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In another non-surprise to Wall Street Insiders and massive surprise to the common investor, the SEC handed out several naked short selling fines over the last month, to prove to casual investors that they are still "looking out for the little guy".

The Wall Street Journal reported:

Jonathan Feldman, who was accused by the SEC of trading billions of dollars of stock and options in ways that misled other investors, was found by the judge to have engaged in a practice regulators say has grown more prevalent in recent years: "naked short selling."

The decision makes it more likely the SEC will proceed with other enforcement cases involving similar activity, say people familiar with the SEC's thinking.

An SEC administrative law judge-an independent judicial officer who rules on SEC allegations of securities-law violations-late Friday ordered Mr. Feldman to disgorge $2.7 million in profits from his alleged trading scheme and to pay a $2 million civil fine.

The judge also ordered optionsXpress Inc., a brokerage firm owned by Charles Schwab Corp (NYSE:SCHW)., to disgorge $1.6 million and to pay a $2 million civil fine for allegedly violating laws prohibiting naked short selling.

Many investors are hoping that the recent light shed on naked short selling, and the corresponding actions by the SEC are paving the way for the SEC to seriously go after what some people call the biggest problem on Wall Street - selling stock that doesn't technically exist.

This comes a year after Overstock.com's (NASDAQ:OSTK) major legal battle against both Goldman Sachs (NYSE:GS) and Merrill Lynch (NYSE:BAC).

Barron's reported last year:

Goldman and Merrill deny engaging in naked shorting or violating the securities laws and say that Overstock's characterization of the e-mails distorts their meaning. A Goldman spokesman, in a statement, calls the filing "an advocacy piece written by Overstock's lawyers that contains selective and highly misleading references to a handful of the many documents produced during the discovery process in the litigation. Overstock's argumentative references omit material information and necessary context and are rife with misleading partial quotations and inaccuracies."

Presumably, if the spokesman is correct, the full records related to the case would show that the references to the e-mails are misleading. Why, then, are Goldman and Merrill seeking to seal them? Both contend that they could reveal "trade secrets."

In its suit, Overstock had accused the prime brokers of conducting "a massive, illegal stock-market manipulation scheme" with short sellers to batter its shares. When the sealed filing surfaced, a gloating Overstock CEO Patrick Byrne maintained that it contained "but a sample of the shenanigans at Goldman and Merrill that have turned up over the course of five years and millions of pages of discovery." However, the Overstock filing appears to fall short of proving any scheme. Ironically, it does more to support longstanding complaints by some shorts-a group Byrne detests-that they're often abused by prime brokers, who impose exorbitant borrowing fees for stock, some of which might never actually be borrowed on their behalf.

In January 2012, Goldman Sachs won a dismissal of the lawsuit against them by Overstock.com.

In May of 2012, journalist Matt Taibbi released an article, "Accidentally Released..." that spoke about all of the proof of wrongdoing that surfaced during an accidental inclusion of an exhibit into a motion that entered into the public domain.

Taibbi's article stated:

The lawyers for Goldman and Bank of America/Merrill Lynch have been involved in a legal battle for some time - primarily with the retail giant Overstock.com, but also with Rolling Stone, the Economist, Bloomberg, and the New York Times. The banks have been fighting us to keep sealed certain documents that surfaced in the discovery process of an ultimately unsuccessful lawsuit filed by Overstock against the banks.

Last week, in response to an Overstock.com motion to unseal certain documents, the banks' lawyers, apparently accidentally, filed an unredacted version of Overstock's motion as an exhibit in their declaration of opposition to that motion. In doing so, they inadvertently entered into the public record a sort of greatest-hits selection of the very material they've been fighting for years to keep sealed.

The article continues:

Now, however, through the magic of this unredacted document, the public will be able to see for itself what the banks' attitudes are not just toward the "mythical" practice of naked short selling (hint: they volubly confess to the activity, in writing), but toward regulations and laws in general.

"F*** the compliance area - procedures, schmecedures," chirps Peter Melz, former president of Merrill Lynch Professional Clearing Corp. (a.k.a. Merrill Pro), when a subordinate worries about the company failing to comply with the rules governing short sales.

We also find out here how Wall Street professionals manipulated public opinion by buying off and/or intimidating experts in their respective fields. In one email made public in this document, a lobbyist for SIFMA, the Securities Industry and Financial Markets Association, tells a Goldman executive how to engage an expert who otherwise would go work for "our more powerful enemies," i.e. would work with Overstock on the company's lawsuit.

Since May of 2012, it appears Overstock has left the lawsuit alone, as nothing new has been brought to the public domain since its dismissal in 2012 and Taibbi's article in May 2012.

While I agree with the sentiment that naked short selling is generally detrimental from an ideological standpoint, I disagree with Byrne that "all shorts" are bad; they're necessary to make a Darwinistic market.

First, to understand any of this mess, you're going to need to know what naked short selling is - so let's start from the beginning with plain old short selling. Let's go with Investopedia's definition of both, so you can have a grasp from the get-go.

(source pages one & two)

Short selling - The selling of a security that the seller does not own, or any sale that is completed by the delivery of a security borrowed by the seller. Short sellers assume that they will be able to buy the stock at a lower amount than the price at which they sold short.

Naked short selling - The illegal practice of short selling shares that have not been affirmatively determined to exist. Ordinarily, traders must borrow a stock, or determine that it can be borrowed, before they sell it short. But due to various loopholes in the rules and discrepancies between paper and electronic trading systems, naked shorting continues to happen. While no exact system of measurement exists, most point to the level of trades that fail to deliver from the seller to the buyer within the mandatory three-day stock settlement period as evidence of naked shorting. Naked shorts may represent a major portion of these failed trades.

So, basically, naked short selling (yes, it's as ludicrous as it sounds) is selling stock that not only do you not own, but hasn't even been confirmed to exist in the first place. And people called me crazy when I called the financial world a destitute cesspool full of crazy tricks, backstabbing, and infinite ways to bilk the public out of their money.

CNBC.com reported last month that a $6mm fine was issued to the CBOE (where are they going to come up with that kind of money? Ha.) for their lack of training and implementation of SEC rule Reg SHO.

The CNBC.com article stated:

The CBOE agreed to pay a $6 million fine and implement major reforms to settle the SEC's charges. This is the first time an exchange has been assessed a fine for violations related to its regulatory oversight role, according to the SEC. (You can read the SEC's press release here.)

The settlement follows a decision Monday by an SEC judge to fine a former Maryland banker accused by the SEC of engaging in billions of dollars in naked short trades. The Charles Schwab owned brokerage optionsXpress and its former chief financial officer were also penalized for violating laws aimed at banning naked shorting.

A naked short trade occurs when a trader sells a stock he does not own and does not intend to borrow to deliver to the buyer. An SEC rule known as Reg SHO is meant to ban the practice, which the SEC regards as abusive and harmful to markets.

Another thing you need to understand is what Regulation SHO is, why it was enforced, and how it is (or isn't) being followed up on.

Regulation SHO, or Reg SHO for short, was a regulation that was implemented in January 2005 to update financial governance legislation that addresses short selling, and the practices surrounding short selling. The Regulation sought to establish standards that aim to prevent the opportunity to sell short for people who trade abusively or unethically. The SEC has a "key points" list about Reg SHO that can be found on their site.

Ready to have your mind blown again? The same institutions that a majority of the naked short selling takes place on, like the major markets, CBOE or the OTC Markets, are self-regulatory organizations - or SROs. What does this mean? It means that these organizations are non-governmental and have the power to come up with their own regulations and standards to safeguard investors.

In layman's terms, these organizations are responsible for holding their own feet to the fire. Sure, the SEC checks in occasionally, but it's a fallacy to think that the SEC has the time and the means to pine over every single excruciating detail of all of these organizations and sniff out any and all wrongdoing. So, naturally, people continue to abuse the system and practice of naked short selling, and the SEC tries to make a statement by making an example of someone every couple of months. It's a tall task ahead of them indeed.

The SEC press release talks about SROs' responsibility:

Self-regulatory organizations (SROs) must enforce the federal securities laws as well as their own rules to regulate trading on their exchanges by their member firms. In doing so, they must sufficiently manage an inherent conflict that exists between self-regulatory obligations and the business interests of an SRO and its members. An SEC investigation found that CBOE failed to adequately police and control this conflict for a member firm that later became the subject of an SEC enforcement action. CBOE put the interests of the firm ahead of its regulatory obligations by failing to properly investigate the firm's compliance with Regulation SHO and then interfering with the SEC investigation of the firm.

So, the SEC found that - hold onto your seats - the CBOE was simply either ignoring the rules or putting the interest of making money ahead of ethics. All of Wall Street isn't like this, but unfortunately, a lot of it is.

"Listen, here's the thing. If you can't spot the sucker in the first half hour at the table, then you ARE the sucker."

- Rounders

In my article, "My Definitive 17 Cardinal Rules for Investing Success", I try to "pull back the curtain" a little bit and prep novice traders as to what is really going on behind the scenes. I made quick mention of naked short selling, among other things:

Even if you don't think you are, you are part of the mass pool of money that makes up retail investors USA. Everything that you're looking at has already been looked at fifty times over by some analyst somewhere at a fund or firm. You are one of the sheep. Your retirement accounts and your hard earned money that you've saved with your blood, sweat and tears are gambled with on a daily basis by banks.

It's probably what you don't want to hear, but you need to know this going into the game. You also need to know that if you don't understand what the fundamentals of the market are, you don't belong anywhere near it. Put your money in a savings account, and grow it the old fashioned way.

The financial world is a dark world that exists on backstabbing, complex vocabularies and secret handshakes. These things all occur under the cloak of secrecy in the secret fraternity that is Wall Street, and if you don't have even the least bit of education on the fundamentals going in, you'll never understand the complexities; and your life savings will be systematically bilked from you and will go towards some billionaire's landscaping bill.

Generally, from an ethics standpoint, I don't have an issue with shorting stock. I think there's an argument for it making a market, and I also think it's a necessary tool for making money in certain situations. At the end of the day, the market has a very simple, Darwinian feel to it. Company posts great numbers, stock goes up. Company posts crap numbers, stock goes down. That's really the essence of the market.

Occasionally, I hear arguments from people that claim that going short, in and of itself, is unethical - and that they won't participate in it because they feel it's detrimental to companies and other investors. These people are, in my opinion, simply not cut out for investing at all. In every trade, you have a buyer and a seller. You have one person that thinks a stock is worth a certain price, and someone else content with selling at that same price - that's how trading works. Why should you not be able to responsibly and legally position yourself on the other end of a trade by going short if you want to?

Technically, with all of the new ETFs being offered (and the subsequent bazillion different positions you can take), you could probably go "long" on some things while the market crashes and make some money, but it's easier to just use the financial instrumentation made available by legally establishing short positions.

Andrew Baker at the Financial Times does a superlative job laying out the positive case for legal & responsible non-naked short selling (I highly recommend you read this entire article, located here):

Short selling is really just a way of expressing a view that a particular stock is over-valued, and it appears now that the doubts many short sellers had about the companies they shorted were more than justified. And it is important there is a powerful incentive for investors to find out what is wrong with individual companies. For example, it was shorters who were the first to work out that something was up with Enron.

Short sellers devote considerable time, effort and resources to establishing the reality behind corporate rhetoric. An enlightened supervisory regime, therefore, would observe their market signals and use them as a sort of early warning system. Rather than being a source of trouble, the practice actually offers regulators a useful way of anticipating trouble.

Finally, it is the ability to short that creates the classic "hedge" that gave the industry its name. Being able to hedge helps to prevent investors suffering losses during downturns. Investors in the hedge fund industry are increasingly institutions such as pension funds (institutional investment now forms a clear majority of all assets managed by the industry). It is surely a good thing that socially valuable investments can be protected in falling markets. In these volatile times, what better example of social utility could there be?

In line with my previous thought, there's also a faction of people that seem to think that naked short selling doesn't happen or doesn't exist. These people are akin to the people that have car problems, but don't want to look under the hood for fear of what they might see. The sooner and quicker you acknowledge what's going on "behind the curtain", the quicker you are to wind up an investing shark, rather than someone that donates to some billionaire's bar tab, while he/she sucks down tropical drinks in the Caymans.

There are an entire group of people that use naked short selling as a tool to not only manipulate markets, but to sometimes (in the case of a lot of OTC stocks) drive entire companies directly into the ground. Companies that are yet to become profitable (like a lot of legit start-up companies on the OTC markets) are often targeted. If a fund or market maker can drive the price of an illiquid and rarely traded stock down by naked shorting, it forces companies to lose value and potentially engage in dilutive financing (read more about that here). If the company goes under from loss of value, the shorter technically never has to even cover their position.

So, is Reg SHO the right idea with historically poor execution by the SEC? I think so. The SEC is trying - but, clearly not doing enough to prevent naked shorting, which is much more commonplace than people think. Don't believe me, ask any insider - any fund manager, any market maker, or any investment professional that's an insider. Chances are, they'll woefully acknowledge.

About 8 or 9 years ago, when I really got into trading on a full-time basis, I paid my regular discount broker in Arizona a visit (I was living there at the time, before moving back to the midwest). I sat him down and told him that unless he started teaching me some "tricks" and letting me in on ways to make money aside from going long, he was going to be replaced. We talked about options trading and ways to position yourself through financial instruments. I was anything but a professional trader at the time, but I was learning extremely quickly. Eager for information, I asked him to explain some things to me in depth. On his cue, the first thing he showed me how to do was sell naked puts.

John Naccarelli does a nice job laying out what naked puts are:

For those that use options to leverage, hedge or simply to generate additional income, I would like to reacquaint you to Naked or Uncovered Puts, an option strategy that is classified as high-risk by the broker-dealers. Naked puts involve selling the puts without being short the underlying security. As the seller or writer of the option, you have taken on an obligation to purchase the underlying security at the contract strike price during the option term (prior to expiration). With this strategy, the maximum potential gain is the premium received upon sale of the Put, while the maximum loss is the strike price minus the premium.

Not only did he show me, but once he knew he was going to show me the whole shebang, he got really excited about it. I remember him saying things like "That's it. The money just shows up into your account and you don't have to do anything."

The point here is less about using naked puts, and more that this was the absolute first thing that came to mind to my broker for a way for me to generate more money. This was my first look into the heads of people in the finance industry. The thought process in finance is pocket the money, by any means possible. This and this alone should speak volumes for the case against SROs and naked shorting.

I'll also add that there are a ton of reputable and ethical financial experts, many of whom I've met through this site. Like everything else in the world, finance has its good guys and its bad guys.

The Overstock case is going to prove to be the tip of the iceberg for this problem. The SEC is doing the right thing in going after traders that trade abusively, but again, has a tall task ahead of it. It's going to need to implement stricter rules and tighter regulation; something that doesn't seem to necessarily fly through Congress.

At the end of the day, it's both the institutions and the SEC that are on the hook here. Naked short selling needs to be governed tighter. The SRO smokescreen is a fallacy - expecting to "leave the cookie jar open" and trust financial insiders to play by the rules. It just doesn't happen. I hope this article served to open some traders' eyes to this ongoing problem, and to cause people to not always be content in the amount that regulators are doing to tackle this problem.

As always, I wish all traders the best of luck.

Source: Naked Short Selling: The SEC's Tall Task Ahead