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

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.

Photo: Christopher Cox, testifying today on financial markets before a Senate panel today. Also at the table: Federal Reserve Chairman Ben S. Bernanke and Treasury Secretary Henry M. Paulson Jr. Chip Somodevilla/Getty Images

Comments

[Martin, Jack]

Why not apply this emergency rule to all stocks. Many other stocks are being illegally naked shorted.

[Fred]

WHAT A CROCK!!!

They are saying it’s illegal to naked short just those 30 stocks and not others?

They don’t need a new rule for it. As you quote Coffee, they just don’t enforce it. Coffee is right.

And now they are making a new rule. This just looks like they don’t want to admit they haven’t been enforcing the existing rules.

Your article falls way short of exposing the extent of the problem. Naked shorting injects “counterfeit shares” into the market. The supply of shares being traded goes way up, so the market price goes down artificially. That’s not price discovery, as would be the case with legal shorting of borrowed shares. People who say it’s price discovery are either ignorant or covering the truth.

[gr8fun4me]

Finally, someone is waking up at the SEC. I complained about this to Congress two weeks before the Bear Stearns fiasco. Something is wrong with the markets. They are being manipulated like I've never seen before. Stocks that have great earnings are being hammered and then the next day are being driven up in huge amounts. Then they are driven down again and then driven up again. I think they need to regulate the amounts that hedge funds can buy, just like they do with the mutual funds. I don't care what new name they call the companies they can only buy a certain percentage of the outstanding shares as an investment. The whole system is out of control and if they don't start showing some common sense in regulating the financial markets, the financial system could collapse under the weight of tremendous losses.

[martscan]

If I have the straight of this, it appears to me that Chairman Cox is splitting hairs more for the public psychology effect of his short selling "plan" than instituting anything new in a restrictive sense.

Naked shorting is already illegal, so what Cox is really saying is that short sellers will have to somehow be able to verify that they did, in fact, have the stock they shorted in hand before entering a sell order.

You can bet that at least until we are out of the woods, short sellers will indeed be able to document a pre-arrangement indicating they sold short legally. From the standpoint of naked shorts, obviously there can't be more short sales of a stock than the number issued.

This may give pause to crooked, reverse 'pump and dumpers' that could go naked at least until settlement but it is hardly a panacea to thwarting those intent on breaking securities laws by maliciously driving a stock's price down. Additionally, there is nothing that says crooked, false rumor instigators for example, can't sell short legally and still reap criminal gains.

Since there is a valid, legitimate reason and need for short selling in free markets, price discovery and hedging easily come to mind, this is a sticky wicket and there is no quick fix to solve the problem.

[martscan]

As an adjunct to these discussions having to do with increased regulation of markets, particularly those of a financial nature, why is it that we are not hearing even a whisper concerning speculators in the oil market? Has there been a single mention in the press of who the losers are in these markets? Of course not...Americans don't kick losers, but we love to kick and see big winners toppled.

Could it be possible, that aside from the fundamentals, speculators are shorting the hell out of oil...and other futures markets...to the benefit of consumers? Hasn't it only been a matter of recent weeks that these sites were overloaded with comments calling for the scalps of oil speculators...much like short sellers of financials are being castigated today?

Crude futures are off the equivalent of over $100K for a little 10 contract trader, be he/she a speculator or commercial hedger...effectively wiping out the total margin required to institute the trade and, insult to injury, putting the trader in a debit position... in less than 2 days!

My point is that "free" markets, saddled with unnecessary, constrictive, politically motivated regulations, are not free.

Free markets eventually work out extraordinary peaks and troughs, as they should, and profits and losses can be extremely damaging and rewarding, as they should.

In the case of Freddie and Fannie, it is agreed by everyone that they are simply too big and too integral to basic financial systems on which so much depends, that they cannot be allowed to fail. Fine, open the Fed window for them, get an open-ended, no limit line of credit with a Congressional imprimatur and do whatever it takes to keep them solvent...and, yes, American taxpayers will stand the risk...but don't lay off the risk on taxpayers while keeping the good times candy for the investors. The Central banks, China, Japan, Germany, UK, etc, that hold most of their paper will have to be dealt with, but the Bernankes and Paulsons will have to stop the charade..go beyond what I term 'Billionaire Socialism' and admit to a piece of just plain, old socialism. NATIONALIZE Freddy and Fanny.

[Don Coyne]

The SEC helped to bring this on themselves by eliminating the required uptick rule for shorting individual stocks in July of last year. The crazy volatility since then is the result. What were they thinking? Here is a short poem I sent out at that time:

NO TICKIE, MUCH SICKIE by Don Coyne

The powers that be seem excessively cruel;
They've abolished the required uptick rule.
And so the market seems more of a beast
Since daily ranges have now increased.
As shorting traders go to town
And push the market further down,
They'll also help each rally extend
As covering comes in to help the trend.
It now will test most traders' ability
To cope with the increased volatility.

Don Coyne
Coyne Capital Management

[martscan]

My complements go to Don Coyne for his familiarity with iambic pentameter, and other skills. I, myself, am hardly on speaking terms with iambics, but nonetheless enjoy 'Trees' and "Lake Isle of Innisfree'.

Unlike my poetic denseness, I do have experience with short sales and I have opposed the uptick rule in equities for years. As a 'free market' advocate, trader and speculator, I am opposed to any restrictions on selling short that are exclusive of trading on the long side. Yes, I'm aware of the reasons why such restrictions are called for, but the simple fact is that any criminal enterprise intent on market manipulation or fraudulent schemes will attempt their schemes regardless of so-called safeguards to prevent them, while inhibiting the right of legitimate bears to trade as freely as do bulls. As to volatility, for Pete's sake (who is Pete and what is his sake?), this is the essence of how markets function..after all, market participation is a voluntary action and if you can't stand the heat...you know the drill.

[rich]

How about RBC shorting the uranium sector.This outfit puts out more bad & depressing news about uranium companies than the whole industry combined.It is so obvious, maybe SEC commish. should start looking at their actions & discipline them to prove a point.HEY RBC, ENOUGH IS ENOUGH;GIVE THE SHORTING A REST !!!!!!

[M Paquette]

There seems to be a faction which believes short selling, including naked shorting, should be unrestricted. Perhaps so, but I'd like to see some balance here.

Recall the uptick rule limiting short sales to an uptick on price, and the argument against it that longs didn't have to wait for a downtick, so removing it was just leveling the playing field? Let's level the playing field for naked shorts as well.

If naked shorting is to be permitted, I want naked longs. I want to 'buy' shares without having to deliver any cash or arrange for margin loans, and I want to sell to cover my naked long position and keep profits. Without needing actual capital on hand, and not needing to borrow cash, think how much more efficient (and profitable) my private fund can be!

[William Aurilio]

June 2, 2005
President Bush, appointment of Cox:"He graduated with honors from Harvard Law School and Harvard Business School, he worked as a security lawyer for nearly a decade, he taught tax law, he served in President Reagan's White House, and was elected to Congress."

Comment: With all those qualifications, you would think there would be a basic knowledge and understanding of the fraudlent practice of naked short selling. I would be happy to give him a quick refresher similar to the driving courses given to DUI, reckless drivers or others who are accused of driving to endager.
WAKE UP CHRISTOPHER, THE PUBLIC IS NOT STUPID!