SEC Studies Lifting Ban on Selling Short When Prices Falling
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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