SEC Issues Emergency Order to Stop Naked Short Selling
In an effort to end naked short selling contributing to the disruption in the securities markets, the SEC issued an emergency order requiring all persons to borrow or arrange to borrow the securities identified in certain issuers prior to effecting an order for a short sale of those securities. In order to allow market participants time to adjust their operations to implement the enhanced requirements, the order takes effect at 12:01 a.m. EDT on Monday, July 21, 2008.
In testimony before the Senate Banking Committee, SEC Chair Christopher Cox said that the emergency order is designed to enhance protections against naked short selling in the securities of primary dealers, Fannie Mae, and Freddie Mac. The emergency order will provide that all short sales in the securities of primary dealers, Fannie, and Freddie are subject to a pre-borrow requirement. In addition to this emergency order, said the chair, the SEC will undertake a rulemaking to address these same issues across the entire market.
The Commission acted because there now exists a substantial threat of sudden and excessive fluctuations of securities prices generally and disruption in the functioning of the securities markets that could threaten fair and orderly markets. The emergency powers granted to the SEC by Section 12(k)(2) of the Exchange Act were invoked.
Noting that false rumors can lead to a loss of confidence in the markets, the SEC said that such loss of confidence can also lead to panic selling, which, in turn, may be further exacerbated by naked short selling. As a result, the prices of securities may artificially and unnecessarily decline well below the price level that would have resulted from the normal price discovery process. If significant financial institutions are involved, reasoned the Commission, this chain of events can threaten market disruption.
The SEC pointed to the events preceding the sale of The Bear Stearns Companies Inc. as amply illustrative of the market impact of rumors. During the week of March 10, 2008, rumors spread about liquidity problems at Bear Stearns, which eroded investor confidence in the firm. As Bear Stearns’ stock price fell, its counterparties became concerned, and a crisis of confidence occurred late in the week. In particular, counterparties to Bear Stearns were unwilling to make secured funding available to Bear Stearns on customary terms. In light of the potentially systemic consequences of a failure of Bear Stearns, the Federal Reserve took emergency action.
Earlier this year in a significant move, the UK Financial Services Authority adopted rules requiring the disclosure of significant short positions in stocks admitted to trading on markets which are undertaking rights issues. For this purpose, the authority defined a significant short position as 0.25% of the issued shares achieved via short selling or by any instruments giving rise to an equivalent economic interest. The obligation will be to disclose positions exceeding this threshold to the market by means of a Regulatory Information Service by 3.30pm the following business day. The new rules took effect on June 20, 2008.
The FSA still views short selling as a legitimate technique which assists liquidity and is not in itself abusive. But it is also the case that the rights issue process provides greater scope for what might amount to market abuse, particularly in current conditions. The FSA believes that improving transparency of significant short selling in such shares would be a good means of preventing the potential for abuse. In these circumstances, non-disclosure of significant short positions gives the market a false and misleading impression of supply and demand in the securities concerned.