July 16, 2008 / 10:33 PM / 10 years ago

FACTBOX: How "naked" short selling happens

NEW YORK (Reuters) - U.S. securities regulators issued an emergency rule on Tuesday to limit certain types of short selling in major financial firms, including Fannie Mae FNM.N and Freddie Mac FRE.N.

Investors who sell securities “short” profit from betting that a stock is overvalued and its price is likely to fall. Short-sellers borrow shares, then sell them, waiting for the stock to fall so that they can buy the shares at the lower price, return them to the lender and pocket the difference.

The emergency rule, which takes effect on Monday and could last up to 30 days, specifically works to prevent investors from making “naked” short sales, which occur when an investor sells stock that has not yet been borrowed. If “naked” shorting is done intentionally it is illegal.

The following explains how a “naked” short sale occurs:

*When investors call a broker to arrange to borrow stock to short, they are aware that short sales are subject to a standard three-day settlement period. This means the sell-side broker has three days to deliver the shares to the investor.

*The broker is supposed to locate shares available to short prior to executing a short sale and make a determination that the shares will be delivered to the investor within the three- day settlement window. However, there are certain exceptions to that rule.

*Some shares are on an “Easy to Borrow” list. For a stock on that list, investors can execute a short sale and the broker does not specifically have to locate, or contact the source of the shares that are being shorted. The broker has a “blanket” assurance about the borrowing capability for that security.

* There is also a “Hard to Borrow” list for securities that are difficult, or unavailable, to borrow. To short stocks on the “Hard to Borrow” list, brokers have to take additional steps to ensure that the stock is available to be shorted.

* If, for whatever reason, the shares are not delivered within the three-day settlement window, this is called a “fail to deliver.”

* That “fail to deliver” essentially leaves the short- seller “naked,” meaning he did not actually possess the shares he has sold.

* If shares have not been delivered for 13 days after a transaction has occurred, the broker must buy them back.

* The emergency rule from the U.S. Securities and Exchange Commission would require a short seller to borrow securities before executing a short sale for certain financial institutions. It would also require the investor to deliver the securities by the settlement date.

The agency identified the following securities affected by its order:

* BNP Paribas Securities Corp (BNPQF.PK) (BNPQY.PK)

* Bank of America Corp (BAC.N)

* Barclays Plc (BCS.N)

* Citigroup Inc (C.N)

* Credit Suisse Group (CS.N)

* Daiwa Securities Group Inc DSECY.PK

* Deutsche Bank Group AG (DB.N)

* Allianz SE AZ.N

* Goldman Sachs Group Inc (GS.N)

* Royal Bank ADS (RBS.N)

* HSBC Holdings Plc ADS HBC.N

* JPMorgan Chase & Co (JPM.N)

* Lehman Brothers Holdings Inc LEH.N

* Merrill Lynch & Co Inc MER.N

* Mizuho Financial Group Inc (MFG.N)

* Morgan Stanley (MS.N)

* UBS AG (UBS.N)

* Freddie Mac FRE.N

* Fannie Mae FNM.N

Reporting by Emily Chasan; Editing by Andre Grenon

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