The Securities and Exchange Commission has acknowledged short selling’s significant benefits to market liquidity and pricing efficiency.

It is illegal for a trader deliberately to try and force a share price lower by spreading false rumors about the company. If caught, traders can be fined or imprisoned.

Regulation SHO

Short Selling Regulation

“Our agency’s rules have long been supportive of short selling, which can help quickly transmit price signals in response to negative information or prospects for a company. Short selling helps prevent ‘irrational exuberance’ and bubbles. Continued legitimate short selling …will act, as it is supposed to, as a way for market participants to invest in the downside and to hedge other positions.”

Former SEC Chairman Christopher Cox July 24, 2008(46)

Taking a short position has been, and continues to be, more heavily regulated than taking a long position. The SEC is vigilant about taking actions against wrongdoers, working independently or in conjunction with the self-regulatory organizations (SROs) and other regulatory authorities.

During the Roaring Twenties, companies often sold securities based on dazzling promises of incredible profits without disclosing meaningful information to investors. Following the stock market crash of 1929, Congress passed the Securities Act of 1933 and the Securities Exchange Act of 1934. Section 10(a) of the 1934 act made it unlawful for any person to effect a short sale of any security registered on an exchange in contravention of SEC rules.

In 1938, following a sharp drop in the stock market, the SEC enacted Rule 10a-1, which included a “tick test” that was designed to restrict short selling in a declining market. An investor could only take a short position at a price above the price at which the immediately preceding sale was affected (“plus tick”), or at the last sale price if it was higher than the last different price (“zero-plus tick”).(47)

Over many years and in many economic and global crises, the SEC has acknowledged the significant benefits of short selling to market liquidity and pricing efficiency,(48) and until July 2008 regulated it with measured rules, adopted after substantial consideration and public comment.(49)

In 2004, the SEC approved Regulation SHO, which targeted “naked” short sales and both simplified and modernized short-sale regulation. The framework’s objectives are:

“[E]stablish uniform locate and delivery requirements in order to address problems associated with failures to deliver, including potentially abusive ‘naked’ short selling (i.e., selling short without having borrowed the securities to make delivery);
“[C]reate uniform marking requirements for sales of all equity securities; and,
“[E]stablish a procedure to temporarily suspend Commission and SRO short sale price tests in order to evaluate the overall effectiveness and necessity of such restriction.”(50)

Compliance with Regulation SHO became effective January 3, 2005.

“Naked” short selling is not defined in federal securities laws, but generally refers to selling short without having borrowed or arranged to borrow the securities to make delivery. This can result in the failure of the seller to deliver securities to the buyer on the date delivery is due (known as “failure to deliver” or a “fail”).(56)

Selling stock short without having borrowed the stock or located the stock for delivery at settlement would violate Regulation SHO (except for short sales by broker-dealers engaged in bona fide market making). Further, naked shorting as part of a manipulative scheme with the purpose of driving down a security’s price would violate various securities laws (including Rule 10b-5 under the Securities Exchange Act of 1934) and both civil and criminal anti-fraud statutes.(57)

“While there may be instances of abusive short selling, 99 percent of all trades in dollar value settle on time without incident,” according to an SEC official.(58) Of all those that do not, 85 percent are resolved within 10 business days and 90 percent within 20 business days.

CONTINUE

Regulation SHO

46. Christopher Cox, “What the SEC Really Did on Short Selling.” Wall Street Journal, July 24, 2008. Available at: http://online.wsj.com/article/SB121685865187779279.html

47. See Exchange Act Release No. 1548 (Jan. 24, 1938) 3 FR 213 (Jan. 26, 1938). Final Rule: Regulation SHO and Rule 10a-1 (July 3, 2007). 17 CFR Parts 240 and 242. Release No. 34¬55970. Available at: http://www.sec.gov/rules/final/2007/34-55970fr.pdf

48. See: Concept Release: Short Sales, Release No. 34-42037 (Oct. 20, 1999) 64 FR 57996 (Oct. 28, 1999), in which the Commission stated: “Short selling provides the market with two important benefits: market liquidity and pricing efficiency. Substantial market liquidity is provided through short selling by market professionals...who facilitate the operation of the markets by offsetting temporary imbalances in the supply and demand for securities.... [S]uch short sale activities, in effect, add to the trading supply of stock available to purchasers and reduce the risk that the price paid by investors is artificially high because of a temporary contraction of supply. Short selling also can contribute to the pricing efficiency of the equities markets. Efficient markets require that prices fully reflect all buy and sell interest.... [S]hort sellers add to stock pricing efficiency because their transactions inform the market of their evaluation of future stock price performance. This evaluation is reflected in the resulting market price of the security.” In an interview in July, Chairman Cox also noted that legitimate short selling provides market liquidity and contributes to price discovery, and is important to a well functioning market by preventing market bubbles. See Statement of Christopher Cox, Chairman of the SEC, in a transcript of a CNBC Interview with Erin Burnett, Subject: Emergency Rule On Naked Shorts, July 16, 2008 (transcript on file with CPIC).

49. In 2004, the SEC adopted Regulation SHO (17 CFR 242.200 et seq.), which is the primary SEC rule addressing short sales. See Release No. 34-50103, July 28, 2004. According to the adopting release, Regulation SHO was adopted after the Commission considered letters from 462 commenters, and upon examination of market practices and the purposes underlying short sale regulation.

50. Securities and Exchange Commission, Responses to Frequently Asked Questions about Regulation SHO. Available at: http://www.sec.gov/divisions/marketreg/mrfaqregsho1204.htm. The Adopting Release for Regulation SHO, Release No. 34-50103; July 28, 2004, may also be found at: http://www.sec.gov/spotlight/shortsales.htm or at http://www.sec.gov/rules/final/34-50103.htm.

51. Securities Industry and Financial Markets Association. www.sifma.org

52. Kevin Warsh, “Market Liquidity: Definitions and Implications.” March 5, 2007. Available at: http://www.federalreserve.gov/newsevents/speech/warsh20070305a.htm

53. Nicholas Economides, “How to Enhance Market Liquidity” in Global Equity Markets, R. Schwartz (ed.). New York: Irwin Professional, 1995. Available at: http://www.stern.nyu.edu/networks/how.pdf

54. Warsh, op. cit.

55. Ibid.

56. SEC, Frequently Requested FOIA Document: Fails-to-Deliver Data, What You Should Know About the Data. Available at: http://www.sec.gov/foia/docs/failsdata.htm

57. SEC, Key Points, op cit.

58. Ibid.