Lawsuits target brokers' role in 'naked shorting' -- and there's Goldman Sachs!

Section:

By Randall Smith
The Wall Street Journal
Wednesday, June 28, 2006

Wall Street's biggest securities firms face a pair of
civil-antitrust lawsuits over the role they play in
the practice of "naked short selling," which can drive
down the price of certain stocks.

The lawsuits, brought by two trading customers, charge
that the Wall Street firms' "prime"
brokerage operations, which cater to hedge funds and
other professional traders, often charge
fees for borrowing stocks without actually borrowing
them.

Defendants in the case include the 11 largest
prime-brokerage operations, led by Morgan Stanley,
Bear Stearns Cos., and Goldman Sachs Group Inc., which
held a combined 60% share of that
market at the end of 2004, according to the Lipper
HedgeWorld service-provider directory.

A spokesman for Morgan Stanley said, "We think the
suits are wholly without merit, and we intend
to defend ourselves vigorously." Officials of Bear and
Goldman declined to comment.

Short sellers, who aim to profit by selling borrowed
shares and buying them back later at a lower
price, routinely rely on prime brokers to locate stock
available to be borrowed for such sales. The
brokers offer stock lending among other services,
including financing and bookkeeping.

The world of short selling will be on display today at
a Senate Judiciary Committee hearing on the
relationship between hedge funds and securities
analysts.

In naked short selling, short sales are executed
without borrowing or arranging to borrow the
securities in time to deliver them to the buyer within
the standard three-day settlement period after
the trade. A Securities and Exchange Commission rule,
Regulation SHO, curtailed naked
shorting. But the lawsuits note that failures to
deliver have declined only 20% since the rule's
adoption in January 2005.

One of the lawsuits, by Electronic Trading Group LLC,
which was filed in federal court in
Manhattan, says the prime-brokerage services
collusively condone "chronic failures to deliver by
which clients are charged for 'borrowing' when in fact
no borrowing actually takes place."

The lawsuits say the brokers charge fees of as much as
25% annually for hard-to-borrow stocks
to which they mightn't be entitled. The
prime-brokerage firms act reciprocally to avoid
forcing
delivery for each other's trades, the lawsuits
maintain, adding that the firms instead operate a
system of "phantom," book-entry transactions.

The Electronic Trading Group lawsuit was filed April
12 by Entwistle & Cappucci LLP, which also
represents the other plaintiff, Quark Fund LLC. Both
trading firms are less active than they were
previously, said Vincent Cappucci, the firm's lead
partner on the case.

Some traders agree with some of the lawsuits'
allegations, according to interviews with people on
Wall Street. But other potential plaintiffs are
"concerned" about going public with such assertions,
fearing a possible loss of access to Wall Street
services, Mr. Cappucci said.

The lawsuits highlight the obscure mechanics of short
selling, which are under scrutiny by
regulators, including the New York Stock Exchange, in
the decline of Vonage Holdings Corp., an
Internet telephone-service provider whose stock price
has tumbled 48% since its initial public
offering May 24.

Vonage's stock encountered heavy short selling on its
first day of trading, and NYSE regulators
have asked Wall Street brokers for records of trades
including short sales, and how naked short
sales were handled. Vonage shares have been listed as
hard to borrow since the IPO, and its
shares also have experienced high rates of delivery
failures -- another sign of naked shorting.

Some short sellers say they can't knock down stock
prices because of "uptick" rules limiting such
sales when prices are falling. However, the SEC has a
pilot program exempting about 1,000
stocks from the rules, which also don't apply to some
trades off the stocks' exchanges.

Josh Galper, managing principal of Vodia Group LLC, a
financial-services consultancy in
Concord, Mass., says the lawsuits may threaten the
profit margins of the prime-brokerage
business.

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