Target of Naked Short Sellers Is Angry, Confused

There seems to be an uncanny correlation between (1) being accused of securities fraud and (2) accusing your enemies of naked short selling.
We keep the "naked short selling" illustrations classy around here. Source: Lentos Museum/ Knoll Galerie via Bloomberg

Here is a lawsuit that I pass on to you mainly because it is adorable. There's a little company called Life Partners Holdings that is "engaged in the secondary market for life insurance known generally as 'life settlements.'" Life Partners has an equity market cap of about $53 million based on yesterday's closing stock price of $2.83 a share, but traded at almost 10 times that price in early 2009.

So it seems to have fallen on hard times. I know very little about the company so I will not speculate on the reasons for that, though I will throw out there that the Securities and Exchange Commission's long-running case against Life Partners and its executives for fraud probably didn't help. However! Life Partners won that case last month, and is perhaps understandably aggrieved about having had to litigate it.

The other thing that Life Partners is aggrieved about is naked short selling, and I must say, there seems to be an uncanny correlation between (1) being accused of securities fraud and (2) accusing your enemies of naked short selling. But Life Partners is pretty sure that naked short selling brought it down, and now it's suing optionsXpress, a brokerage subsidiary of Charles Schwab Corp., for helping those naughty naked shorts. From its complaint:

Plaintiffs are informed and believe and thereon allege that Defendants, and each of them, have engaged in the unlawful creation and sale of millions of shares of counterfeit-phantom stock which said Defendants have mischaracterized to be the genuine stock of Life Partners and 24 other public companies. ...

Once the counterfeit-phantom stock trade is placed into circulation, it continues in circulation in the securities markets much like counterfeit bank notes continue in circulation after they are introduced into the monetary system. It thus has the effect of increasing the supply of stock available on the market for sale. The increased supply of stock, albeit counterfeit-phantom stock, generally has a depressing effect on the price of the genuine stock of the public company whose name the counterfeit-phantom stock bares. As alleged below, naked short sales of counterfeit-phantom stock harm investors holding genuine stock, investors who receive the phantom stock, and the public company whose stock is diluted with counterfeit-phantom stock.

It goes on irresistibly in that vein; I'll put a generous selection in the footnotes. 1

None of this is even a little bit true, but, like I said, it's adorable. I mean, wait, no, one important part of it is true: OptionsXpress really did facilitate illegal naked short selling in Life Partners stock! I guess that's a big one. Here is the SEC's case against optionsXpress, and here is the administrative law judge's decision (referred to by Life Partners). OptionsXpress totally helped its clients do a lot of naked short selling, in Life Partners and other stocks, and was fined millions of dollars for it.

Otherwise, though, nope. We've talked about naked short selling before (and about optionsXpress's naked short selling before that). The key thing to remember about naked short selling is that it's a way to make money off of stock borrow costs without taking stock price risk; it's not usually a way to make money by manipulating stock prices.

The scheme here seems to have been all about stock borrow. OptionsXpress's clients would effectively buy Life Partners common stock, and then write deep-in-the-money call options. 2 So they'd be long Life Partners on one trade and short on the other. The call options would be exercised immediately, 3 so the clients would have to deliver stock -- they'd be "naked short." They would deliver this stock by buying it in the next day, but also immediately writing another deep-in-the-money call option. 4 That call option would also be exercised almost immediately, and the cycle would continue.

So the result is that the optionsXpress client would continually be long Life Partners on one trade and short on the other. They were neutral to any moves in Life Partners' stock; they had no reason to want it to go up or down. A pointless trade, except that it was very expensive to borrow Life Partners stock. It was expensive to borrow because, one, its chief executive officer owns about half of the outstanding stock and wouldn't lend it, so supply was low. But also because demand was high: A lot of people wanted to borrow and short it. Not naked short it, mind you: Naked shorting doesn't drive up borrow costs. Only regular legal shorting does. And a lot of people wanted to short Life Partners stock, because they thought it would go down. (It did!)

So the optionsXpress clients could make money lending the stock that they were long, 5 not pay to borrow the stock that they were (illegally naked) short, and not take price risk. It was a pure stock-borrow strategy, indifferent to moves in Life Partners' stock price. If you wanted to manipulate the price, this strategy -- of buying and selling the same amount of Life Partners stock -- would make no sense. The naked short sellers did create supply of Life Partners stock, I guess, but they also soaked up the same amount of supply by buying Life Partners stock. Their net result was a nothing.

As for counterfeit shares of stock that still circulate ... no? Nobody had a printing press. If you look again at the mechanics of how the naked shorting worked, you can see that the short positions were deep-in-the-money written call options that were open for a few days at a time. The options would be exercised, the client would buy shares (real shares!) and deliver them, and would then get naked short again through another call option.

When the scheme was shut down, the call options vanished: They were exercised and not replaced. There's no vast pool of phantom -- sorry, "counterfeit-phantom" -- Life Partners stock outstanding that is driving down the price of the real stock. 6 This whole thing is a phantom.

Look, naked short selling really is confusing. And it sounds so evil and nefarious. Markets are rigged, haven't you heard? Because it sounds so bad and is so confusing, it is very tempting for troubled companies to blame their troubles on naked short selling. This is always wrong. 7 The more a company complains about naked short sellers driving down its stock price, the more worried you should be. But not about naked short sellers.

(This corrects footnote 6's characterization of disclosed shareholders: The Bloomberg HDS screen shows the total percentage of outstanding stock held by all disclosed shareholders, not just the top 19 holders shown on the first page.)

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.
  1. Because you may find it less enjoyable than I do. But I love it. Here:

    Plaintiffs are informed and believe, and thereon allege, that Life Partners and its real shareholders continue to be irreparably harmed by Defendants' sale of counterfeit-phantom stock which they trade as genuine Life Partners stock. As alleged herein, the issuance and sale of counterfeit-phantom stock which purports to be genuine stock depresses the price of the lawfully issued stock of Life Partners.
    The volume of counterfeit-phantom stock traded by Defendants, as alleged herein, equaled 100% of the lawfully traded shares of Life Partners stock. By doubling the amount of Life Partners stock traded daily, Defendants whipsawed the price of the stock at their whim. This causes and continues to cause erratic volatility of Life Partners stock, which is unrelated to economic, fundamental or technical factors affecting the stock's price, makes the stock less attractive to prospective investors and traders and therefore diminishes the value of the stock.
    Plaintiffs are informed and believe, and thereon allege, that Life Partners and its real shareholders continue to be irreparably harmed by Defendants' creation and circulation of counterfeit-phantom stock passed off as legitimate Life Partners stock in that it discourages traders and investors from purchasing Life Partners stock, because they do not know and cannot know whether they are purchasing genuine stock or counterfeit-phantom stock. Nothing on the confirmation slips from the broker-dealers executing the purchases of phantom stock informs the buyer that they have purchased counterfeit-phantom stock.
    When investors buy counterfeit-phantom stock believing it to be genuine, they become phantom shareholders. They do not receive dividends, cannot earn fees by lending the stock, may not exercise the shareholder rights to vote for the board of directors or on other issues, and have no entitlements if the corporation is acquired in a merger or dissolved with its net assets distributed to shareholders. Such uncertainty whether an investor is buying counterfeit-phantom or real stock puts downward pressure on the price of the stock.
  2. The clearest explanation is at paragraphs 22 to 36 of the SEC's complaint. I am simplifying in the text; in particular, the way they got long was not by actually buying Life Partners stock but rather by a synthetic transaction, buying a call and writing a put.

  3. Because for very hard-to-borrow stocks it is rational to prefer to own the stock rather than a deep-in-the-money call on the stock. The call has essentially no option value, and you can make money lending the stock.

    Incidentally the immediate exercise is not part of the strategy: The customers would have been happier not being exercised, and in fact on page 15 of the ALJ decision you see one of the optionsXpress customers trying to avoid getting assigned. The fact that the calls were exercised against the clients was an inevitable byproduct of their strategy, but not their goal. They'd have been just as happy being "naked short" through one long-lasting call option rather than by a series of frequently replaced call options.

  4. This is apparently illegal, though optionsXpress contested that mightily. See paragraphs 47 to 50 of the SEC complaint for discussion of the law. Basically, if you can't be naked short, you can't buy in and immediately write a call option that will make you short again -- that's too cute.

  5. Again, this oversimplifies; people don't really make money lending the stock in their brokerage accounts. (That money goes to the brokers!) Paragraphs 35 and 36 of the SEC complaint explain it correctly:

    The Customers received a net credit for their initial position because of a difference in the relative value of the put and the call. Normally, the price of the put and the call will be in parity; however, the stock associated with the options traded by the Customers was generally hard-to-borrow and therefore expensive to borrow. Because of this, the cost of borrowing the stock was incorporated into the price of the put. Thus, the value of the put was higher relative to the value of the call.
    Due to the cost of borrowing such hard-to-borrow stocks, the increased price the Customers received for selling the put would have been completely offset by the cost of instituting and maintaining the stock position, had optionsXpress and the Customers complied with their delivery obligations. In order to comply with those obligations, they would have had to borrow or purchase shares of the underlying stock in order to close-out the failure-to-deliver position.

    That's economically the same as what I say in the text, but a bit more complicated.

  6. By the way, one unscientific but interesting way to tell is, look at the disclosed holders of Life Partners stock:

    [imgviz image_id:i1M2DaNJJQSg type:image]

    Some 62 percent of the outstanding stock is represented by disclosed holders. That's a reasonable number. (Apple is 64 percent, Google is 89 percent, JPMorgan is 78 percent.) On the other hand, companies with lots of short interest -- not naked short interest, mind you, just regular short interest -- tend to have much higher numbers. (Even regular short selling creates "phantom" shares: Investor A owns a share, lends it to Investor B to short and Investor C buys it, so now both Investor A and Investor C "own" one share.) So the disclosed holders of Herbalife stock somehow own 115 percent of the outstanding shares -- because a lot of them own shares that short sellers borrowed from someone else:

    [imgviz image_id:ixTC9h7hBV0k type:image]

  7. Short sellers, fine. I'm not a fan of demonizing short sellers, but they really do tend to drive down prices. The "naked short selling" thing is a myth.

(Matt Levine writes about Wall Street and the financial world for Bloomberg View.)

To contact the author on this story:
Matthew S Levine at

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Zara Kessler at

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