Naked shorting creates a risky game of musical chairs for investors.

So says Robert Shapiro, an economist and former Under Secretary of Commerce for Economic Affairs for President Bill Clinton. Today, he's a consultant in some lawsuits filed against several investment firms and brokerages over the issue of naked short sales.

"If every investor called for those shares all at once, you would have a very big problem trying to cover all of those shares and a very expensive problem for certain institutions," he said. "This is about insurance companies, mutual funds -- anybody who purchased these 'failed to deliver' shares without even knowing it."

Naked shorting is a big part of the failed to deliver issue, which happens when an investor buys shares in a company but doesn't receive the shares for weeks, or ever. The Securities and Exchange Commission last year tightened regulations for failed to deliver, also called phantom, short sales with its Regulation SHO. Now, SEC staff has two pending proposals that would tighten regulations even more.

Vonage Sparked Concern

Naked shorting seldom is in the news, but this year reports surfaced that the New York Stock Exchange was looking into whether shares for Internet phone service provider Vonage Holdings (NYSE:VG - News) were hurt by naked shorts when the firm made its initial public offering in May.

Meanwhile, Utah Gov. Jon Huntsman has signed a bill to help crack down on naked short selling. Overstock.com (NASDAQ:OSTK - News), an online liquidator based in Utah, is a stock that is often naked shorted, according to SEC records. Its outspoken chief executive, Patrick Byrne, may be the best known critic of naked short selling.

Byrne and others are trying to take action because the SEC hasn't done enough, Shapiro says.

"The SEC has spent years saying this isn't a problem," Shapiro said. "To acknowledge the dimensions of the problem requires that they acknowledge they were wrong. That's very difficult for any public institution to do."

Brent Baker, a former SEC special counsel, says he helped prosecute several cases involving abusive short sellers. That didn't stop the abuses, says Baker, a deputy general counsel for Overstock.com.

"I left the SEC in part because they were fiddling while Rome burned," he said.

But not everyone is so concerned.

Jim Cramer, host of the CNBC investment TV show "Mad Money" and founder of investment-focused Web site TheStreet.com (NASDAQ:TSCM - News), says naked shorting exists "because the system has gaps in it." It's not unlike government's attempts to stop illegal immigration, Cramer says.

"Is it illegal? Yes. Is it fair? No. Should everyone play by the rules. Yes," he said. "But it's not an issue that's enforced very well."

Cramer says he doesn't consider naked short selling a big issue.

Small hedge funds and mutual funds buy naked short and failed to deliver shares because they lack tough trading departments to stop the practice, says Frederick Kobrick, founder of Kobrick Capital, a mutual fund.

"Brokers are overpromising and they are probably doing more (naked shorting) now because it's so much tougher to trade lower liquidity markets (smaller companies that have fewer shares)," he said. "But it certainly is a big risk."

Failed to delivers and naked shorting have been thorny subjects on Wall Street for the past 10 years, says Wes Christian, a partner at Christian, Smith & Jewel. The law firm represents 18 companies in 20 lawsuits against investors and brokerages including Southridge Capital Management, Bear Stearns and Morgan Stanley. (Shapiro is a consultant on some of these suits.) None of the three firms responded to e-mails seeking comment on the suits. Some of the suits also target the Depository Trust & Clearing Corp., or DTCC, the nation's principal securities depository.

"This is systemic, it's intentional, it is Wall Street brokers and dealers at the highest level selling hundreds of billions of securities that they are not authorized to sell, that they never deliver, that they steal from their customers' accounts and deliver to other people," Christian said.

Many disagree.

Failed to delivers account for just 0.1% of the 23 million new transactions processed daily by the National Securities Clearing Corp. a unit of the DTCC. So wrote Larry Thompson, deputy general counsel for the DTCC, on the DTCC's Web site.

In January 2005, the SEC started the Reg SHO listings to help control naked shorts and failed to delivers. 20 Million Becomes 60 Million

Overstock has issued 20 million shares, but CEO Byrne says up to an additional 40 million phantom shares have been traded -- because of naked short selling.

Analysts say the SEC expected the attention given to companies that appeared on the Reg SHO list would make them less of a target for naked short sellers. But it's having the opposite effect, says Mark Griffith, general counsel for Overstock.

"The SEC published the names of these companies, which is tantamount to publishing the names of rape victims and not the names of the rapists," he said. "It seems to be only a bulletin board inviting further abuse of these companies."

On its Web site, the SEC says many cases of undelivered shares are mundane. They include an inability by a broker to borrow shares in time for a settlement and delays in obtaining a transfer of ownership title of a security.

Comments from SEC chief Christopher Cox in July about the proposed amendments to Regulation SHO appear to tell a different story.

"We are particularly concerned about the potential negative effect that substantial and persistent fails to deliver may be having on the market in some securities," he said. "These fails to deliver can deprive shareholders of the benefits of ownership -- voting, lending and dividends from issuers. Moreover, they can be indicative of abusive naked short selling, which could be used as a tool to drive down a company's stock price."

In 2004, the SEC hired Leslie Boni, an economist from the University of New Mexico, to look into the issue of failed to deliver shares. She found that "a substantial fraction of issues (42% of listed stocks) had persistent fails of five days or more."

Boni also found that undelivered shares often are the result of strategic failures -- short sellers choose not to deliver shares that are expensive to borrow. She wrote: "We argue that the long lived ('persistent') fails -- companies that continually have undelivered shares -- are more likely the result of strategic fails rather than inadvertent delivery errors or delays."

Most companies decline to discuss the issue. Most are small companies that have generally had some problems. Besides Overstock, some of the bigger companies that have been on the Reg SHO list this year include Marchex (NASDAQ:MCHX - News), a online search marketing firm, Blue Nile (NASDAQ:NILE - News), an online retailer, and Netflix (NASDAQ:NFLX - News), an online video rental service. All declined to comment.

Overstock's Byrne, however, continues to wage a noisy fight. Critics say his campaign against naked shorts is an attempt to mask his company's own problems, which include continuing losses and slowing sales growth. The company's stock has been falling for two years. Shares plummeted Monday after Overstock reported third-quarter results that lagged expectations.

Byrne, though, says the issue is bigger than just Overstock. "We think there is a lot of evidence that there is an extraordinary amount of phantom shares," he said. "What it means is that our whole system of governance is turning into a hoax."

The failed to deliver issue is gaining more attention also because some big companies have made the SHO lists. They include Delta Air Lines and real estate firm Fairfax Financial Holdings (NYSE:FFH - News).

Most companies won't speak about the issue because they fear angering the SEC, says Baker, the Overstock attorney.

But applying more controls on naked short selling could have a backlash effect on legitimate short sellers, says Daniel Clifton, executive director of the American Shareholders Association.

That's one issue. But getting better regulatory controls on naked short selling also will be tough because stock trading brings profits to Wall Street, says Overstock's Griffin. "Eventually," he said, "it's going to be shareholders and taxpayers that are going to foot the bill for this if the regulators don't get their arms around it soon."

Copyright 2006 Investor's Business Daily, Inc.

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