Regulating short selling: dos and don'ts

In recent weeks, the SEC has created new rules in seeking to combat naked short selling.

Yet even after all of these rules were implemented, the markets continued to fall as mounting fear of the fragile state of the US economy emerged and the United States Congress wrestled with a $700bn bill to buy trouble loans from a variety of financial institutions.

There is no doubt that falling stock prices contributed to the general unease on Main Street - what is in doubt is the effectiveness of the new short sale regulations.

These include strict close-put requirements for failures to deliver securities; the elimination of the option market maker exception to close-outs provisions for failures to deliver; the addition of anti-fraud rules for persons who deceive brokers about their intention or ability to deliver securities by settlement date; a ban on short selling of certain financial issuers (recently ended) and a disclosure requirement of short positions by institutional investment managers.

The debate continues regarding the pros and cons of short selling, with opponents believing many short sellers harm the market by pushing stock prices down based on speculative naked short selling, or, even worse, by outright manipulation, while proponents point to the added liquidity short sellers provide.

Further, short selling advocates point to the frozen convertible bond market as a indication of the implications of the short selling bans. Most agree that short selling is a necessary component of the derivatives markets as many market participants hedge options and bonds by selling short the underlying stock.

In theory, the most effective tool to combat manipulative short sellers is the prosecution of any person who enters into short strategies with manipulative intent. For example short selling financial stocks while spreading rumors about the demise of those institutions.

Unfortunately, however, those cases have been historically difficult to prove. Technical rules, like the ones enacted by the SEC usually lead only to technical rule violations, which often occur due to honest errors that result from the complexity of the provisions. The complications of the fraud case and the unlikely real impact of the technical cases demonstrate the limitation of the present short sale regulations.

It is reported that the SEC is now contemplating a rule that would impose a short selling ban in securities that have an intra-day drop of a certain percent. The ban would remain in effect for a period of time following the triggering drop in price. It may be that these temporary “time-outs” strike the correct balance between the adversaries and proponents of short selling.

Another approach suggested by commentators is to reinstitute the "uptick rule", which prevented short selling on consecutive negative price movements. However the conclusions of the SEC’s multi-year study of the uptick rule was that it was not effective.

But whatever rules the SEC does impose on a permanent basis, they should be narrow in scope, targetting only speculative short selling implemented with manipulative intent.

Gary Distell is a partner and a member of the financial services and financial services litigation practices at US-based Katten Muchin Rosenman.