Naked Short Selling — A Recurring Topic

Naked short selling and its impact on the market is becoming a recurring topic. The SEC recently took the extraordinary step of banning short selling in the shares of Fannie Mae, Freddie Mac and primary dealers at commercial and investment banks unless certain steps are met in view of the current market crisis, as discussed here. Now, in the wake of criticism regarding the selective nature of the ban, the Commission is reportedly considering extending it.

In court, the SEC has had more difficulty with its short selling theories. In hedge fund cases involving the short selling of company shares in connection with a PIPE offering for example, the Commission has lost each claim it litigated with court’s rejecting the SEC’s argument that using the shares which would be registered under the resale registration statement of the PIPE violated Section 5 as discussed here.

Now, the Ninth Circuit has rejected state law claims based on naked short selling brought against the Depository Trust & Clearing Corporation, the Depository Trust Company and the National Securities Clearing Corporation. Whistler Investments, Inc. v. The Depository Trust and Clearing Corporation, Case No. 06-16088 (9th Cir. August 22, 2008).

In that case, Whistler Investments, Inc., a publicly traded company, claimed that naked short selling facilitated by the three clearing agency defendants drove down the price of its stock, thereby injuring the company and its shareholders. According to the complaint, National Securities Clearing created a Stock Borrow Program to facilitate the settlement of failure-to-deliver transactions. Under this program, when there is a failure-to-deliver settlement, it is facilitated by electronically “borrowing” the required number of shares of the undelivered security. Plaintiffs claim that, at times, the fails-to-deliver are not cured for long periods, which has the effect of creating more electronic shares in the marketplace. As a result, plaintiffs claim that Whistler’s share price is artificially driven down.

The Court affirmed the dismissal of the state law claims, concluding that they are preempted under Exchange Act Section 17A. There are two types of preemption, according to the Court. Under “field preemption,” Congress is said to have occupied the field, leaving no room for state law. Under “conflict preemption,” the statute must be examined to determine whether federal and state requirements are impossible.

Under Exchange Act Section 17A, Congress provided for the registration of clearing agencies to remove impediments to a uniform national system for the prompt and accurate clearance and settlement of securities transactions. The three defendants are registered under this Section. Rules promulgated to create the Stock Borrow Program were approved by the SEC.

The Ninth Circuit concluded that field preemption does not apply in view of the savings clause in the Exchange Act regarding state remedies. Conflict preemption however, precludes the claims brought under Nevada state law here because they directly challenge a program implementing rules approved by the SEC under Section 17A.

Other cases brought by issuers claiming that short selling caused their share price to decrease have also been dismissed. See, e.g., Atsi Communications, Inc. v. The Shaar Fund, Ltd., 493 F.3d 87 (2nd Cir. 2007) (affirming dismissal of complaint for failing to properly plead a manipulation claim, in part because it was not “plausible” within the meaning of the Supreme Court’s decision in Twombly as discussed here). Nevertheless, naked short selling seems to be a topic of continuing concern.