OT - Re: 8/17/01 - Bloomberg: SEC Studies Lifting Ban on Selling Short When Prices Falling
08/17 08:38
SEC Studies Lifting Ban on Selling Short When Prices Falling
By Philip Boroff
New York, Aug. 17 (Bloomberg) -- The Securities and Exchange Commission may allow short selling when share prices are falling, repealing a prohibition adopted in the agency's earliest days to prevent a rerun of the 1929 crash.
SEC regulations bar short sales -- selling borrowed shares with the aim of replacing them later at a lower price -- when a stock's last move was a ``downtick,'' or drop. The rules were written to keep short sellers, who profit from declining prices, from accelerating a stock's decline.
The SEC staff is preparing a proposal to temporarily exempt the most active stocks from the short sale rule as a test of whether it should be permanently eliminated or altered. Mary Bender, regulatory chief of the Chicago Board Options Exchange, said she expects the test to include 100 to 150 stocks.
``If you start with the most active stocks that are the least susceptible to manipulation, you can get a good sense of whether the doomsayers are right,'' she said.
Larry Bergmann, the SEC's senior associate director of market regulation, declined to provide specifics about the plans. ``We're preparing proposals to modernize short sale regulations,'' he said. To take effect, any proposal by the SEC staff must be backed by the commission and circulated for public comment.
SEC Chairman Harvey Pitt couldn't be reached for comment.
Hurts Hedging
The CBOE, some brokerages and the Managed Funds Association, a hedge fund trade group, have told the SEC they want the 63-year- old short sale rule modified. They say it hampers hedging -- selling short to protect portfolios from market declines -- as well as arbitrage, or trading to profit from discrepancies between related securities or markets.
The New York Stock Exchange said it wants the rule preserved because it prevents manipulation and fraud. The Nasdaq Stock Market, which isn't covered by the SEC regulation, adopted its own short sale rule in 1994 and wants to maintain it in part because it's popular with companies that trade on the electronic market.
Short sales are bets that a stock will decline, and can push down a stock price if sellers overwhelm buyers. Shorting isn't a sure thing, though: buying back the stock can lift a thinly traded issue higher. In 2000, NYSE short sales accounted for 11 percent of Big Board volume.
``It carries a negative connotation, because people don't like it when stock prices go down,'' said Greg Rogers, head trader at Aronson & Partners, a Philadelphia money management firm that oversees $5 billion.
In the aftermath of the 1929 crash, President Herbert Hoover and much of Congress and Wall Street blamed organized short selling for worsening the panic. In the 34 months ending in July 1932, NYSE prices fell 83 percent. General Electric Co. tumbled from 396 1/4 to 8 1/2.
Otto Kahn, a partner with Kuhn, Loeb, one of the largest investment banks at the time, testified in a congressional hearing that shorting was ``inherently repellent to a right-thinking man'' and a ``social evil.''
Congress created the SEC in 1934 and the SEC established the short sale rule four years later to reduce the likelihood of another market meltdown. It survived repeal efforts in the 1970s in part because companies and floor traders supported the rule and exchanges spoke out on their behalf.
``There is a sacred cow element to the short sale rule,'' said Roger Blanc, a partner in the law firm of Willkie Farr & Gallagher, who wrote to the SEC in 2000 on behalf of Bear Stearns & Co., Credit Suisse First Boston, J.P. Morgan Securities Inc. and PaineWebber Inc. In the letter, the firms asked the agency to provide an exception to the rule for hedging.
Reviewing the Rule
The SEC began reviewing the rule in 1999 after lobbying by the CBOE, brokerages and short sellers such as David Rocker of New York's Rocker Partners LP. The agency proposed eight options, from eliminating the rule outright to providing an exception for actively traded stocks, currently the staff's top choice, according to industry officials.
With NYSE volume up 1,000-fold since 1938, ``bear raids'' -- organized short-sellers working together to drive down prices -- are no longer feasible, backers of the proposal say. They add that computerized market surveillance systems can identify unusual trading activity.
``The rule is a response to the last battle,'' said Ted Aronson of Aronson Partners. ``It fit the 1930s just perfectly. Today it's a nuisance.''
Bender of the CBOE said people are trading in ways that didn't exist in the 1930s. For example, traders on the world's largest options market often hold options positions -- which gives the holder the right to buy or sell a stock at a specific price at some future time -- that are equivalent to owning the stock itself. A trader may need to sell stock to hedge his position, but has to wait until the stock stops falling on the NYSE first.
``If he can't sell the stock because the market is dropping, he is at tremendous risk,'' Bender said.
Bender said the rule protects NYSE specialists -- who are responsible for maintaining orderly markets in stocks and often buy shares when they are declining -- at the expense of options floor traders. She said specialists are afraid of loosening the short sale because they may have to buy falling stocks.
Options traders ``bear all the exposure,'' she said. ``We're looking for a balance.''
Rocker of Rocker Partners said that unrestrained short selling would help prevent stock valuations from becoming inflated. He proposed to the SEC staff that traders be able to sell short as long as the share price is above its prior day's close. Otherwise, he says, the rule as is should kick in.
``The system is not in balance,'' said Rocker. ``It's like a ratchet that can go up and can't go down.''
Critics
Backers of the short sale rule say despite changes in the markets, the dangers that the SEC identified in the 1930s still exist. ``If anyone thinks that bear raiders are less sophisticated or less well financed than they were in the early days of the 20th century, they're kidding themselves,'' said Robert Fagenson, vice chairman of Van der Moolen Specialists USA, an NYSE specialist firm. ``Removal of the short sale rule will hatch an entirely new breed. Investors are still prone to panic.''
The NYSE last year reiterated its opposition to a blanket repeal of the prohibition in a letter signed by Senior Vice President James Buck. The letter said current rules ``provide important safeguards in protecting the public's interest, preventing fraudulent and manipulative acts and practices and promoting just and equitable principles of trade.'' NYSE Spokesman Ray Pellecchia declined to elaborate.
Companies that trade on the Nasdaq market ``remain gung-ho'' about its short sale rule, President Richard G. Ketchum said. ``Also, there is a psychological benefit when buyers are aware that shorts alone can't take down a stock.''
The rule's effectiveness has been debated from the start. In 1932, NYSE economist J. Edward Meeker wrote that market declines were typically due ``to the rise of prices to heights unjustified by business conditions'' and not to short selling. A 1963 SEC study concluded the rule ``did not prevent the harmful effects of short selling,'' although a 1996 National Association of Securities Dealers study found the Nasdaq's short sale limitations do slow short sales when prices are falling.
The SEC proposed a temporary suspension of the rule in 1976 so it could study its effects further, but it couldn't overcome the objections of the NYSE, the American Stock Exchange and AT&T Corp. The phone giant told the SEC that suspending the rule might increase volatility in its share price. A spokeswoman declined to comment on whether that is still the company's position.
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