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.

A New Mutual Assistance Agreement; A Challenge to PCAOB Rejected

Australian agreement: The SEC announced another mutual recognition agreement on Monday, this time with the Australian Minister for Superannuation and Corporate Law and the Australian Securities and Investments Commission (“ASIC”). Under the terms of the mutual recognition agreement, the SEC and the Australian authorities agreed to consider giving exemptions to exchanges and securities brokers in their respective countries. Pursuant to this arrangement, U.S. brokers may be able to offer their services, subject to conditions, in Australia. The converse may also be true.

A key facet of the arrangement is an Enhanced Enforcement Memorandum of Understanding and a new Supervisory MOU. These agreements will allow for greater regulatory and enforcement cooperation between the SEC and the ASIC.

The SEC has frequently utilized international agreements to facilitate its enforcement investigations. This is particularly true in the insider trading areas where the Commission has had success bringing a number of cases involving trading in the U.S. securities markets from outside the country as discussed here.

As the same time the Australian markets have a less than favorable reputation among the local business community. Recent reports, discussed here, suggest that insider trading is so rampant as to be almost common place thus undermining confidence in those markets.

PCAOB: Last week, the D.C. Circuit rejected a constitutional challenge to the PCAOB, created as part of the Sarbanes Oxley Act. Free Enterprise Fun and Beckstead and Watts, LLP v. Public Company Accounting Oversight Board, No. 07-527 (D.C. Cir. Aug. 22, 2008). In a two to one decision, the court rejected a facial claim to the statute alleging that it violated the constitutional appointment power of the President and separation of powers because it does not permit adequate Presidential control of the PCAOB. Rather, Congress made the Board’s exercise of its duties subject to what the court called “comprehensive control” by the SEC. In reaching its decision, the court upheld a grant of summary judgment by the district court in favor of the Board.