Re: 1/21/03 - Investrend.com: Georgetown Professor Proposes ‘Upday Rule’ to Curb Naked Shorting
Georgetown Professor Proposes ‘Upday Rule’ to Curb Naked Shorting
Now that Canadian market regulators are giving serious thought to joining the U.S. in restricting naked short selling, Georgetown University Associate Professor James J. Angel, Ph.D., has formulated a proposed “Upday Rule” for both U.S. and Canadian regulators, including its application to the OTCBB, which has no regulation at all.
In September, he provided the proposed rule as a “white paper” for the CEO Council (http://www.ceocouncil.net) which hosted the September, 2002 “CEO Summit” in Washington, DC, and whose members were invited to participate in the U.S. Securities and Exchange Commission’s Government-Business Forum on Small Business Formation.
Both were covered by FinancialWire.
The rule would curb naked shorting, a topic that has gained substantive recent media attention due to a public feud between Dow Jones (NYSE: DJ) columnist Carol Remond and a number of OTCBB companies – GeneMax Corp. (OTCBB: GMXX), Hadro Resources (OTCBB: HDRS), Vega Atlantic Corp. (OTCBB: VATL, Ten Stix, Inc. (OTCBB: TNTI) and Intergold Corp. (OTCBB: IGCO), Edgetech Services, Inc. (OTCBB: EDGH), Sionix (OTCBB: SINX) and FreeStar Technologies (OTCBB: FSTI).
FreeStar has accused Vfinance (OTCBB: VFIN) or its associates of shorting its stock, and most of the companies have announced they are exiting the Depository Trust Corp. electronic system and have signed on with Global Securities Stock Transfer, of Denver, CO., for physical transfer of their certificates to combat what they claim has been “illegal naked short selling trade abuses.”
According to Angel, the “upday” rule would severely restrict short selling at prices below the previous close, but still allow unrestricted short selling at higher prices. “Such a rule would be easier than the current rule to implement and enforce, and would allow stabilizing short selling while deterring ‘piling on’,” he stated.
Angel said that while short selling serves a number of “useful purposes” in securities markets, “some observers believe that abuses of short selling are harmful to the market. Some issuers believe short sellers have an incentive to bad mouth a company and its products, potentially damaging not only its stock price, but also its real business. Such defamation causes real economic damage far beyond the damage caused by stock price manipulation.”
Because short sellers often destablize prices by “piling on,” repeatedly selling short while a stock falls, chasing away liquidity and pushing stock prices artificially below their true level, the U.S. has adopted an “uptick” rule. For NYSE/Amex listed securities, short sales can only be made at a price higher than the last trade, or at the same price if the last change in price was an uptick. On the Nasdaq National Market, the bid-test permits short sales at the bid only if the bid is higher than the last previous bid.
There is, however, no such rule for the Nasdaq Small Cap, the OTCBB, or the Pink Sheets marketplaces. Angel said that replacing the “uptick” rule with an “upday” rule, unlimited short selling would be allowed when prices are going up, stabilizing to the market because it would help to keep prices from overshooting on the upside. He noted that the previous close is an easy to get number that is stable throughout the day. It does not change from moment to moment like an uptick rule or bid test, and therefore is easier to implement and regulate.
In Canada, there are no restrictions or requirements for short selling, allowing U.S. citizens and foreign lenders to open accounts in Canada to bypass U.S. rules. Executives at the Investment Dealers Association and British Columbia Securities Commission have said they are earnestly looking at the problem now, and noted the matter was discussed at the SEC meeting in September.
investrend.com
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Re: Professor Angel's 'Upday Rule.'
The “Upday” Rule for Short Selling
Summary
Decimalization has virtually eliminated the current “uptick” rule. A better alternative is an “upday” rule that severely restricts short selling at prices below the previous close, but allows unrestricted short selling at higher prices. Such a rule would be easier than the current rule to implement and enforce, and would allow stabilizing short selling while deterring “piling on.”
Introduction
Short selling serves a number of very useful purposes in securities markets:
• It allows those who do not own the stock, but who have done their research and have come to believe that a stock is overvalued, to bring that information to the market through short selling.
• It allows market makers who have run out of inventory to continue to provide liquidity and stabilize prices.
• Short selling makes it easier for arbitrageurs to make sure that the prices of derivatives such as options, convertibles, and futures are in the proper relationship to the underlying stock.
• Short selling also allows investors to hedge various exposures. For example, a “market-neutral” or “long-short” investor may hedge the automotive sector risk incurred by going long Ford by simultaneously shorting GM, Daimler, and Toyota.
On the other hand, some observers believe that abuses of short selling are harmful to the market. Some issuers believe, rightly or wrongly, that short selling damages the market for their stock. In particular:
• Short sellers have an incentive to bad mouth a company and its products, potentially damaging not only its stock price, but also its real business. Such defamation causes real economic damage far beyond the damage caused by stock price manipulation.
• In the past, short sellers have been accused of destabilizing prices by “piling on,” the practice of repeatedly selling short when the stock is falling. This practice allegedly chases away liquidity and pushes stock prices far below their true level. Some fear that this practice exacerbates market swings and increases the risk of a systemic meltdown.
In response to the “piling on” problem, the United States has adopted an “uptick” rule. For NYSE/Amex listed securities, short sales can only be made at a price higher than the last trade, or at the same price if the last change in price was an uptick. On the Nasdaq National Market, the bid-test permits short sales at the bid only if the bid is higher than the last previous bid. There is, however, no such rule for the Nasdaq Small Cap, the OTCBB, or the Pink Sheets marketplaces.
Decimalization has effectively eliminated the uptick rule/bid test. Quotes flicker so fast that the rule no longer imposes any significant restriction on short sellers. At worst, even in a severely down market, one has only to wait a few seconds for the tick or bid to flicker up a penny before a short sale can be executed.
Furthermore, the existing uptick/bid-test rules have the perverse property that they can also interfere, however, briefly, with short selling at times when stock prices are rising. At these times, short selling can be an important stabilizing factor that can reduce the volatility of stock prices.
An improvement: The upday rule
If restrictions on short selling are desirable, an upday rule would be a significant improvement over the current short sale rule. Basically, the upday rule is very simple: No short sales would be allowed at prices below the previous day’s closing price. There would be no restrictions on short sales at prices higher than the previous close.
This rule prevents piling on when the stock price is really going down. Manipulators would not be able to take advantage of momentary upflickers to get their short trades off. Indeed, in the current environment it is trivially easy to create an uptick or upbid at very low cost. With an upday rule, it is much harder to manipulate yesterday’s close in order to get a short trade off today.
However, this rule would allow unlimited short selling when prices are going up. This would be stabilizing to the market because it would help to keep prices from overshooting on the upside.
Such a rule would be very simple to implement. The previous close is an easy to get number that is stable throughout the day. It does not change from moment to moment like an uptick rule or bid test.
Of course, there is the question of what constitutes the previous close. With trading taking place in different venues and different times, one can come up with several candidates for the “last” trade. For example, should after-hours trades be included?
For the purposes of this rule, it would be whatever number is disseminated by the primary market for a security. The primary market would use its best business judgment to come up with a representative closing price, which could be based on the last trade, the last several trades, quotations, or some other system. If more than one exchange claims to be the “primary” market for a security, then the issuer would decide which exchange sets the definitive price.
As with the existing rule, there needs to be some exceptions to the restrictions. For example, there is no need to restrict legitimate arbitrage transactions. Shorting also allows market makers to continue to provide liquidity when they run out of inventory, so they should also be exempt. Passive matching systems such as POSIT do not affect the price so they should be exempt as well.
Appendix: Draft Text of Amended Rule 10a-1: Short Sales
(a) No person shall, for his own account or for the account of any other person, effect a short sale of any equity security below the closing price for the previous day.
(b) Definition: The closing price for the previous day is that price disseminated as such by the national securities exchange or national securities association that is the primary market for that security. Such price may be based one or more actual transactions or quotations or other methods based on the business judgment of that national securities exchange or national securities association. In the event of a dispute over which market is the primary market, the issuer shall designate one national securities exchange or national securities association as the primary market for the purposes of this paragraph.
(c) In determining the price at which a short sale may be effected after a security goes ex-dividend, ex-right, or ex-any other distribution, all sale prices prior to the "ex" date may be reduced by the value of such distribution.
(d) No broker or dealer shall, by the use of any facility of a national securities exchange or national securities association, or any means or instrumentality of interstate commerce, or of the mails, effect any sell order for a security registered on, or admitted to unlisted trading privileges on, a national securities exchange or national securities association unless such order is marked either "long" or "short".
(e) No broker or dealer shall mark any order to sell a security registered on, or admitted to unlisted trading privileges on, a national securities exchange "long" unless
i. the security to be delivered after sale is carried in the account for which the sale is to be effected, or
ii. such broker or dealer is informed that the seller owns the security ordered to be sold and, as soon as is possible without undue inconvenience or expense, will deliver the security owned to the account for which the sale is to be effected.
The provisions of paragraphs (a) of this section (and of any exchange rule adopted in accordance with paragraph (a) of this section) shall not apply to:
1. Any sale by any person, for an account in which he has an interest, if such person owns the security sold and intends to deliver such security as soon as is possible without undue inconvenience or expense;
2. Any broker or dealer in respect of a sale, for an account in which he has no interest, pursuant to an order to sell which is marked "long";
3. Any sale by an odd-lot dealer or an exchange with which it is registered for such security, or any over-the-counter sale by a third market maker to offset odd-lot orders of customers;
4. Any sale by an odd-lot dealer on an exchange with which it is registered for such security, or any over-the-counter sale by a third market maker to liquidate a long position which is less than a round lot, provided such sale does not change the position of such odd-lot dealer or such market maker by more than the unit of trading;
5. Any sale of a security covered by paragraph (a) of this section by a registered specialist or registered market maker for its own account on any exchange or national securities association with which it is registered for such security, or by a third market maker for its own account over-the-counter;
6. Provided, however, that any exchange, by rule, may prohibit its registered specialist and registered exchange market makers from availing themselves of the exemption afforded by this paragraph (e)(5) if that exchange determines that such action is necessary or appropriate in its market in the public interest or for the protection of investors;
7. Any sale of a security on a national securities exchange effected with the approval of such exchange which is necessary to equalize the price of such security thereon with the current price of such security on another national securities exchange which is the principal exchange market for such security;
8. Any sale of a security for a special arbitrage account by a person who then owns another security by virtue of which he is, or presently will be, entitled to acquire an equivalent number of securities of the same class as the securities sold; provided such sale, or the purchase with such sale offsets, is effected for the bona fide purpose of profiting from a current difference between the price of security sold and the security owned and that such right of acquisition was originally attached to or represented by another security or was issued to all the holders of any such of securities of the issuer.
9. Any sale of a security registered on, or admitted to unlisted trading privileges on, a national securities exchange effected for a special international arbitrage account for the bona fide purpose of profiting from a current difference between the price of such security on a securities market not within or subject to the jurisdiction of the United States and on a securities market subject to the jurisdiction of the United States; provided the seller at the time of such sale knows or, by virtue of information currently received, has reasonable grounds to believe that an offer enabling him to cover such sale is then available to him such foreign securities market and intends to accept such offer immediately;
10. Any sale by an underwriter, or any member of a syndicate or group participating in the distribution of a security, in connection with an over-allotment of securities, or any lay-off sale by such a person in connection with a distribution of securities through rights or a standby underwriting commitment; or
11. Any sale made through passive systems which do not engage in price discovery (e.g. POSIT); or
Any sale of a security covered by paragraph (a) of this section (except a sale to a stabilizing bid complying with Rule 104 ) of Regulation M by any broker or dealer, for his own account of any other person, effected at a price to the most recent offer communicated by such broker or dealer to an exchange or association pursuant to Rule 11Ac1-1 in an amount less than or equal to the quotation size associated with such offer, if such offer, when communicated, was above the previous closing price.
For the purposes of paragraph (e)(9) of this section, a depositary receipt of a security shall be deemed to be the same security as the security represented by such receipt. For the purposes of paragraphs (e)(3), (4) and (5) of this section, the term "third market maker" shall mean any broker or dealer who holds itself out as being willing to buy and sell a reported security for its own account on a regular and continuous basis otherwise than on an exchange in amounts of less than block size.
A broker-dealer that has acquired a security while acting in the capacity of a block positioner shall be deemed to own such security for the purposes of Rule 3b-3 and of this section not withstanding that such broker-dealer may not have a net long position in such security if and to the extent that such broker-dealer's short position in such security is the subject of one or more offsetting positions created in the course of bona fide arbitrage, risk arbitrage, or bona fide hedge activities.
This rule shall not prohibit any transaction or transactions which the Commission, upon written request or upon its own motion, exempts, either unconditionally or on specified terms and conditions.
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