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Whistleblowing: Naked Short Selling

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In screening whistleblower claims seeking awards from the SEC under the Dodd Frank Act, the firm has given special attention to complainants who have solid evidence of naked short selling. As discussed below, these cases appear to have a better chance of triggering an SEC Enforcement case and thus a substantial whistleblower award.

Until the fall of 2008, the SEC and the media had been skeptical of claims by public companies that naked short sales had caused sharp drops in their stock prices. The skepticism seemed reasonable, since public companies—other than prime brokerage firms—rarely had access to the trading records necessary to prove their claims.

The SEC’s skepticism quickly faded in the fall of 2008 when the CEOs of Goldman Sachs and Morgan Stanley complained to the SEC that naked short selling was causing the collapse of their stock prices and thus deepening the financial crisis. Unlike other public companies, these investment banks had access to trading records and were likely aware of the mechanisms used by sophisticated traders to conceal naked short sales.

The SEC’s response included the issuance of a rule (Rule 204T), which was supposed to close the regulatory gaps that concealed the naked short selling. Eleven months later, the SEC filed the first of nine cases alleging naked short selling and other violations of Regulation SHO against brokers, hedge funds, and their executives. Uncovering the naked short sales in most of these cases was not easy: they were cleverly concealed by complicated options strategies. 

Rule 204T has only been partially successful. Naked short sales continue to ravage stock prices. A recent settlement between FINRA and UBS tells how UBS continued to violate Regulation SHO for 27 months after Rule 204T went into effect. Trading records often demonstrate scenarios that imply naked short selling, but provide no clues of the identity of the perpetrators.

These circumstances create unique opportunities for a whistleblower who has hard evidence that any person or institution is engaged in naked short selling or is helping others conceal these trades from detection. The Dodd Frank Act provides that a whistleblower “who voluntarily provided original information to the [SEC] that led to the successful enforcement” case may be awarded between 10% and 30% of the amount recovered by the SEC.

The Dodd-Frank Act and SEC regulations are designed to protect whistleblowers in multiple ways. To begin with, SEC regulations prohibit an employer from taking “any action to impede an individual from communicating directly with the Commission staff about a possible securities law violation, including enforcing, or threatening to enforce, a confidentiality agreement.”  SEC regulations also allow a whistleblower’s identity to remain anonymous when the complaint is filed, if he or she is represented by counsel. However, the identity of the whistleblower must be disclosed before the monetary award is made. 

The size of the recoveries—which sets the range of possible whistleblower awards—seems to be on the upswing. The SEC imposed a fine against UBS in 2011 for $8 million for violations of Regulation SHO. In 2012, the SEC ordered two brothers and their company to pay $14.5 million in connection with naked short sales and violations of Regulation SHO. A potentially larger case is currently under submission, In re OptionsXpress, 2012 SEC LEXIS 1222 (SEC 2012), in which a subsidiary of Schwab allegedly participated in billions of dollars of naked short sales.


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