Comment letters are pouring into the Securities and Exchange Commission as the agency is set to weigh in on the proposed reinstitution of the uptick rule, setting up a showdown between vocal proponents and critics of the measure. On Wednesday, the SEC is expected to announce several proposals to permanently restrict traders who engage in abusive short selling. "We are going to put forward about four different proposals, and one of them does include the original," SEC Chair Mary Schapiro said Monday in an address to a conference organized by the Council of Institutional Investors. However, comment letters fielded by the commission are divided in their support of an uptick rule or a modified version of one. Some state that a form of an uptick rule will help restore investor confidence in U.S. equities, while others argue that a reinstitution of short sale restrictions is ineffective and could be harmful to capital markets. The uptick rule, created by the SEC in 1938 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 borrows stock from a broker, sells it, and tries to buy it back at a lower price later before returning it to the original lender. The difference in the transactions is kept as a profit.
The SEC eliminated the rule in 2007 after an analysis showed it did little to prevent the manipulation of share prices. Many market participants now point to the 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 sellers could pile in created an environment where shorts accelerated the failures of a number of financial companies, like Bear Stearns, Lehman Brothers and Washington Mutual. Other financial names, 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.
Three large U.S. stock exchanges -- the New York Stock Exchange, the Nasdaq and the BATS Exchange -- have also come out in favor of a tool to prevent abusive short selling. In a joint comment letter, the exchanges argued for a modernized version of the previous uptick rule. Still, they acknowledged that a return to the old rule would be difficult to implement and enforce in the current environment where dozens of trades are performed in a single second. Under a modified uptick rule, the exchanges proposed that the execution of a short sale would occur only at a higher price than the prevailing market at the time of initiation. Additionally, a circuit breaker would be used to trigger the modified uptick rule only after the price of a stock has declined by a certain percentage. "A circuit breaker permits normal market activity while a stock is trading in a natural range and short selling is more likely to benefit the market," the exchanges said in their comment letter.
Direct Edge says that circuit breaker that would enforce a modified uptick rule after a certain percentage decline would distort price action by creating more selling pressure in a rapidly falling market. "The existence of short sale circuit breakers, or any trigger based on a market condition for that matter, could artificially increase selling pressure on stocks as their value approached the relevant price level, as sellers would have an incentive to engage in premature selling in anticipation of the restriction becoming active," the company wrote. Direct Edge did acknowledge that naked short selling, which occurs when a trader sells short a stock without first borrowing shares, is a bigger problem that the SEC should do a better job of enforcing. "Further, given the enactment of more stringent regulations respecting naked short selling and fraudulent conduct, the Commission now possesses more powerful new tools that it can deploy to surveil, control and combat abusive short selling," Direct Edge said. Other market participants are more critical in their argument against the need for an uptick rule. Eric Newman, co-portfolio manager with TFS Capital, told TheStreet.com in February that short sellers have been a scapegoat for the real cause of the market's decline, namely that stocks went down because they were overvalued and there was too much leverage. "People like blaming somebody and they don't like to admit that maybe they made a bad investment," Newman said at the time. "It's like everyone's at a cocktail party, talking about and blaming the short sellers. The rhetoric can get pretty heated. But these stocks are falling because they're losing billions of dollars. At the end of the day, it's business and earnings that drive stock prices."