May 6, 2009
Summary: The proposed four amendments to Regulation SHO are fatally flawed because they interfere with essential price discovery instead of preventing stock manipulation. Instead, the Commission should adopt a trading rule that is designed to preclude stock manipulation that has been the purpose of short sale regulation since 1938.
Short selling regulation came into existence as a response the manipulative trading pools during the 1920's. The Commission has always recognized the legitimate economic function of short selling. Judge Posner's opinion in Sullivan and Long Inc. v. Scattered Corp. 47 F.3d 857 (7th Cir. 1998) states the economic case for unlimited short selling in an extreme example where more stock was sold short than was outstanding. While the Commission has by rule prohibited naked short selling, it has never explicitly disagreed with the idea that massive quantities of short selling can be justified to promote rational pricing expectations in both specific securities or the securities markets generally.
The Commission should not in these proposed amendments adopt rules that create market dislocations. Since neither options nor stock futures contracts have any tick or bid test rules, the adoption of short selling stock rules that have tick or bid test constraints will lead immediately to disfunctional markets. Both the Brady Report and the Commission in its study of the 1987 Market Break recognized the essential and necessary unification of all securities markets including derivative markets.
Circuit breakers have been adopted for extreme market dislocations. In addition, the Commission has used its authority to suspend individual securities up to seven days where it believes fraudulent or manipulative actity has taken place. No special circuit breaker rules are needed or required for short selling regulation.
The Commission in Release 34-48795 issued interpretive guidance on Rule 3b-3 and Married Put Transactions to prohibit certain transactions that can have manipulative effect. To the extent that credit default swaps combined with short selling can be manipulative, the Commission can either bar a combination of these transactions or limit their use by imposing a "net long" standard that is similar to requirements that preclude short tendering. Other interpretive guidance can be given on specific transactions that may be deemed manipulative, as new trading strategies develop, without limiting general authority to prosecute manipulation.
In extremely negative market conditions, options and futures sell at significant discounts to cash markets. Buyers of options at discounted prices to cash markets can exercise such options and sell "long" to capture arbitrage profits. Similarly, stock futures buyers at discounts can convert such holdings to stock and also sell "long" to capture arbitrage profits. Tick or bid test short selling regulation is completely inapplicable to such transactions.
General anti-fraud regulation under Section 9 or 10 of the Securities Exchange Act is available to prevent manipulation. While the standard of proof for stock manipulation is intentionally high, both the Commission in administrative or court proceedings and the Department of Justice have been able to satisfy that standard.
Most vulnerable to short selling manipulations are small companies that have minimal capitalizations and liquidity. Apart from "pump and dump" schemes, there are not a significant number of enforcement actions, civil or criminal,to police the lowest tier of securities. Reduction of the 90 second rule for reporting transactions to 15 seconds or less for all NASDAQ securities will assist the special efforts, task forces, and resources that are needed to adequately enforce the laws regarding manipulation. I have suggested separately, to the Commission staff, that in combination with the Department of Justice, aggressive prosecution and widespread public notice of the federal Misprison of Felony Statute will alert brokers,investment advisors, hedge funds,other entities, and the public generally of the duty to alert regulators of felonious misconduct immediately. Insiders at various levels of authority typically are aware long before others of criminal misconduct.
Finally, a trading rule that prohibits successive short sales at lower prices either by individuals or by groups is consistent with civil and criminal manipulation cases that have been prosecuted with success. A new trading rule that focuses on stock manipulation by short sellers rather than price regulation that hopes to prevent short selling manipulation is the solution to extreme market conditions.