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The fiduciary law that governs our business culture reaches back to the 15th century and requires those who are entrusted with managing our largest corporations or pools of money to act in the best interests of their shareholders or clients. But the evolution of fiduciary law has developed into a mode of thinking that privileges short-term, single-company results over long-term, society-wide results. Consequently, fiduciaries are driven by a logic that dictates a focus on the short term, which can be more accurately predicted than the long term.

But there is something deeper at work in this mindset. Fiduciary thought privileges form over substance, procedure over justice. Decisions that serve a single corporation's shareholders may cause significant harm to a wider array of interests. The entire concept of fiduciary duty must be rethought if capitalism is going to flourish in a borderless, digitalized world. Instead of a narrow focus on the interests of a single firm's shareholders, the fiduciaries of our large business enterprises are going to have to widen their arc of concern to a wider group of constituencies. Without such a broadening of focus, narrow interests will continue to place the entire system in jeopardy because of the networked nature of today's financial markets.

-- Michael Lewitt, "How to Fix It"
HCM Market Letter, April 1, 2008

I open with that quote from my good friend Michael Lewitt because as we contemplate restoring the uptick rule, it is important that we get it right -- there is more at stake than just another regulation. What we do not need is form over substance -- some toothless directive designed only to placate the elected officials, provide a great sound bite to make it look like we are being proactive, but in reality does nothing to solve the original intent of the rule. A watered-down version will only further the lack of faith the markets have in our regulators and will contribute to the lack of confidence in the markets overall.

Let me start by saying I do believe short-selling has value in the market, so I do not wish to ban the practice. There is a thought rumbling through my head that was sparked by a comment Scott Rothbort made regarding shareholders' rights vs. the rights of the short-seller. It got me thinking about whether short-selling is a "right" or a "privilege." A privilege extended because short-sellers can provide liquidity to the market ... but without an uptick rule, the short seller becomes a liquidity taker, not a liquidity provider.

I don't want to stir the pot and be overly controversial -- because again, I believe short-selling has a place in the market -- but it would be very interesting to examine the rights of the speculator to profit vs. the interest of the government to protect interstate commerce.

Any market wants -- maybe even needs -- speculators to provide liquidity, so let's not go into the competing interest debate. However, the capital markets serve broader purposes than speculation; they are about capital formation so that we can build commerce, create products and services, employ people, pay taxes and enhance our society through the economy. The last decade or so, we seem to have lost sight of that broader purpose -- people speculating on homes, hedge fund proliferation, the prop trading desk more influential than the customer trading desk, people spending time figuring out if they "could" rather than if they "should." The markets should be about investing in our collective and individual futures, and allocating capital to businesses that can contribute to that future.

That is still capitalism, and there is still failure in capitalism to be sure. Other than liquidity provision, the other argument for short-selling is the contribution to price discovery -- everyone (myself included) trots out the Jim Chanos/ Enron example. But playing devil's advocate for a minute, what about private companies? One of the arguments for "going private" is that management can focus on running the company and not stress over the quarterly estimates. No one can short those companies. So what about price discovery there? If a company is too highly valued, competition will come into that segment, which will balance things out -- it is just that short-selling can get us there faster, so there is a certain efficiency to it. That's a great, maybe insurmountable, intellectual argument ... but do you think the stakeholders in Bear/ Lehman/ Citi ( C) are pleased the message was accelerated in the way it was?

Since short-selling does contribute to price discovery, perhaps as a result we get higher multiples in the capital markets (after all, the exit strategy for private equity is always the public market multiple expansion). This is why I do not want to eliminate short-selling in the markets. But the private equity model -- the traditional model, not the "cheap financing, so let's do a deal"-driven model -- of taking a company private, rehabilitating it out of the scrutiny of the markets, not worrying about quarter to quarter, and then releasing it back to the markets does suggest that a circuit breaker on rampant bear raids has value.

If bear raids become commonplace, why on earth would anyone want to be a public company? Of course, if we move to a strictly private ownership model, that may concentrate wealth in fewer hands, and the average American will not be able to participate in the growth of our economy. Of course, there may be less capital available to finance businesses, hindering our growth.

OK -- so why did I just take all this time going through that? Because I think if we are going to reinstate the uptick rule, we need to understand why it is there in the first place. The intent was to create a circuit breaker so that fear did not overwhelm the markets into a negative downward spiral. So it was handled by a simple rule, where the buyer -- not the short-seller -- was the aggressor, therefore preventing a manipulation of emotions. But the rule was developed long before options, long before ECNs, long before decimalization, long before computer program trading, long before levered short-sided ETFs. The rule was done away with because it became too hard to enforce -- all sorts of exemptions completely emasculated (Cramer's term, but quite fitting) the rule. So rather than try to enforce something that wasn't working, they just gave up.

Of course it was, and will be, hard to enforce. But have we gotten so soft that when a problem is tough to tackle, we just throw our hands up in the air and move on? Last time I checked, that strategy was the antithesis of the American ethos. So how do we make it work this time around?

The problem with rules is that there is an entire SWAT team out there whose job it is to find ways to get around rules. So if we create an exemption for ETF market maker/swap hedging, then the rule will do nothing. Rules do not contemplate innovation -- in fact they instead spawn innovation ... innovation to get around the rules (see: AIG Financial Products), and that isn't really a productive use of resources. I'd much rather have those creative people working to build the capital stock of our economy instead of finding ways to circumvent the rules.

When we reinstate the rule, we should make sure the rule lives up to the intent -- to prevent manipulation of emotions and prices and the disruption of capital formation. We must make sure we close all loopholes, so that the rule isn't easily skirted via deep-in-the-money options, married puts, off-exchange trades, or levered short-sided ETFs.

We'll need to come up with sophisticated enforcement mechanisms to stay ahead of the algorithms used by the quants. We need to follow every side of the transaction and be on the lookout for manipulation of the rule.

So my thoughts keep gravitating toward a principles-based system rather than a rules-based system. That is a lot of work, but hey, we are contemplating overhauling the regulatory regime anyway. For the uptick rule, maybe we state the intent, and then just say, "No exceptions." This is why a principles-based system may actually work -- it contemplates people trying to get around "the rule." The uptick rule could be the first step toward principles-based regulation.

Of course, one issue is that our entire legal and accounting structure in this country is rules-based. So maybe we get to a principle-based process by having a rule, but also placing in that rule broad anti-fraud provisions. It is no longer acceptable to follow the simple letter of the law; we must hold people accountable to the spirit and intent as well. Only then will we have a rule that will do something.


Know what you own: The banks were hit hard by short-sellers and would get a boost from a reinstatement of the uptick rule. Companies in the industry include Wells Fargo (WFC), Bank of America (BAC), Goldman Sachs (GS), Morgan Stanley (MS), JPMorgan (JPM) and U.S. Bancorp (USB).

At the time of publication, Oberg had no positions in the stocks mentioned.

Eric Oberg worked in fixed income, currencies and commodities for Goldman Sachs for 17 years before retiring as a managing director.

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