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A recent SEC internal audit reveals that few naked short selling tips have been forwarded to the Enforcement Division for further investigation. Of all naked short selling tips reviewed in the audit, only 2.5 percent were referred to Enforcement for possible investigation. None resulted in enforcement actions.

The reason is clear: naked short selling can occur for legitimate reasons, and there may be and often are perfectly legitimate reasons for failures to deliver. Indeed, it remains to be seen whether naked short selling, provided it is not done to an extreme, has any sort of material market impact.

The audit, which the SEC says was prompted by “numerous complaints alleging that Enforcement has failed to take sufficient action regarding naked short selling,” follows a series of formal and emergency orders issued by the SEC in the fall of 2008 to address what it described at the time as “abusive short selling” practices.

A written response from Enforcement, however, rejects some of the audit’s key proposals; questions whether the SEC should devote additional resources toward naked short selling complaints; and notes that the audit provides no evidence regarding the market impact of naked short selling.

The Audit

The audit, conducted by the SEC Office of Inspector General, focused on whether Enforcement had established policies and guidelines to respond to naked short selling complaints and referrals, and whether Enforcement followed existing policies and procedures for responding to such complaints. The review period was January 1, 2007 to June 1, 2008, with fieldwork conducted from May 2008 to January 2009. In addition to reviewing records, the audit team interviewed staff and managers at various SEC divisions and regional offices and submitted questionnaires to all 11 regional offices.

The SEC’s Enforcement Division does not have separate procedures and processes for handling complaints about naked short selling. As a result, the audit examined Enforcement’s general complaint receipt and processing procedures as applied to the receipt and referral of naked short selling complaints.

Findings

During the review period, Enforcement brought no actions based on naked short selling tips, and very few tips were forwarded for any further investigation. Of approximately 5,000 naked short selling complaints received during the 17-month review period, only 123 – or 2.5 percent – were forwarded for further investigation. And those 123 complaints were forwarded only because the complaint subjects were involved in ongoing Enforcement investigations.

Complaints submitted to Enforcement ranged in specificity, from requests that Enforcement investigate specific instances of naked short selling to complaints that Enforcement generally was not taking sufficient action regarding the practice, to broad concerns about the impact of naked short selling on the market.

The audit offers various explanations for the dearth of complaints forwarded to Enforcement.

First, Enforcement’s policies and procedures do not include specific steps to determine which naked short selling complaints are likely to compel Enforcement staff to open an informal inquiry or formal investigation. However, Enforcement does have specific procedures for handling other categories of complaints, such as spam driven manipulations, unregistered online offerings and insider trading.

Second, the policies and procedures of the Enforcement Complaint Center – the SEC’s front line for receiving tips from the public, mostly via the SEC web site and e-mail – expressly instruct staff not to forward for further investigation complaints based on data obtained from “Level II” trading terminals. Level II data shows the best bid and ask prices and the number of shares available for every market maker and electronic communications network. Many investor complaints were based on information obtained from Level II trading screens, but none were analyzed further or forwarded to Enforcement unless they pertained to an existing enforcement matter.

Third, no supervisor reviews the initial screening decisions made by Enforcement Complaint Center staff.

Fourth, the SEC has no uniform set of procedures for accepting and processing complaints received by SEC headquarters and regional office enforcement staff, outside the normal complaint channels. These types of referrals, not submitted through the Enforcement Complaint Center, are known within the SEC as Complaints, Tips and Referrals, or CTRs. Enforcement and other SEC divisions do not have a designated official overseeing the handling of CTR submissions. Furthermore, regional office procedures are inconsistent as to when and whether CTR complaints are entered into the SEC’s complaint tracking database.

Finally, SEC headquarters and regional offices are not complying fully with existing written policies and procedures for complaints received outside of the Enforcement Complaint Center. Most complaint files created during the review period were incomplete, omitting certain documentation that is required under the written policies. Furthermore, of the 11 SEC regional offices, only 5 performed required monthly CTR reviews.

Recommendations

The audit report offers a series of recommendations to improve Enforcement’s capacity to respond to naked short selling tips:

• Revise Enforcement Complaint Center written policies and procedures to include in-depth triage analysis for naked short selling complaints, similar to the steps currently specified for other types of complaints.
• Ensure that investor naked short selling complaints based on information obtained from less sophisticated computer terminals, such as Level II computer screens, are given a proper level of scrutiny.
• Include naked short selling in the categories of complaints listed on the Enforcement Complaint Center page on the SEC website.
• Develop uniform written policies and procedures for the CTR program at headquarters and the regional offices, and designate an office or individual at headquarters to oversee the program nationwide.
• Ensure that senior officials at regional offices perform monthly CTR reviews, as required by existing policies and procedures.
• Improve existing information technology systems for the receipt and processing of complaints to increase functionality, analytical capabilities and tracking of complaint referrals.

Response from Enforcement

In a written response included with the audit report, the Enforcement Division accepts some but not all of the Office of Inspector General’s recommendations.

In particular, Enforcement explicitly disagrees with the first three recommendations summarized above: (1) developing a written triage analysis specifically for naked short selling complaints; (2) giving more scrutiny to complaints based on Level II computer screens; and (3) adding naked short selling to the categories of complaints listed on the SEC web site. Enforcement’s reasoning for opposing these recommendations:

• The naked short selling tips submitted to the Enforcement Complaint Center generally do not provide sufficient information to warrant pursuit of the complaint;
• Level II assertions of market manipulation from retail investors based purely on observations of private computer terminals “are really no more reliable an indicator of fraud than a dart tossed at a dartboard full of company names”; and
• In light of those deficiencies, pursuing the audit report’s first three recommendations would not yield a higher quality of investigative referrals to Enforcement attorneys.

Enforcement’s response also notes that although abusive naked short selling is a serious issue, the practice of naked short selling can occur for legitimate reasons and there may be legitimate reasons for failures to deliver. The response adds: “a small but vocal cadre of advocates has emerged decrying the practice,” but “there is hardly unanimity” that naked short selling is prevalent or dangerous, and some see the threat as “wildly exaggerated.” Perhaps demonstrating the lack of unanimity on the issue, Enforcement notes that the audit report cites “no bona fide studies or empirical data regarding the practice’s market impact.”

Enforcement’s Continued Focus on Hedge Funds

While Enforcement may be less focused on naked short selling, the Securities and Exchange Commission continues to scrutinize hedge funds with a new focus on redemptions. In testimony before the House Financial Services Committee, Commissioner Elisse Walters stated that a surge in redemption suspensions and liquidations has created “particular concern as to whether hedge fund advisers may be favoring their own interests above others.” Ms. Walters also stated that the Commission has “dozens of active investigations” involving people linked to hedge funds.