Opinion ID: 61651
Heading Depth: 2
Heading Rank: 2

Heading: The Basics of Short Selling

Text: A short sale is a sale of securities that are not owned by the seller. Provost v. United States, 269 U.S. 443, 450-51, 46 S.Ct. 152, 70 L.Ed. 352 (1926). Where the traditional investor seeks to profit by trading a stock the value of which he expects to rise, the short seller seeks to profit by trading stocks which he expects to decline in value. Zlotnick v. TIE Commc'ns, 836 F.2d 818, 820 (3d Cir.1988). The Third Circuit described a short sale as follows: Short selling is accomplished by selling stock which the investor does not yet own; normally this is done by borrowing shares from a broker at an agreed upon fee or rate of interest. At this point the investor's commitment to the buyer of the stock is complete; the buyer has his shares and the short seller his purchase price. The short seller is obligated, however, to buy an equivalent number of shares in order to return the borrowed shares. In theory, the short seller makes this covering purchase using the funds he received from selling the borrowed stock. Herein lies the short seller's potential for profit: if the price of the stock declines after the short sale, he does not need all the funds to make his covering purchase; the short seller then pockets the difference. On the other hand, there is no limit to the short seller's potential loss: if the price of the stock rises, so too does the short seller's loss, and since there is no cap to a stock's price, there is no limitation on the short seller's risk. There is no time limit on this obligation to cover. [4] Selling short, therefore, actually involves two separate transactions: the short sale itself and the subsequent covering purchase. Id.; see also James W. Christian, Robert Shapiro, & John-Paul Whalen, Naked Short Selling: How Exposed are Investors?, 43 HOUS. L. REV. 1033, 1041-42 (2006) (describing a traditional short sale). Although the Third Circuit was addressing the short sale of stocks in Zlotnick, the basic principles that it describes are equally applicable to the short sale of T-Notes. In this case, the Trust's short sale of $100 Million (face value) of T-Notes on December 27, 1999 generated sale proceeds of $102.5 Million. The covering transaction occurred on December 30, 1999, when Czerwinski purportedly executed the covering transaction and acquired the borrowed T-Notes for $102.7 Million, resulting in a short-term capital loss of approximately $200,000, i.e. the excess cost of acquiring the replacement securities over the proceeds from the sale of the borrowed securities. However, the Trust reported a short-term capital loss of $102.6 Million on its tax return.