SEC is floating options to limit short sales

April 8, 2009 6:02:06 AM PDT
Federal regulators are floating several options for reining in the practice of short-selling stocks, as investors, corporations and lawmakers clamor for restrictions on moves they say gutted vulnerable companies and worsened the market's downward spiral. Members of the Securities and Exchange Commission are meeting Wednesday to vote on new rules restricting short-selling, in which traders try to profit from a stock's decline by selling borrowed shares. Several proposals are expected to be put forward for public comment.

The agency could settle on one plan and formally approve it sometime after the comment period.

It marks the second time in less than a week that financial relief measures pressed by Congress were taken up by overseers. Last Thursday, the independent Financial Accounting Standards Board gave companies more leeway in valuing assets and reporting losses.

Both sets of changes would especially benefit banks and other financial institutions, whose balance sheets have been battered in the financial crisis and whose stocks have often been targeted by short sellers.

The SEC's move is the first major initiative by the agency under Chairman Mary Schapiro, who was appointed by President Barack Obama and assumed the position in January.

Short-selling is legal and widely in use on Wall Street. The practice involves borrowing a company's shares, selling them, then buying them back when the stock falls and returning them to the lender. The short seller pockets the difference in price.

Proponents of short-selling say it can make markets more efficient, bring in more capital and raise warning signs about weak or badly managed companies. But companies and regulators maintain that the practice widened the scope of the financial crisis and contributed to the collapse in value last fall of a number of bank stocks - as well as the demise of investment bank Lehman Brothers.

As the market has plunged, pressure has been building from investors and Congress for the SEC to reinstate the so-called uptick rule, which it abolished in 2007. The rule was established in 1938 during the Depression that followed the 1929 market crash. Those pushing for its restoration say the absence of the rule has fanned volatility in the market, prompting bands of hedge funds and other investors to target weak companies with an avalanche of short-selling.

Professional short sellers and some analysts, on the other hand, have warned of possible negative consequences of restricting short-selling, maintaining that such a move could actually distort - not stabilize - edgy markets.

The uptick rule requires short sellers to wait to sell shares until a stock trades at a price at least slightly above its previous trading price. The idea is to install "a bit of a speed bump in a declining market," Schapiro told reporters on Monday.

Schapiro confirmed that another option being considered, in addition to reinstating the uptick rule, is a sort of "circuit breaker" for stock prices. That approach would force short sellers to sell shares above the going market rate when they execute a short trade - it would only go into effect after a stock price has had a sharp decline by a certain amount.

Another option, known as an upbid rule, would allow short sellers to come in only at a price above the highest current bid for the stock.

Whatever changes are adopted won't stifle short-selling in a blanket way, Schapiro said.

The SEC repealed the uptick rule in July 2007, when the stock market was near its peak. A test by the SEC earlier that year, removing the uptick rule for one-third of the stocks in the Russell 3000 index, found it could be eliminated without causing significant harm.

"Those studies were done in quite a different time," Schapiro said Monday.

Last fall, the SEC adopted measures aimed at imposing protections against abusive "naked" short-selling. That refers to sellers selling shares they haven't even borrowed yet, and then looking to cover positions immediately after the sale.

In addition, some Wall Street firms have cut back on lending stocks to short sellers, The Wall Street Journal reported Tuesday. As a result, the number of stocks in which large blocks of shares haven't been properly delivered to investors has dropped to a daily average of 79 in the first quarter from 529 in the first nine months of 2008, according to the newspaper's analysis of trading data from major stock exchanges.

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