The Short End of the Short Sale

Ever since the first profit was pocketed by a short-selling strategy, the conflicts surrounding the practice have abounded. But the dark underbelly of that increasing popular world just got a little darker today.

The Securities and Exchange Commission today charged 38 people with fraudulent schemes around stock loans for short-selling transactions. The defendants include traders at brokerages including Morgan Stanley, Janney Montgomery, A.G. Edwards, and Oppenheimer. Separately, the U.S. Attorney in New York brought criminal charges against five of the individuals.

Some of the schemes allegedly took place over the course of a decade, and officials estimate that the defendants netted about $12 million.

In order to facilitate a short-sale, an investor needs to borrow securities from someone else who owns them. The investor then sells the securities, hopes their value falls, and then buys them back at the lower price and returns them to the lender. The trader nets the difference between the two prices. It's a risky tactic, and one that has become increasingly popular with the rise of the hedge fund industry.

The practice has spawned a separate industry of stock loan finders -- people who match investors with available securities for borrowing. These are the folks at the heart of today's charges. The federal authorities, who investigated the suspects over the course of two years, say that the traders and "finders" exchanged illegal kickbacks and skimmed profits by inflating the cost of borrowing the securities. The victims, in many of the schemes, were the Wall Street firms that employed the defendants.

In some cases, the defendants allegedly took "sham" finders fees when no services had been provided, or they took cash bribes. In some cases payments went to the relatives of the accused finders. All of the defendants reside in New York or New Jersey.

The charges brought by the U.S. Attorney include money laundering conspiracy, making false statements, and conspiring to commit securities and wire fraud. The accused face 25 years in prison.

Previously, nine of the people charged by the S.E.C. today had already pleaded guilty to criminal charges in the probe. One agreed to forfeit $3.6 million.

by Megan Barnett