short sales q & a

7/21/2019 Short Sales Q & A

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Securities Lawyer 101

Short Sales Q & A

Published by:Hamilton & Associates Law Group, P.A.101 Plaza Real South, Suite 202 NorthBoca Raton, Florida 33432www.securitieslawyer101.com



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Boca Raton, FL 33432

Telephone: (561) 416-8956

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Short Sales Q & A

Short selling can be a legitimate trading strategy. It is often endorsed for its beneficial effects onthe securities markets, which include increasing liquidity. Short selling is also criticized. Shortsellers profit by identifying companies that are weak or overvalued, and companies whose shares

have been manipulated to rise to artificially high share prices. The most widely misunderstoodaspect of short selling is under what circumstances it becomes illegal. We created this SecuritiesLawyer 101 Series to address the most common questions we receive about Short Sales.

Q. What is a Short Sale?

A. A short sale is the sale of a security that theseller does not own but has borrowed fordelivery to the purchaser of the security. In ashort sale, the short seller speculates that the

price of a particular company’s shares willdecrease.

The Short Seller borrows shares to sell in theopen market at the stock’s then tradingprice. The loan of shares is arranged by hisbrokerage firm. The stock may come from thefirm’s own inventory, the accounts of otherclients on margin, or from anotherlender. Eventually, the Short Seller will repaythe borrowed shares by purchasing the shares

in the open market. If the stock pricedecreases as the Short Seller expected, he orshe can buy to cover at a lower price, andkeep the difference as profit. If the priceincreases, the Short Seller must pay thedifference and so will take a loss.

Q. What is a Naked Short Sale?

A. A naked short sale occurs when the shortseller does not borrow or arrange to borrow

the securities in time to make delivery to thebuyer, within the standard three-daysettlement period. As a result, the short sellerfails to deliver securities when delivery is

due. This is known as a “failure to deliver”.

Q. Did Regulation SHO make naked shortselling illegal?

A. In January 2005, the Securities and

Exchange Commission (“SEC”) launchedRegulation SHO, which was intended toreduce persistent failures to deliver. Failuresto deliver are sometimes, though not always,associated with short selling. The new ruleshave been largely successful.

Q. What is the Alternative Uptick Rule?

A. In February of 2010, the SEC adopted Rule201 under Regulation SHO; it is also known asthe Alternative Uptick Rule. The AlternativeUptick Rule restricts short selling when theprice of a security drops at least 10% in thecourse of one session. At that point, shortselling is permitted only if the price of thesecurity is above the current highest bidprice. The rule remains in effect for thatsecurity for the rest of the session, and for thefollowing day. The Alternative Uptick Rulealso requires that brokers establish, maintain,and enforce written policies and procedures

that are reasonably designed to prevent theexecution or display of a prohibited shortsale. Short selling is not illegal in thesecircumstances; it is merely regulated.






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Q. A broker-dealer shorted my company’s stock and failed to cover. Is this legal?

A: Broker-dealers who make a market in asecurity must be ready to buy and sell thesecurity on a regular and continuous basis atthe publicly quoted price, even if there are noother buyers or sellers. This results in marketmakers selling the security to a buyer evenwhen no stock is available. Because it maytake the market maker considerable time topurchase or arrange to borrow the security,he may need to sell the security short withouthaving the immediate ability to borrowshares. This is most common for marketmakers in thinly traded, illiquid stocks such assecurities quoted on the OTC Markets. Thisactivity is legal.

Q. What is T + 3?

A. Rule 204T requires that the short seller’sbroker-dealer, as opposed to the short seller,locate an entity that the broker reasonablybelieves can deliver the shares within threedays after the trade (“T+3″). If reasonable, thebroker-dealer may rely on the short seller’s

assurance that he or she has located a lenderwho can deliver the security in time forsettlement. Rule 204T made it a violation of Regulation SHO if a clearing firm fails topurchase or borrow shares to close out afailure to deliver that results from a short salein any equity security by no later than thebeginning of trading on the day after the failfirst occurs (T+4). Beyond that point,penalties will be imposed.

Q. I think a broker shorted my Company’s stock and failed to cover. Is this illegal?

A. If a broker accepts a short sale for a large

percentage of an issuer’s float without havingthe ability to cover, it may have an extremelydifficult time demonstrating it actedreasonably. Selling stock short and failing todeliver shares at the time of settlement

doesn’t necessarily violate any rules unless itwas done for the purpose of driving down thesecurity’s price. The latter is considered to bemanipulative activity and violates thesecurities laws, including Rule 10b-5 underthe Securities Exchange Act of 1934.

Q. What is a manipulative short sale?

A. Market manipulation is intentional orwillful conduct designed to deceive ordefraud investors by controlling or artificiallyaffecting the price of a security. Marketmanipulation can cause a stock’s price toincrease or, in a short sale, can cause it todecrease.

Q. Can short sellers release information aboutmy company to drive the stock price down?

A. Short sellers engage in manipulativeconduct when they attempt to drive down astock’s trading price by spreading false

and/or misleading information. This practiceis manipulative if short seller’s trade incollusion, because as the group’s sell ordershit the market, the stock price declines whilethe short sellers profit. The more precipitousthe drop, the more profit the short sellersmake, and the more devastating it is to thesecurity.

Q. What are some examples of manipulativeshort selling?

A. One example of a manipulative practicewould include announcements of negativeinformation concerning an issuer, such as






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false statements about SEC investigationsand/or trading suspensions or DTCchills. Other examples include false ormisleading statements indicating a companyhas engaged in fraudulent activity when it has

not. A common example that has come uprecently involves an alleged fraudster whofiles frivolous litigation accusing publiccompanies of spam or other illegal activitywhile at the same time his cohorts engage inshort sales of the same company. This isclearly illegal.

Another form of manipulation can occurwhen the Short Seller shorts a largepercentage of the public float of the security

he or she is trading. Under thesecircumstances, it may be difficult for the ShortSeller to establish that he or she intended tocover. His or her broker may also have

difficulty showing that he or she actedreasonably in accepting the Short Seller’sorder.

Q. Where do I report illegal short sales?

A. If you believe your company has been thevictim of illegal short selling then you shouldreport the activity to:

FINRA – Regulatory Tips1735 K Street, NWWashington, DC 20006-1500Fax: (866) 397-3290

Office of the WhistleblowerSecurities & Exchange Commission100 F Street, NE, Mail Stop 5971Washington, DC 20549Fax (703) 813-9322

For further information about Short Sales, please contact Brenda Hamilton, Securities Attorney at 101Plaza Real South, Suite 202 North, Boca Raton, Florida, (561) 416-8956, or by email [email protected]. This securities law Q&A is provided as a general informational service toclients and friends of Hamilton & Associates Law Group, P.A. and should not be construed as, and doesnot constitute legal advice on any specific matter, nor does this create an attorney-client relationship.

Please note that the prior results discussed herein do not guarantee similar results.

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