Speech by SEC Commissioner:
Opening Remarks Regarding Short Sale Price Restrictions
Commissioner Elisse B. Walter
U.S. Securities and Exchange Commission
February 24, 2010
Thank you, Chairman Schapiro. I, too, would like to thank the Division of Trading and Markets for all your hard work in preparing for today's open meeting. My thanks go especially to Jamie Brigagliano, Josephine Tao, and Tory Crane, who have labored so tirelessly over the last several years as the Commission has taken a number of important steps to address the particular challenges posed by short selling. I would also like to thank the staff in the other Divisions and Offices who worked on the proposal before us today.
I support the staff's recommendation.
Let me start by saying that this was not an easy decision for me. The issue of short selling is very controversial and sparks a great deal of emotion. Since I became a Commissioner, I have received more calls and letters from brokerage firms, exchanges, issuers, and, importantly, individual investors on short selling than on any other topic. Hardly a day goes by that I am not lobbied by someone to do, or not to do, something about short selling. I am particularly struck by the flood of responses from retail investors urging the Commission to act in this area. I have listened and tried to weigh the different arguments from both supporters and detractors as fairly and impartially as I can.
Assessing the merits of possible restrictions on short selling, including price restrictions, is difficult for a number of reasons.
To begin with, as the Commission has frequently stated, short selling provides the market with important benefits, including supporting market liquidity and pricing efficiency. It allows parties to hedge the risk of an economic long position in the same security or in a related security. It can help to combat market manipulation on the upside, such as in pump and dump schemes, and can also sometimes serve as a healthy corrective in bringing down the prices of stocks that are overvalued. Therefore, I can understand some people's belief that imposing any restrictions on short selling would be artificial and could be detrimental to the markets.
However, short selling may also be used to drive down the price of a security or as a tool to accelerate a declining market in a security. Short selling may be used to illegally manipulate stock prices, such as in a "bear raid," where an equity security is sold short in an effort to drive down the price of the security by creating an imbalance of sell-side interest. Unrestricted short selling could exacerbate a declining market in a security by increasing pressure from the sell-side, eliminating bids, and causing a further reduction in the price of a security by creating an appearance that the security's price is falling for fundamental reasons, when the decline, or the speed of the decline, is being driven by other factors.
As has already been pointed out, there never was a single uniform price restriction imposed on the market as a whole. Before the Commission eliminated all short sale price test restrictions in July 2007, there were two different rules — the "uptick rule" or "tick test" that applied to exchange-listed securities and the NASD "bid test" that applied to certain Nasdaq securities. To further muddy the waters, each of these tests was subject to numerous exceptions to accommodate changing market practices.
And, the markets have only gotten more complicated in recent years—decimalization, the increased use of matching systems, the spread of fully automated markets, and the proliferation of exchanges, and alternative trading venues, such as dark pools, to list just a few notable developments. This makes it difficult to precisely determine what effect the introduction of a short sale price restriction might have in today's market.
At the same time, investor confidence is crucial to the health and integrity of our capital markets. I believe that rebuilding and maintaining justifiable investor confidence should be a primary objective of our regulatory efforts. We have been entrusted with an overarching statutory mandate to maintain public confidence in the fairness and integrity of the nation's securities markets. Let me quote, oddly enough, from an SEC Orientation Handbook from the early 1980s. It stated:
[T]he Commission and staff
know, more than anyone else, that disclosure to investors, detecting fraud and preventing it where possible, promoting fairness in the marketplace . . . and encouraging high standards of business conduct all combine to build public confidence in the nation's securities markets. Being able to provide continued confidence is the bulwark of the SEC's charter.1
More recently, as former Chairman Arthur Levitt remarked:
Our system of law demands that the economy be organized to achieve more than just ruthless, relentless efficiency. Honest commerce must also be guided by a spirit of fairness . . .Our markets are a success precisely because they enjoy the world's highest level of confidence. Investors put their capital to work—and put their fortunes at risk-because they trust that the marketplace is honest. They know that our securities laws require free, fair, and open transactions. . . As long as the rules of the game are fair to all, investors' confidence will remain strong. But if there is a perception of unfairness, there'll be no investor confidence—and precious little investment.2
The goal of restoring investor confidence animates much of our recent rulemaking, whether it is to strengthen money market funds or to provide greater transparency for dark pools. I think restoring investor confidence also has a place in considering whether to adopt short sale price restrictions.
Let me emphasize this point. When investors themselves are saying that they feel less confident in putting their capital into the markets due to short selling, I think it is incumbent upon us, as regulators responsible for maintaining investor confidence in the markets, to listen, even if these sentiments may be difficult to quantify.
In considering the various short sale price restrictions that the Commission proposed last year, I have studied and analyzed the evidentiary record regarding the effect of particular short sale price restrictions on the functioning of the financial markets, as well as the need to restore investor confidence in the integrity and fairness of those markets. Each of these factors has to figure into the equation as we try to determine what path to take in regulating short selling.
Some argue that there is little evidence regarding the overall beneficial effects of the former short sale price tests. For example, some commenters submitted data or referenced studies in support of their position that a short sale price test restriction would not have a positive impact on the market. Others believe that they have found a possible association between the recent market downturn and the elimination of former Rule 10a-1, and that a price test restriction would have a positive impact on the market. Overall, I found the results of the various studies submitted to the Commission to be mixed, and I would point out that most studies submitted by commenters were too general to apply to any of the proposed structures or the structure before us for adoption.
Some people will also be disappointed by the Commission's decision to adopt a short sale price test restriction, or more specifically a circuit breaker approach followed by the alternative uptick rule, either because the Commission is affirmatively imposing a restriction on short selling or because the Commission has not gone far enough. But, while we are always informed and sometimes guided by the views of commenters, my vote as a Commissioner must turn on what I think is right.
I agree with the staff that, despite the mixed data and the conflicting reactions from commenters, there remains a real concern that excessive downward pressure on individual securities accompanied by a fear of unconstrained short selling can negatively impact the smooth and normal functioning of the markets. And it is certainly appropriate for the Commission to consider the potential effect short selling can have on the markets when it's being used to further drive down a declining market in a security and to adopt effective measures to address this issue.
That said, however, I do not believe that the Commission can justify adopting any short sale restriction on a market-wide basis, given the various costs associated with it and the fact that it is overbroad—in other words not targeted at restricting the type of short selling that we are concerned about, namely, short selling being used as a tool to exacerbate a declining market in a security. I do not believe this can be effectively accomplished through a market-wide short sale price restriction that would impact all trading all the time, including legitimate trading.
Rather, I support Rule 201 mainly because it takes a measured, targeted approach. It is structured so that the circuit breaker generally will not be triggered for the overwhelming majority of covered securities at any given time. Specifically, the short sale price test restrictions of Rule 201 will apply to a security only when it is undergoing significant downward price pressure. This will preserve the benefits of legitimate short selling for those securities that are stable or rising, or which are undergoing minimal downward price pressure. In fact, as indicated in the release, during a period of low volatility, it was estimated that the 10% trigger level of Rule 201 would have been triggered for only about 1.3% of covered securities. Thus, market participants could freely engage in short selling in most instances. In my view, Rule 201 is narrowly tailored to address situations when a particular security is most vulnerable to manipulative short selling, but in a manner that minimizes potential adverse consequences.
Once the circuit breaker is triggered, the alternative uptick rule will then become effective. As a result, short selling will only be permitted at a price above the current national best bid. By not allowing short sellers to sell at or below the current national best bid while the circuit breaker is in effect, the short sale price test restriction in Rule 201 will allow long sellers, who will be able to sell at the bid, to sell first in a declining market for a particular security. In other words, short sellers will not be permitted to act as liquidity takers when the alternative uptick rule applies, but will participate, if at all, as liquidity providers (unless an exception applies), adding depth to the market. This will further the Commission's goal of allowing long sellers to sell first in a declining market. It will also prevent short sellers from flooding the market with sell orders at or below the national best bid and causing further losses to multiply in such circumstances.
The circuit breaker approach of Rule 201 will also help benefit the market for a particular security by allowing participants, when a security is undergoing a significant intra-day price decline, an opportunity to re-evaluate circumstances and respond to volatility in that security. This "breathing space" should benefit the market and its participants, including issuers and individual investors. And that timeout is lifted after the next trading day
Finally, and as importantly, I believe Rule 201 will help to restore investor confidence in the markets, especially during times when securities' prices are declining. Once the circuit breaker has been triggered for a particular security, investors can be more confident that the security's continued price decline will more likely be due to long selling and the underlying fundamentals of the issuer, rather than to other factors. And as long sellers, investors will have preferred access to bids in a declining market for a security. Just as important as the beneficial effects of this targeted rule in stopping short selling from exacerbating a declining market in a security, so are the positive implications that this rule will have in building the confidence of U.S. investors, whom we have a duty to protect.
I suspect that the actions we take today will not obviate the need for further consideration of the issues surrounding short selling and that they will remain live and active within the Commission and the industry. I assure all of you that we will continue to monitor the impact and effectiveness of our new rule, including its effect on market quality.
Once again, my thanks go to all the individuals of the staff involved in this rulemaking, and I am pleased to support your recommendation.