Actually, Mr. B borrows from a broker. If they are shares held by the broker in inventory, then the broker is Mr. A and obviously your description is wrong.
But even in other cases it's wrong: the shares may be from Mr. A's margin account with the same broker, in which case the margin account contract included the right for the broker to lend the shares; so Mr. A has already been asked about loaning shares and accepted.
Similar analysis can be extended to the case where Mr. A is either another broker lending inventory shares to the broker lending to Mr. B or where Mr. A has a margin account with such a broker.
No one is lending shares unless they own them or have a contract with the owner where the owner has agreed to allow such lending.
Securities in a cash account can't be lent out by the broker without the written agreement of the customer. The necessary language could theoretically be put into the standard account agreement, so if you care you should read it. However, it is not common business practice to include that in retail customer account agreements. Also, the broker is required to notify you whenever your shares are borrowed, and this requirement cannot be waived by the agreement. So if you haven't been notified about lending activity, your broker is not lending your shares. The same requirements hold for fully paid securities held in a margin account, so even if you have a margin account, if you're not actually borrowing money from them, they're not lending your shares without your knowledge.
> If they are shares held by the broker in inventory, then the broker is Mr. A
except then Mr A does not own the shares, there is in fact a Mr Ax who lent Mr A's shares to Mr B.
> No one is lending shares unless they own them or have a contract with the owner where the owner has agreed to allow such lending.
as others point out, this is going to be in the small print of the brokers account
However, I think Mr B is still fraudulent as Mr C bought some shares that were not for sale. I guess shares are supposed to be fungible but in some way they are not exactly - if the company has a share register, and shares are numbered then what number does Mr C get? If Mr C is offering to buy future-shares then he knows that he doesn't have a share today but that isn't what happened, he understood that he has bought something not an option to buy.
> I guess shares are supposed to be fungible but in some way they are not exactly - if the company has a share register, and shares are numbered then what number does Mr C get?
Currency is also numbered. If I lend you $20, it's not fraud to give me a $20 back with a different serial number on it. It's not even fraud to give me back two $10s. Adding those kinds of restrictions would defeat much of the point of lending you $20 in the first place. It's also not fraud to spend it at Mr C's eatery for lunch, and hope you can replace it later - in fact, that's the whole point of borrowing money.
> However, I think Mr B is still fraudulent as Mr C bought some shares that were not for sale. I guess shares are supposed to be fungible
The entire idea of margin accounts, stock exchanges, etc., is that shares of the same class in the same firm are, in fact, absolutely and perfectly fungible; thats the agreement you make when you participate in those systems. If that wasn't the case, you'd have specific bid/ask prices for individual shares.
> if the company has a share register, and shares are numbered then what number does Mr C get?
The one that was borrowed, which must be replaced by the borrower with an equivalent one at the end of the specified term, per the terms of the contract under which it was borrowed (this is true for all the borrowers in the chain, however deep it may be.)
Most broker agreements allow them to lend out your shares without your consent or knowledge. It actually works against the long stock holders, but it does help brokers to lower their customers' transaction fees.
Even worse is Naked Short Selling, a practise where short sellers don't borrow the shares in the first place. This artificially creates shares and dilutes the value of the stock being shorted. Although illegal since Reg SHO was introduced, it still goes on due to lack of enforcement and comically low fines - google "Reg SHO Violations".
Some public pension funds forbid the lending of the shares they own for shorting. The minimal interest gained by lending shares is not worth the downward pressure to the stock price created by the short which undermines the asset value.
> Most broker agreements allow them to lend out your shares without your consent or knowledge.
This is straddling the line between completely untrue and highly misleading. For cash accounts, brokers cannot lend your shares without a written agreement allowing it. Although the standard agreement could include agreeing to a securities lending program, this is not common in retail brokerage contracts. Additionally, even if that clause was in your contract, they have to notify you whenever they lend your shares. That right to notification CANNOT be waived in the agreement. So if you have a cash account, no one is lending your shares without your knowledge, period.
Even for margin accounts, the same requirements hold for fully paid securities. So if you have a margin account, but you're not actually borrowing any money, no one is lending your shares without your knowledge.
The only case where your broker might lend your securities without your knowledge is when you have a margin account and you are actually borrowing money.
You didn't mention whether it was a cash account or a margin account, or if there's an exception for fully paid securities. If it's a margin account, that is indeed how it works for non-fully paid securities. If it's a cash account, or there's no exception for fully paid securities, regulators will probably not view that agreement favorably. You can file a complaint at https://www.sec.gov/complaint/tipscomplaint.shtml. In my experience, they actually read and act on complaints. (Well, at least small easy to investigate ones... ones requiring a lot of investigatory work like the Madoff case are a different story.) The relevant regulation is 17 CFR §240.15c3-3, paragraphs b(1), b(3), and b(3)ii. (http://www.ecfr.gov/cgi-bin/text-idx?SID=f07570958d348a3f75d...)
> even if that clause was in your contract, they have to notify you whenever they lend your shares. That right to notification CANNOT be waived in the agreement.
>> The minimal interest gained by lending shares is not worth the downward pressure to the stock price created by the short which undermines the asset value.
yes - if someone wants to borrow, shouldn't the lender demand a fee? At many brokers there is a program to route a portion of that interest back to the client.
also - the interest rate is often negative : ie the lender PAYS THE BORROWER to take the shares. The borrower posts cash collateral that the lender gets to earn interest on...
The pension fund thing is interesting, because interest on shares is linear with respect to number lent, while downward pressure on asset price is quadratic (number of shares * per-lending downward pressure).
I believe the logical conclusion to this scenario is that Mr. B suspects the stock price will drop. He has borrowed from Mr. A, and promised to give it back later. When the stock price drops, Mr. B re-purchases a share at a price lower than what he sold it for to Mr. C.
Mr. B returns the share to Mr. A, and pockets the difference. This isn't fraud, it's relatively common.
Naked shorting is practically legal, and basically unenforced. The seller only has to claim that there was "good faith reason to believe" that shares could be reasonably acquired within the settlement period (3 days). See Goldman Sach's infamous "Easy to Borrow List"[0].
Coordinated naked shorting attacks are real and legal. Flood the market with false shares and tiny lots of low-asks. Rapidly drop the price down to capture the easy stop-losses that retail investors might set. It is fool-proof because you know those shares can be obtained at a certain price (hedge-funds and market-makers can see the stop-losses). As soon as you acquire the stop-loss shares, pull off the selling pressure and use the shares just obtained to fulfill the short-contract. There is no borrowing.
I've had my stop losses trigger at the daily low for a share multiple times. It basically touched my stop loss then bounced back up. I think using conditional orders, which some brokers support makes this less of an issue.
- Mr. A intentionally lent out the stock (not fraud - there's no reason to lend out the stock other than to enable this kind of scheme AFAIK, Mr. A will generally not be an ignorant and deceived party here)
- Mr. A signed some fine print allowing his stock to be lent out for such schemes (not fraud)
- Mr. A signed some fine print saying some proxy (his broker?) technically owns the stock and they can lend it out for such schemes (not fraud)
- Mr. A owns his stock outright, and signed nothing allowing it to be lent out (step #2 isn't called "borrowing" in this case, it's called "theft")
clort, Thanks for raising this issue - there is an informative discussion in the responses. You might not want to be so fired up about fraud being the explanation for a thing you don't understand very well. Ignorance is perfectly fine - but assuming malice as the explanation is not going to serve you or this forum very well.
Usually this is part of the fine print when you sign up for a margin account. By the margin agreement, your shares can be lent out at any time. Don't like it, use a cash account.
Presumably, this is the premise behind T0 [1] in that it would allow beneficial owners, instead of brokers, to be able to lend their securities to short-sellers. In that case, there is no problem of tracking ownership - if you lend your shares to the short-seller, you're no longer the beneficial owner, and any agreement, like paying of dividend, has to be worked out between the two parties without involving a broker.
I agree that the problem here is the basic concept of loaning shares of stock. It's a practice that just doesn't make sense except for people playing games. You could say the ability to bet against a company isn't a game, it's a strategy. But the whole concept of stocks is primarily shared ownership, not a casino. Short selling could be banned but don't hold your breath.
My understanding is that short selling is still a useful tool for signaling that a company is overvalued. Without short selling we would see even more asset bubbles and then eventual crashes. Plus short selling allows for hedging strategies which allows investors to, well, invest more, which is generally a good thing.
Short selling can't really be banned without mangling the right to enter contracts. There's too easy of an effective substitute - start writing contracts that have the payments to the same parties as shorting a stock.
You make a contract that's functionally equivalent.
You think the judge is going to say "oh, well it's not _exactly_ short selling... YOU GOT ME!"? Intent is everything, those sorts of tricks don't work. You're up against judges and other humans on this sort of thing, not some AI you're trying to trick.
That contract is called a CFD and I'm not sure it's legal in the USA, but there are other synthetic forms of shorts that are. They do not have to follow the same rules as short sales such as respecting the uptick rule when it is in effect.
I understand that synthetic shorts exist, I was speaking in the hypothetical that the SEC decides "no more short selling, period."
If there was a rule against short selling, I imagine that synthetic shorts would also have those rules applied to them unless there are enough differences to qualify them as "not short selling".
Though I guess the uptick rule already doesn't apply, so they're already seen as different in some sense?
practically speaking - short selling helps the market find the right price for the security. this is a vitally important feature of markets.
philosophically, shorting is an emergent feature from basic property rights. I have a thing, you want to borrow it, we're both consenting adults and negotiate an arrangement.
A naked short seller doesn't need to deliver the share(s) at the time of the sale, but must deliver according to the terms of the contract, whatever those may be.
Kind of like selling things online. You take the cash, then you ship the product. Or like the extreme form of "Lean Startup Method" -- sell the product, then build it.
The problem with naked short selling is the ability for rampant, cheap, and extremely profitable manipulation to cause "artificial" price-drops. There is basically no penalty for failure-to-delivers and companies share price can be gutted while no real shares have been traded.
I understand that this is the way it has worked for some time, but franky I don't see how this is anything but fraud.