VERY IMPORTANT TO UNDERSTAND: COVERED SHORTING
While technically not the same as "naked shorting," it's effects are just as bad, more widespread, and it is just as damning of Maret Makers:
"SEC Regulation S allows US public companies to sell shares of their stock very quickly. The rule was originally intended to help growing companies to raise money without time consuming and costly regulatory interference. Unfortunately, Reg S has instead been used as one of the most common conduits for securities fraud. Reg S shares are typically sold at a significant discount to the current market price because they can only be sold overseas to non-US individuals and investment entities. The other major catch is that they can not be resold into the US market for a specified period, usually 45 days from the date of closing. The idea is that the company can raise money quickly with a minimum of regulatory requirements and the newly issued stock does not flood the market. Unfortunately in practice, this has often not been the case. Some of the buyers of Reg S shares have actually been Americans hiding behind ownership in offshore investment companies. The biggest problem with Reg S shares, however, have been violations of the required hold period. Because the Reg S shares are sold at a discount to the current market price, there is a huge temptation for the buyer to quickly resell the stock into the open market to capture and pocket the difference. This is difficult to do since the certificates are restricted. What is often done instead is the stock certificate is deposited in a foreign brokerage account (often Canadian) and then a like amount of shares are sold short. This immediately "locks in" the full amount of the difference between the discount sale and the current market price, minus commissions and margin interest. When the required hold period is up, the now unrestricted certificate is turned over to the transfer agent and the short position is eliminated. Technically, this is not "naked shorting" but "covered shorting" because the seller owns the same amount of shares it has sold short. It has the same overall effect on the stock, though, especially since the stock is sold so quickly and without the requirement of public filings current shareholders usually know nothing about it. The SEC recognizes that Reg S abuse has been a huge problem. They have begun to take steps to clean up the Reg S market.
The convertible securities that are such a problem for OTCBB companies are often called "death ride" or "death spiral" convertibles. Normal convertibles give the holder the right to convert the first security (either a stock or a bond) into another type of security (usually common stock) at a given price (i.e., since the price is fixed, the total number of shares underlying the convertible instrument is a known quantity. Death Ride's, however, are not convertible at a given price per share but instead at the number of shares required to meet the face value of the convertible instrument. For instance, if the convertible is preferred stock worth $1000 and the common stock is worth $1, then the convertible is worth 1000 common shares. However, if the common stock subsequently declines to 50 cents, then the preferred is now convertible into 2000 shares. What some buyers of the death rides do is to play them like they do Reg S shares. They deposit the convertible shares into a brokerage account and then short sell a like amount of the common stock. The short selling activity helps drive the common share price lower, which means the convertible is worth a higher amount of common shares. The additional common share equivalent is then sold short, driving the share price even lower. This almost never-ending cycle is why these instruments are called "death spirals". Since the short sellers own the convertibles, this is also considered by many to be covered shorting and not naked. If the issuer of the convertibles is on the Federal Reserve list of marginable securities, then the owner can conduct their shorting with a U.S. brokerage. If the issuer is traded on the OTCBB, then they will often use a Canadian brokerage because, in certain situations, they do allow shorting OTCBB securities.
Most individual investors cannot -legally- short bulletin board stocks in the US. There are several reasons why, but for this discussion I think it is enough to say it really is not done. If anyone doesn't know why, ask your broker or drop me a line and I will explain it further. Although individual investors cannot short these stocks, market makers can. Market makers can go short on any stock as long as it is related to ""bona fide market making activity" (Rule 3350). Naturally, the key is the term "bona fide". The NASD manual clearly states that market makers should not go short a security simply for speculative purposes. However, there are several market makers widely known to do almost nothing but short stocks for their own account. NASD rules make it extremely easy for a market maker to begin making a market in any stock very quickly, so these particular MM's often show up suddenly in many hot, high-flying OTC stocks. When they do, it is a pretty good indication that they stock price will soon be under pressure and it is a good time to take a hike. Besides the fact that market makers are professionals and some do a efficient job identifying overpriced stocks, they also have very deep pockets. Considering the average OTCBB stock has a tiny market capitalization, it doesn't take much to help nudge a stock one way or the other.
Finally, we come to the last form of shorting, the so-called "naked" shorting. Yes, it does occur in OTCBB stocks. Yes, Canadian exchanges do allow for shorting of OTCBB shares. However, the actual amount of shorting in these shares by individuals is probably a lot less than most people think. For some reason, every time an OTCBB stock goes down it seems someone starts screaming "naked shorts". The facts are that although Canadian securities regulations do allow OTCBB and other low priced shares to be both marginable and shortable, the amount of collateral required is large. For instance, to short an OTCBB stock selling for under 50 cents per share, Vancouver Stock Exchange rules require the account must have credit equal to the market value of the shorted stock plus 50 cents per share. Can an American short OTC BB shares this way? This is where it gets sticky - US regulations say no. This is almost certainly one of several areas in which the ongoing SEC investigation of Canadian brokerage firms is focusing upon. More on this later.
Just about every stock promoter likes to trot out the "naked shorting" excuse when the stock they are hyping is falling. With 20/20 hindsight (and some help from regulators' legal briefs) we can often see that these same stock were declining not because of "naked shorting" but because insiders, control persons as well as the promoters themselves were dumping huge blocks of stock into the open market. Thus, they were using the "naked shorting" excuse to cover their tracks and perhaps entice gullible investors into buying more of the stock, which is likely the promoter's own shares. Often, this selling and shorting is being done through Canadian brokerages."
