By: James English

A current shift in technology is presenting an opportunity for a drastic improvement in securities regulation. Instead of FINRA and the SEC acting as toll collectors for those who flout securities regulation. Modern technology allows a new system of securities settlement to be created where securities laws are enforced proactively. Certain securities laws are easier to enforce than others in this nature and this blog series will focus on a specific form of market manipulation known as “naked short selling.” The first blog post will focus on the problem broadly while the second one will focus on the implementation and outcomes of this new proposed system.

In 2003, publicly traded companies began requesting their shares be returned from the DTC.[1] This was a novel issue for the DTC because they only had procedures for withdrawal requests from participants at the DTC, not issuers of the stock themselves.[2] The DTC then proposed the following rule “DTC will process withdrawal requests submitted by participants in the ordinary course of business but will not effectuate withdrawals based upon a request from the issuer.”[3]

The SEC, tasked with approving or denying this rule change, received eighty-eight letters in total regarding the new rule change: fifty-two letters opposed to the rule change and thirty-six in favor.[4] Twenty-six of the letters argued that issuers should have the choice to withdraw their shares from the DTC in order to protect their share price from the consequences of naked short selling.[5]

Short selling is defined by the SEC as: “…when an investor borrows a security and sells it on the open market, planning to buy it back later for less money.”[6] To facilitate more honest market participation Rule 203(b)(1):

prohibits broker-dealers from either accepting a short sale order or effecting a short sale for their own account, unless the broker-dealer has borrowed the security, entered into a bona fide arrangement to borrow the security, or has reasonable grounds to believe that the security can be borrowed so that the security can be delivered on the date delivery is due.[7]

This is where the “naked” segment comes in. When shares of a company are shorted prior to borrowing or locating them, the sellers are “naked” short in violation of Rule 203(b)(1). This allows more shares to trade on the market than are available resulting in “failures to deliver.”[8] Simply by “locating” them, broker-dealers can satisfy section (c). Without any overarching share tracking mechanism, market participants can be unable to exit their short position if party A decides to close their short position on the shares party B was relying upon to close theirs.

In typical market conditions, this is not a problem as other shares can be located. However, in times of high volatility and low liquidity, the inability to locate can be devastating as those with short positions cannot close and are exposed to potentially infinite losses.[9] Despite many letters opposing the DTC change in 2003, the change was made anyway, removing stock issuers’ ability to retract their shares from the DTC.[10]

Naked short selling is an issue that has been attempted to be resolved previously. In 2009, Delaware Senator Ted Kaufman proposed, before a SEC roundtable, the issue be further investigated in the wake of the 2008 financial crisis.[11] Kaufman notes the 2008 financial crisis was propelled in large part by short sales, and Kaufman identified the recent repeal of the “uptick rule” as a large factor in facilitating the downturn. Kaufman also noted the need for restrictions on “naked short sales” but conceded that the SEC board is “stacked against the need for restrictions on naked short selling.”[12] The rule Kaufman cites is Rule 10a-1, first implemented in 1938 by the Securities and Exchange Act of 1934.[13] This rule provided a short sale must be initiated on a price higher than the last traded price of the security.[14] Coincidentally, Rule 10a-1 was repealed in 2007 prior to the financial crisis.[15] Although the impact of this rule change on the crisis is unknown, Kaufman and others called for the change.[16]

Their demands included further accountability by members of Wall Street themselves. Kaufman’s calls were met with a somewhat pacifying law: Rule 201, the Alternative Uptick Rule, implemented the same aforementioned short sale restrictions that Rule 10a-1 did, but only went into effect after a security had fallen more than 10% in a single day.[17]

Who was responsible for implementing these rules? The broker dealers who were participating in the behavior.[18] Rule 201 provides banks have been tasked with labeling their own trades or the trades of others and ensuring that none of them are “short” when they are not supposed to be. [19] In addition, trades can be marked “short exempt” if they believe the trade can be executed and falls under an exemption to an SHO rule.[20] This strategy essentially allowed regulators to act as toll collectors of impermissible trades made by those parties violating SHO rules.

Fines that amount to millions of dollars are nothing more than the cost of doing business for institutions such as Citadel, who made $6.6 billion globally in revenue in 2020.[21] In just one instance, Citadel had mislabeled 6.5 million trades due to an error in their labeling system.[22] The FINRA report notes Citadel’s self-supervisory program “missed” this oversight and an $180,000 fine was imposed.[23]

For corporations, short selling drives down the prices of companies without any ability to control the shares they issue.[24] Reduced share prices make capital raises more difficult, increase the likelihood of hostile takeovers, and can destroy companies without any merit for the bet against them.[25] This happens regardless of the intrinsic value of the stock, the potential benefits of its product, research, or medicine. Despite the obligations of boards to fulfill their fiduciary duties to shareholders, they are prevented by federal law from leaving the DTC.[26]

While fines are imposed against market participants who engage in these activities, the fines are not prohibitive and retroactive. The retail investors and companies who were impacted by this type of short selling rarely have any recourse.[27] However, retail investors have begun to take specific aim at short sellers creating wild swings in the prices of equities and distorting price discovery. This problem begins to create further market instability with longer than permissible short positions colliding with incessant buying of a single equity by retail investors.

Part two will highlight how implementation of a share tracing can be an important first step in proactive regulation.

[1] The Depository Trust Company Rulemaking Order Granting Approval of a Proposed Rule Change Concerning Requests for Withdrawal of Certificates by Issuers, Exchange Act Release No. 34-47978, 68 FR 35037, (June 4, 2003) [hereinafter SEC Rule Change Regarding Withdrawal of Certificates]; The DTC is the sole owner of the stocks for all of the brokers who have accounts with the DTC.  Cede and Co. as the nominee of DTC, maintains all of the master certificates for shares owned by participants of the DTC.

[2] Id.

[3] Id.

[4] Id.

[5] SEC Rule Change Regarding Withdrawal of Certificates.

[6] Complaint at 23, Securities and Exchange Commission v. BTIG, LLC., 2021 WL 2024113 at *7 (S.D.N.Y. May 19, 2021).

[7] Id at *2.

[8] Id at *2.

[9] Complaint at 23, Securities and Exchange Commission v. BTIG, LLC., No. 21 Civ. 2521, 2021 WL 2024113, at *7 (S.D.N.Y. May 19, 2021) (The loss you can experience betting against a company are technically infinite due to no “max number” being know

while in a long position your losses are limited to when the company trades

for 0.).

[10] SEC Rule Change Regarding Withdrawal of Certificates.

[11] Press Release, Kaufman and Isakson Statement on Tomorrow’s SEC Roundtable on Short Selling, office of Sen. Ted Kaufman (September 30, 2009),

[12] Id.

[13] 17 C.F.R. § 240.10a-1 (2003).

[14] Id.

[15] Ekkehart Boehmer, Unshackling Short Sellers: The Repeal of the Uptick Rule, Colum. bus. sch. (December 11, 2008)

[16] Id.

[17] Press Release, SEC Approves Short Selling Restrictions, S.E.C. (February 24, 2010),

[18] Id.

[19] 17 C.F.R. § 242.

[20] Id. (This occurs typically when a trader holds pacifying positions such as 100 shares long and 100 shares short, this makes the short sale “short exempt.”).

[21] Tom Maloney, Citadel Securities Gets the Spotlight, Bloomberg (April 6, 2021),,authorized%20to%20reveal%20them%20publicly.

[22] Letter of Waiver, Citadel Securities – 116797, FINRA (November 13, 2020),

[23] Id.

[24] SEC Rule Change Regarding Withdrawal of Certificates.

[25] Comments, Walter Cruttenden, Shorting America, S.E.C.,, (last visited November 8, 2021).

[26] SEC Rule Change Regarding Withdrawal of Certificates.

[27] Akustair Barr, ‘Naked’ short selling is center of looming legal battle, Market Watch (June 14, 2006); Complaint, Securities and Exchange Commission v. BTIG, LLC., No. 21 Civ. 2521, 2021 WL 2024113 (S.D.N.Y. May 19, 2021).