Hedge fund to be sued over 'naked shorting'

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US regulators are about to take their first legal action against a hedge fund involved in the controversial practice of "naked short selling", whose critics say it distorts the stock market and drives down company share prices.

The New York-based Sandell Asset Management has been told by the Securities and Exchange Commission that it faces a civil lawsuit for trading in shares affected by the fallout from Hurricane Katrina last year.

A short seller normally borrows shares and then sells them, betting they can be repurchased later at a lower price. A "naked short" is when the sale is made without borrowing the shares.

The practice has caused a furore in the US in recent months, thanks in part to a high-profile campaign by the online retail entrepreneur Patrick Byrne, who claims shares in his company, Overstock.com, were driven down by a conspiracy of naked short sellers.

Congressmen investigating the hedge fund industry have zeroed in on short selling, and naked shorts in particular, as they examine ways to prevent the offshore industry manipulating the US stock market. The hedge fund industry has argued short selling just improves the efficiency of the market.

The SEC weighed into the controversy earlier this year, promising to overhaul some of the technical rules around naked shorting. However, it does not believe short sellers can be forced to borrow stock to cover their position. It is instead focusing on traders who deliberately or repeatedly fail to deliver the stock they have sold.

In July, Christopher Cox, the SEC chairman, said that naked shorting might hurt investor confidence and a company's ability to attract capital. "Selling short without having stock available for delivery, and intentionally failing to deliver stock within the standard three-day settlement period, is market manipulation that is clearly violative of the federal securities laws," he said.

The SEC refused to comment on its investigation of Sandell Asset Management, but it is understood to have sent the hedge fund a letter last month which said it was recommending civil action over trading in Hibernia, a New Orleans bank that was being taken over by Capital One Financial.

Sandell opened a naked short position in Hibernia after Hurricane Katrina slammed into New Orleans last August. Capital One subsequently slashed the value of its offer for Hibernia.

Sandell, which declined to comment yesterday, has been updating its investors on the SEC investigation, telling them it is cooperating with the regulator but disputes several of its assertions. The fund was set up in 1998 by Thomas Sandell, a former executive at the investment bank Bear Stearns and once Sweden's number two badminton player.