By James Hamilton, J.D., LL.M.
Senators Ted Kaufman and Johnny Isakson said that the partial action taken by the SEC will neither provide investors with the same protections as the uptick rule nor address the enforcement issues surrounding the current naked short selling rule. The SEC voted 3-2 to require short sellers, if a company’s shares fall 10 percent in one day, to exceed the prevailing bid for the remainder of the trading day and the following day in short sales of that security.
While encouraged that the SEC took some action to protect investors from manipulative short selling, adding that the circuit-breaker/bid test rule is a step forward, the senators said it will be of limited use, helping only in the worst-case scenarios that could occur during a terrorist attack or financial crisis. The uptick rule worked for 70 years as a systemic check on predatory bear raids; they emphasized, and this approach will not provide investors with the same protections as an always-on bid test.
Moreover, they continued, the real problem is that the SEC does not have an enforceable rule to punish those who undertake market manipulation through abusive naked short selling and rumor-mongering. To this point, they noted that the SEC has not yet brought a single enforcement case in the 2008 naked short selling incidents that helped take down Bear Stearns and Lehman Brothers, said the senators, and the new rule does not address that glaring problem.
The senators were also dismayed that the Commission has never sought comments on a hard locate requirement for short sellers, even after eight senators pointedly made this suggestion last July and seven senators have co-sponsored a bill calling for this. The Commission still failed to seek comments even after the SEC acknowledged in a September roundtable that the naked short selling rule did indeed pose enforcement difficulties.
The senators pointedly ask what would have been the downside to proposing a firm requirement that before stocks can be sold short, the short-seller must have a legally enforceable right and obligation to deliver the stock at the time of settlement. Just by proposing that type of rule, they noted, the Commission would have been in a position to adopt a pre-trade hard-locate requirement, or a circuit-breaker approach combined with a hard-locate requirement, instead of a bid test, for example.
Earlier this year the senators introduced a bill, S. 605, calling for the SEC to adopt regulations prohibiting any person from selling securities short, unless that person demonstrates, at the time of the sale, that such person possesses, at the time of the sale, a demonstrable, legally enforceable right to deliver the securities at the required delivery date.
Specifically, 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 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.
In a June 25 letter to SEC Chair Mary Schapiro, the senators said that focusing on the uptick rule alone puts too narrow a frame on the problems associated with naked short selling. The problem at its root may be that the current rules against naked short selling are both inadequate and impossible to enforce.
In a July 22 letter to the SEC Chair, Senators Kaufman and Isakson, and five other senators, suggested a pilot program as proposed by the Depository Trust & Clearing Corporation (DTCC) to prohibit short sales that do not first acquire a hard locate. They said that this centralized hard locate system seems to offer a viable way to eliminate over selling of stock inventories, in that there would no longer be multiple locates on the same shares of a security.
According to the senators, the DTCC proposal could standardize requirements across the industry, can be configured in a way that will not disrupt markets, would streamline locate documentation requirements, and can be overseen directly by the SEC to ensure regulatory compliance.
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