As regulators mull next steps to calm jittery U.S. markets, observers say the Securities and Exchange Commission’s unusual move to ban “naked” short selling of the securities of all public companies isn’t likely to have much impact beyond the short-term.

In an extraordinary measure aimed at restoring shaken investor confidence amid extreme market turmoil, the SEC on Sept. 17 barred naked short sales of all publicly traded companies with the adoption of new rules.


“It’s not unprecedented, but from a historical perspective it’s an extraordinary move,” says Charles Landy, a partner with Pillsbury Shaw Pittman, formerly a lawyer in the SEC’s Enforcement Division.

A short seller bets that a company’s stock price will fall. To profit, the seller borrows shares and sells them; once the stock price drops, the seller buys cheaper shares to cover the borrowed one, pocketing the difference. In a naked short transaction, however, the seller doesn’t actually borrow the stock. The SEC says such “abusive” short selling can allow manipulators to drive prices down lower than possible in legitimate short-selling conditions.

Regulators and companies have blamed short sellers for contributing to the financial crisis by spreading false rumors and selling stock short to profit. Earlier this summer, the SEC barred naked short sales on 19 financial stocks under an emergency authority that expired Aug. 12.

As the financial crisis worsened last week with the meltdown of major Wall Street firms, the SEC adopted three rules designed to address specific concerns related to naked short selling, covering all companies.


SEC Chairman Christopher Cox said the actions “make it crystal clear that the SEC has zero tolerance for abusive naked short selling.”

Gary Distell, a partner at Katten Muchin Rosenman says the SEC’s action “demonstrates the fragile state of our financial markets.”

“There definitely is a significant group of people who believe that short sellers have aided in the rapid decline of the price of financial stocks,” says Distell. The rules, “if nothing else, may aid stock prices based on the belief of those market participants.”

Effective Sept. 18, the SEC adopted a temporary rule to Regulation SHO, Rule 204T, that imposes a penalty on short sellers and broker-dealers for failure to deliver securities by the close of business on the settlement date—three days after the sale transaction date, or T+3.

It also adopted a final rule that amends Regulation SHO Rule 203(b)(3) to eliminate the options market maker exception from Regulation SHO’s close-out requirement, requiring those market makers to abide by the closeout requirements that effectively ban naked short selling.

Finally, the SEC adopted a short selling antifraud rule, Rule 10b-21, which makes clear that short sellers who lie about their intention or ability to deliver securities in time for settlement are violating the law when they fail to deliver. The SEC staff, along with FINRA and NYSER, also posted a two-page list of “tips” aimed at helping broker-dealer firms in preventing failures to deliver securities.

Several public companies contacted by Compliance Week did not respond to requests for comment. However, pubic company advisers don’t expect the action to have much long-term impact.


“The new antifraud rule gives the SEC specific authority against naked short sellers and sends a message about the SEC’s focus on abusive short selling,” says Susan Grafton, a former SEC attorney now at Gibson Dunn & Crutcher. “Practically, however, it’s not clear what impact it will have on day-to-day trading.”


Gregory Gnall, an attorney with White & Case, says the rules may have some short-term impact by “slowing down the mania a little bit,” but he says they’re mostly a “band aid.”

Pillsbury’s Landy agrees that the rules are unlikely to have a “significant long-term impact.”

The rules don’t appear to be “based on any empirical data, but rather on calls from Wall Street and elsewhere to limit abusive short selling,” says Landy.

“This has happened repeatedly in the last century, but it doesn’t go to the root cause of why markets are trending downward,” he says. “Any artificial restraint on the operation of the free markets is nothing but a short-term palliative.”

Too Little, Too Late?


Meanwhile, Perrie Weiner, co-chairman of DLA Piper’s securities litigation practice, says current regulations under Reg SHO already are sufficient to curtail naked short selling, and further rules are unnecessary.

“The additional regulations will only operate, at worst, to scare broker-dealers from executing any short sales under any circumstances for fear of facing an SEC or FINRA investigation or other civil proceeding … or, at best, will significantly increase transaction costs,” says Weiner.


The Staff of the SEC’s Division of Trading and Markets and the Office of Compliance Inspections and Examinations, along with FINRA and NYSER are providing the following information to assist broker-dealer firms in preventing failures to deliver

securities. Firms conducting short sales are encouraged to consider practices to prevent

delivery failures, including, for example:

Borrowing. Borrowing and obtaining control of the securities before settlement,

rather than entering into an agreement to borrow such securities. One firm, for

example, has indicated that it has made a practice of borrowing or maintaining

adequate inventory to allow it to deliver securities by settlement date and thereby

prevent a fail to deliver in that security.

Arrangement to borrow. Entering into an agreement to borrow securities,

especially in transactions in hard-to-borrow securities, in order to ensure that the

firm will be able to settle the transaction on T + 3. This practice provides

assurance that the shares will be available upon settlement and that the trade will

not fail.

Earmarking. If the firm enters into an arrangement to pre-borrow shares without

obtaining control, determining that the source of shares for the pre-borrow will be

available on T + 3. Shares may be specifically earmarked for each arrangement to


Maintaining an inventory. Maintaining adequate inventory of securities in which

the firm frequently executes short sales sufficient to cover anticipated short sales

and to cover any pre-borrows granted by the firm. Reducing the shares available

from inventory in order to ensure that adequate shares are available to deliver by

settlement date.

Documenting the source of shares. In instances where a customer relies on a

broker-dealer other than the executing broker-dealer to settle a transaction, the

broker-dealer that settles the customer’s transaction documents the source of the

customer’s pre-borrow. Additionally, the executing broker-dealer has adequate

controls in place to ensure that locates or pre-borrow arrangements provided by

the customer are valid. In addition, executing broker-dealers are reminded that

when a customer provides assurance that it has access to shares to settle their

transaction, the executing broker-dealer is required to document the source of the

customer’s pre-borrow.

Monitoring locates. Monitoring the performance of the locates provided by

customers to assess future reliability.

Encouraging timely affirmations. Working with institutional clients to encourage

the development of efficient systems for confirmation and affirmation of trades, to

assure timely delivery of DVP trades.

Direct market access/sponsored access. Firms may also want to consider the

practices outlined here in conjunction with their policies and procedures regarding

short sales entered via direct market access or sponsored participant

arrangements. Document the source of pre-borrowed shares when a short sale

transaction is entered via a direct market access and/or other sponsored access



Securities and Exchange Commission (2008).

The real problem is that the companies are troubled, says Weiner. “They will fail with or without short selling activity. Short selling merely brings the over-inflated price of a public company’s stock into the range of its fair market value.”

Wachtell Lipton Rosen & Katz attorneys Edward Herlihy and Theodore Levine say the SEC actions are “too little too late.” The authors of a Sept. 17 client alert on the topic said the new antifraud provision isn’t necessary and won’t help eliminate abusive short selling practices.

The SEC measures “fall far short of the type of bold measures needed to constrain the abusive short selling and rumor mongering taking place,” Herlihy and Levine wrote. They called for the SEC to immediately re-impose the “uptick rule,” a price test restriction that was eliminated in June 2007, to consider measures such as placing limits on short sales for a period of time and to scrutinize short sellers and their related transactions “to determine whether these strategies are contributing to the severe dislocations taking place in the marketplace.”

They also urged the SEC to make public the results of its examinations of short selling activities and take immediate enforcement action against those engaging in “abusive manipulative conduct.”

Not surprisingly, chairman and CEO Patrick Byrne, an outspoken critic of naked short selling, blasted the SEC’s actions. Among other things, Byrne’s Sept. 17 press release described the short selling anti-fraud rule as “a carefully contrived joke.” However, Byrne applauded the elimination of the options market maker exception, which he called “long overdue.”

Meanwhile, in addition to the new rules, Cox has also asked the Commission to consider on an emergency basis a new disclosure rule that will require hedge funds and other large investors to disclose their short positions.

In a Sept. 17 statement, Cox said the new rule would require managers with more than $100 million invested in securities to begin public reporting of their daily short positions. In addition, the Enforcement Division will expand its ongoing investigations by “undertaking a series of additional enforcement measures against market manipulation.”

The Enforcement Division will obtain disclosure from significant hedge funds and other institutional traders of their past trading positions in specific securities. “Those institutions will also be required immediately to secure all of their communication records in anticipation of subpoenas for these records,” the SEC statement said.