Naked Short Selling—Overstock.com Lawsuit against Goldman Sachs & Merrill Lynch
Short selling occurs when a seller borrows shares from a brokerage house and then sells those shares. At a later date, the seller buys the shares and delivers them to the brokerage house. If the price falls during the shorting period, then the short seller makes a profit and generates a loss if the stock price rises. In theory, short selling is supposed to be done when the seller has made arrangements to deliver shares in order that the total shares sold should not exceed the number of borrowable shares. Naked short selling occurs when the seller sells shares that he or she does not own and has not borrowed. When the seller does not purchase the shares that it has shorted within a required time frame, then the seller has “failed to deliver” the securities. Naked short selling permits the number of shares sold to expand to any level, thus driving down prices abnormally, to the great disadvantage of the existing shareholders. Unfortunately, it can be used aggressively to intentionally decrease a stock price. Overstock.com, also known as O Co., is an online retailer of overstocked merchandise. In May 2007, O Co. successfully sued various brokers and hedge funds for colluding to damage its stock through short selling. These were followed by lawsuits against Goldman Sachs and Merrill Lynch. O Co. alleges that these two brokerage houses collusively urged their clients to take out naked short sales on O Co., thereby driving down its stock price. Although much of the evidence presented by the defense was under a publication ban, an error by legal representatives released some into the public domain in May 2012, as reported in The Economist and elsewhere. Much of the released evidence was in the form of emails that provided evidence of appalling ethical values, if not illegalities, at these two brokerage houses. Email excerpts showed that stock deliveries on short sales were intentionally failed by the two brokerage houses, even though both houses had millions of shares available. By permitting failure to deliver, the expected purchases to cover the short sales were never consummated, and therefore the market price sank lower than it should have. Merrill’s internal compliance officers described some of this conduct as totally unacceptable. However, their warnings were ignored by Merrill’s traders. One senior executive suggested that Merrill “might want to consider allowing … customers to fail.” Another said, “F___k the compliance area—procedures, schmecedures.”1 In June 2015, a California court found that it did not have jurisdiction over Goldman Sachs, but in January 2016, Overstock reached a settlement with Merrill Lynch for $20 million.
Questions
1. Should short selling be outlawed?
2. Should naked short selling be outlawed?
3. How would you describe the ethical cultures at Goldman Sachs and Merrill Lynch with respect to failed trades?
4. Short of wholesale firings, fines, and jail terms, can you suggest ways that the ethical cultures at Goldman Sachs and Merrill Lynch could be corrected?
