January 14, 2000
Mr. Jonathan G. Katz
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549-0609
Re: File No. S7-24-99; Concept Release on the Regulation of Short Sales of Securities
Dear Mr. Katz:
The Managed Funds Association (MFA), a national trade association of more than 690 members, represents the managed futures, hedge funds, and fund of funds industry. MFA membership is composed primarily of financial and commodity trading advisors, pool operators and trading managers who are responsible for the discretionary management of the vast majority of the estimated $35 billion currently invested in managed futures, as well as significant amounts invested in hedge funds and other financial and commodity-linked investments. MFA membership also includes the sponsors, investment managers and brokers for substantially all of the financial and commodity pools marketed on either a public or private basis in the United States.
MFA would like to express certain general comments on the SEC Concept Release referred to above (the "Release"). MFA, whose members represent a wide range of hedge fund managers, fully supports and endorses the Commission's objectives of ensuring free and orderly markets, with regulation and supervision enacted only as appropriate and necessary to protect market participants from unfair trading practices. As recognized in the Background section of the Release, the practice of short selling provides significant benefits to the market place. It is MFA's belief that the limitations placed upon short selling by the present regulatory scheme are unduly restrictive and have the effect of constraining the practice without offering the requisite justifying benefits. For the reason stated below, MFA believes the short sale rule should be repealed.
The investing public, both institutional and private, is best served when equity markets are permitted to respond freely to changes in market conditions. With the instantaneous free flow of market information currently available and the wide range of market participants, each with its own investment outlook and objectives, the artificial constraint on short sales imposed by current regulation is an anachronism whose sole effect is to impede market efficiency and results in market asymmetry. The evils, real or perceived, which the short sale rule was originally designed to prevent are, due to independent developments, considerably less likely to occur today.
Information Benefits All Investors and Reduces Possibility of "Bear Raid"
Many advances and refinements have been introduced into the trading arena since the adoption of the short sale rule 60 years ago and the amendment of the rule in 1975. Perhaps the most significant of these has been the introduction of advanced communications technology, which has so thoroughly revolutionized the way trading is conducted that it has essentially rendered the short sale rule obsolete. Modern communications technology reduces significant information gaps that might hamper segments of the market: the Internet will substantially level the playing field, making information immediately available to market participants. Efficient market theory suggests that it is good for the economy, and for all investors, for new information about an issuer, whether positive or negative, to be rapidly incorporated into its stock price. It is not necessarily bad for a stock price to decline; when it happens, there is likely to be a good reason for it.
Indeed, other deterrents to a "bear raid" exist and should be retained. These include NASD's Affirmative Determination Rule 3370(b)(2) and the similar Rule 440C.10 on the New York Stock Exchange. Under these rules, members must make an affirmative determination that the stock in question is available for borrowing prior to the placing of an order to sell short; as such, short sales will always be constrained by supply and cannot be limitless. Moreover, market transparency and the level of surveillance that exist in today's markets serve as additional deterrents to any potential "bear raids".
Corporate events such as mergers and acquisitions should affect the market, as quickly as the market can digest any newly available information. Short selling based on these events is not an abuse but a reflection, in a free market economy, of an investor's opinion of a stock's value in light of new information. No constraint exists on an upside swing, which creates an asymmetry that favors issuers. Artificially supported prices are not immunized against decline; in fact, there are many examples of investors being harmed by unconstrained upward market spikes, followed by an immediate free-fall to more rational levels. Eventually a stock which should fall, will. Elimination of pricing inefficiencies which might be introduced by the existence of the short sale rule, however, would ultimately result in more liquid markets, to the benefit of all investors.
Other Costs and Inequities
In addition to the pricing inefficiencies caused by the short sale rule, the rule also imposes other costs and inefficiencies. Specialists or specially designed systems are required to handle and monitor compliance with the short sale rules, which results in an inefficient use of capital. Additionally, the need for complex systems for monitoring and tracking compliance with the present rules in fast-moving markets might actually disadvantage the smaller market participant, who will need to rely on specialists or larger market participants to effectuate short sales. Furthermore, present application of the "Aggregation" rules, with the exemptive relief granted large multi-service firms, has the effect of giving such entities a potential competitive advantage not enjoyed by other, smaller market participants with regards to intra-day short selling.
Proposal: Phase in Repeal of Short Sale Rule
The MFA recommends that, having outlived its regulatory usefulness, the short sale rule should be repealed. However, we suggest a gradual phasing in of a repeal by creating an initial exemption for "high cap" stocks. This exemption would give the Commission the ability to study the effects on the market of unhindered short sales in the stocks that are by and large the most actively traded and which are most difficult to manipulate due to the extreme transparency of the markets in which they trade. We propose that the exemption be based upon a defined universe of stocks, such as those that comprise the Russell 3000 index, for example. This index would provide a good "high cap" benchmark because the stocks included therein are easy to identify and are included in the index every six months, based on objective rather than political criteria.
At a Minimum Hedging Transactions Should be Exempt
If the Commission determines not to repeal the rule as MFA recommends, then, at a minimum, the Commission should create a broad exemption for hedging transactions. As noted in part II D of the Release, short selling is an integral and important part of many hedging strategies and, as such, has historically been permitted, under exemptions from the existing rules. As is evident from the Release's long discussion of exemptions for hedging, identifying appropriate strategies for relief is very difficult. Therefore, we recommend that the Commission work with the industry to develop a more flexible definition of hedging: definition that would include existing strategies as well as permit the development of new strategies.
If you have any questions concerning this letter or wish any additional information, please contact John G. Gaine at 202.828.6040.
John G. Gaine