SEC votes to propose restrictions on short selling

By Cydney Posner

At an open meeting this morning, the first for new SEC Chair Mary Schapiro, the SEC voted to propose rules restricting short sales under certain circumstances. As discussed in the New York Times today, the imposition of limitations on short sales has been relatively controversial. In 2007, after several years of study and an analysis of the impact of a pilot program, the SEC voted to eliminate the uptick rule. At the time, the empirical evidence showed no real evidence of market manipulation arising out of elimination of the rule, and the practice of short selling was viewed to benefit the market generally by providing enhanced liquidity, fairer price discovery and risk allocation. However, in more recent public discourse, short sellers have been blamed for the extreme volatility and steep price declines experienced during the global financial crisis, particularly with respect to the precipitous drops in the stock prices of Bear Stearns, Lehman and other financial institutions. Market watchers and investors have expressed concerns regarding "bear raids" (where short sales are effected in an effort to drive down the price of a security) and the potential for short selling to exacerbate a declining market in a stock, creating a (possibly false) appearance that the stock price is falling for fundamental reasons. Concerns regarding the impact of "naked" short selling led the SEC in 2008 to adopt new rules targeting naked short abuses (which, according to testimony today, have been successful in seriously reducing the level of "fails to deliver,") as well as, in the midst of crisis, to impose temporary bans on short sales of securities of certain financial institutions (actions about which former Chair Christopher Cox subsequently expressed regret). Although the SEC was not aware of any new empirical evidence to suggest that the elimination of the uptick rule was in part responsible for the recent market turmoil, the decline in investor confidence in the market, together with public perceptions that unrestricted short selling has been a causal factor, has led the SEC to propose a reinstatement of additional limitations on short-selling. Given the controversy, the SEC is scheduling a round table to discuss the issue, and Schapiro indicated that the SEC intended to be very deliberative in it approach.

The proposal involves two basic alternatives, with variations to each. The first alternative involves application of price tests on a permanent, market-wide basis either through reinstatement of an uptick rule (similar to former Rule 10a-1), generally prohibiting short sales below the last reported sale price, or a modified uptick rule, known as an "upbid" rule, that would allow short sales only at a price above the highest current bid price for the stock. The second alternative involved the imposition of temporary short-sale circuit-breakers applicable only to the affected security during a period of intraday decline of 10% or more. There are three proposed variations on this theme. (The press release, which may provide more detail regarding the proposals, has not yet been posted.) In response to questions, Director Erik Sirri argued that changes in the markets have meant that the SEC could not simply reinstate the old uptick rule. He contended that the increment limits suggested in the proposal would not impede the ability to implement fundamental short-sale strategies; however, if the increments were increased too dramatically (e.g., to $0.10), given current market practices, the rule would effectively bar short sales.

The commissioners were all begging for empirical data addressing whether the absence of the uptick rule has contributed to recent market volatility and precipitous declines. While the vote to offer the proposal was unanimous, some of the commissioners were clearly more skeptical of this link than others. Commissioners Casey and Paredes appeared to be fairly persuaded that the elimination of the uptick rule remained on balance beneficial to the smooth functioning of the capital markets and fairly unpersuaded that elimination of the uptick rule had any role in market volatility. The Casey questioning elicited testimony regarding data showing that short sellers were essentially contrarians and, as such, would be conducting short sales primarily in rising markets and, therefore, not accelerating declining ones. There was also concern implied by Casey that adoption of any of the proposals might be driven more by politics and public pressure rather than empirical data and careful balancing of risks and benefits. Commissioner Aguilar expressed concern that, because of express limitations on the SEC's authority over certain derivatives, the proposal did not extend to all financial products. He worried that the prohibition would simply shift short sellers to unregulated shadow markets where they could create synthetic short sales using swaps and other complex derivatives. Commissioner Paredes was uneasy about the possibility that, while adoption might bolster short-term investor confidence in the markets, the adverse impact on market quality could impair investor confidence in the markets in the long-run. He wondered rhetorically whether the decline in investor confidence resulted from the absence of the uptick rule or from the recession itself.