A RARE slip-up by lawyers has helped to shed some rather interesting 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. In 2007 Overstock, a Utah-based online retailer, sued a dozen big brokers, alleging that they had caused its share price to fall sharply by helping their clients to engage in “naked” short selling.

In a normal short sale, the shares are borrowed (or at least “located”) with a broker's help before being sold. In the naked version, there is no attempt to pre-borrow the stock or even check that it exists. This can create “fails to deliver”, where the trade is not settled when it should be because there are not enough actual shares available for delivery. This messes with the laws of supply and demand, allowing shorting to take place beyond the natural limits set by the number of borrowable shares. Regulators have long frowned upon naked shorting. The rules against the practice have been tightened up a number of times over the past seven years.

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. Just 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 argued that virtually everything should remain sealed, in part because the documents contained “trade secrets”. Four media groups, including The Economist, jointly 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 the end of last week, when the defendants' lawyers sent their opposition to a plaintiffs' motion to the other parties in the case. One of the exhibits attached to this, presumably inadvertently, was an unredacted version of an earlier filing by Overstock, opposing the defendants' motion to seal papers. Within this exhibit is an intriguing six-page section, “Facts Defendants Improperly Seek to Seal” (pages 14-20 of this), containing excerpts of e-mails written by Goldman and Merrill employees.

In a number of 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]?” In another e-mail he requests an update from a lieutenant on “how we are going to fix fails and I want to know what we nees [sic] to do to make 369 market makers fail.” In response to a question from a large client about efforts at “cleaning up” fails, a Goldman man says that “we will let you fail.” In another message, he refers to a senior colleague “really backing down from…cleaning up fails.”

Compliance officers repeatedly questioned this behaviour, according to the filing. A Merrill compliance person is quoted describing it as “totally unacceptable—we are failing when we have over a million shares of stock available…Is there a blanket agreement that we allow every market maker client to continue failing even if there is enough availability?” She adds that fails need to be “cleaned up regardless of who is causing them.”

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. In one message, 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?” The Overstock filing also refers to a telephone transcript in which a Merrill compliance officer and a colleague discuss the fact that Mr Arenstein's “recycling” of short sales is “not okay”. 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. In a 2005 e-mail, the president of one of Merrill's stock-clearing businesses responds to internal concerns about the intentional failing of short sales thus: “Fuck the compliance area—procedures, schmecedures.” He has since assured the court that this statement was a joke, according to the filing.

Goldman and Merrill have denied throughout that they participated in any sort of naked-shorting conspiracy. Their supporters argue that the legal action brought by Overstock is a crude tactic by Patrick Byrne, the retailer's mercurial boss, to divert attention away from its long history of underperformance. (The firm continues to struggle, despite no longer being plagued by settlement failures.) Some question the link between failed trades and naked shorting, arguing that fails are generally the result of operational problems and other factors rather than naked nefariousness.

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 those involved were aware regulators would not look kindly upon some of the activity; that some of the firms' internal policemen were unhappy with the explanations they received for the proliferation of fails; and that at least one senior executive appeared to have an unusual attitude towards compliance.

The e-mails are just a very small part of the communications and other 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, shining more light on an issue that has hitherto been as frustratingly murky as it has been controversial.