June 8, 2009
Summary: All of the alternatives proposed inhibit valuable price discovery, to a greater or lesser degree, while not addressing the central historical purpose of short selling regulation which was to prevent stock manipulation.
Short selling regulation was adopted by statute in 1934 and by rule in 1938 as a response to the manipulative pools in the 1920's and subsequent manipulative trading in the 1930's. At no time, did the legislative history suggest that lawful price discovery should be curtailed. Unfortunately, over-inclusive regulation of exchange trading only by imposition of a uptick on short selling was the regulatory response. Subsequently, the NASD adopted a short selling "bid test" for competitive reasons rejecting the conclusion of a study by former Commmisioner Pollack that such regulation was not needed.
With regard to the circuit breaker proposals, it should be noted that circuit breakers exist for general market declines at the 10 %, 20 % and 30 % percent levels. With regard to specific securities, the S.E.C.("Commission") has existing authority, which the Commission has used, to suspend systemwide trading for seven days if it believes manipulative or fraudulent trading exists. On numerous occasions,an individual security has declined dramatically in response to adverse corporate news. No policy reason exists to retard that immediate price decline to lower price levels reflecting updated expectations.
Tick test rules for short selling, whether the traditional "uptick" rule on Exchanges or the "bid test" rule adopted for NASDAQ National Market securities, are over-inclusive in the absence of manipulative intent. Those rules prohibit legitimate price discovery particularly in rapidly declining markets. When markets decline rapidly, markets in options and futures are selling at discounts to the cash market. Purchase of options, which are then exercised, permit "long" sales to an unlimited degree as long as those market conditions exist. Similarly, purchases of stock futures at a discount, which are then converted into stock also a are "long" sales in unlimited quantities. As both the Brady Report and the Commission's study of the 1987 market break point out, the securities markets are fully integrated. A rapid decline in one market immediately affects all other markets. It has not been suggested that this arbitrage between markets is either fraudulent or manipulative.
The Commission has to take into account the economic analysis set forth in Chief Judge Posner's opinion for a 7th Circuit panel in Sullivan Long Inc. v. Scattered Corp. 471 F.3d 857 where it was held lawful to sell short more than the outstanding number of shares. While that court sanctioned the delivery of new shares via the exercise of warrants coming out of a bankruptcy reorganization, which has probably been abrogated by Commission rules on borrowing and delivering existing shares, there has been no suggestion that massive short selling in an individual security or securities is per se illegal. In fact,short sellers of bank and broker shares in the 2006 to 2008 time frame displayed a greater understanding of the future prospects of banks and brokers than other market participants and regulators. Studies of the recent temporary ban on any short selling of bank and broker shares have demonstrated that such a ban was ineffective to prevent price declines based upon adverse news and created discontinuities with both the options and futures markets that had no selling restrictions.
In contrast, Commision action to prevent specific manipulative activity such as the Married Put Release, 34-48795, is effective. The Commission could and should adopt rules precluding other manipulative activity such as "death spiral" financing where no limit exists on either "short" or "long" selling to a lower price where additional stock is acquired by the financing entity particularly where broker intermediaries are used to conceal the "short" selling near the close of trading and where such brokers are guaranteed a profit by the sale of "long stock" to the broker intermediaries by the financing entity after the close.
Notwithstanding significant congressional and other pressure to readopt short selling rules that inhibit legitimate price discovery and do not directly preclude stock manipulation, the better approach is to adopt a trading rule where manipulative conduct can be inferred reasonably. Consecutive or near consecutive short sales within a tightly defined time period by an individual,group or entity would qualify for the prohibition.