Q. What is “naked shorting”?

A. As I explained last week, shorting is a way to profit from a decline in the price of a stock. Shortsellers, though often vilified, play an important role in the stock market and were the first to spot the frauds at Enron and WorldCom.

It is important to distinguish naked shorting from regular shorting. In its simplest terms, naked shorting involves selling shares of stock that don’t exist. While not always forbidden, naked shorting done to manipulate a company’s stock price is unequivocally illegal.

Illegal naked shorting is typically done by hedge funds, or so it is theorized, with indirect support from those funds’ brokerages and an institution called DTCC, a critical player in the administrative world of stock certificates.

How do hedge funds short shares of stock that don’t exist? Depending on your point of view, naked shortsellers can create those shares out of thin air due to either glaring inefficiencies in the back-office world of certificate transfers…or institutionalized fraud on a massive scale.

The heart of the naked shorting issue revolves around locating shares to short. Last week I mentioned how in the process of shorting a stock a brokerage must first locate those shares for its shortselling client, typically borrowing them for a fee from another customer. The brokerages don’t always find those shares quickly, though. Brokerages often allow hedge funds to short shares before they have actually been located.

Can you see where this is going? The potential exists for aggressive hedge funds to keep asking for more and more shares to short, and as long as the brokerage keeps assuming it will be able to find those shares…and the DTCC keeps looking the other way…the pressure exerted by that naked shorting can continue to drive a stock’s price lower. By effectively shorting counterfeit shares, hedge funds can drive a company’s stock price significantly lower.

Wall Street denies naked shorting is a problem. Others, including the CEOs of companies that claim to be victims of naked shorting, believe otherwise. I’ll leave it to you to form your own opinion.