Short Selling Clamp Down

Following the seizure of IndyMac by bank regulators on 11 July, and the emergency life-line extended to FreddieMac and FannieMae on 13 July, the U.S. Securities and Exchange Commission (SEC) has instituted an emergency rule applicable to 19 major financial firms (including FreddieMac and FannieMae) to curb short selling.

This move by the SEC brought about an immediate response from all quarters of the securities industry, resulting in a number of exemptions being granted before the order even came into effect on 21 July. Additionally, the general view has been that it is unfair to apply the ruling to only 19 firms, and major players to boot, as this leaves smaller entities even more vulnerable to short selling abuses.

The SEC’s ban on short selling was motivated by concern that this practice was being used to manipulate the market through the spreading of false rumors about various firms. This in turn would cause their share prices to plummet, enabling short sellers to cover at a profit. This temporary ban buys the SEC some time in which to investigate whether there has been any intentional spreading of false information and by whom – which could be a lengthy process.

Under normal circumstances, a proposed SEC rule change involves public consultation and can take months to approve and institute. However, these are not considered to be normal circumstances and the SEC exercised its right to institute an emergency order, a move that long-time stock market players are calling unprecedented.

Short selling is when a seller sells securities that he does not own, but has borrowed through his broker, in the hope of repurchasing these stocks later at a lower price. If carried out correctly, this is a legally acceptable stock market investing practice. Naked short selling is when the seller sells securities that he does not own, he has not borrowed, and has not ensured could be borrowed. Although this practice is not necessarily a violation of SEC laws, it becomes illegal when the practice actively drives down stock prices and/or dealer-brokers do not have reasonable grounds to believe the securities in question can be borrowed to facilitate settlement. As with most controversial practices, there are seemingly valid arguments for and against short selling. Those for it, assert that the practice is a vital part of the price discovery mechanism and is instrumental in uncovering fraudulent accounting, citing Enron and Tyco as examples. Those against it are generally of the view that short sellers profit from the misfortune of others and continually walk a fine line between the “legal” aspects of short selling, and the “illegal” aspect of being responsible for a decline in share prices – and it is a fine line that is difficult to define and difficult for regulators to keep track of. Some short sellers have had legal proceedings instituted against them by companies claiming that short selling has detrimentally affected their share prices.

Whether the SEC will respond to calls to extend the current short selling ban to all stock market listed companies remains to be seen. In the current market, investors are learning to expect the unexpected and, as has been shown in the past few months, some precedents are being set that will no doubt go down in stock market history.