'Market Cop' Cox Urges Restraint

by Joseph McCafferty

SEC Chairman Christopher Cox, in an op-ed piece published in today's Investor's Business Daily notes that while naked short selling is not illegal the abusive practice of naked short selling is far different from ordinary short selling, which is a healthy and necessary part of a free market.

 

Earlier this week, the SEC iimposed a form of martial law on Wall Street. The securities regulator took the highly unusual step of putting restrictions on traders who sell short shares of financial stocks.

 

The steps, issued through what it called an "emergency order," limit short trading in 19 financial services companies, including Citigroup, Bank of America, Lehman Brothers, and Freddie Mac and Fannie Mae. The Commission will require that traders borrow shares they wish to sell short before they actually trade them, eliminating the possibility of naked short selling, when traders sell shares but do not produce them by the transaction closing date.

 

What follows is the full text of Cox's article.

 

The demise of IndyMac, coming on the heels of Bear Stearns' desperate sale to JPMorgan Chase, is a sure sign of the fragility of today's markets. What's needed now, more than ever, is reliable information for investors and confidence that trading can be conducted without the illegal influence of manipulation.

 

Because financial institutions depend on confidence, they are uniquely vulnerable in the current climate. A "run on the bank" can take hold quickly, and can be fatal. But stampedes are not always rational.

 

When an irrational panic is fueled by a sense of urgency, false rumors that must be acted on immediately and the fear that everyone else may get out first, market integrity is threatened. It is the job of market cops to provide a measure of confidence that financial information about public companies is accurate and reliable — and when it is not, to punish those responsible.

 

Who profits from intentionally false information in the marketplace? Those who are in on the scam and positioned to benefit from the predictable response of others who believe the fraudulent information to be true.

 

The classic "pump and dump" scheme, in which a stock is inflated through false information and then dumped on unsuspecting investors when the perpetrators flee, is one example of how this works. "Distort and short" is the same thing in reverse.

 

Naked short selling can turbocharge these "distort and short" schemes. In a naked short, the usual process of short selling is circumvented, because the seller doesn't actually borrow the stock and simply fails to deliver it. For this reason, naked shorting can occur even when actual shares aren't available in the market. It allows manipulators to force prices down without regard to supply and demand.

 

Next week, the SEC will implement an emergency order designed to prevent naked short selling in the financial firms that the Federal Reserve Board has designated as eligible for access to its liquidity facilities.

 

Because these are large firms with substantial public float, honest short sellers can readily locate shares to make good on their short positions. Continued legitimate short selling in these issues will act, as it is supposed to, as a way for market participants to invest in the downside and to hedge other positions.

 

At the same time, eliminating the prospect of naked short selling will help assure investors that it is safe for them to participate, and that the current declining market is not the product of unseen manipulators and "distort and short" artists.

 

Our emergency order is not a response to unbridled naked short selling in financial issues — so far, that has not occurred — but rather it is intended as a preventative step to help restore market confidence at a time when it is sorely needed.

 

Many people think naked short selling is already illegal, but that isn't true. Shares are normally delivered to the buyers within three days of the trade. But in most stocks, including those covered by our emergency order, that three-day period can be extended indefinitely.