Divided Commission Adopted Alternative Uptick Rule for Short Sales

The below excellent analysis of the SEC's action today was filed by my colleague John Filar Atwood, who attended the SEC's open meeting at which this action was taken.

In a 3-to-2 vote, the SEC adopted amendments to Rules 200(g) and 201 of Regulation SHO that will restrict short selling in instances where a company’s shares drop 10% or more in value in one day. The Commission originally proposed the alternative uptick rule last April, held a roundtable discussion on it in May and then issued an additional call for comments in August. The agency received more than 4,300 comment letters on the controversial issue.

Under the newly-adopted rule, a circuit breaker will be triggered any time a stock declines 10% in one day and short selling will be permitted in that security only if the price is above the current national best bid. Once the circuit breaker has been triggered, the rule would apply to short sale orders in that security for the remainder of the day and the following day.

The alternative uptick rule will apply to equity securities that are listed on a national securities exchange, whether traded on an exchange or in the over-the-counter market. Under the rule, trading centers will be required to establish, maintain and enforce written policies and procedures that are reasonably designed to prevent the execution or display of a prohibited short sale.

Once the circuit breaker is triggered, long sellers will have preferred access to the bid price and will be permitted to sell their shares ahead of any short sellers. Robert Cook, Director of the Division of Trading and Markets, said that this part of the rule is intended to boost investor confidence by assuring them that sales are being made by investors taking a long view of a company’s fundamentals.

SEC Chair Mary Schapiro acknowledged that short selling can have a beneficial impact on the market. However, the Commission is concerned that excessive downward price pressure on individual securities, accompanied by the fear of unconstrained short selling, can destabilize markets and undermine investor confidence. She believes the rule addresses these concerns by preventing short selling, including potentially manipulative short selling, from further driving down the price of a security that has experienced a 10% price decline. Limiting the potential for abuse is an important goal of the new rules, she said.

Commissioner Kathleen Casey opposed the rule amendments, stating that there is no evidence to support the claim that a circuit breaker can stop price declines, or that it would boost investor confidence. She referred to the amendments as “regulation by placebo,” where the agency is putting a rule in place and hoping that it will convince investors that everything will be alright.

Compliance costs for the rule will be in the billions of dollars, she said, and she has no confidence that the new rules will have a positive effect. In her view, the rules will not have their intended impact in the short term and will expose the Commission to considerable criticism in the long term. She believes that enhanced surveillance and enforcement on abusive short selling is the appropriate course of action.

Commissioner Elisse Walter supported the rule changes, but acknowledged that it was a difficult decision. Since becoming a commissioner, she has received more calls on short selling than any other topic, she said. Much of the feedback she has gotten is that investors feel less confident putting their money into the market because of short selling. We must listen to investors, she said, even if the effect of short selling is difficult to quantify.

She supported the amendments to Rule 201 because they take a measured, targeted approach and the short selling restrictions will not apply to the majority of traded securities at any one time. During periods of low volatility, the staff expects the circuit breaker to apply only to about 1.3% of covered securities, Walter noted. Based on the comments the SEC received, she expects many people to be disappointed that the circuit breaker restricts short selling, while others will claim that the rule does not go far enough.

Among the objections of Commissioner Troy Paredes to the rule changes was that he feels a 10% threshold is indiscriminate and not narrowly tailored as suggested by the staff. He believes there is no evidence to suggest that a 10% price decline is not just an effective and appropriate revaluing of a publicly traded security. He also feels that the central rationale that the rule amendments will boost investor confidence is speculative and unsubstantiated.

Cook responded that the staff’s recommendation was based on many factors, including that two-thirds of the comments it received expressed the view that the rule would boost investor confidence. Ultimately, the staff must make a judgment on data that will never be perfect, he said. Henry Hu, Director of the Division of Risk, Strategy and Financial Innovation, concurred, noting that investor confidence is extremely hard to quantify. Existing data is insufficient in either direction, he said.