Short-selling litigation: An enlightening mistake A RARE slip-up by lawyers has helped shed some light on a high-profile legal battle, the details of which some of the largest Wall Street firms have been fighting to keep under wraps. The case concerns allegations of illegal "naked" short selling, where the rules have been tightened several times over the past seven years. In 2007 Overstock sued 11 brokers, alleging that they had caused its share price to fall by helping their clients to naked-short the Utah-based retailer. In a normal short sale, shares are borrowed (or at least "located") with a broker's help before being sold. In the naked version, there is no attempt to borrow or locate the stock. This can create "fails to deliver," where the trade is not settled when it should be, and messes with the laws of supply and demand, allowing shorting to take place beyond the natural limits set by the number of borrowable shares. As the pre-trial discovery period proceeded, Overstock narrowed its focus to two firms, Goldman Sachs and Merrill Lynch, now part of Bank of America. Before the case was set to go to trial in California, however, the judge dismissed it on jurisdictional grounds, ruling that not enough of the alleged wrongdoing had taken place in the state. Overstock appealed and pushed for all of the evidence to be unsealed. The defendants objected. Four media groups, including The Economist, opposed a motion to seal on public-interest grounds. The judge decided that some of the documents should be released but stayed his ruling, pending appeal. That was how things stood until May 11th, when the defendants" lawyers served the other parties in the case with their opposition to a plaintiff's motion. Inadvertently included in this was an unredacted version of an earlier filing by Overstock containing excerpts of e-mails from Goldman and Merrill employees. In these they discuss deliberately failing to settle client trades. One Merrill executive suggests the firm "might want to consider allowing...customers to fail," to which a colleague replies: "We are going to look into that." Another asks: "How and when can we prevent the delivery [of shares]?" To a question from a large client about efforts at "cleaning up" fails, a Goldman man says that "we will let you fail." Compliance officers questioned this behaviour, according to the filing. One at Merrill is quoted calling it "totally unacceptable - we are failing when we have over a million shares of stock available." The e-mails also suggest close commercial links between the two firms and at least one trading outfit that was a target of regulatory probes into shorting violations, SBA Trading. A Merrill employee forwards a sanctions order against SBA's Scott Arenstein to a counterpart at Goldman, referring to Mr Arenstein as "our boy" and asking: "You think there will be any fallout on clearing firms?" In another e-mail, the deputy head of Goldman's securities-lending group describes Mr Arenstein as being "the other side of a lot of our activity." Other missives suggest a cavalier attitude to the rules. The president of one of Merrill's stock-clearing businesses responds to internal concerns about failed trades thus: "Fuck the compliance area - procedures, schmecedures." He later assured the court that this statement was a joke, according to the filing. Goldman and Merrill deny that they participated in unlawful naked shorting. Their supporters argue that the legal action brought by Overstock is a crude tactic by its mercurial boss, Patrick Byrne, to divert attention from its long history of underperformance. Some question the link between failed trades and naked shorting. Nevertheless, the release of the e-mail excerpts will have done the brokers no favours. They suggest that trades were being intentionally failed; that some of the firms" internal policemen were unhappy with the explanations they received for the proliferation of fails; and that at least one executive had an unusual attitude towards compliance. The e-mails are just a small part of the material unearthed during the four-year discovery process. If the court of appeal unstays the partial unsealing order, there will be much more to pore over.