Review of the policy debate over short sale regulation during the market crisis.

AuthorMcCaffrey, David P.

I. INTRODUCTION

This article summarizes the recent history of short sale regulation, and academic research on the subject. It then discusses the impact of the market crisis beginning in 2007 on short sale regulation, the current debate over the Securities and Exchange Commission's ("SEC") revisions to Regulation SHO, and a general issue of public perception of risk and regulatory policy in complex financial markets.

II. OVERVIEW OF SHORT SALE REGULATION

Short sales serve three purposes. First, traders use short sales to profit from anticipated declines in stock prices, selling borrowed shares at a high current price and hoping to repay the loan with shares purchased at a subsequent lower price. Second, market makers, responding to incoming buy orders for stocks they do not have in inventory, sell shares that they do not possess but can acquire within designated settlement periods as part of their market-making function. Third, short sales are an important component of complex electronic trading and hedging strategies; for example, to manage overall portfolio risk, participants combine long positions that increase in value as prices increase with short positions increasing in value as prices go down.

Short sales in market making or complex trading and hedging strategies do not target anticipated declines in the price of stocks; they facilitate transactions by others, or are part of a broader technique based on the relative prices of different securities. These now constitute the largest share of short selling, especially as electronic trading comprises such a large share of market activity. For example, Credit Suisse notes that only 0.7 percent of hedge funds' short sales are "dedicated shorts," or designed to profit from anticipated declines in specific stock prices. (1)

"Dedicated short" selling, however, generates the most attention in regulatory debates. Those defending short selling maintain that short sellers improve markets by investigating and disclosing information about over-valued stocks. (2) Corporate issuers, holders of particular stocks, or other parties maintain, however, that short sellers, by selling at progressively lower prices, spreading negative rumors about companies, and other manipulative methods, commonly induce stock price declines by concerted short selling rather than correct inflated prices.

Market declines historically produce calls for tighter controls on short selling. In 1932 J. Edward Meeker reviewed how this debate was an important part of financial crises going back hundreds of years, (3) and Charles Jones discussed how the debate played out in the 1930s and in the market declines in 2008. (4) In 1938 the SEC issued Rule 10a-1 under the Securities Exchange Act, prohibiting short sales of exchange-listed securities at levels below the last sale price, or at the last sale price "unless that price was above the next preceding different price" (a zero-plus tick); the purpose was to prevent short sellers from driving prices down through sales at progressively lower prices. (5)

The Securities and Exchange Commission reviewed recent history of short sale regulatory proposals in a 1999 concept release. (6) The SEC's Report of the Special Study of the Securities Markets in 1963 suggested that short sale regulation "did not prevent the harmful effects of short selling that the rules were designed to prevent," but acknowledged that the data to support such conclusions needed improvement. (7) In 1976, the SEC proposed temporary suspensions of short sale pricing rules to permit analysis of how the markets would function without them. (8) Eight of the twelve comments on the proposal, including those by the New York Stock Exchange ("NYSE") and Amex, opposed the suspensions, arguing that even temporary relaxation of short sale restrictions would damage the markets. The SEC withdrew the proposal in 1980.

The House Committee on Government Operations issued a report on short selling in 1991. (9) The report said that short selling benefited the equity market, but that short sale regulation through the uptick test should be retained and an equivalent rule applied to the NASDAQ OTC market. (10) The committee report said that many complaints about short selling reflected a poor understanding of how short selling actually operated, but also that there was some evidence of abusive short selling through spreading of rumors. (11) The report said that the investing public overestimated short sellers' manipulative powers, but public misperception itself increased short selling's effects because investors' reactions reinforced short sellers' activities. (12) The committee called for more disclosure of general statistics on short selling and large individual short positions. (13) Since the 1991 report, the National Association of Securities Dealers ("NASD") adopted a short sale bid test to restrain short selling, and the NYSE and NASD required members to report additional data on their short positions. (14)

The SEC's 1999 concept release solicited comments on major revisions of short sale regulation. (15) It raised the idea of removing short sale price tests when markets had risen by a large amount; the reasoning was that short sales are most likely to benefit markets by restraining bubbles, and short sellers were least likely to be able to manipulatively drive down prices in rising markets. (The year 1999 was the peak of the internet bubble.) (16) It requested comment on price test exceptions for actively traded securities; focusing short sale regulation on specific events, such as mergers, acquisitions, and tender offers; and exempting hedging transactions from short sale regulation. (17) It also discussed modifying short sale regulation given developments such as after-hours trading and decimalization, revising the definitions of short sales, extending short sale regulation to listed securities in the Over-the-Counter COTC") markets, and also eliminating short sale regulation entirely. (18)

After receiving 2,778 comment letters on the 1999 concept release, the SEC proposed a major revision of short sale regulation in 2003. (19) The proposed Regulation SHO followed certain SEC enforcement actions related to short selling in 2003 and the SEC staff had alluded to the upcoming revision of short sale regulation in its report on hedge funds in September 2003. (20) It noted, in footnote 269 of the hedge fund report, that

[a]mong the most common trading practices used by hedge fund advisers is short selling. The staff makes no recommendations to the Commission regarding short selling at this time, but notes that it is currently considering recommending that the Commission propose rule amendments that would modernize short sale regulation designed to target areas of abuse, including naked short selling. ("Naked" short selling generally refers to a sale of securities when the seller does not own the securities sold and makes no arrangements to borrow the securities in order to make delivery on the sale.) The amendments would also be designed to ease regulatory restrictions where they are unnecessary or inhibit beneficial short selling. (21) III. REGULATION SHO AND EARLY AMENDMENTS

In 2004 the SEC adopted Regulation SILO, after receiving 462 comment letters on the 2003 proposal. Regulation SHO defined ownership for short sale purposes, clarified rules for determining net aggregate short sale positions, required that sales be marked as long, short, or "short exempt," and strengthened Regulation M governing short selling in connection with securities offerings. (22) A new Rule 203 targeted naked short selling by requiring broker-dealers to locate securities available for borrowing prior to effecting short sales. (23) The rule made some exceptions for the locate requirement, including short sales by registered market makers in connection with bona-fide market making. (24) The rule also imposed additional requirements on threshold securities, or securities where for five consecutive settlement days there were aggregate fails to deliver of 10,000 shares or more per security, where the level of fails was equal to one-half of one percent of the issuer's total shares outstanding, and the security was included on a list published by an SRO. (25) The rule required a participant of a registered clearing agency to close out a fail to deliver that had remained open for thirteen consecutive days by purchasing securities of like kind and quantity, and prohibited the participant and any broker-dealer for which it cleared transactions from effecting further short sales in the threshold security until the failed position was closed out. (26) The requirement to close out fail to deliver positions in threshold securities did not apply to positions that were established prior to the security becoming a threshold security. (27)

Regulation SHO also established a one year pilot that suspended the tick test under Rule 10a-1 for about one third of the stocks in the Russell 3000, for sales in securities in the Russell 1000 index executed after 4:15 P.M., and for sales in all other securities between the closing and the next day opening of the consolidated tape the next day. (28) The Regulation SHO announcement said that "[t]he Commission's Office of Economic Analysis ("OEA") will gather and analyze data during the pilot period to assess trading behavior in the absence of short sale price restrictions. Additionally, researchers are encouraged to provide the Commission with their own empirical analyses of the pilot." (29)

In 2007, the OEA's analysis of the pilot concluded, subject to cautions, that

[w]e find no evidence of "bear raids" associated with the pilot.... Our evidence suggests that removing price restrictions for the pilot stocks has had an effect on the mechanics of short selling, order routing decisions, displayed depth, and intraday volatility, but on balance has not had a deleterious impact on market quality or...

To continue reading

Request your trial

VLEX uses login cookies to provide you with a better browsing experience. If you click on 'Accept' or continue browsing this site we consider that you accept our cookie policy. ACCEPT