Naked Shorting Pets.com

October 22, 2007 10:22 AM

Hypothetical Finance Filter: What would happen if I did naked shorting on a company that eventually goes out of business?

Let's say I time travel back to the halcyon days of the dot-com bubble, when Pets.com, eToys.com and several other publicly traded companies went tits up. I naked short these companies before the bubble bursts, which means I'm selling shares I don't own without any reserve. What happens if in the intervening period, before I have to deliver the shares, the company goes out of business, like Pets.com did?

Did I just get something for nothing?

posted by Cool Papa Bell to work & money (15 comments total)

yes
posted by caddis at 10:54 AM on October 22, 2007

When you say "naked short", are you referring to a speculative play rather than a hedging transaction or are you referring to the illegal practice of shorting a stock without first determining if shares can be borrowed?
posted by mullacc at 10:55 AM on October 22, 2007

Yes, you got the value of the short. It is interesting to note that at one time there was no provision for how to treat this tax wise. If you never buy it back either because you cannot or the stock stops trading, you have not closed your position so you have no tax obligation. You have not booked your gain. Now there is a provision to address this in a tax code.

Quite frankly, the likelihood of this naked short to zero happening is pretty low. Not because it is difficult to pick the right stock, but most likely, you will not be able to borrow the shares the whole way down. You will be forced to buy back the stock to return the shares you borrowed to make the short sale.

Something for nothing? No you got something for the risk you took of the stock going up and for the research you did to pick the short.
posted by JohnnyGunn at 11:56 AM on October 22, 2007

When you say "naked short", are you referring to a speculative play rather than a hedging transaction or are you referring to the illegal practice of shorting a stock without first determining if shares can be borrowed?

The speculative play. I'm honestly wondering what would happen if you sold a stock that became no longer available in the intervening period between sale and delivery (which can legally be as long as three days in some instances).

The hypothetical is that you had some kind of magic foreknowledge of the bankruptcy event before it happened.
posted by Cool Papa Bell at 12:10 PM on October 22, 2007

There is no such thing as magic foreknowledge. There is a such thing as inside information. Knowing this helps in "hypothetical situations." Like in not getting "hypotheticaly" sued.
posted by Ironmouth at 12:22 PM on October 22, 2007

most likely, you will not be able to borrow the shares the whole way down. You will be forced to buy back the stock to return the shares you borrowed to make the short sale.

What is the event or mechanism that would force the short-seller to buy and return the shares? Is this a matter of the rightful shareholder establishing standing in bankruptcy proceeds? Or maybe tax reasons?
posted by mullacc at 12:42 PM on October 22, 2007

er, proceedings
posted by mullacc at 12:43 PM on October 22, 2007

Here is a simple explanation from sec.gov. Here is a more complicated explanation, also from sec.gov.

The short answer is that there'd be a failure to deliver. Regulations are in place to prevent failures to deliver and to deal with the consequences of them when they do.

Also, you asked "What would happen if I did this?" One of the more important take home lessons here is that the rules are different for you (presumably a retail investor) and for your broker (who is, or is acting on behalf of, a market maker.) Market makers are educated, tested and licensed and presumably they wouldn't have to be asking this question.

As I understand it, the simplest explanation is that it's your broker's responsibility not to accept a short order that can't be covered. The retail investor isn't breaking the law by trying to submit such an order. Your broker can still accept such an order if they're doing it in the legitimate process of making the market. Other reasons, which are illegitimate reasons, for participating in a naked shorting transaction aren't permitted.
posted by ikkyu2 at 12:45 PM on October 22, 2007

What is the event or mechanism that would force the short-seller to buy and return the shares?

The brokerage firm retains the right to request the shares back when they lend them to you. Usually they don't ask but if the stock is plummeting to zero and company is headed towards bankruptcy they might request them to stem their losses. (The other reason is that the stock is rising and they have exceeded their margins and are forced to cover, but in the question asked the stock is just going down.)
posted by caddis at 1:00 PM on October 22, 2007

that should be you have exceeded your margins
posted by caddis at 1:01 PM on October 22, 2007

Usually they don't ask but if the stock is plummeting to zero and company is headed towards bankruptcy they might request them to stem their losses.

An real life examples of this happening? I'd be interested to read about a situation where a broker was put in a tough spot because one set of clients needed to show proof of standing as equity holders in a BK and another set of clients were trying to squeeze the last couple cents out of its short positions while shares were being kicked around on the pink sheets. I would've thought that equity holders are usually so out of the money in BK proceedings that the broker wouldn't have to bother settling their shares.
posted by mullacc at 1:12 PM on October 22, 2007

Er, I suppose clients whose shares were borrowed would be more concerned about selling and stemming loses as you said rather than anything to do with BK, but I'm still wondering how frequently this conflict comes up.
posted by mullacc at 1:19 PM on October 22, 2007

If the lender of the securities sells his stock his clearing firm will request the shares back. Your clearing firm would then have to find someone else from whom to borrow the shares. By then others will have shorted it so there are few shares to borrow or, often, in an effort to prevent shorts from putting pressure on stocks, the owners of the stocks will ask for their shares back and revoke the hypothication agreement for those shares. They will move them into a cash account. Also, stocks under $5 are not marginable and thus generally not shortable.

The owner of the shares does not give up any rights or standing as the owner of the shares when he lends them out. He often has no idea that his clearing firm has lent them. He still gets his dividend (you pay it) he still retains all rights.

Reg SHO addresses fails to deliver and the treatment of shorts.

You as the short will be able to purchase it at a lower price. That simple.
posted by JohnnyGunn at 3:01 PM on October 22, 2007

I believe there are also situations - far more common in Europe - where the owners of the underlying security will choose not to lend out their shares anymore. I've seen that happen.

Its also very common for shares for a new short not being available.

BTW - I don't believe you get your loan called just because the exact shares that you sold short were sold by the owner, but only when the total number of shares the prime broker has access to is less then the demand for shorts they have. When this happens he begins to discriminate between clients, so if you are a 50mil HF you are far more likely to have your borrow called in then if you run a 5 bil hedge fund. If you are the 5 bil fund you get called away very very rarely.

Also there is a whole arcane world of tax arbitrage surrounding stock lending that can also play into how you have created your short position.

But - yes you can get your borrowed shares called back in, but for most bigger investors it is very rare. But it is common for the price of borrow to increase. Also don't forget as a short works its actual position size decreases so you may need access to additional shares to keep you bet at the size you want, and that can often be very difficult to do.
posted by JPD at 5:06 AM on October 23, 2007

Without looking into the whole borrowed stock thing, most bankrupt companies stocks continue trading long after they go broke as the bankruptcy plays out. These shares trade on the OTC BB for a few cents, presumably to speculators hoping the assets will somehow exceed liabilities.
posted by bystander at 11:20 PM on October 23, 2007