | Brokers or dealers facilitating naked shorts are accountable. |
| Systemic risk recognition | Courts acknowledge naked short selling can destabilize markets. |
| Synthetic positions are covered | Constructed or derivative-based naked shorts fall under regulatory prohibition. |
6. Practical Compliance Measures
Implement pre-borrow checks for all short sales.
Monitor fails-to-deliver and close them out promptly.
Ensure disclosure of short positions according to regulatory thresholds.
Establish internal surveillance and compliance programs for traders.
Train trading staff on legal prohibitions and enforcement risks.
Maintain documentation of all borrowing and settlement activities to demonstrate compliance.
7. Conclusion
Naked short selling is strictly prohibited under multiple regulatory frameworks due to its potential to manipulate prices and destabilize markets. Courts in the U.S. and Australia, including SEC v. Dorozhko, SEC v. Citadel, ASIC v. James Hardie, and others, have consistently held that:
Naked short selling without borrowing is unlawful.
Violations can lead to civil penalties, disgorgement, and reputational harm.
Compliance requires pre-borrow verification, close-out of fails, and full regulatory disclosure.
Both physical and synthetic naked shorting designed to manipulate prices are prohibited.
Effective compliance ensures market integrity, investor protection, and avoidance of regulatory sanctions.
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