The Securities and Exchange Commission could be forced to reinstate the so-called uptick rule courtesy of legislation introduced Monday in the U.S. Senate, which takes aim at abusive shorting and naked short selling. The bill, co-sponsored by Sen. Ted Kaufman (D., Del.) and Sen. Johnny Isakson (R., Ga.), seeks to reinstate the uptick rule that prohibited short sales that are not made on an increase in the price of the stock. The senators are asking the SEC to write regulations within 60 days. "Abusive short selling is tantamount to fraud and market manipulation and must be stopped -- now," Sen. Kaufman said during the introduction of the legislation on the Senate floor. "The uptick rule should have never been repealed. To permit people to sell shares they don't have and won't be able to deliver turns investment into pure speculation. The time has come for this practice to stop." The uptick rule, instituted by the SEC following the Great Depression, said that the short selling of stocks could be done only after the share price ticked higher above the prior sale. The rule was designed as a guardrail that slowed down the short selling process, preventing short sellers from driving the price of a stock lower at a faster clip. In a short sale, an investor can borrow a stock from a broker, sell it to other investors, and attempt to buy it back at a lower price before returning it to the original lender. The difference in the transactions is kept as a profit.
The SEC made the controversial decision to eliminate the uptick rule in June 2007 after its analysis showed it did little to prevent the manipulation of share prices given the proliferation of electronic trading. Of course, many market participants point to the SEC's decision as the catalyst that helped short sellers thrive in 2008. The argument is that the lack of a rule that required share prices to tick higher before more short sales could take place created an environment where shorts could accelerate the failures of a number of companies, especially financial names like Bear Stearns, Lehman Brothers and Washington Mutual. Other financials, like Citigroup ( C), Bank of America ( BAC), AIG ( AIG), Goldman Sachs ( GS) and Morgan Stanley ( MS), have also seen their share prices driven down dramatically, with many attributing the moves lower to short sellers benefiting from the suspension of the uptick rule. The uptick rule has been put into the spotlight more and more. Last week, Rep. Barney Frank (D., Mass.), among others, expressed support for the reinstatement of the regulation. The measure introduced by Sens. Kaufman and Isakson also calls for the SEC to alter several other rules. If passed, the bill would require exchanges and other trading venues to execute the trades of long sellers ahead of short sellers, all other things being equal. Additionally, all short sales would be required to settle on the same time frame employed for long sales of the same securities. "There is no reason short sellers should have 13 days to deliver shares when long sellers have only three days," Kaufman wrote on his Web site.
The bill also seeks to offer greater protection to financial stocks, as it would prohibit short sales of the securities of any financial institution unless that trade is affected at a price (in minimum lots specified by the SEC) at least 5 cents higher than the immediately preceding transaction in such securities. "Our financial sector, and financial stocks, are in a fragile state -- and our taxpayers now hold substantial shares of many institutions," read a statement on Kaufman's Web site. "If the Treasury and
Federal Reserve believe they need additional protection in these times, this legislation permits it." The legislation also takes aim at abusive naked short selling, which occurs when a short sale occurs but the trader does not first borrow the shares and fails to deliver on the transaction. The bill attempts to "tighten up the rules" already in place that prohibit any person from selling securities short unless that person has at the time of the short sale a demonstrable legally enforceable right to deliver the securities at the required delivery date. Naked short selling is considered extremely harmful to certain stocks because it can keep share prices artificially depressed, allowing unscrupulous traders to take advantage of the stock. While certainly illegal according to SEC regulations, many investors argue that naked short selling occurs often enough to be destructive and that the SEC does little to enforce the rules against the practice.