Saturday, December 9

Criminal Charges for Hedge Fund Over Naked Shorting

Don't tell me that naked shorting does not exist. Don't tell me that it is not a problem either.

When you review SEC action again brokerages, in most cases the firms agree to pay a fine but do not admit any guilt in any wrongdoing. In some cases the firms even lose their license to continue trading, in effect, removing their direct access to the stock market. This type of oversight has been criticized as a failure by the SEC to police brokerages.

However, one of the hedge funds was so brazen in it's naked shorting that even the SEC cannot ignore their illegal activity and appears ready to bring criminal charges against the firm.
Sandell Asset Management is the mystery hedge fund that securities regulators claim tried to cash in on Hurricane Katrina.

The Securities and Exchange Commission last week formally notified the New York-based fund, which has more than $4 billion under management, that it could face a civil fraud action, sources say.

The potential regulatory charges arise from some short sales Sandell made in shares of Hibernia just before it was acquired late last year by Capital One.

A spokesman for the hedge fund, which recently sent a letter to its investors alerting them to the possible action, declined to comment.

Last month first reported that the SEC was investigating an unidentified hedge fund for supposedly making improper short sales just as Katrina was laying waste to the bank's hometown. Regulators believed the hedge fund sought to profit from Wall Street speculation that the storm devastation would force Capital One to cut the price of its planned acquisition of Hibernia -- as it later did. - The Street
So why is this case so different? For one, it is hard to short a stock when there is clear documentation that there were few shares available to short.
When the hedge fund tried to short shares of Hibernia, it likely had difficulty finding a broker from whom it could borrow shares. That's because so much of the stock had been taken out circulation in anticipation of the deal with Capital One closing as intended on Sept. 1.

In mergers, shareholders of the company being acquired must "tender" their shares to their broker in order to collect on the payout. When the shares are tendered, they generally can't be lent out by brokers to short-sellers who bet against stocks.

A trader with another hedge fund said it too had been thinking about shorting shares of Hibernia after Katrina hit. But it couldn't find a broker that had shares to lend out, so it passed on the trade.

Yet sources say Sandell went ahead and shorted Hibernia anyway. The fund allegedly told brokers at several big Wall Street firms that it was borrowing shares from another brokerage and the big Wall Street firms executed the trades. - The Street
This puts the SEC in a difficult position. If they press the case and prosecute, it will further fuel the claims by those who claim that naked shorting is a problem. Looking at the NASD's own monthly Disciplinary Action Reports, I would have to agree with them that it is a problem. If they don't nail this fund to the wall for naked shorting, then that will be further evidence that the SEC is ignoring the problem.

Keep in mind that most traders like you and I can't get away with shorting improperly if you can manage to short a stock at all. That is because we trade online and have to clearly identify our trades as a short sale. The online trading programs will not let you sell any stock you want without having it in your portfolio. However, brokerages are getting in trouble time and time again for failing to mark sells as 'short Sales'. So they are either modifying your trade before it is executed, because they don't have the shares to loan, but do not want to lose your trade, or it is their traders who are regularly abusing the ability to sell shares short.

Why is it that the brokers who execute short trades be required to have the shares they are borrowing 'in-hand'?

Morgan Stanley fined $2.9 Million for Rogue Trading - 26 October 2006
Congress Should Investigate Short Selling Records - 9 June 2006
Are Brokers 'Screwing' Stockholders through Short Selling? - 6 April 2006

Sandell Under Shorting Scrutiny - The 1 Nov 06
Thomas Sandell's Execution Problem - The 3 Nov 06

'Failed To Deliver' Shares A Persistent Issue -
Not All Shares Deliver -
Overstock Short Interest Now 107% of Float on Deposit at DTCC – Overstock
Regulation SHO Threshold Security List - NASDAQ
Dividend Tax Breaks at Risk –
A Review of Current Securities Issues - US Senate
Corporate Voting Charade (PDF Format, but an excellent read) Bloomberg Markets
Hedge Funds: Got Kleenex? - Forbes
The Stock Market is Patently Unfair - The Street
NASD Suspends Broker for 90 Days - NASD
NASD NTM Disciplinary Actions Report for October - NASD (PDF)
Monthly Disciplinary Actions 2006 - NASD

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