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 BearStearns’ desperate sale to JPMorgan Chase, is a sure sign of thefragility of today’s markets. What’s needed now, more than ever, isreliable information for investors and confidence that trading can beconducted without the illegal influence of manipulation.
Becausefinancial institutions depend on confidence, they are uniquelyvulnerable in the current climate. A “run on the bank” can take holdquickly, and can be fatal. But stampedes are not always rational.
When an irrational panic is fueled by a sense of urgency, falserumors that must be acted on immediately and the fear that everyoneelse may get out first, market integrity is threatened. It is the jobof market cops to provide a measure of confidence that financialinformation about public companies is accurate and reliable — and whenit 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 thepredictable response of others who believe the fraudulent informationto be true.
The classic “pump and dump” scheme, in which a stock is inflatedthrough false information and then dumped on unsuspecting investorswhen the perpetrators flee, is one example of how this works. “Distortand 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 iscircumvented, because the seller doesn’t actually borrow the stock andsimply fails to deliver it. For this reason, naked shorting can occureven when actual shares aren’t available in the market. It allowsmanipulators to force prices down without regard to supply and demand.
Next week, the SEC will implement an emergency order designed toprevent naked short selling in the financial firms that the FederalReserve Board has designated as eligible for access to its liquidityfacilities.
Because these are large firms with substantial public float, honestshort sellers can readily locate shares to make good on their shortpositions. Continued legitimate short selling in these issues will act,as it is supposed to, as a way for market participants to invest in thedownside and to hedge other positions.
At the same time, eliminating the prospect of naked short sellingwill help assure investors that it is safe for them to participate, andthat the current declining market is not the product of unseenmanipulators and “distort and short” artists.
Our emergency order is not a response to unbridled naked shortselling in financial issues — so far, that has not occurred — butrather it is intended as a preventative step to help restore marketconfidence at a time when it is sorely needed.
Many people think naked short selling is already illegal, but thatisn’t true. Shares are normally delivered to the buyers within threedays of the trade. But in most stocks, including those covered by ouremergency order, that three-day period can be extended indefinitely.
Even without these extensions, and even when a short seller locatesshares that can be borrowed, there can be problems because the shortseller is not currently required to actually borrow those shares untilsettlement.
As a result, securities lenders can tell multiple short sellers theycan borrow the same shares of stock — a sure recipe for a failure todeliver. Once the commission’s order takes effect, this possibilitywill no longer exist.
The SEC is committed to maintaining orderly securities markets. Theabusive practice of naked short selling is far different from ordinaryshort selling, which is a healthy and necessary part of a free market.
Our agency’s rules are highly supportive of short selling, which canhelp quickly transmit price signals in response to negative informationor prospects for a company. Short selling helps prevent “irrationalexuberance” and bubbles.
But when someone fails to borrow and deliver the securities neededto make good on a short position, after failing even to determine thatthey can be borrowed, that is not contributing to an orderly market —it is undermining it. And in the context of a potential “distort andshort” campaign aimed at an otherwise sound financial institution, thiskind of manipulative activity can have drastic consequences.
It was famously — perhaps too famously — said that “markets willfluctuate.” That is certainly true if they are well-functioning. Asmarket referee, the SEC neither can nor should direct the market’sfluctuations. Instead, our most basic role is to ensure a continuedflow of liquidity to the markets from participants who are confidentthe game isn’t rigged against them.
Naked short selling can undermine the market’s integrity. For thefinancial sector in this crisis, certainly, but as soon as possible forthe entire market, this is one worry investors shouldn’t have.