Updated from Wednesday, Sept. 17
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
American International Group
and a bankruptcy filing by
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.
By not reinstating the "uptick rule" -- which only allowed a short transaction to occur as a stock was moving upward -- critics say the SEC has effectively allowed speculative investors to hammer shares further and further into the ground. The agency did away with the regulation in July 2007.
"The SEC is really flapping its gums here -- it's really not doing anything different," says Robert Ellis, senior vice president of wealth management at Celent. "They missed another opportunity to bring back the uptick rule. I guess lobbyists and hedge funds don't want them to bring it back."
Nearly 30 billion shares were sold short in the market in late August, a sixfold increase over the last decade, according to
. Ellis says that trend has effectively transferred wealth from retirement accounts, which are unable to short stocks, into hedge funds. He notes that brokerages can profit on both ends, because the collect fees on both the long and short positions, and don't necessarily have to tell clients that they are lending out the stock.
Still, just the promise of a more watchful regulatory eye and the threat of enforcement action may lead some traders to close out questionable short positions, says Ellis. A sharp decline in share price -- the proxy for market confidence -- can destroy a financial services company, which relies on that confidence to do business.
"The financial firms are unique in the sense that when they fail they not only bring down shareholders but the firms that deal with them," says Sreedhar Bharath, assistant professor of finance at the University of Michigan. "It's a domino effect for everybody."
Still, Coffelt believes companies are faltering due to weak fundamentals -- even if stock declines appear rapid. He is "personally skeptical" that there is much naked short selling occurring.
"You look at AIG, and if there was real value there, rather than see the federal government buy it, you would have seen Warren Buffet buy it," says Coffelt. "He was offered it and he didn't buy it."
There is little debate over whether firms like
, Freddie, Fannie, Lehman, AIG or Merrill have faced serious problems amid the housing and credit crises. But there is a strong debate over whether
exaggerated those issues, and whether the companies might have been able to ultimately survive without bailouts, bankruptcies or fire-sale acquisitions.
Bharath notes that the temporary restrictions put in place by the SEC in July and August did not significantly reduce short positions in the 19 financial stocks it affected. In fact, the broader market fared worse while those regulations were in place -- suggesting that the restrictions may have unnaturally stymied genuine opinions. Since the restrictions have been lifted, four of the firms in question have essentially gone under.
Bharath says the new SEC rules are "probably useless" in the long term, but might prove effective as a short-term tactic to calm irrational selling.
"It is very important to send the psychological message that manipulation will not be tolerated to calm down the markets," says Bharath. "Whether it has a real effect is not clear."
To see lists of stocks that could be aided by the naked short-selling ban, please see our story on "threshold securities," compiled Tuesday by the New York Stock Exchange and the Nasdaq.