Naked Short Selling is not as Sexy as it Sounds

In the stock market, short selling is the practice of borrowing, then selling shares of a stock that you do not own with the intention of profiting by buying them back at a lower price at a later point in time. Shorts sellers get a lot of unnecessary negative publicity in my mind. They're really just part of the stock market eco-system. Often times they're the first ones to sniff out corporate malfeasance, and they add liquidity to the market overall.
Naked short selling is an altogether different story. Naked shorting involves selling short shares that you did not borrow, which means that when it comes time to settle the trade, you have no shares to deliver to the buyer.
To illustrate: imagine you saw a house in a neighborhood that you thought was overvalued and was going to get cheaper in the future, so you sold it without the owner's permission, and at the close of escrow you did not deliver the house to the buyer because not only was it not your house, you never asked the owner if you could sell it in the first place! Aside from being dishonest, think of the problems it would cause to you, the buyer and the escrow company.

In an earlier post I talked about the class-action lawsuit brought against Vonage regarding the debacle surrounding their recent IPO. The class-action suit seeks to bring charges against the company and recover damages for all the investors that were "mislead" into investing in the company and subsequently lost money on the deal. On June 9th the NYSE decided to investigate whether or not naked short selling was at least partly to blame for the poor performance on it's first day of trading. The investigation is on going at this time.

Today the Wall Street Journal (subscription only) announced a pair of civil-antitrust lawsuits being brought against 11 of the largest prime-brokerage operations (they are responsible for making sure shares are "borrowable" and delivered upon settlement)-- including Morgan Stanley, Goldman Sachs and Bear Stearns--over the role they play in the practice of "naked short selling."

One of the lawsuits, by Electronic Trading Group LLC, which was filed in federal court in Manhattan, says the prime-brokerage services collusively condone "chronic failures to deliver by which clients are charged for
'borrowing' when in fact no borrowing actually takes place."
The lawsuits say the brokers charge fees of as much as 25% annually for hard-to-borrow stocks to which they mightn't be entitled. The prime-brokerage firms act reciprocally to avoid forcing delivery for each other's trades, the lawsuits maintain, adding that the firms instead operate a system of "phantom," book-entry transactions.

The lawsuits highlight the obscure mechanics of short selling, which are under scrutiny by regulators, including the New York Stock Exchange, in the decline of Vonage Holdings Corp., an Internet telephone-service provider whose stock price has tumbled 48% since its initial public offering May 24.

The SEC has been chronically understaffed which makes it difficult to carry out the tasks for which they've been charged. Regardless, I believe that short sellers who engage in naked shorting should be severely fined and their licenses revoked after repeated violations. The same thing applies to the prime-brokerage firms that tacitly allow it to happen. The only instance when it should be allowed is when a registered market maker is acting as the contra-party when facilitating a trade on behalf of a customer, and only then when there is a "reasonable" expectation the shares will be readily borrowable.

The class-action firm going after Vonage seems to be barking up the wrong tree.