Last week, when I wrote about naked short sellers and Regulation SHO, I suggested none too subtly that the new rules seem to deal pretty lightly with any bad guys operating outside the law. If the Securities and Exchange Commission is acknowledging a problem, as it seems to be, then Reg SHO seems like a pretty weak tool for controlling it.

But that was last week's subject. Having gotten to that point, I was left wondering how extensive the problem really is. As I said then, I'm deeply skeptical of some conspiracy theories that suggest that short selling is not only rampant, but also a part of a coordinated scheme involving brokers, media, and regulators trying to bring down targeted companies. In fact, let me say at the outset that after spending many hours looking at this issue, I remain unconvinced of the larger conspiracy theories and agnostic on how extensive naked short selling is or how exactly it happens. There is no shortage of theories -- some of which I'll discuss here -- but little in the way of concrete answers. So the first and most obvious question is, how much of this is going on?

Rare or everywhere?
Unfortunately, nobody seems to know. The Depository Trust & Clearing Corporation (DTCC), a holding company that clears and guarantees almost all trades in the U.S., very recently posted an interesting Q&A on naked short selling, an article well worth reading if you're at all interested in the subject. "While naked short selling occurs," says DTCC First Deputy General Counsel Larry Thompson in the document, "the extent to which it occurs is in dispute." Ain't that the truth.

Nevertheless, the DTCC has a good reason to say something public about the issue. The subject of naked short selling has gained some momentum with the introduction of Reg SHO early this year and a rising tide of complaint from companies like (NASDAQ:OSTK) and others. But in addition to this general attention, 12 separate lawsuits have accused the DTCC itself of engineering naked short-selling schemes. Nine of these, according to Thompson, have been dismissed or withdrawn, while three are still pending.

The basic accusation is that the DTCC itself counterfeits shares through its stock borrow program. This program has been around for more than 20 years and helps guarantee transactions when one party fails to produce promised shares. While the DTCC itself doesn't own shares, a network of participating broker-dealers lists shares available for borrowing with the program, and these are called on to complete failed transactions.

Lawsuits have claimed that the DTCC loans out shares it never collects from participants. These, in turn, presumably show up as new "fails to settle" transactions, but from the point of view of the market, they appear to be new shares floating around -- in electronic form, that is, without stock certificates to back them up. These can then be relisted, the theory goes, as available for borrowing, and the process repeats itself, allowing the folks manipulating the system to essentially manufacture any number of phantom shares.

Thompson calls these accusations "either an intentional misrepresentation of the SEC-approved system, or a profoundly ignorant characterization of this component of the process of clearing and settling transactions." I want to stress that I'm not supporting these accusations -- I mention them because they describe one popular theory of how naked short sellers operate.

Something's going on here
But if we rule this out, how does one explain the suspicious volumes and consistent, ongoing settlement failures experienced by companies like BioLaseTechnology (NASDAQ:BLTI), Netflix, or Rule Breakers pick Taser (NASDAQ:TASR) on the Threshold Security lists? Thompson, while acknowledging that naked shorting does happen, suggests that many settlement failures are innocent. "An investor can get a physical certificate to his broker too late for settlement," he suggests. "An investor might not have signed the certificate, or signed in the wrong place. There may have been human error, in that the wrong stock (or CUSIP) was sold, so the delivery can't be made. Last year, 1.7 million physical certificates were lost," he continues, "and sometimes that isn't discovered until after an investor puts in an order to sell the security. There are literally dozens of reasons for a 'fail to deliver,' and most of them are legal. Reg SHO also allows market makers to legally 'naked short' shares in the course of their market making responsibilities, and those obviously result in fails."

But can unsigned or lost certificates really explain why some companies have lingered on the list for weeks, meaning that more than 10,000 shares per day or over 0.5% of the company's entire float is subject to failed settlement on a daily basis? If that's the root cause, it would certainly seem to point to some pretty shoddy settlement practices among broker-dealers. If that's really all there is to this, then maybe Reg SHO will serve its greatest purpose in embarrassing some brokers into improving their settlement procedures.

Who's making the market?
Yet, as I noted last week, it is the market-making exemption that still seems to me like a source of potential trouble. Market makers don't have to locate shares before executing short sales in most circumstances. Their role is to keep an inventory of readily available stock, to smooth volatility, and to manage their own risk, and this sometimes requires them to short shares. A prime example of why this is sometimes a valuable function and even protects investors can occasionally be seen with companies emerging from bankruptcy.

When US Airways (OTC BB: UAIRQ.OB) was planning to re-emerge from bankruptcy in 2003, for instance, its old common stock, trading on the OTC BB, rallied -- apparently because some investors mistakenly thought the news was somehow good for shareholders in the old common stock. But the plan called for the issuance of new stock, and the old shares were to become worthless. Market makers, by shorting the old common shares, could burst a speculative mini-bubble in the making and stop more ill-informed investors from losing their shirts. (Of course, one wonders why stocks are allowed to trade at all in these situations, but that's another matter). In any case, this is an extreme example of one function legitimate market makers serve by shorting stock and why they are given an exemption to the rules.

The potential problem is that unscrupulous folks could potentially register as market makers to take advantage of the exemptions. (Do you want to be a market maker? Go here for an application! It's not a rubber-stamp process, but it's not as hard as you might think.) Right now, "bona fide" market making is judged by the individual transaction rather than by the individual market maker, so no market maker gets a blanket exemption, but any market maker -- even the ones posting $0.001 bid/$10,000 ask spreads -- get a pass in the right circumstances. It's a situation that seems to hold potential for mischief.

Overseas intrigue?
And here is a final source of potential trouble I'll suggest. Say the broker placing the order to short a stock is in an offshore location where naked short selling is legal. This would seem to open up the same opportunities purportedly exploited to naked short the stock of companies that have issued floorless convertible debt.

A floorless convertible bond (a vehicle of what is sometimes called the "convertible death spiral") is a debt instrument issued by desperate or dishonest companies to raise cash; the bondholder can convert the debt into stock at variable, below-market prices.

It's not a deal a responsible company should enter into. When a company does a floorless convertible, its stock, not surprisingly, drops. The new bondholders have every reason to short the stock unmercifully, and as the price drops further, they get more shares upon conversion because the conversion rate changes. Thus, the original shareholders lose virtually all their stake in the company. Meanwhile, the bondholders simply short all the shares they can, take their profit, and then hope the stock price continues to drop until they get more than enough shares upon conversion to cover the original short.

As long as the bondholders are using legitimately borrowed shares and not engaging in unscrupulous tactics to manipulate share price lower, this is a legal strategy -- although it is hard to see why such floorless converts, devastating for existing shareholders, are in fact legal. But if the bondholders are in an offshore location where they can legally naked short, they might theoretically short more shares than they can get their hands on. After all, the shares they have coming back to them are multiplying as the price drops, so why not?

At the root of the conspiracy theory?
There are folks out there who believe this is the main source of naked short selling in the market. Certainly, in this scenario the bondholder has an incentive to naked short the stock, and one could expect to see massive issuance of new shares as the debt is converted to stock at a rock-bottom price. Failed settlement and suspicious volume in one neat package, right?

Maybe. But since most of the companies on the Threshold Security List haven't issued toxic convertibles, of what relevance is this? Only this: If an offshore concern can naked short the shares of a company to which they've issued a convertible loan, why can't a foreign broker naked short a company for which there is simply high demand for borrowed shares?

When I look at the Threshold Security List, even ignoring the penny stocks, I see companies that a lot of investors want to short (OK, that's pretty much true by definition). The very appearance of these companies means that not everyone is getting to borrow the shares they want -- you won't see Microsoft (NASDAQ:MSFT) or General Electric (NYSE:GE) on the list. Couldn't an enterprising broker in some foreign location be executing naked short sales to satisfy some of this demand? Wouldn't this cause persistent settlement failure?

I have no way of proving this -- it is just surmise. But notice that this scenario does not suggest that the naked shorts are successfully pushing down the price of the threshold stocks to any significant degree. It only suggests that the real demand for shares to short is being satisfied by extra-legal means -- brokers who have set up shop to transact shares of a popular short target. Investors who see value and want to take a long position in these same stocks should naturally balance out the shorts, absent some highly organized conspiracy to spook the market. Thus, I don't think investors in threshold companies should necessarily believe that their stock is artificially depressed to any substantial degree.

More unanswered questions
This may only go part of the way toward explaining unusual volume, however. Last week, I mentioned Global Links (OTC BB: GLKCE.OB), a penny stock that has a listed float of a little over 1 million shares but traded many times that volume in a single day despite there being one shareholder who claimed to own the entire float. I mentioned that particular company because it came up by name at the March 9 Senate Banking Committee hearing, and the story makes a good illustration of the kinds of absurdities showing up on the Threshold Security List.

But in fairness, I should point out that in this particular case, there are other factors that might explain the volume. Among other things, the company has a huge overhang of preferred shares convertible to common stock. It's impossible to tell from the SEC filings alone exactly what's going on here, and while it's an interesting story, a smoking gun it ain't. This is part of what makes penny stocks really bad investment ideas for nearly everyone.

But while Global Links is a strange and perhaps poor example of suspicious trading volume, there are other examples out there. Overstock CEO Patrick Byrne has noted seeing four or five times his company's float trade hands in a day. The same thing has happened to other threshold companies. What explains this?

I'm afraid I still don't know. Is it day traders on steroids, frantically trading back and forth? Perhaps. Could it be a few hedge funds painting the tape, hoping to make it look like the sky is falling? Maybe. Could it be huge numbers of phantom shares out there, making the reported float inaccurate? I guess it's possible.

Unfortunately, Reg SHO appears to raise more questions than it answers. As the DTCC is quick to point out, its job is simply to report the failed settlements. It is up to the SEC to actually do something about it.

By the way, I'll look at some more of the specifics of naked shorting and what they mean to investors in the next issue of the Rule Breakers newsletter.

Karl Thiel is a member of the Rule Breakers newsletter team. Click here for a free trial. He does not own stock in any companies mentioned in this article. The Motley Fool has a disclosure policy.