By James Hamilton, J.D., LL.M.
Six US Senators have written a letter to SEC Chair Mary Schapiro urging the Commission to adopt and enforce regulations putting an end to naked short selling. At a minimum, those regulations should address the need for an uptick rule, as well as a pre-borrow requirement to prevent naked short sellers from artificially depressing or diluting stock values. If the SEC fails to signal clear action at its April 8 meeting, at least to reinstate some form of the uptick rule and impose a pre-borrow requirement on short sellers, said the Senators, Congress will consider legislation directing the Commission to do so. The six Senators are Ted Kaufman (D-DE), Johnny Isakson (R-GA), John Tester (D-MT), Arlen Specter (R-PA), Carl Levin D-MI, and Saxby Chambliss (R-GA).
Naked short selling has been a controversial practice for several years and, while not illegal per se, abusive or manipulative naked short selling, such as intentionally failing to borrow and deliver shares sold short in order to drive down the stock price, violates the federal securities laws.
The letter focused on a recent SEC Inspector General report detailing the results if an audit of the Division of Enforcement policies and procedures for processing complaints about naked short selling. The report noted that, despite receiving more than 5,000 complaints about abusive short selling, not one enforcement action resulted. Further, said the senators, the Division of Enforcement only agreed with one of eleven of the Inspector General’s recommendations to improve processing and analyzing abusive short sale claims. Equally troubling to the Senators is the Division’s reluctance to agree with the Inspector General and the SEC itself that naked short selling is harmful. When it adopted a naked short selling antifraud rule, rule 10b-21, in 2008, noted the Senators, the SEC expressed its concern about abusive naked short selling. However, in response to the Inspector General’s report, the Division said that there is hardly unanimity in the investment community or the financial media on either the prevalence or the dangers of naked short selling.
More broadly, the Senators emphasized that investors and the financial markets are waiting to know if the SEC will restore an uptick rule, and whether it will take additional steps to address abusive short selling practices. There is a widespread belief that the abuse of naked short-selling, which is the selling of stock that the trader does not own, has added fuel to the fire of distressed stocks and markets. The letter emphasized that investors need to know that the market fairly values the actual shares issued by a company and that their transactions will not be distorted by manipulative naked short sellers creating phantom shares. The senators clarified that they do not oppose short selling per se, which they said can enhance both market efficiency and price discovery. But naked or abusive short selling has gone unaddressed for far too long, they said, and the practice must end.
Sens. Kaufman and Isakson have been pushing the SEC to make progress for a month. Senator Kaufman initially proposed the reinstatement of the uptick rule in a March 3 letter to Chair Schapiro. On March 16, Sens. Kaufman and Isakson introduced bipartisan legislation, S. 605, directing the SEC to write regulations within 60 days to end abusive short selling. Each has spoken on the floor, and after Chair Schapiro's testimony before the Senate Banking Committee last week, they said they were "cautiously optimistic" that the SEC may take action on April 8, but remain concerned over whether it will go far enough.
S. 605 orders the SEC to reinstate the uptick rule, which was repealed in July 2007. The uptick rule, Rule 10a-1, required all short sale stock transactions to be conducted at a price that was higher than the price of the previous trade.
The legislation directs the SEC to write regulations within 60 days accomplishing five things to end abusive short selling. First, the SEC must reinstate the substance of the uptick rule prohibiting short sales that are not made on an increase in the price of the stock. This is designed to prevent short sellers from piling on a declining stock, driving prices down. Second, the SEC must require exchanges and other trading venues to execute the trades of long sellers ahead of short sellers, all other things being equal.
Third, with the concurrence of Treasury and the Federal Reserve Board, the SEC must prohibit short sales of the securities of any financial institution unless that trade is affected at a price (in minimum lots specified by the Commission) at least 5 cents higher than the immediately preceding transaction in such securities. Since the financial sector is in such a fragile state, if the Treasury and Fed believe they it needs additional protection, the legislation permits it.
Fourth, SEC rules must prohibit any person from selling securities short unless that person has at the time of the short sale a demonstrable legally enforceable right to deliver the securities at the required delivery date. Under current law, many short sellers fail to deliver. Fifth, the SEC will require that all short sales settle on the same time frame employed for long sales of the same securities. There is no reason, said the senators, that short sellers should have 13 days to deliver shares when long sellers have only three days.