Goldman Sachs, short selling, and naked short selling

I do not directly trade in stocks although like anyone with a retirement account, someone is trading on the stock market with my savings. My lack of interest may be related to my lack of interest in gambling generally and to my lack of a desire to make more money. I have a job that pays me enough for my needs and that is enough. My main interest in the financial world is more on the macro side, to understand how it impacts the political and social worlds. But the recent global financial turmoil has resulted in me learning more about the world of high finance than I ever wanted.

Matt Taibbi, the scourge of Goldman Sachs, writes about how a slip by one of its lawyers resulted in the release of information about its activities that the company had vigorously sought to conceal. As Taibbi says, “The bank has spent a fortune in legal fees trying to keep this material out of the public eye, and here one of their own lawyers goes and dumps it out on the street.”

In the process, he explains some investment terminology that I did not fully understand, such as ‘short selling’ and ‘naked short selling’.

Short selling is a gamble that an investor makes when he or she thinks that a company’s stock is overvalued and likely to go down in price. The investor then borrows stock from someone who has them, sells them at the current price, and then buys them back later when the price drops and returns them to the lender. Of course if the stock price goes up instead of down, the investor loses money. The investor can actually sell the stock before borrowing it because there is a small window of time that the investor has to actually borrow the stocks after he has sold it and properly close the books on the deal, but (I think) the investor is expected to have arranged the borrowing before doing the actual selling, so that all that remains is the bookkeeping.

Short selling is legal and in some cases serves a desirable goal. Suppose that a stock is over-valued for some reasons that are not widely known. Savvy deep-pocketed investors who are aware of the weakness will short sell it and thus nudge the price down towards more realistic levels, and this may actually benefit the stock market which is supposed to reflect the ‘true’ value of stocks. This in theory helps prevent price bubbles though as we have seen recently, even savvy investors can get sucked into bubble hype.

But in some cases, people wishing to short sell a stock may find that the people holding the stock are not be willing to lend it out or may charge a fee for doing so. In such cases, some investors sell stock they do not actually have, thus effectively creating virtual stock. This is what is known as ‘naked short selling’. This practice seems bizarre and many people denied that it happened at all and that reports of such actions were myths.

The reason this practice is frowned upon by regulators, if not downright illegal, is that by selling stocks that you do not possess, you are artificially inflating the amount of stock for sale and thus can drive down the price for reasons that have nothing to do with the actual worth of the stock. If the naked short seller sells so much stock as to be able to force the price downward, he or she is guaranteed to make money on the deal. It becomes a sure thing, rather than a gamble.

Goldman Sachs had been accused of naked short selling but had vigorously denied the allegations. But what the accidentally released documents reveal is that they have been engaged in short selling on behalf of their clients. As Taibbi writes:

More damning is an email from a Goldman, Sachs hedge fund client, who remarked that when wanting to “short an impossible name and fully expecting not to receive it” he would then be “shocked to learn that [Goldman’s representative] could get it for us.”

Meaning: when an experienced hedge funder wanted to trade a very hard-to-find stock, he was continually surprised to find that Goldman, magically, could locate the stock. Obviously, it is not hard to locate a stock if you’re just saying you located it, without really doing it.

I know that some commenters (‘Tis Himself for one) are far more knowledgeable about the financial world than I am and would be curious to hear their insights on this topic.


  1. Tracey says

    This is all such a scam. In my lifetime, many companies once had pension plans for their employees. However, the 401k shell game needed more money for their Ponzi scheme, so CEOs were persuaded to make their employees risk their retirement future in the stock market. However, this is a losing game, so the fresh blood of the American employee wasn’t enough to keep the stock shell game afloat for very long, and now they need new blood…but there’s no more to be had. The 99% have given it all.

  2. Gregory in Seattle says

    Speaking as a licensed broker in the US (Series 7 and Series 66)….

    Investing is not, itself, gambling, although there are many ways to gamble with your investments. Short selling is one of those ways to gamble.

    Naked short selling is not illegal, but it is heavily regulated by the Securities Exchange Commission and banned in most situations (in theory, at least: there is a lot of evidence that it remains a widespread practice despite the rules being tightened after the 2008 collapse, and that regulations are not being enforced.) Many exchanges and national securities commissions have similar rules regulating naked short selling, and generally do a better job of enforcing their rules.

    Making smallish naked short sales as a very risky investment gamble is bad. Making large naked short sales to drive down stock prices is illegal market manipulation.

    What Goldman Sachs has been accused of doing is telling high value clients that the company had obtained stocks that the client wanted without actually having obtained them, then allowing the client to trade these non-existent stocks without the client knowing that they were being defrauded. Such a practice violates just about every principle, every regulation and every law that exists in the financial industry. If the accusations pan out, then everyone who had even the slightest knowledge of the practice — from the traders themselves to the hired help who typed the memos — will be facing very, very long prison sentences.

    In theory, at least.

  3. says

    I have a very dim view of stock markets in the first place (such as the way it leads to abominations such as profitable companies laying off workers to increase profits). This sort of thing is not shocking at all.

  4. says

    I’m not sure I completely understand how this even works. How does the investor sell stock he does not have? What is he actually selling? Is he just lying to the buyer by claiming to have stock for sale, but really giving him nothing for his money? Surely there must be some record of stock ownership–I’m having a hard time understanding how this happens.

  5. unbound says

    Very insightful information. Thanx.

    “If the accusations pan out, then everyone who had even the slightest knowledge of the practice — from the traders themselves to the hired help who typed the memos — will be facing very, very long prison sentences.

    In theory, at least.”

    That seems to be a common thread of some of the biggest issues. Little to no accountability when illegal things do happen.

  6. Jared A says

    I’m not really knowledgeable at all on this, but the way it was explained to made even regular short selling seem ripe for abuse. If the investor is powerful enough (e.g. Carl Icahn), the mere act of short-selling lowers the price, regardless of circumstances. Thus, it is a self-fulfilling prophesy.

    Does this apply to all types of short selling, or is it specifically about naked short selling? Is this an over-simplification?

  7. Mano Singham says


    Good question!

    I am hoping that someone more knowledgable chimes in but until then here’s my take.

    In such sales, there is no actual transfer of physical stock certificates from seller to buyer. It all exists as electronic records. Yes, in the short run the short seller is not giving the buyer (A) anything but remember that when the price drops, the seller buys the stock back from someone else (B) and now has actual ownership of stock that can be transferred to A. It all happens rather quickly and if all goes smoothly, A would never know that for a while he/she had paid for a non-existent product.

  8. Trebuchet says

    Like Mano, I do not invest directly in stocks, but others are doing so at least ostensibly on my behalf. It makes me nervous sometimes.

    Re the comparison of the stock market to gambling: The difference between Las Vegas and Wall Street is that there are far fewer crooks in Vegas and the games are far less likely to be rigged.

  9. says

    Yes, but a large enough buyer can drive the price up by buying. That doesn’t really help unless the market moves with you. If you buy and the market says “hey, this price is high now I’m gonna offload” then your stock is now worth less than you paid for it.

    Same thing with shorting, but the other direction. If others say “hey, this stock is deal right now” and buy, then your price dip evaporates and you lose.

    Of course, people are known to jump on trends, buying high and selling low, but the potential for manipulating the market seems the same to me. (Or maybe it’s more emotionally compelling when the trend is downward?)

    I don’t understand why shorting stocks (the normal, fully clothed version) is any better or worse for the market, in principal, than buying on margin. In both cases you’ve made a bet on credit that the market is wrong about the value of a stock. If we’re not opposed to trading in markets, and not opposed to credit, then why is combining them bad?

    Perhaps people just dislike the idea of betting against success? Selling already does that though.

  10. Vorn says

    On the other hand, buying stock increases the price. These increases and decreases cannot yet be used to glean profit off the transaction, though: selling the stock again lowers the price.

  11. Mano Singham says

    As I see it, ‘buying on margin’ (which is buying stock without paying for it in full out of your own pocket but with money borrowed from the broker) in the anticipation of selling it at a profit quickly and returning the money, is the buying equivalent of short selling (where one sells stock borrowed from the broker who is holding it for someone else). So as I see it, it is neither better or worse, as you point out.

    I am not sure if there is a buying equivalent of naked short selling, though, which is the problematic transaction.

  12. Henry Gale says

    I guess my question at that point is why the ‘system’ doesn’t recognize that there are more stocks outstanding than have been issued by the company?

  13. Eric Riley says

    This is only tangentially related – but why is it the only ‘regulation’ that Wall Street seems to adhere to is the ‘legal requirement’ that those running the companies must maximize shareholder return. I put the quotes because I keep *hearing* that there is a legal obligation, but no-one seems to be able to actually point to either statute or regulation with that language (which means little since the discussion is among people who are all fairly uninformed) – since there seems to be some expertise floating around these comments – can anyone tell me where to look for the legalities of fiduciary responsibility and what that actually means? I cannot believe it is a requirement to *maximize* profits, since how can you, in practice, show that any action you’ve taken has maximized the long-run profitability (not to mention making the types of investment Bain Capital was doing completely illegal) – so what is the legal requirement?

  14. says

    I have never heard the obligation to maximize profits for the shareholders’ benefits described as legal requirement. Can you give me an example of someone claiming that they are required by law to do this?

  15. Mano Singham says

    Jamie Raskin writing in The Nation says “Today, corporations are chartered without any public purposes at all. They are legally bound to pursue a single private purpose: profit maximization.” He does not specify a statute.

    Since corporations are incorporated in a state, I think they are covered by state law. This article by Robert Hinkley traces it to Section 716 of the Business Corporation Act in Maine and he says that other states have similar laws.

  16. Eric Riley says

    “…their general fiduciary duty is to maximize value for the shareholders of the business…”

    “They have a fiduciary duty to their shareholders to maximize value.”

    I have often heard this interpreted as ‘maximizing profit’, and I am not claiming that it is the *correct* interpretation of the law, but that it is widespread and I was wondering just what law (or laws) describe the fiduciary duty of a corporation to its shareholders? I have yet to find anyone who can tell me – but I haven’t really been asking the people that necessarily could.

  17. says

    I also have frequently heard people say that corporations have an obligation to their shareholders to “maximize profits” or a similar phrase. I have never interpreted that to mean they they are beholden to any law requiring them to do so, but rather that they are simply working on behalf of someone else who is footing the bill, and it’s their job to provide them with something of value, just like any other employee who has a boss to answer to.

    But I am pretty unfamiliar with finances and corporate law in general, and Mano’s post below makes it sound like there probably are state laws dealing with this situation. I, too, would like to learn more about this subject.

  18. Eric Riley says

    section 13A repealed and replaced with 13B and 13C. I cannot find anything in there that states the purpose of a corporate to be other than, “A corporation subject to this Act has the purpose of engaging in any lawful business unless a more limited purpose is set forth in the articles of incorporation.”

    To do business – not even (necessarily) to make money – 13C section 301.

    I’ll keep looking… It makes sense that there must be *some* kind of fiduciary responsibility – to prevent the corporate officers from defrauding shareholders, if nothing else, but I don’t see how you can legally require people to make a profit at all, much less to maximize profit…

  19. Eric Riley says

    I too thought that, but when I press people on it, the maintain that there is a legal obligation – in general the people I speak to about this have at most a rudimentary business education, but I have heard similar statements from experienced businesspeople as well (having years of business experience and an MBA education). What I have *not* heard from are people who are either brokers or lawyers to weigh in.

    What I *think* is happening is that people are using ‘fiduciary responsibility’ as a scapegoat to justify their own bad behavior, and whatever legal requirements there are do not, for example, obligate (for example) the wholesale deconstruction of workers’ pension plans to generate higher revenue than if you kept the pensions.

    But – the law is a funny thing, and I would not be surprised if there were some interpretation of the fiduciary responsibility of corporate officers to do just that. Saddened and wanting to change the law, but not surprised.

  20. Eric Riley says

    And a general thank you for addressing my question – to both Carl and Mano and anyone else who jumps in…

  21. Gregory in Seattle says

    How this works is exploiting a loophole that was necessary 40 years ago, but is no longer necessary now.

    First, some backgound. Back in the day, there were about two dozen stock exchanges. A stock would typically trade only in one of those exchanges, because the issuing corporation had to have a nearby transfer office.

    At this time, stocks existed as physical paper. If you wanted to buy stock, you would have an agent at the exchange where the stock traded make the purchase. After the transaction was made, the agent took a transfer of ownership slip and the physical, paper shares of stock to the transfer office and file the sale. The transfer office would make a leger entry of the sale, invalidate the old stock certificate, and issue new certificates in the new owners name. The agent would then pick up the new stocks and either hold them for the client or forward them. All this took a while, and regulations were written to require that the time window from sale to reissue be no more than four business days.

    Back in the 60s, with the rise of teletypes, the process was condensed into typically a few hours. However, the regulations still allowed for four business days, so the practice of short selling appeared. Nowadays, with the reliance on electronic trading, the process takes a few minutes. Regulations still allow for four business days.

    So, for the last several decades, it has been possible to buy and sell shares several times over that you have only in theory. As long as you actually have the shares when the first trade settles, you are in the clear. If you do not, then the whole chain of trades falls apart.

    Defaulting on a trade — not having the shares when it is time for settlement — is not technically a violation; again, this harkens back to the day when a sale might be brokered but there were delays in getting the physical certificates from the holder, or some kind of problem at the transfer office. Having a habbit of default, however, will usually bring a lot of attention from the regulators, which no one wants to have to deal with.

    Ultimately, the problem comes down to the fact that most of the existing process for handling securities trades was created in the early 30s, and hasn’t been updated since. The vast change in technology allows for a lot of abuses.

  22. Mano Singham says

    Thanks so much for this explanation. I had no idea that the window for the trades was as long as four days. No wonder that short selling is so common.

  23. says

    I am not a lawyer nor do I own or manage any corporation, but I’ll take a shot at addressing the discussion above about the requirements of a for-profit corporation.

    As far as I have read, in the United States there is no specific requirement among most state codes that the directors and executives of a for-profit corporation must specifically seek the maximization of short-term profits above all other goals. That would obviously interfere with decisions on long-term planning and the stability of the organization.

    However, there is essentially always either an explicit requirement or implicit liability through various clauses to seek shareholder interests. Even if the corporate charter or articles of incorporation specify purposes other than specifically business profits, it is still ultimately the shareholders who own the company who get to determine the final interpretation of what that means.

    There are no direct or immediate consequences of failing to do everything possible to maximize corporate profits in any jurisdiction I know of. Rather, what will happen eventually in some or most cases is that shareholders will replace management with someone more amenable to their goals. In the extreme cases, they may specifically file lawsuits against former executives for “poor” business decisions.

    Keep in mind that there is more than one type of corporation defined in many places. Non-profit or not-for-profit corporations both explicitly and implicitly follow different behavioral guidelines. Public benefit or “B” corporations are now possible in at least half a dozen U.S. states, as well.

  24. Art says

    Whether this law, in whatever form, demanding that corporations pursue shareholder value is enforced by government agency or not it is clear that shareholders can and do sue corporation, and apparently sometimes win, if the corporate officers are sufficiently lax in their duties to pursue shareholder value. As I understand it such cases are subject to such a low standard that the corporate behavior has to be both obvious and egregious.

    This was cited as the reason why corporations with mailing lists and other customer information cannot simply destroy the data before they are sold or go out of business. Doing so would be destroying shareholder value which, by right, has to preserved or sold. It also means that the pinky-swear the company that gathered the information from you made, claiming they would never ever hand it out, has little meaning and they cannot protect the information if the business closes or is sold. Whoever buys the information can do with it pretty much as they please as the original agreement is with an organization that no longer exists.

  25. Eric Riley says

    Do you have any citations for those lawsuits? I have heard that claim before, but have never been able to find any actual examples.

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