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An ordinary and proper short sale involves borrowing the shares from a stockholder and then selling them into the market. Nothing at all wrong with this practice; the short seller (or his brokerage) must return the shares to the lender when the short seller closes the trade.

A naked short sale, contrarily, does NOT involve the borrowing of shares and simply executes a sale. This has many problems.

1) a naked short sale does NOT deliver shares to the purchasor (the person on the other side of the short sale). This is termed a "fail to deliver" and is a violation of securities rules AND, if repeated or done in sufficient quantity, of Federal statutes. There are now billions of shares of "fails" floating around due to the 'wink-wink, nudge-nudge' attitude of many brokerages toward naked short sales.

2) a naked short sale effectively creates stock shares out of thin air, which is impossible in the practical world and unlawful in the legal world.

Example: suppose a company has issued 10,000,000 shares. Suppose also that someone naked shorts 25,000 shares. Someone else buys these shorted shares. The buyer does not have possession of the shares, but they are carried in his account on the brokerage books as an asset. This trade affects in no way the original 10,000,000 shares issued, yet now 10,025,000 shares can be 'lawfully' sold.

Multiply this transaction by, say, 1000 and you end up with more naked short 'shares' than actually exist in the world. Ridiculous, you say -- can't happen? Sorry, this is the exact state of affairs in AT LEAST 209 listed companies' shares in the US, as of May 1, 2012.

And the authorities do nothing whatever about it.

And you see nothing wrong with this? Sheesh. You must be a goobermint accountant whose job also involves fantasy.

Multiply this transaction by, say, 1000 and you end up with more naked short 'shares' than actually exist in the world. Ridiculous, you say -- can't happen? Sorry, this is the exact state of affairs in AT LEAST 209 listed companies' shares in the US, as of May 1, 2012. And the authorities do nothing whatever about it.

If regulators wanted to actually do something about it, it would be easy. Impose a fine for "fail to deliver" at an amount equal to the highest trade price for the affected stock between the naked short sale and the delivery date -- on top of actually having to deliver the shares (buying on the open market at whatever price necessary). Naked shorts would immediately stop.

Please give me ONE example of a company where TOTAL short sales, naked or borrowed, exceed total issued shares.

For examples, two of the most shorted stocks currently:
Frontier Communications Corp. (FTR)- 204 million short shares (20.5X ave. daily trading volume in stock) versus total issued 1 billion shares
RR Donnelly (RRD)- 57 million short shares (32X ave. daily volume) versus 182 million issued shares

Legally a broker can sell shares he doesn't hold only in the course of market-making, where he has a reasonable expectation to cover by the settlement date.

Given the penalties and regulatory risk, a reputable broker-dealer would not deliberately engage in short selling.

I don't believe there's any evidence that naked short selling is a big risk, I suspect it's a cat's paw to eliminate short selling entirely, so that corporate executives can better entrench themselves from gimlet-eyed opportunist investors.

Then we'd have to depend more on the "gubbmint" to expose securities fraud.

He who sells
what isn't hizn,
must make it good
or go to prison.

-Burma Shave