January 20, 2004
Mr. Jonathan G. Katz
U.S. Securities and Exchange Commission
450 Fifth Street, NW
Washington, DC 20549-0609
Re: File No. S7-23-03
Ladies and Gentlemen:
On November 6, 2003, the Securities and Exchange Commission published for public comment in the Federal Register proposed regulation SHO. This letter responds to that regulation.
We applaud the Commission for considering the first major revisions of the short sale regulations in more than 60 years. We expect that changes to the short sales rules will make the US markets more efficient and fair. The current rules are rife with opportunities for regulatory arbitrage, inconsistent in their application to different securities and market participants, and troubling in their implication that selling stocks short is less legitimate than buying them.
The SEC should:
I. Quickly implement the pilot program to allow relatively unrestricted short selling in a group of highly liquid stocks.
II. Maintain the current dual system of an up-tick test for NYSE stocks and an up-bid test for Nasdaq National Market System stocks in the hope that all price tests will be eliminated quickly through the pilot program.
III. Impose stricter borrowing and delivery rules for shorting stock to avoid "naked short selling."
IV. Consider an arbitrage/hedging exemption from short sale restrictions.
We are senior managers at a hedge fund group, but the views expressed herein are our own and do not necessarily represent those of our employer.
I. Pilot Program
We support the Commission's program to test relatively unrestricted short selling, in a group of highly liquid stocks, without the current requirement to short on an up-tick or up-bid. Subsequently, we expect that the Commission will permanently eliminate short sale restrictions on all, or most, stocks.
Certainly, the last few years have demonstrated that buying stocks at inflated prices can lead investors to real financial disaster. Anything that eliminates extreme market swings should benefit most investors. Hence, the Commission has a duty to not discourage legitimate short selling, and level the regulatory treatment between buying long and selling short.
II. Uniform Bid Test
Some inconsistencies and regulatory arbitrage opportunities have developed since the SEC promulgated the up-tick rule in 1938. Therefore, the Commission has proposed a new "uniform bid test" that would allow short sales at one cent above the consolidated best bid. This would replace the current split system of a "tick" test on the NYSE and a "bid" test on Nasdaq.
We understand the motives for creating a uniform rule for all markets, appreciate the Commission's reasonable price test compromise, and welcome the prospect that the new rule might lead to more unrestricted short selling. Nevertheless, we fear that the proposed rule might benefit one group of market participants over another. Moreover, implementing this new uniform rule might delay the more important task of eliminating any price test for short selling.
Therefore, we encourage the SEC to keep the current dual system and focus its energy on administering the pilot program.
III. Naked Short Selling
The Commission should enforce stricter borrowing and delivery requirements on short sales to ensure the maintenance of fair and orderly markets. Moreover, tales of improper "naked short selling" contribute to fears about legitimate short selling. Therefore, the SEC has arrived at a fair set of rules.
Traders can use naked short selling to generate leverage and exert greater downward price pressure on a stock than would be possible with short selling of a borrowed stock. These trades, if extensive, can perhaps over-accelerate price declines, leading to inverted bubbles and increased volatility.
We have considered the argument that naked short selling is necessary to combat excessive stock promotion or even fraud in the micro-cap or small-stock market. BusinessWeek's Gary Weiss, a veteran journalist covering this market, recently editorialized that efforts to clamp down on naked short selling would harm small investors by increasing the level of fraud in thinly capitalized stocks. "There's no doubt that shorts often drive down the prices of thinly traded stock," he observed. "The problem is that such stocks often became tempting to shorts only because they are richly priced as a result of manipulation."
Even if overvalued stocks deserve to be sold short, good public policy dictates that the Commission should write rules that ensure no naked short selling.
IV. Hedging/Arbitrage Exemption
In the 1999 Short Sales Concept Release, the Commission discussed a broad exemption from the uptick rules for bona fide hedged transactions. The Commission expects that both its uniform-bid-test and pilot program will eliminate the need for a hedging exemption.
Removal of uptick restrictions would make a special rule for hedged trades unnecessary; nevertheless, we are disappointed that the Commission bypassed this issue. The restrictions on short selling as they affect bona fide hedging or bona fide arbitrage may be the most illogical part of the current short sales restrictions. Short selling related to true arbitrage and hedging activities provides significant, valuable liquidity to the markets. For example, convertible bond arbitrageurs generally are "long" the bond while simultaneously "short" the stock, but they have not sold short the stock in the hope of driving the price down. In fact, arbitrageurs can lose money on their overall position, even if the stock declines, and they can earn money on their overall position, even if the stock rises. What matters is whether the spread between the two securities has widened, narrowed, or remained the same, as well as the cost to hold the positions and income received thereon.
Ironically, arbitrage traders, who present the least danger to the market, may suffer the most from current short sale rules. A dedicated short seller betting on a massive collapse in a security may not be too concerned about waiting for an uptick to short a stock. Delay, however, can be detrimental to a person trying to achieve a bona fide hedge or exploit inefficient mispricings as part of a bona fide arbitrage trade.
Although the Commission has granted some relief in regard to arbitrage positions, the exemptions from the short sale rules are narrow and cover only a small portion of arbitrage trading.
We recognize that it would be difficult to define precisely the universe of hedging transactions, and understand the potential for abuse in an arbitrage exception. For example, a bona fide arbitrageur may "dynamically hedge" positions, and subsequently unwind, for a time, just one side of the hedged position. This illustrates the difficulty in defining what a hedged transaction is. Moreover, if the market value of the short position does not perfectly match that of the long position, guidance may be required to define a bona fide hedge.
Nevertheless, the Commission should consider such an exemption, perhaps based on a "safe harbor" provision that would attempt to clearly define the full range of hedging transactions, if the pilot program encounters delays.
Thank you for allowing us to comment on these important rules. Please feel free to contact us at (203) 861 3232, if you have any questions.
Hal Lux Leon M. Metzger