Whose shares are lent out to short sellers?

Does anyone know the answer to this question?  A short seller must borrow shares at a fee, and so I wonder whose shares they borrow.  The other day I was reading at Stockhouse that bullboarder had put a sale order on his shares of Petrobakken @$30 per share  in order to prevent his brokerage from lending out his shares.  Does this mean that my shares are among those which may be lent out?

My friend “Just Me” sent me an article this morning about the subject of short-selling, A not-so-short story, at the Economist which deals with Patrick Bryne’s fight against the short-sellers who harmed his online-retail company.  But there were a few lines that caused me to wake up to the practice of shortselling:

The failure to deliver shares (and thus to settle trades) that goes hand-in-hand with naked shorting is more than just a plumbing problem: a buyer who does not receive his share cannot technically vote it.

What if my brokerage lends out to short seller, who sells them and then my shares are actually delivered.  We have the following scenario.

Stockholder A has 100 shares long.

Stockholder B sells short A’s shares.

Stockholder C buys 100 shares on open market and receives delivery on settlement date.

Now the problem is that if a brokerage can rent out A’s shares at a fee to B, and C receives them, then 100 fictional shares now exist in the market and these are non-voting shares (because only real shares can vote).  So only A or C can vote but not both.  But if C receives fictional shares, then only A can vote.

I reported that I never received ballots for my shares of SKW at Beating the Index.  I wonder if it was because my shares were the fictional ones and that the real ones were borrowed.  Does anyone know the answer to this question?

Given the meltdown of MF Global, I think we should all be concerned.  Perhaps we should go back to the system of my grandfather’s day when you received the stock certificates upon settlement and you kept them in safety deposit box.  Finally, if my brokerage is lending out my shares, I should be told and I should receive part of the fee that the brokerage receives from the short seller.  Has anyone else experienced not receiving ballots for important votes, such as the election of officers?

11 thoughts on “Whose shares are lent out to short sellers?

  1. I’m commenting about the “short selling hurt his company” and not who holds the rights because I don’t deal in stocks anymore.

    The function of going LONG or SHORT (buying and selling) is fundamental to the markets. A term which I *deeeespise* hearing “speculators”. It seems like every time a business executive or a politican makes a stupid decision, they blame it on the speculators. This is uniform across every country I can speak the language. So why shouldn’t politicians blame speculators?


    Whoever makes a purchase today, thinking that prices will be higher is the future is a speculator (inverse for the short position). Even my little old grandma who buys a plane ticket today because the price is cheap now compared to what she thinks prices will be in the future, is speculating.

    Speculators are essential to markets. Without them, there would be liquidity and prices would not be anywhere near their perceived or fair value. But this is a double edge sword that rewards companies and governments who run their business well and it punishes those that perform badly.

    Governments sometimes like to put restrictions on “speculating”. The most common form around the world is to ban short-selling. I haven’t quite figured this out yet because it is proven that this is futile; prices will still drop, even with this government intervention. My guess is that there is a more corrupt reason behind it, like giving time for well-connected people to get out quickly, while smaller investors are left holding the bag.

    So the next time you hear a politician or executive blame “speculators”, just remember: that person most likely made a dumb decision and is now paying the consquences.

  2. My understanding is that if your shares are held at a brokerage firm, they’re held in the name of the brokerage firm. The brokerage firm keeps track of how many shares each person holds, but those shares aren’t exactly held in their name. When someone wants to short sell shares, the brokerage firm takes the shares in their pool and loans them out. So, technically, those shares could be one person’s shares or a few shares from many, many people. At least, that’s the way it works in the U.S.

    I looked this up a while back because I was wondering what happens if the person whose shares are lent out wants to sell. Apparently, the brokerage firm just shifts things around in their books and sells other shares from the large pool.

  3. Ugh, sorry for the typo…I just saw it – should be “My understanding” not “My understand”.

    I’m not sure why you didn’t receive your ballots. Even if your shares had been lent out for short selling, you’re still supposed to retain the right to dividends and votes.

    Oh, and I agree with you – the person whose shares are lent out should receive a portion of the fee the brokerage gets. I doubt we’ll ever see that day though…

    • If what you say is correct, that there is a pool of stocks that the brokerage “owns” and assigns to different clients, then a number of those shares are fictional. That very well could explain the missing ballots. I think up to the day of the vote, Skywest shares were heavily shorted. On that point, perhaps Mich at Beating the Index has an answer.

  4. Hi There

    I’m a retail investor. I try my best to fully understand before I invest, and shorting (hitherto avoided) is looking like an important consideration in these volatile markets. I did some research, but am certainly no expert:

    Your example above does not create 100 fictional shares. From a strict accounting point of view, Shareholders A & C both hold 100 shares, but shareholder B holds -100 shares: all totaled = 100 shares.

    You are correct to question the issue of voting, and in your example above (simplistically) Shareholder A loses his voting rights. In reality the broker (who handles all the dynamics and accounting of the shorting procedure) is unlikely to take all the shares from one client. Probably Shareholder A will lend out (and lose voting rights) on a portion of his shares, possibly comensurate with the ratio that the stock is held short/long by the broker’s clients.

    How is this fair that Shareholder A unwittingly loses his voting rights? Well there are strict rules as to which clients’ stocks may be lent out. A broker may only lend out the stock of clients who have margin accounts, and then only when they are actually using such margin facility … which I interpret to mean a negative cash balance. So if you utilise margin you tacitly accept potential loss of voting rights.

    Another interesting shorting consequence is that of dividends. How do both Sharholders A & C receive a dividend. Well apparently Shareholder B (who receives the negative dividend from his -100 shares) pays it to Shareholder A. Presumably this is handled automatically by the broker.

    There are no doubt strict laws governing a broker’s handling of shorting, but I have read concerns about so-called naked shorting. Whether through loopholes or non-compliance, it is safe to assume that there are some ficticious shares out there. How to avoid holding them? Reputable broker and no margin would be my guess. I believe this problem is much more severe in the commodities markets where they use extreme margin and shorting to trade rights and obligations rather than the underlying product (when did an oil trader last take delivery of his 1000 barrels of oil?). This is only likely to affect the private investor in the case of precious metals. I have heard that there may be many paper gold ounces in circulation for every real one. How to protect yourself? Sell your GLD (or other precious metal ETFs) and buy Krugerrands.

    As I said, don’t take everything I say as gospel … I’m a beginner myself. If you want more authority, much of what I learnt I got from Investopedia under the Articles and Tutorials tabs.

    Hope this has helped.

    • Sure your response is very interesting and helpful. Thank you for sharing.

      Let me see if I can parse what I am saying. First if A lends 100 real shares to B who sells them to C, I would contend that +100 non-voting shares and -100 non-voting shares have been created through a sort of derivative contract. The net number of shares is still only 100 shares. But, nevertheless, the -100 shares and the +100 non-voting shares are not real, but a fictional derivative of the real shares that were lent to B and sold to share holder C. So shareholder C is the only one with real shares.

      In the case of naked shorting, the same number of fictional shares are created: B sells 100 shares to C. But now it is C, not A, who is holding the fictional shares.

      The real distrubing thing is that the brokerages themselves are taking excessive risks, such as Lehman’s, Bear Stearns and MF Globl. IN the case of this last company, the retail investors had their cash stolen out of the accounts and their positions undermined. Thus, the brokerages themselves are not worthy of our trust, and I think it is preferable to go back to each stockholder receiving actual physical delivery of the stock certificates, as it was in the early days when my grandfather (d. 1991) was a value investor.

      Also, I didn’t receive ballots from any of my shares of SKW; and most of them were in registered accounts which are not margin accounts by definition.

      I love investopedia as a source. It is really helpful especially for its online dictionary of financialese.

  5. A question among many retail investors’ mind is how to prevent short sellers from borrowing our own shares. This is a good question because when our shares are lent to short sellers the shares are effectively used against ourselves in helping put downward pressure on our stock. In principle, if people can’t borrow shares they can’t do further short selling.

    Short must locate shares for shorting.
    To enact a short sale, Trader A must first confirm that he will be able to borrow the number of shares he plans to sell. Brokers keep a list of available inventory on what is called a Box List. Brokers populate the Box List through their own inventory and shares of others, including their customers who borrow on margin and agree to lend their shares, and other third-party brokers.

    Instructions how to stop a broker lending YOUR SHARES to a short:
    1. Call your broker. When you own shares at a brokerage house, those shares are actually held in what is called “street name.” You have rights to the shares, but the brokerage house is allowed to loan out the shares held in your account to facilitate a short sale for another buyer. This often happens without you knowing, but you can call your broker and request that he does not allow the shares to be located for a short sale transaction.

    2. If your broker does not fulfill your request, you have the right to transfer your shares directly to the transfer agent. The transfer agent will keep your shares in safekeeping and the shares will be registered in your name. This will take a few business days, and there may be fees assessed for initiating the transfer.

    3. Request a stock certificate. The only way to be absolutely sure your shares are not being loaned out to facilitate a short sale is to physically hold the certificate in your hands. This way, you are in complete control of your shares of stock, and shares held in certificate form are nearly impossible to be used for short sale purposes.

  6. These are helpful suggestions. In Canada RRSP and TFSA accounts are allocated by law.

    Of course, having your stocks in the pool is part of the arrangement when one has a margin account. Today there is so much fraud in the US, I’m not sure I’d want one in the US. I’m not as worried about Canada–no MF Global has happened here yet.

  7. When A lends shares to B and B sells them to C, C has the shares and C has the vote.

    My understanding was that brokers could lend shares held in margin accounts but not shares held in cash accounts. So if A has a margin account the broker can lend A’s shares to B, but if Z has a cash account the broker cannot lend Z’s shares. I never heard about pooling the way it’s described in this discussion, so I don’t know who’s right, I only know what my understanding was.

    Shares in brokerage accounts used to be registered in brokers’ names as described in this discussion, but I think they’re all registered in the name of Computershare now. If you pay a fee you can get a certificate (and then of course it can’t be lent).

    I’m not quite sure what is meant by naked shorting here. The short seller is always naked in the sense of not owning the shares before selling. If the broker wants to make things easier for short seller, the broker might put themselves in the position of A, taking a long position themselves and lending the shares to the short seller. Brokers often do their own investing so this isn’t a big step, unless the company is one which the broker didn’t want to take a long position in.

    When I was B and the company paid a dividend the broker transferred money from my account to A’s account.

    My question is what happens when A, B, and C don’t all have the same status with regard to non resident tax withholding by the company’s country — especially now that Canadian brokers know which customers aren’t supposed to be subject to US non resident withholding.

    • If I understand it, naked shorting is the shady practice of allowing stockholder B to sell shares but there are no shares owned by A to lend to B. Seemingly unlimited fictional shares could thus be created.

      Some people are saying something like this is happening in the gold market–where many fictional oz of gold are created with very little physical to back it. The banksters have unlimited access to fiat money, so the fictional paper gold is covered by unlimited amounts of cash.

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