To restore trust in market, stop abusive short selling
By Edward E. Kaufman and Johnny Isakson
Tuesday, May 05, 2009
Of all the challenges confronting our financial system, none is more important than restoring investors’ trust and confidence in the market.
After the disastrous losses of the past year, millions of Americans will refuse to put their money back into the stock market until they believe the system is once again sound, fair and adequately overseen by the Securities and Exchange Commission.
In the not-so-distant past, a strategy of long-term buying and holding offered a road map for comfortable living in retirement. Then, the market valued companies based on a company’s fundamentals and expected future profits. Today, many view the stock market as another gambling casino, dominated by volatility and susceptible to predatory short sellers who profit from false rumors.
The SEC urgently needs to reflect a clear commitment to meaningful change. It’s time to restore the integrity, efficiency and fairness of our securities markets by preventing manipulative short selling, ensuring that the market fairly values the actual shares issued by a company and outlawing the current ability of short sellers to create “phantom shares.”
The opaque derivatives market allowed some people to play a shell game by leveraging to the hilt and buying and selling synthetic instruments that ultimately crashed in value. The same thing happens through abusive short selling, when traders sell shares they don’t own and have no ability to deliver at the time of sale.
It’s like making copies of your car’s title, and then selling title to the car three times, while hoping you can find other cars to deliver if the buyer proceeds. In some cases, the short interest in a company’s stock on a given day has exceeded the actual number of the company’s outstanding shares.
Let us be clear: The problem isn’t short selling itself, which can enhance market efficiency and price discovery. The problem is that under current rules short sellers can sell stocks they haven’t actually borrowed in advance of their short sale. The current standard requires only a “reasonable belief” that a short seller can locate the necessary shares by the delivery date; that’s no standard at all and subjects the market to rife abuse.
News reports based on SEC data confirm that so-called “naked” short selling contributed significantly to the demise of Lehman Brothers and Bear Stearns.
Those companies took horrendous gambles and their share values reflected those serious missteps, but in the absence of naked short selling both might have survived. And the SEC’s inspector general noted how poorly the SEC has pursued thousands of naked short selling complaints.
One important step the SEC should take now is to reinstate the substance of its former “uptick” rule. The uptick rule served us well for 70 years until the SEC rescinded it in July 2007.
It required short sellers to take a breath and wait for a sale at a higher price before continuing to sell short in declining markets. Fed Chairman Ben Bernanke, bipartisan members of Congress and former regulators favor reinstating it.
To alter fundamentally the way stocks trade today, the SEC must also require — and enforce — short sellers to possess at the time of the sale a demonstrable legally enforceable right to deliver the shares — a so-called “pre-borrow” requirement.
We simply can’t tolerate a market that permits short sellers to create phantom shares that dilute a company’s value, erode the value of citizens’ stockholdings and manipulate share prices downward. (my bolding for emphasis)
Sens. Ed Kaufman (D-Del.; left) and Johnny Isakson (R-Ga.) wrote a bill directing the SEC to fix short selling.
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