First, Let's Kill All the Short-Sellers

Overstock.com (Nasdaq: OSTK  ) CEO Patrick Byrne is right.

"Recent concerns about short-selling have culminated in a regulatory flurry of emergency orders and amendments. What should be of concern, however, is not short-selling per se: As its devotees frequently remind us, short-selling is a vital and legitimate market activity," Byrne recently wrote in a Forbes editorial.

So why, then, is SEC Chairman Christopher Cox pushing rules that would severely limit all shorting by money managers? Has presidential candidate John McCain's stinging yet specious rebuke of his leadership at the agency caused this mostly intelligent reformer to check his brain at the door?

A ban is a ban, no matter what you call it
I'm speaking specifically of rules that would require money managers to file a new form called "SH," describing in detail their short positions at the beginning, middle, and end of every trading day in a weekly summary, Reuters reports.

That's not all. Quoting from the SEC's website:

The disclosure requirement applies only to short sales effected after 12:01 a.m. EDT on September 22, 2008, the effective date of the Order. If a manager has a short position reflecting short sales effected prior to the effective date of the Order ("Pre-Existing Short Position" or, collectively, "Pre-Existing Short Positions"), that Pre-Existing Short Position is not required to be reported under any of the columns on Form SH or for any days throughout the calendar week-long period that must be reported in the Form SH filing. Thus, the manager is not required to add that Pre-Existing Short-Position to any new short positions created after the effective date of the Order. Transactions effected after the effective date of the Order to close out that Pre-Existing Short Position also should not be reported. [Emphasis added.]

See the takeaway here? If you're a hedge fund with existing short positions, taken before midnight on Sept. 22, you needn't disclose them. But if you sell during the disclosure period, well, sorry, we need to see your records. Who dreams up this stuff?

I'll take "people who ignore the law of unintended consequences," for $200, Alex
And think about the paperwork. It's mind boggling -- and I say that as a guy who did sideline statistics for ESPN from time to time during his six years in sports PR. Imagine what money managers think.

We know how this ends if we're honest with ourselves. Increasingly onerous regulation will eventually cause funds to stop shorting, thereby extending the ban well beyond the borders of financial conglomerates such as (ahem) AutoNation (NYSE: AN  ) , IBM (NYSE: IBM  ) , and H&R Block (NYSE: HRB  ) . And when funds stop shorting, so will common investors. They'll go long as they watch prices rise and rise and rise and ...

Helloooooooo, Mr. Bubble. Not-so-nice to see you again.

From good intentions come unintended consequences, Mr. Chairman. Yeah, naked shorting is a problem, has been for years. But you know that. You also know that, while it's a good idea to shield bankers and brokers such as BB&T (NYSE: BBT  ) , US Bancorp (NYSE: USB  ) , and E*Trade Financial (Nasdaq: ETFC  ) in a credit crunch, legitimate short sellers seed the ground from which long-term stock market profits sprout. They create equilibrium -- a market of give and take. Do you really want to step on the scale?

Since this is The Motley Fool, we'll close with a quote from our beloved bard, William Shakespeare, whose Dick the Butcher says this in part 2 of Henry VI, Act IV, Scene II: "The first thing we do, let's kill all the lawyers."

Lawyers are an easy mark. We decry them till we need one. It's no different with short sellers. And mark my words: We'll need them again, right about the time when the snorting bull returns to cast a massive shadow over the Street, as he always has, every few years. Now is the time to tread carefully, sir.

Get a delicious mouthful of related Foolishness:

Fool contributor Tim Beyers is happy that the ban covers his shares of IBM. He didn't own shares in any of the other companies mentioned in this article at the time of publication. He hunts for the best of tech as a contributor to Motley Fool Rule Breakers. Here's how to try this market-beating service free for 30 days. Get access to all of Tim's Foolish writings here.

BB&T and US Bancorp are Income Investor picks. The Motley Fool's disclosure policy is short Alpaca farming. It's seen far too many late-night infomercials.


Read/Post Comments (8) | Recommend This Article (9)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 30, 2008, at 4:10 PM, jasonjim wrote:

    Ordinary short selling is a legitimate excercise necessary for an orderly stock market. Naked short selling is an abomination which should be banned completely, and the markets should be regulated severely to prevent it if bad guys persist in doing it. The bad guys should be fined the amount of the naked short sale if they are caught doing it. Nobody should be allowed to sell something they do not own or haven't legitimately borrowed. Otherwise, in the extreme more shares could be sold than actually exist which can only lead to disaster, which has actually happened as hedge funds with big bucks have conducted naked short sales on weak banks leading to their demise.

  • Report this Comment On September 30, 2008, at 10:11 PM, SPQRusa wrote:

    Where do you learn this drivel? "short sellers seed the ground from which long-term stock market profits sprout." What total baloney. As a long shareholder I have a right to NOT let you sell my shares on the open market because you are, in effect, devaluing my shares. This whole notion of short selling is a gamblers fantasy. The idea that someone can borrow my shares without permission and sell them on the open market is one of the problems with the stock market today.

  • Report this Comment On October 01, 2008, at 2:10 AM, jcdaris wrote:

    Is this right..naked Short sell example..

    My brother has a share of abc

    I ask him if I can sell it short and I'll get it off him when I have to deliver..

    My other ten brothers ask him if they can also short sell the share..

    Now we're eleven naked shorts selling ten shares that do not exist..

    When the share drops, we purchase (real shares) and we deliver the ten share that did not exist..

    And as long as we stay short with the share and we do not deliver, there are all these invisible non existent short shares (phantom shares) out there keeping the price down..

    for no apparent reason but to bring prices down with no relation what so ever to the fundamentals of the company...

    Close?

  • Report this Comment On October 01, 2008, at 9:50 AM, TMFMileHigh wrote:

    Hello jcdaris. You're sort of correct. Naked shorting would only occur if your brother *didn't have the stock to begin with.* So it'd be more like this:

    You brother tells you he's going to buy stock X. You think stock X is overvalued and tell him you'd like to short sell it, using the stock he's going to buy as your cover. But then he never does, leaving you with no shares to deliver.

    That's a naked short.

  • Report this Comment On October 01, 2008, at 11:49 AM, Foolme2x wrote:

    The common assertion that short selling is necessary for orderly markets is disingenius at best. While short selling may in some cases contribute to liquidity for some stocks, the primary contribution of short selling is to amplify the normal cyclical actions of markets for stocks. Thus, short selling is the trader/speculator's friend, but otherwise has no redeeming economic (nor social) value.

    Most seem to readily support the idea that naked shorting is and should be illegal. But the truth is that by far the majority of short selling is really naked shorting if we take an honest look at it. Does the short seller typically find someone who owns the stock in question and make arrangements to borrow it before shorting? Obviously, the answer to that question is no.

    If you owned shares in XYZ and some stranger approached you saying they would like to borrow your shares for some unspecified time (by the way with no offer of benefit to you), would you turn your certificate over to them? Without the would-be borrower even a offering a scrap of collateral? I know I would not.

    Brokers have gotten around this "problem" (which would reduce market volume and thus their commissions) by hiding somewhere in the fine print of their account agreement forms, the notation the broker will be allowed to use the shares in certain types of accounts to loan to other account holders. Has the typical brokerage account holder been aware of this provision (at least before the past few months)? No, certainly not. Even today with short sale bans being talked about on daily TV news, the majority of account holders (including all 401k, IRA, etc accounts) probably are completely oblivious to the fact that their broker may freely loan out their shares with no compensation to the account holder.

    So, should short selling be banned, or if not banned, should it be more regulated? My opinion is that it should be recognized and treated for what it is - a legal form of gambling. As such, it should be both strictly regulated and taxed commeasurate with other types of legalized gambling. Betting on sports is legal in many states, so why not shorting of stocks? But regulations are put in place to insure that the betting doesn't affect the outcome of the game, and the same should be true for shorting stocks. And as is typical for other forms of gambling, "winnings" should be taxed (withheld at payout) as ordinary income, and losses in the event that they exceed winnings should not be deductible as expense.

  • Report this Comment On October 01, 2008, at 6:09 PM, descmath wrote:

    It is very possible that the current economic crisis is driven by a short bubble. That is shorts seem to be reinvesting their winnings from their short positions in even longer short sales. I know several who intend to hold their short winnings until they become long term capital gains.

    I was expecting the short interest to drop when the market dropped. They did not. This disproves all of the claims that shorts will create economic stability.

    Tim Beyers talks about how shorts save us from stock bubbles.

    Beyer's argument that shorts saved us from the Dot Com bubble are also ridiculous. The heavy shorting started on the down side of the collapse. Short selling magnified the hurt from the collapse.

    Short selling dramatically increases market instability.

  • Report this Comment On October 02, 2008, at 3:31 PM, unfatcat wrote:

    I'm pretty new to the stock market but I've reading like crazy in recent weeks about shorts, naked shorts, the Uptick rule, combining shorts and puts, all sorts of esoteric stuff that mostly makes my head hurt. I can see how shorting is a way for gamblers to make piles of money but as to how short selling can possibly benefit the market in any way -- I don't see it. All the defenses of shorting and "explanations" I've read (like the one above) don't seem to ring true. Most of the short defenders claim shorting keeps runaway prices in check, bursts bubbles etc. and that it's critics are wimps and panic mongers.

    I have my doubts.

    Is it a bubble when stocks with solid fundamentals like good earnings and low P/E ratios continue to rise in price and earnings? I thought bubbles that needed bursting, like the dot com bubble, were about worthless stocks rising to ridiculous prices.

    I'm thinking about the current crash in commodity related stocks which are getting relentlessly driven into the ground while still showing very strong fundamentals and solid earnings. Each little rally is beaten down the next day. It's too systematic to be chalked up to panic.

    It's got to be the short sellers using their dirty little tricks to squeeze the profits out of good companies as they kill them off.

    I vote for killing them all.

  • Report this Comment On October 03, 2008, at 6:01 AM, ReinerOtto wrote:

    I am not against complete ban of short selling, but it must be properly regulated:

    - "First borrow, then sell".

    You can not sell, what you do not have.

    Very simple.

    And this must be strictly controlled, so that no double-lending/borrowing can occure.

    - There must be more explicit permission of the owner of the shares to make them available for shorting. For instance, in case you have a margin account with E*Trade, your shares are automatically available for shorting !

    And you can not do anything against it.

    So your own shares can be sold, with possible negative consequences regarding the price-per-share of your position.

    Which is really pathetic.

    Only in case, you have a cash account, then it is possible to protect your shares.

    For me, it is a real scnadal, that actualle the SEC completely banned shorting of most of financial stocks, but shorting still is allowed with other stocks. Actually, it is possible to drive down significantly the price-per-share of all stocks within 3 days. When IBM can drop about 5% in one day, this confirms pure manipulation, possible because of shorting only. And that is pure gambling, has nothing to do with a real market.

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