How Different Brokers Handle Lending Shares To

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Feb 5, 2013 at 3:46 AM

How Different Brokers Handle Lending Shares To Short-Sellers

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. There are exceptions to this principle, i.e., naked short selling which is done both legally and illegally. Market Makers are allowed to legally naked short a stock as long as they stay within the parameters of law. Whether the legal requirements are always followed is another story.

A recent headline exposed illegal naked shorting and immoral practices at Goldman Sachs (NYSE: GS) and Bank of America (NYSE: BAC) (Goldman, Merrill E-Mails Show Naked Shorting, Filing Says?).

Many retail investors think by placing a Good Till Canceled order (GTC) they can prevent their shares from being lent. A quick survey of some brokers indicated this to be more of a myth than reality. While some brokers may act as such, most don't recognize an open order as prohibitive of lending shares.

The surest way to prevent lending of shares is to have shares in a "Cash" a.k.a. "Type 1" account. Some brokers like Fidelity Investments allow positions to be in Type 1 and Type 2 (Margin) in the same account. Some like Scottrade do not allow mixing of Type 1 and Type 2 in the same account so a customer has to open two separate accounts, one as Cash and one as Margin.

Moving shares between account types is simple - some brokers even allow it to be done on the phone - some require a fax or email confirmation.

Different brokers treat margin accounts differently as stated in their margin agreement. Some like Charles Schwab (NYSE: SCHW) only lend out shares up to the amount of the account's margin debit balance. This is a more favorable treatment than Wells Fargo's (NYSE: WFC) policy that regardless of carrying a debit balance or not if you have shares in a margin account they're lent out. This is in line with Wells Fargo Brokerage's poor ratings. Scottrade is somewhere in between. They will only lend out shares if you have a debit balance but even a 1 cent debit balance allows them to lend out all your shares (although their margin agreement says they can lend out shares in a margin account regardless of whether there's a debit balance or not).

The best way to prevent borrowing of shares is to have all of one's shares in a Cash account, or transfer the shares to the Transfer Agent, or get a certificate. If margin buying power is needed a good practice is to have only enough shares in a margin account to give the buying power one needs and the rest in a Cash account.

This subject is particularly important to holders of heavily shorted stocks which have had a big run up like Arena Pharmaceuticals (NASDAQ: ARNA) which has recently doubled and in my opinion is on the way for at least another double upon FDA approval which is expected on or before 27 June 2012. When a stock makes a big upward jump, shorts can get margin calls and some big shorts may want to dampen the rally by shorting more so they need to borrow shares.

In the case of Arena the majority of shares are held by retail investors which makes the stock more volatile. When the majority of shares are owned by institutions, which typically have lower turnover, a stock price is more stable. Being able to borrow shares is important for day traders and swing traders who short highly volatile stocks. With imminent approval, demand for shares by institutions should put further pressure on short sellers. Many retail longs like to help put further pressure on shorts and one of the easiest ways to do this is to make sure their shares are held in a "Cash" account.

Lastly, some brokers have a securities lending program which return to the customer some of the interest earned from lending their shares out. Some brokers just pocket that interest and the customer gets nothing for lending shares out. In my opinion lending out shares is never a good idea because it makes your shares work against yourself, and even if you earn a bit of income, you'd probably make more from a rise in the stock price which you'd help with by not making your shares available for shorting.

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