It's going to cost customers of at least one online brokerage more to short some favored bear stocks. Starting next month, Harrisdirect, a division of Chicago-based Harris Bank, is going to begin charging customers for any additional costs the brokerage incurs in trying to execute a short sale in so-called hard-to-borrow stocks. Harris Bank is owned by Bank of Montreal ( BMO). In the past, Harrisdirect, like many retail brokerages, didn't pass on these extra charges to their short-selling customers. Rather, the brokerage absorbed the added charges, viewing them as a necessary cost of doing business. But some say the extra trading fee -- anything from a few to a few hundred dollars -- is a sign of things to come in the brokerage industry. That's especially so in light of a new Securities and Exchange Commission regulation that's aimed at cracking down on abusive short-selling practices in hard-to-borrow stocks. A hard-to-borrow stock typically is a smallish stock such as Martha Stewart Living ( MSO), NovaStar Financial ( NFI) and Netflix ( NFLX), with relatively few shares outstanding, many of which have already been sold short. On Jan. 3, the rules for shorting these and other hard-to-borrow stocks got a lot tougher under a new SEC measure called Regulation SHO. Regulation SHO doesn't alter the basics of short-selling, which remains a respectable way for traders to make money by borrowing shares from a broker and betting a stock will decline in price. However, the rule does make it more difficult for traders to establish new short positions in stocks that already are the subject of a high number of bearish bets. The rule prohibits brokers from permitting traders to short a stock unless there are "reasonable grounds" for believing there are shares available to borrow. If those shares cannot be later found, the rule sets down a procedure for brokers to close out the short positions in relatively short order.
One aim of the rule is to clamp down on naked shorting, a dubious and often-illegal practice in which a trader places short bets without actually borrowing shares -- or even determining that any exist to borrow. The new rules require the New York Stock Exchange and Nasdaq Stock Market to compile so-called "threshold lists" of hard-to-borrow stocks that are more likely to be involved in naked-shorting transactions. The lists, which will be updated daily, are intended to serve as red flags for brokers and traders. (The NYSE and Nasdaq will begin posting the first official threshold lists on their respective Web sites after the close of trading Friday.) Some have been predicting Regulation SHO ultimately will lead to higher trading costs in hard-to-borrow stocks because brokers would be forced to pay higher fees to locate the shares to satisfy their customers' demands. The problem is especially thorny for smaller brokerages such as Harrisdirect, which don't have a ready supply of shares to dip into because they lack the heft of a Merrill Lynch ( MER) or a Morgan Stanley ( MWD). "The cost of borrowing is going to go up for any broker that has to go out into the open market to borrow stock," says a trader with a Midwestern hedge fund. Officials at Harrisdirect say there's no linkage between the new pricing policy on short sales and Regulation SHO. Rather, the brokerage says it's simply becoming too costly for it to continue to absorb the cost of accommodating shorts when the average commission it charges on a stock trade is $9.95. "In the old days, people just ate them," says Michael Hogan, Harris' chief operating officer. "But when you charged $125 a trade, it was expected." The new charges, which Harrisdirect refers to as "negative rebates," aren't insignificant and could deter some investors from shorting hard-to-borrow stocks.
Maintaining a short position valued at $10,000 in a hard-to-short stock will cost about $41.67 a month, the brokerage says. In some instances, the extra monthly fee could run as high as $400. Shares of Travelzoo ( TZOO), the online publisher of travel-related deals, which were up 1,000% last year, are currently the most costly for a Harris customer to maintain a short position on. For the same $10,000 position, the monthly charge on that stock could reach $493. Hogan says passing on this added fee is not entirely new for the brokerage. For a number of years, Harrisdirect has negotiated arrangements with some of its larger investors about picking up some of these costs. Now, the brokerage intends to make it a firmwide policy. Hogan also points out that Harrisdirect isn't trying to make money off these fees. He says the brokerage is simply passing on the costs it occurs in locating the shares it needs to complete a customer's order. So far, it appears HarrisDirect is the only retail brokerage to begin charging higher fees to customers shorting hard-to-borrow stocks. Officials with Charles Schwab ( SCH) and E*Trade Financial ( ET) were checking into their firms' policies on short sales in hard-to-borrow stocks. Bryce Engel, a managing director at Ameritrade ( AMTD), says the online firm plans to stay with it's "long-standing practice" to "eat" any added costs for its customers. But Hogan says he won't be surprised if other brokerages eventually follow suit. "These charges need to be passed on, in fairness," says Hogan.