SEC Adopts Rules to Curb Abusive Short Selling

Against the backdrop of roiling markets, the SEC adopted rules to curb abusive naked short selling that go beyond its previously issued emergency order, which was limited to the securities of financial firms with access to the Federal Reserve's Primary Dealer Credit Facility. These rules, effective on September 18, will apply to the securities of all public companies, including all companies in the financial sector. They signal the SEC’s zero tolerance for abusive naked short selling, said Chairman Christopher Cox.

The Commission adopted, on an interim final basis, a new rule requiring that short sellers and their brokers deliver securities by the close of business on the settlement date (three days after the sale transaction date, or T+3) and imposing penalties for failure to do so.
If a short sale violates this close-out requirement, then any broker-dealer acting on the short seller's behalf will be prohibited from further short sales in the same security unless the shares are not only located but also pre-borrowed. The prohibition on the broker’s activity applies not only to short sales for the particular naked short seller, but to all short sales for any customer.
Although the rule will be effective immediately, there will be a 30 day comment period on all aspects of the rule. The Commission expects to follow further rulemaking procedures at the expiration of the comment period.

Also, effective on September 18, the SEC adopted Rule 10b-21, which expressly targets fraudulent short selling transactions. The new rule covers short sellers who deceive broker-dealers or any other market participants. Specifically, the new rule makes clear that those who lie about their intention or ability to deliver securities in time for settlement are violating the law when they fail to deliver.

Finally, the SEC approved a final rule eliminating the options market maker exception from the close-out requirement of Rule 203(b)(3) in Regulation SHO. This rule change also becomes effective on Sept. 18, 2008. As a result of the rule, options market makers will be treated in the same way as all other market participants, and required to abide by the hard T+3 closeout requirements that effectively ban naked short selling. Regulation SHO was adopted to update short sale regulation in light of numerous market developments since short sale regulation was first adopted in 1938.

A short sale is the sale of a stock that the seller does not own or that the seller will borrow for delivery. Short sellers believe the price of the stock will fall, or are seeking to hedge against potential price volatility in securities that they own. If the price of the stock drops, short sellers buy the stock at the lower price and make a profit. If the price of the stock rises, short sellers will incur a loss. In a naked short sale, the seller does not borrow or arrange to borrow the securities in time to make delivery to the buyer within the standard three-day settlement period.