The SEC has announced 2 possible approaches to regulating short selling, each of which has sub-possibilities, on which the SEC is soliciting public comment. From the press release:
Market-Wide, Permanent Approach
- Proposed Modified Uptick Rule: A market-wide short sale price test based on the national best bid (a proposed modified uptick rule).
- Proposed Uptick Rule: A market-wide short sale price test based on the last sale price or tick (a proposed uptick rule).
Security-Specific, Temporary Approach
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Circuit Breaker: A circuit breaker that would either:
- Ban short selling in a particular security for the remainder of the day if there is a severe decline in price in that security (a proposed circuit breaker halt rule).
- Impose a short sale price test based on the national best bid in a particular security for the remainder of the day if there is a severe decline in price in that security (a proposed circuit breaker modified uptick rule).
- Impose a short sale price test based on the last sale price in a particular security for the remainder of the day if there is a severe decline in price in that security (a proposed circuit breaker uptick rule).
From SEC Chairman Mary Shapiro's opening statement:
In my short tenure as Chairman, the issue of short selling has undoubtedly resulted in more letters from investors, brokerage firms and exchanges, more inquiries from members of Congress, and more questions from reporters than any other topic. Even before I arrived at the SEC, I heard from hundreds of investors concerned about short selling. Clearly, the practice of short selling has both strong supporters and detractors. Today, we begin what will be a thoughtful, deliberative process to determine what is in the best interests of investors.
The problem is that the detractors are idiots. Shapiro's statement continues:
The Commission has long held the view that short selling provides the market with important benefits, including market liquidity and pricing efficiency. But, short selling may also be used to illegally manipulate stock prices. One example is the "bear raid" where an equity security is sold short in an effort to drive down the price of the security by creating an imbalance of sell-side interest. In addition, unrestricted short selling can exacerbate a declining market in a security by increasing pressure from the sell-side, eliminating bids, and causing a further reduction in the price of a security by creating an appearance that the security price is falling for fundamental reasons, when the decline, or the speed of the decline, is in fact being driven by other factors.
She's right that short selling has benefits, but utterly wrong about the supposed costs. First, even if short selling is sometimes used by manipulators, so what? Manipulation is already illegal! There is nothing to prevent the SEC from using the existing statutes and rules banning stock manipulation to go after perpetrators of a bear raid. We don't need a prophylactic ban on short selling to punish and deter market manipulators.
The Third Circuit thus has observed that:
The Supreme Court has indicated that market manipulation "generally refers to practices, such as wash sales, matched orders, or rigged prices, that are intended to mislead investors by artificially affecting market activity." Santa Fe Indus. v. Green, 430 U.S. 462, 476, 97 S.Ct. 1292, 1302, 51 L.Ed.2d 480 (1977). "The gravamen of manipulation is deception of investors into believing that prices at which they purchase and sell securities are determined by the natural interplay of supply and demand, not rigged by manipulators." Gurary v. Winehouse, 190 F.3d 37, 45 (2d Cir.1999). In that vein, courts must distinguish between legitimate trading strategies intended to anticipate and respond to prevailing market forces and those designed to manipulate prices and deceive purchasers and sellers. …
Requiring a Section 10(b) plaintiff to establish that the alleged manipulator injected "inaccurate information" into the market or created a false impression of market activity cures this problem. Such a construction permits courts to differentiate between legitimate trading activities that permissibly may influence prices, such as short sales, and "ingenious devices that might be used to manipulate securities prices," Santa Fe Indus., 430 U.S. at 477, 97 S.Ct. at 1303, such as wash sales and matched orders. As the court in Olympia Brewing, 613 F.Supp. at 1292, stated, "[r]egardless of whether market manipulation is achieved through deceptive trading activities or deceptive statements as to the issuing corporation's value, it is clear that the essential element of the claim is that inaccurate information is being injected into the marketplace."
GFL Advantage Fund, Ltd. v. Colkitt, 272 F.3d 189, 208 (3d Cir. 2001).
Short selling standing alone thus is not manipulative, because it does not – by itself – inject inaccurate information into the market place.
Second, you need not be a die-hard proponent of efficient capital markets theory to recognize that "a further reduction in the price of a security by creating an appearance that the security price is falling for fundamental reasons, when the decline, or the speed of the decline, is in fact being driven by other factors" creates a buying opportunity. Even if the market is swept by herd behavior for a brief period, such that the market price of the stock being sold short falls below its economic value, the market will correct soon enough as rational investors start buying.
Accordingly, a ban on short selling of any type is likely to reduce market efficiency without offering any competing benefits. As Professors Gilson and Kraakman have observed:
In a short sale, the arbitrageur sells a security she does not own. To accomplish this, she must first find an existing owner of the overpriced security who is willing to lend the security to the arbitrageur. The borrowed stock is then sold, the arbitrageur betting that the price of the security will fall before the security must be purchased to repay the loan.
Securities Exchange Act Rules 10a-1 and 10a-2 provide the basic regulatory framework. Rule 10a-1, the "uptick test," generally prohibits a short sale at a price below the security's last reported price, and Rule 10a-2 restricts activities by broker-dealers that could facilitate a violation of the uptick rule. The idea behind the prohibitions, dating to aftermath of the stock market crash of 1929, is to prevent "speculators" from driving down the price of a stock by continuing to sell stock below the market price. The difficulty with the rule is simply the obverse of its asserted benefit. Short-selling, through its information revealing properties, pushes stock prices to a lower, more efficient level; to the extent that the uptick rule actually succeeds in restricting arbitrage, the level of market efficiency suffers.
Ronald J. Gilson & Renier Kraakman, The Mechanisms of Market Efficiency Twenty Years Later: The Hindsight Bias, 28 J. Corp. L. 715, 727 (2003).
There is NOTHING wrong with short selling. The SEC should not adopt any of the 5 alternatives. Each would reduce market efficiency and liquidity, with no compensatory benefits.
Update: You can add the following to the list of idiots: Edward E. Kaufman (D-Del.), Jon Tester (D-Mont.), Carl M. Levin (D-Mich.), Johnny Isakson (R-Ga.), Saxby B. Chambliss (R-Ga.), and Arlen Specter (R-Pa.). According to BNA, they co-authored a joint letter to the SEC demanding "'an unambiguous commitment to promulgate and enforce regulations that put an end to naked short selling.' At a minimum, the senators contended, the new regulations should provide an uptick rule—that is, a price test to restrict short selling—and a pre-borrow requirement to curtail the abusive potential of naked short selling."
