Sec Ban on Naked Short Sales

With the permanent ban on naked short selling of stocks, the SEC has replaced its earlier limited-period restriction on short selling of financial stocks imposed in the aftermath of the credit crisis last year.

Several stocks were ruthlessly hammered to ridiculously low levels towards the end of September last year. Traders were pulled up for concerted raids on AIG (Symbol: AIG), Lehman Brothers (Symbol: LEHMQ), Citigroup (Symbol: C) and Bank of America (Symbol: BAC) among others. It is another matter that the measure failed to stem the rot as prices continued to fall or at best stagnate, probably reflecting the weak fundamentals of these companies.

Why the permanent ban on naked short sales? Critics maintain the trader does not own or borrow the shares being shorted, which adds momentum to the decline in stock prices. The naked short trader does not plan to deliver the shares shorted as the intention is to cover the short position before the mandatory delivery date of the short sale – usually three business days.

Following its announcement in late July 2009 the SEC said self-regulatory organizations, such as the Financial Industry Regulatory Authority, will start displaying more information on their websites about short sales, including (on a one-month delay) the exact time at which a trader places a short-sale and the size of the position. The anonymous data is intended to inform investors and others if traders were actually zeroing in on a company in an improper, coordinated way.

Additional disclosures are being mandated on daily aggregate volume information of short-selling in each exchange-traded stock. The SEC also would speed up disclosure of failed short trades, when a trader never completes the trade by replacing the borrowed stock, across all companies from once a quarter to twice a month. Failed trades could provide significant clues to stock manipulations.

The SEC, however, has refrained from its earlier move to require hedge funds and other money managers to disclose weekly their short positions once they reach a certain concentration. Instead, it is sharpening its regulatory oversight of hedge funds as part of a broader financial regulation overhaul proposed by the Obama Administration.

Under a rule that was finalized last week of July 2009, short-sellers must complete the trade within three days by replacing the borrowed stock, or they would be deemed to have failed to deliver, leading to penalties.

Several senators urged the SEC to incorporate a so-called “hard locate” or pre-borrow requirement, essentially locking up stock so that it cannot be lent out to anyone else, as a disincentive for naked short sellers.

The SEC is also contemplating the re-introduction of an old ‘uptick’ rule, done away with in July 2007, which required traders to wait till a stock rose at least a penny before placing a short sale. It was to deflate aggressive short-selling in a market downslide. This again, is a limited utility measure like trading halts to cool an overheated market. The point to note here is that the SEC cannot afford to wait till September when it proposes to conduct a public hearing to debate stock lending and disclosure issues related to short selling. Seasoned investors know the virtues of short selling and how it creates a fertile ground for a strong rally as was witnessed from early April 2009. This is the time to deal with the menace of naked short sales when there is sanity in the market, rather than wait till another crash happens.