SEC targets illegal short-selling in Fannie, Freddie and 17 other financial stocks, but risks howls of ‘market interference’

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In its battle against abusive short sellers, the Securities and Exchange Commission may risk burning down the market in order to save it.

SEC Chairman Christopher Cox today surprised Wall Street with a plan to curb short selling in major financial company shares. In his initial comments he mentioned Fannie Mae and Freddie Mac as two stocks that would get protection under the plan, but a list the SEC released late in the day also included 17 other big financial firms, including Bank of America Corp., Citigroup Inc., Lehman Bros. and Credit Suisse Group.

Short sellers, of course, are traders who bet on falling stock prices. In a short sale a trader borrows stock (usually from an investment firm’s inventory) and sells it, expecting the market price to decline thereafter. If the bet is correct, the trader can buy new shares later at a lower price, repay the borrowed stock, and pocket the difference between the sale price and the repurchase price.

That’s all legal -- unless short sellers are ordering stock sales without having arranged to borrow actual shares. Shorting what you don’t have is “naked” shorting, which can be illegal, says John Coffee, a securities-law professor at Columbia Law School.

But the rules against abusive naked shorting haven’t been enforced much, Coffee adds.

So now comes the SEC to crack down, amid what has been a severe hammering of financial stocks -- to the point where investors are beginning to question the firms’ survival.

Beginning on Monday, the agency will require that “anyone effecting a short sale in these securities arrange beforehand to borrow the securities and deliver them at settlement.” The emergency rule will be in effect through July 29, but could be extended until Aug. 21, the SEC said. And Cox said the agency eventually expects to cover the entire stock market with the new rule.

For the 19 stocks on the list, the change means that brokers no longer will be able to take a short seller’s word that he actually has borrowed the shares he wants sold. (“Sure, I have ’em for you, I’ll deliver ’em later.”) And that, in turn, could curb situations where multiple short sellers are expecting to borrow the same shares for sale -- like, say, five different people all putting the same car up for sale, even though only one of them can deliver the vehicle.

The SEC suspects that some short sellers are ganging up on financial stocks, engaging in naked shorting while spreading rumors that the companies are in dire straits. Bear Stearns Cos.’ rapid collapse in March has been Exhibit A for many people who are ranting about short-selling abuses.

The first salvo in the SEC’s latest offensive came Sunday, when it announced that it would “immediately conduct examinations aimed at the prevention of the intentional spread of false information intended to manipulate securities prices.”

It’s part of the SEC’s job to go after people who spread lies about publicy traded companies. But Wall Street can’t help but wonder if this anti-short-seller campaign is about more than just the naked shorts. If the SEC can curb short selling in general -- and trigger a wave of buying to cover outstanding short positions -- imagine what that could do for the stock market’s abysmal mood.

But the longer-term effect could be to raise questions about just how free the U.S. market is from government interference. That kind of stuff is supposed to happen in Third World countries, not in America.

Legitimate short sellers bet against companies whose shares they believe are overvalued. That makes the shorts an important element of what academics call “price discovery” in the market. The shorts find out things companies often would rather that shareholders didn’t know.

For the long-term health of the market, “You don’t want to restrict people’s ability to invest on negative information,” warns Jill Fisch, a securities-law professor at Fordham University.