SEC Ponders Temporary Ban on Short-Selling


Cracking down on short-sellers, the SEC may go beyond the action of British regulators, who banned the trading practice for financial stocks

As financial regulators here and abroad crack down on short-sellers—the Securities & Exchange Commission was said to be planning a temporary outright ban on the practice late Sept. 18, following a similar move by British regulators for financial stocks—securities experts and former SEC officials are urging caution.

Short-sellers attempt to profit from falling share prices by borrowing stock, selling it at the current price, then returning the shares to the lender after the price has dropped and the cost of replacing the shares has fallen. A growing chorus of lawmakers and regulators in the U.S. and overseas say abusive short-sellers are spreading false rumors or selling shares they haven't actually borrowed as part of an effort to force share prices down artificially. "Speculators pounded the shares of even good companies into the ground," said Republican Presidential candidate John McCain, in a speech that criticized SEC Chairman Christopher Cox's handling of short-sellers. In a statement, Cox said his agency has aggressively pursued improper short sales.

Britain's Ban Through Yearend

A broad ban by U.S. regulators—which The Wall Street Journal reported was in the works late Sept. 18—would mark the strongest of a series of steps against shorting taken by U.S. and foreign regulators this week. On Sept. 17, the SEC issued new regulations designed to tighten restrictions on abusive short-selling practices, and the next day New York State Attorney General Andrew Cuomo announced an investigation into allegations that short-sellers of major Wall Street firms spread false rumors to send shares lower. The SEC is also investigating rumor-mongering. Britain's Financial Services Authority on Sept. 18 banned the short-selling of financial company shares until early next year.

Lawmakers other than McCain, too, have pressured the SEC to crack down on shorts, with several criticizing the agency for last year eliminating the so-called "uptick rule," which allowed investors to sell shares short only as prices were rising. Securities market experts say the rule had lost its effectiveness once stocks could rise and fall by the penny, rather than being traded in larger increments of an eighth of a dollar.

The SEC's move to stop "naked shorting"—selling shares without even making arrangements to borrow them first—has drawn support from many in the U.S. financial system. But it has also brought criticism as attacking a problem only peripherally involved in the current financial crisis. "I'm certain people were shorting stock, but were they doing it abusively? And how much did that lead to the downfall?" says Barbara Black, a University of Cincinnati law professor and editor of Securities Law Prof Blog. "I'm kind of skeptical of that myself."

Liquidity Concerns

Moreover, restricting short-selling too much could cause more harm than good, securities market experts say. By borrowing and then selling shares from investors who would otherwise simply hold them, short-sellers can be a valuable source of liquidity in the stock market—ensuring shares are available even when the market is trending strongly in one direction, says Stephen Bainbridge, a securities law professor at UCLA. "We know from corporate finance research that short-selling can be a very important contributor to market efficiency," says Bainbridge.

An outright ban would be "an excessive and potentially dangerous solution to a far more complicated problem," says Harvey Pitt, SEC chairman from 2001 to 2003. Speaking before the SEC's proposed shorting ban became public, he noted that, in the days before the markets reopened after the September 11, 2001, terrorist attacks, corporate executives repeatedly asked the SEC to ban short-selling altogether, at least temporarily. "My reaction at the time was: I may look stupid, but I'm not as stupid as I look," Pitt said. "If you ban all short-selling, what you're really doing is depriving the market of liquidity. You're not helping the market."

Francis is a writer in BusinessWeek's Washington bureau.

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