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Naked-Shorts Ban Gets Chilly Reception

Updated from Wednesday, Sept. 17

The Securities and Exchange Commission on Wednesday outlined restrictions on "naked" short-selling in an effort to prevent pessimistic investors from driving down stock prices too far, too fast.

However, critics said that the SEC has not gone far enough to prevent stock manipulation, and some short-sellers said the rules will do little to stem the market's decline.

A new "close-out" requirement will force short sellers and their broker-dealers to deliver borrowed securities within three days of the transaction date. In addition, options market makers are no longer immune from the naked short rules. A third rule makes short sellers liable for fraud to lie about their intention or ability to deliver securities in time for settlement.

"These several actions today make it crystal clear that the SEC has zero tolerance for abusive naked short selling," SEC Chairman Christopher Cox said in a statement. Regulators "will now have these weapons in their arsenal in their continuing battle to stop unlawful manipulation," he added.

Broker-dealers who violate the close-out requirement will be prohibited from future short sales in the same security without locating and pre-borrowing them first. The penalty will apply for any customer, not just the initial short seller.

The new close-out rule will apply to all securities and are effective as of 12:01 a.m. on Thursday, while the anti-fraud regulation is effective immediately. The elimination of the options market maker exception will go into effect five days after publication in the Federal Register.

There will be a 30-day comment period for input about the close-out rule, after which the SEC expects to follow additional rulemaking procedures.

In a separate statement later Wednesday, Cox said he's asking the SEC to consider on an emergency basis a new disclosure rule that will require hedge funds and other large investors to disclose their short positions. The new rule requires managers with more than $100 million invested in securities to promptly begin public reporting of their daily short positions. The managers are required currently to report their long positions.

In an ordinary short sale, an investor borrows a stock for a fee, and sells it betting that the price will go down. He then buys back the stock at a later time to return it to the owner. In "naked" short sales, the investor must locate shares to borrow, but does not actually borrow or deliver them.

The SEC had put in place temporary restrictions on naked short selling of certain financial stocks over the summer as several firms were suffering from precipitous declines in market value. When those temporary rules expired in August, the stocks continued falling hard and fast, culminating in federal takeovers of Fannie Mae (FNM), Freddie Mac (FRE) and American International Group (AIG) and a bankruptcy filing by Lehman Brothers (LEH).

Critics assert that the SEC already has been putting a tighter leash on short sellers, making a greater effort to enforce rules that already existed. Some portfolio managers that oversee funds with short positions say that the changes won't have a major effect on the share prices of firms getting hit hardest.

"It's very hard to manipulate in the current environment because, first, we know we're being observed," says Vivienne Hsu, senior portfolio manager of the Schwab Hedged Equity Fund. "And, second, the market would squeeze out those types of buyers."

Mark Coffelt, president and chief investment officer of Empiric Funds, which has both long and short positions, was also unfazed by the changes.

"Essentially what they're saying is, 'We're going to enforce the rules,'" says Coffelt.

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