Despite sounding like the scene from a risque, smoke-filled cabaret, hundreds of companies are finding themselves set up to be the victims of a naked shorting scam on a small and, until recently, unheard-of German bourse, the Berlin-Bremen Stock Exchange.
Short selling is a perfectly valid tactic of investors. Oftentimes, it is a short seller who uncovers the dirt of a seedy operation, or at least some weakness in a business plan. Professional short sellers are known to be very thorough in their research.
In a regular equity transaction, an investor buys shares of a company and goes "long" in the hopes that they will go higher. When it does, she sells the stock and pockets the profit. She's buying low and selling high.
A short sale works the same way, only backwards.
When an investor shorts a stock, he borrows shares from a broker's inventory and puts them back on the market, hoping the price of the shares fall. He's actually borrowing shares from someone who is long. If the price falls, he buys them back (called "covering") at the lower price and returns them to the broker. He, too, pockets the profit by selling high and buying low.
The Motley Fool's old Rule Breaker portfolio even shorted companies on occasion, like it did with Guitar Center
"Naked shorting" is a completely different kind of striptease act. There is no borrowing of shares, so there can be no returning them to the buyer. This can result in more shares being traded than were actually issued, diluting the value of the stock, which can lead to panic among legitimate investors as share prices are driven sharply lower.
Until the Securities and Exchange Commission began cracking down on the practice of naked short selling, Canada was a prime location for these operations. Now they've apparently moved overseas to Germany, to the Berlin-Bremen Stock Exchange. In fact, Investors Business Daily has said that a single broker at market-maker Berliner Freiverkehr is primarily responsible for listing hundreds of companies on the bourse without their knowledge.
Most of those listed without their knowledge are small, over-the-counter stocks like 5G Wireless (OTCBB: FGWC) and China Wireless (OTCBB: CWLC). Not exactly household names and thus more easily scammed. But a few other larger companies have been affected as well. Teva Pharmaceuticals
The insidious practice caused GoAmerica
Companies have been demanding that their stocks be removed from the German exchange in droves. For the most part, the bourse has complied, but it takes into account how long the shares have been trading there, whether they are also listed on other exchanges, and whether the listing standards in the company's home market are similar to those of Berlin-Bremen. It, of course, denies any wrongdoing.
Short selling is a valid investment strategy, one even practiced here at The Motley Fool on occasion. Yet the practice of naked shorting has left many companies feeling, well, naked.
Fool contributor Rich Duprey feels the public would be traumatized if he were to go naked. He does not own any stocks mentioned in this article.