On November 13, 2014, the California Court of Appeal handed down a detailed opinion in the Overstock.com, Inc. case.[1] The opinion provided a framework for financial services firms engaged in executing, clearing, and settling securities transactions to consider in performing those functions. The Court in Overstock.com not only concluded that these firms can be subject to primary liability under California Corporations Code § 25400(b), but also defined the contours of conduct that might result in significant liability under that provision. The Court’s careful analysis of “naked short sales” was particularly notable, given California case law’s sparse treatment of the topic.

What are “naked short sales”?

A traditional short sale is simply a mechanism by which an individual can bet against a stock.[2]Specifically, the individual (who is the seller) borrows from a lender a share of stock the seller wishes to “short.” The seller/borrower then sells this borrowed share on the open market, before eventually turning around and purchasing replacement shares of the same stock. In addition to paying a borrowing fee, the seller/borrower returns the replacement shares to the original lender. The economics of the deal are straightforward—“[t]he seller profits if the stock price falls enough to cover all costs and fees associated with the sale, including borrowing the stock.”[3]

Although a “naked” short sale appears similar to a traditional short sale, it differs in one critical respect: the shares at issue are never actually borrowed in the first place.[4] Accordingly, after the initial sale, the seller does not deliver the shares to the buyer, resulting in a “fail to deliver.”[5] As stated by the Court in Overstock.com, one advantage of naked short selling is that the seller need not worry about covering the borrowing fees associated with a traditional short sale—thus making the naked short sale more profitable.[6]

Although short sales resulting in “fails to deliver” are not per se illegal, naked short selling can be employed in a manipulative fashion to, among other things, artificially drive down the price of a given stock or create a misimpression of trading volume in a given stock.[7] In 2003 and 2004, the Securities and Exchange Commission (“SEC”) took aim at abusive naked short selling with the adoption of Regulation SHO.[8] In short, Regulation SHO “requires brokers to have a reasonable belief they can ‘locate’ the shares to be sold and requires ‘participants’—i.e., clearing firms—to ‘deliver’ shares on a timely basis.”[9]

Brokerage and Clearing Firms, California Corporations Code Section 25400(b), and Naked Short Sales

The facts of the Overstock.com case are complex. At its core, the complaints alleged that certain market brokerage and clearing firms wrongfully engaged in their clients’ allegedly abusive naked short selling.[10] Perhaps equally important to the Court’s holding on the particular facts was its insightful analysis of the governing legal principles.

First, the Court unequivocally held that California Corporations Code § 25400(b) “can include execution, clearing and settlement activities by brokerage and clearing firms.”[11] The Court reached this conclusion only after engaging in a close textual analysis of the California statute, drawing analogies to the federal securities laws.[12] Section 25400(b) is a critical component of California’s securities laws and provides that it is unlawful “[t]o effect…a series of transactions in any security creating actual or apparent active trading in such security or raising or depressing the price of such security, for the purpose of inducing the purchase or sale of such security by others.”[13]

Second, the Court noted the “well-established rule that a private civil action under sections 25400 and 25500 [of the California Corporations Code] does not reach aiders and abettors,” but rather reaches only primary violators.[14] However, despite this, the Court recognized that certain conduct can transgress the line between acting as an aider/abettor and acting as a primary violator.[15] Taking guidance from federal courts, the Court in Overstock.com summarized the principles governing a clearing firm’s liability. Specifically, according to the Court, “‘normal clearing services’” do not result in liability, even if the firm knows that the trader in question is engaged in wrongdoing.[16] A clearing firm may be liable, though, if it “‘shed[s] its role as clearing broker’” and plays a far more active part in “directing,” “orchestrating,” or “instigating” the trader’s scheme, or if it has an “intimate” involvement in the wrongdoing, assumes “direct control” of the scheme, or “provid[es] a specialized tool for the client to engage in unlawful trading.”[17]

What does it all mean?

The decision in Overstock.com provides an unusually deep discussion of the interplay between short selling (specifically, naked short selling) and both the California and federal laws designed to prevent market manipulation. Thus, firms that execute, clear or settle these short sales (or securities transactions, generally) are on notice: courts have demonstrated their ability to grasp the complexities of naked short sales, and are comfortable applying well-established legal principles to analyze these transactions.

Moreover, clearing firms should pay particularly close attention to the Court’s holding that California Corporations Code § 25400(b) can expose them to liability for their conduct.[18] As a best practice, these firms would also do well to digest the Court’s succinct summary of the types of conduct that might lead to liability and consult counsel to navigate any of these complicated nuances.[19]