Wall Street Journal - Front page article on short selling (Wed Edition )( no bias here ! : ))
SEC Moves to Curb Short-Selling
By KARA SCANNELL and JENNY STRASBURG
July 16, 2008; Page A1
WASHINGTON -- The Securities and Exchange Commission took unprecedented action against short sellers on Tuesday, acting on a widespread concern that negative bets against bank and brokerage stocks might be exacerbating the financial sector's woes.
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In a dramatic emergency order, the SEC said it would immediately move to curb improper short selling in the stocks of struggling mortgage giants Fannie Mae and Freddie Mac, as well as those of 17 financial firms, including Goldman Sachs Group Inc., Lehman Brothers Holdings Inc., Morgan Stanley and Merrill Lynch & Co.
The plan, which is expected to go into effect on Monday, will expire in 30 days. But the SEC will also begin considering whether to extend the new requirements to all stocks traded in the U.S. The actions represent one of the most extensive attempts by a government agency in recent years to control short selling.
It's far from clear whether the move, which sparked a barrage of criticism, will curb the activity of short sellers. While its aim is to curb abuses, it also would add an additional layer of bureaucracy to legitimate transactions.
Some critics say the move is simply an attempt by the SEC to show that it is taking action when it is under pressure for not doing enough to police markets. SEC Chairman Christopher Cox, in particular, has come under fire for not being a more visible figure at a volatile time.
Short selling is a legitimate trading strategy in which traders aim to profit from falling stock prices. Shorting can act as a corrective force at times of rampant bullishness in markets, its defenders say. But it has long been controversial because it pits investors, notably hedge funds, against companies that are eager to see their share prices high.
[Christopher cox]
Richard Baker, the former Louisiana congressman who is now president of the Managed Funds Association in Washington, the biggest hedge-fund industry group, said the SEC's emergency action "is aberrant, it's unusual, and it may be without precedent. I was a little surprised by the scope of this, the speed with which the decision was made, and the potential consequences to market functioning." The MFA will seek meetings with regulators to discuss their reasoning, he said.
The regulatory action is of great symbolic importance to Wall Street, which has complained long and hard about what they suspect is manipulative trading in their stocks, which have been pummeled this year. Bear Stearns Cos. imploded in March and now is part of J.P. Morgan Chase & Co.; Lehman's shares have plunged this year. The financial firms placed under the SEC's protective umbrella have been some of the hardest hit in recent trading.
The chief executives at Lehman and Bear Stearns have made private calls in recent months to, among others, Goldman Sachs Group Inc. CEO Lloyd Blankfein to raise questions about whether Goldman was helping to fuel, even indirectly, pressure on their firms' shares, according to people familiar with the matter. Short interest, or the amount of short positions outstanding, is at an all-time high, at 18 billion shares, for NYSE Euronext listed stocks.
The battle between regulators and short sellers has a long history -- dating back at least to the South Sea Bubble of the early 18th century -- and short sellers have usually won. It's hard to prove that short sellers manipulate markets or that they perpetuate false rumors that pummel stocks.
In a short sale, a trader borrows stock and then sells it, in hopes it will later fall in price. If it does, the short seller then buys the stock in the open market at the lower price, returns what was borrowed, and pockets the difference.
The SEC said Tuesday's move aims to stop "unlawful manipulation through 'naked' short selling." Naked shorting refers to the practice of selling stock short without taking steps to borrow it.
Critics say short sellers band together and sell shares of a company all at once, overwhelming the market and driving its stock price down. That can set off a chain reaction, with shareholders getting nervous and selling. Critics say the short sellers then close out their bets at tidy profits. In practice, this is extremely difficult to do with big companies whose stocks are heavily traded, although smaller companies are more vulnerable.
Under current rules, a short seller must first locate shares to borrow, but does not have to enter into a contract with the share lender. Often, more than one trader is able to borrow the same shares, creating a multiplier effect in the size of the total short position.
Under the emergency order, a short seller would be required to have an actual agreement to borrow the shares. The new move would effectively take shares out of the market for borrowing, which could reduce the amount of stock available for selling short.
The SEC has started clamping down on short selling, indicating it is worried about the impact such trades are having on the financial system. It's investigating whether traders used a combination of false rumors and short selling to drive down shares of Bear Stearns earlier this year. Lehman is engaged in a public fight with certain short sellers, which has also prompted an SEC investigation.
On Sunday, the SEC said it would crack down on firms or individuals that illegally spread false rumors. In its various short-selling investigations, the SEC has sent subpoenas to more than 50 hedge funds, some as recently as Monday.
Critics of the SEC's move Tuesday asked why certain financial firms were being protected -- but not the broader market -- especially when many of those firms are also active short sellers.
"For heaven's sakes, they're the very ones we believe have been doing this...to thousands of public companies," said James "Wes" Christian, a lawyer with Texas law firm Christian, Smith & Jewell, who represents companies who have filed lawsuits relating to short selling.
An SEC official said the agency focused on financial firms that were of a significant size. "Drastic falls [in stock prices] can end up destroying confidence in the firm altogether, which is not true for bricks-and-mortar industrial companies," the official said.
Evading Restrictions
It's unclear to what extent the emergency action will reduce short selling in the stipulated stocks. The financial companies have large "public floats," meaning many shares are available in the market for short sellers to borrow. James Angel, an associate finance professor at Georgetown University, said that if the rules were extended to other stocks, the biggest impact would be on thinly traded stocks that are hardest to borrow.
Charles M. Jones, a finance professor at New York's Columbia University, says there are numerous ways to evade restrictions on short selling. Traders are free to short U.S. stocks in overseas markets, unhindered by U.S. securities rules.
New York hedge-fund manager Whitney Tilson called the proposals a "desperation move" that could end up silencing investors who are among the first to point out problems at troubled companies.
"What do I think is really going on here?" he asked. "I think that regulators are very, very concerned about the collapse of the stocks of major U.S. financial institutions and are grasping at straws as to what to do about it." Mr. Tilson's hedge fund has had short positions on banks and brokerage firms, including Lehman, Washington Mutual Inc. and Wachovia Corp., as well as big bond insurers.
Some market observers say the SEC's elimination of the so-called up-tick rule in 2007 has contributed to the current market volatility, and they want the agency to reinstate that rule instead of taking the emergency action.
The up-tick rule barred short sellers from selling unless the stock price was rising, which had the effect of cushioning the market impact of such selling. It was a symbolic barrier against the kind of short selling that could cause stocks to fall precipitously.
Mr. Cox said the SEC was open to implementing some kind of similar price test, but he didn't elaborate.
For nearly as long as stock markets have existed, authorities have tried to restrict short selling. And for as long as they have tried, they have failed. In 1733, in the aftermath of the South Sea Bubble, the British House of Commons banned what today would be called naked short selling. The law remained in force for more than 150 years, even though, as financial historian Charles Duguid noted in 1901, "it was at no time seriously operative."
On Apr. 10, 1792, the New York state legislature banned short selling. Five weeks later, two dozen stockbrokers banded together to sign the Buttonwood Agreement, which created what became the New York Stock Exchange, where short selling occurred with abandon. Last month, Pakistan banned short selling on the Karachi Stock Exchange for a month, after declines. In the 1990s, Hong Kong temporarily banned short sales, and the Malaysian finance ministry proposed that anyone caught short selling should be punished by caning. Neither measure prevented those markets from falling during or after the 1998 Asian crisis.
Efforts to restrict short selling are "silly but harmless," says short-selling expert Owen Lamont, formerly a finance professor at Yale and now a money manager at DKR Fusion in Boston. Mr. Lamont adds that the SEC initiative "might have some impact on investors' faith in the system. But I don't see how it could possibly stabilize the markets in a fundamental way."
Minimal Impact
Other legal experts predicted the new SEC program would have minimal impact. "In the near term, short sellers may see some marginal increase in their cost of borrowing, as brokers adjust their operations," said Laurel FitzPatrick, a partner at the law firm Ropes & Gray LLP, who advises hedge funds on trading and other regulatory issues. "Ultimately, neither this rule, nor the SEC's indications that they are looking to bring enforcement cases against sellers spreading rumors, will reduce short selling if sellers believe a stock is overvalued."
The SEC announcement didn't bolster shares of Fannie Mae or Freddie Mac, which fell 27% and 26%, respectively, on Tuesday.
Short sellers have been targeting Fannie and Freddie more aggressively than they were a year ago. At the end of June, there were 138.7 million shares shorted of Fannie, compared with 17.2 million for June 2007. For Freddie, the figures were 82.8 million shares, versus 12.5 million a year ago.
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