Full Disclosure: Naked Shorting and Increased Regulation

No one in the business world has chaffed at the bridle bit of regulation more than the securities industry. Many argue that contractual rewards and constraints are sufficient to govern behavior, while others advocate full disclosure as a means to keep market participants honest. Regulation of naked short selling was the topic of the November 3, 2006 post to our Small Cap Copy web log entitled “Peter and Paul.” That debate, which often pits aggressive hedge fund investors against issuers, who want outright prohibition against egregious short sales of stock, is likely to continue for a while.

The discussion could be aided by consideration of a study recently completed by three professors, in which securities laws in forty-nine countries around the world were assembled into a database and analyzed. Their conclusion: financial markets should not be left to market forces alone as securities laws are conducive to strong stock market development, particularly those laws which call for disclosure and define liability for wrong doing.

The professors, Rafael Porta of Dartmouth College, Florencio Lopez-de-Silanes of the University of Amsterdam and Andrei Shleifer at Harvard University published the results of their work in the February 2006 issue of the Journal of Finance in an article entitled What Works in Securities Laws? Interestingly, they took a quantitative approach to their analysis, sifting through extensive data from prospectus requirements to enforcement agency characteristics.

The data was divided into three indices: disclosure requirements, liability standards, and public enforcement. The trio used regression techniques to test the impact of these three categories on stock market development as measured by capitalization, listed companies per capita, average IPO raise and four other factors. The tests showed that disclosure requirements and liability standards had much greater predictive power for more successful stock markets than public enforcement efforts. In simple terms, when rules are set down and penalties for noncompliance are clear, business runs better.

Going back to our discussion of naked short selling, perhaps the professors would advocate full disclosure of such discrepancies as failures to deliver stock against sales, much like the Threshold Lists published under Regulation SHO. Then there should be clear penalties and remedies for those who break the rules.

The Threshold List for November 30th included quite a variety of stocks. The Nasdaq list includes the usual members - Taser International, Inc. (TAZR: Nasdaq) and Pegasus Wireless, Inc. (PGWCE: OTC/BB) - which are the subjects of contentious debate between bears and bulls. PW Eagle, Inc. (PWEI: Nasdaq), one of the stocks profiled in our Small Cap SEARCH newsletter, is also on the list for the day, although it has been relatively controversy free.

Many contend the list represents the ordinary constraints of settling transactions. I am inclined to agree with that view at least as far as PW Eagle is concerned. I imagine that is the reasoning that the NYSE Group, Inc. (NYS: NYSE) would also put forth given that its stock was also on the November 30th NYSE Threshold List. Then again I wonder how quickly the prohibitions against naked short selling might rise, if NYS shares were the subject of the same aggressive shorting tactics as TAZR and PGWC.