The Long and Short of It: the Securities and Exchange Commission Should Reinstate a Price Restriction Test to Regulate Short Selling

• Publication year: 2022

43 Creighton L. Rev. 593. THE LONG AND SHORT OF IT: THE SECURITIES AND EXCHANGE COMMISSION SHOULD REINSTATE A PRICE RESTRICTION TEST TO REGULATE SHORT SELLING

THE LONG AND SHORT OF IT: THE SECURITIES AND EXCHANGE COMMISSION SHOULD REINSTATE A PRICE RESTRICTION TEST TO REGULATE SHORT SELLING

I. INTRODUCTION

After the 1937 market break, the Securities and Exchange Commission ("SEC") adopted a rule involving short sale price restrictions to restrict short selling.(fn1) The rule was known as the uptick rule and it prevented a security from being sold short unless one of the following exceptions was met.(fn2) First, the SEC allowed a security to be sold short if the short sale was at a price higher than the immediately preceding sale price of the security.(fn3) Second, the SEC allowed the short sale of a security when the short sale was at the same price as the last sale price so long as the last sale price was greater than the last different price of the security.(fn4) After the implementation of the uptick rule, the SEC left the chief provisions of the rule fundamentally unchanged for virtually seventy years.(fn5) However, in mid 2007, the SEC eliminated the uptick rule altogether and prohibited any self-regulatory organization from implementing any type of short sale price test.(fn6)

Since the elimination of the uptick rule, the financial markets experienced extreme turbulence due to turmoil in the financial sector as well as severe volatility and sharp declines in securities prices.(fn7) In 2008 and early 2009, significant financial institutions experienced sizeable reductions in the value of their securities.(fn8) Volatility and steep changes in the prices of securities scarred the status of the markets subsequent to the elimination of the uptick rule.(fn9) Although the SEC did not recognize any empirical data that the elimination of the uptick rule increased the volatility of the markets, many investors and other members of the public associated the recent volatility of the markets along with sharp declines in security prices and the loss of investor confidence with the removal of the uptick rule.(fn10)

This Note analyzes the effects of the SEC's elimination of all short sale price test restrictions, particularly the uptick rule.(fn11) First, this Note discusses the definition of a short sale.(fn12) Next, this Note examines the SEC's history of regulating short sales.(fn13) This Note will also discuss recent market volatility along with international views on short selling.(fn14) Primarily, this Note advances the argument that the SEC should reinstate a price test restriction through a modified uptick rule along with a circuit breaker halt rule to prevent abusive short selling and to restore investor confidence in the markets.(fn15) In support of this argument, this Note analyzes market volatility subsequent to the elimination of the uptick rule, the electronic trend of today's markets, potential benefits of short selling, the SEC's justification for the removal of the uptick rule, and the SEC's role in the regulation of short selling.(fn16)

II. BACKGROUND

A. DEFINITION OF A SHORT SALE

A short sale occurs when a seller sells a security that the seller does not own and has to borrow to make delivery.(fn17) In a short sale transaction, a short seller will sell a security that the seller does not own, borrow the security from a broker to meet the delivery obligation after selling the security, and then purchase an equivalent security to return to the broker that lent the security to the short seller.(fn18) A brokerage firm generally will loan the short seller the stock from either the firm's inventory, the margin account of other firm clients, or a different lender.(fn19) The short seller will be responsible for interest charged by the brokerage firm on the lent stock.(fn20) The securities that the short seller will return to the lender are typically purchased on the open market.(fn21)

A seller commonly will make a short sale if the seller anticipates the particular security's price to decline.(fn22) The short seller will realize a profit if the security's price declines in the time between the sale and the purchase.(fn23) However, if the price of the stock increases, the short seller will not produce a profit but instead will incur a loss.(fn24) As an illustration, consider an investor that anticipated a decrease in the stock price of Corporation A.(fn25) If Corporation A's stock was trading at $60 per share, the investor would have borrowed shares of Corporation . stock at $60 per share and then sold the shares without delay in a short sale.(fn26) If Corporation A's stock subsequently decreased to $40 per share, the investor would have profited if the investor later bought shares on the open market to replace the borrowed shares.(fn27) On the other hand, if Corporation A's stock subsequently increased, the investor would have incurred a loss rather than produced a profit.(fn28) For example, if Corporation A's stock subsequently increased to $80 per share, the investor would have lost $20 per share if the investor bought shares on the open market to replace the borrowed shares.(fn29)

In contrast to a short sale, a "naked" short sale occurs when the seller does not borrow and does not arrange to borrow securities.(fn30) As the seller does not borrow or arrange to borrow the securities, the seller will fail to deliver the securities to the purchaser when the delivery of the securities is due.(fn31) The seller may intentionally fail to deliver securities to manipulate the price of a security or a seller may intentionally fail to deliver securities to avoid the borrowing costs that are associated with short sales.(fn32)

B. HISTORY OF SEC REGULATION OF SHORT SALES

1. Regulation of Short Sales from 1938 to 2007

The Securities Exchange Act of 1934 ("Exchange Act")(fn33) gave the Securities and Exchange Commission ("SEC") authority to regulate short sales.(fn34) The Exchange Act limits the SEC's authority to regulate short sales to only those securities registered on a national securities exchange.(fn35) The SEC's authority is comprised of the power to prescribe rules and regulations that are necessary or appropriate for the protection of investors or in the public interest.(fn36) In 1938, the SEC utilized its authority and adopted a rule to restrict short selling, known as the uptick rule.(fn37) The SEC adopted the uptick rule following an investigation on concentrated short selling effects that the SEC conducted throughout the market break of 1937. (fn38) The uptick rule provided that a seller could short sell a listed security at a price higher than the price of the sale preceding the last sale price, known as a plus tick, or a seller could short sell a security at the last sale price, but only if it was higher than the last different price of the security, known as a zero plus tick.(fn39) For almost seventy years, the central provisions of the uptick rule remained largely undisturbed; however, in response to changes in the securities markets, the SEC did add exceptions to the uptick rule and granted relief from the rule's restrictions.(fn40)

In July 2004, the SEC studied the effectiveness of short sale price tests by creating a one-year pilot ("pilot program") that temporarily suspended the uptick rule for short sales of certain securities.(fn41) The SEC established the pilot program to determine whether changes to the uptick rule were appropriate at the time of the program and whether changes would further the purposes of the short sale price test regulation.(fn42) The pilot program studied changes as to whether the SEC should remove the uptick rule, or if the uptick rule was to remain in action, whether the rule should apply to additional securities.(fn43) To analyze the changes, the SEC examined the influence of price tests on market quality, any price changes that could be caused by short selling, the costs associated with the use of price tests, and short positions established through alternative means.(fn44) The SEC selected securities to be used in the pilot program to represent the Russell 3000 index as a whole.(fn45) The chosen securities represented various levels of liquidity to allow the SEC to examine the difference between price tests on securities with minimal liquidity and those with significant liquidity.(fn46) The remaining securities in the Russell 3000 index not chosen in the group of pilot stocks, which were similar to the stocks in the pilot group, served as a control group.(fn47) Securities that were not subject to a price test at the time of the pilot program were excluded from both the group of securities selected for the pilot group and the remaining securities in the control group.(fn48)

The SEC's Office of Economic Analysis ("OEA") gathered and analyzed the data during the pilot program.(fn49) The OEA compiled a summary report on the pilot program, which it provided to the public.(fn50)At the time the OEA set forth the summary report, the OEA explained that it found little empirical justification for sustaining short sale price test restrictions including the uptick rule.(fn51) The OEA found that the short sale price tests did not have a sizeable impact on daily volatility, little evidence existed that the restrictions altered a security's price, removal of the restriction did not affect realized liquidity levels, and price tests operated as a restraint on...