Coming Full Circle: The SEC Proposes New Rules On Short Selling

One of Bob Dylan’s most famous songs is “The Times They Are A-Changin’”. One of the SEC’s long standing and recently most talked about rules is the uptick rule, instituted in the 1930s, abolished in 2007 and now coming back, if many have their way. Are the times changing (sorry Bob) or just going round in circles?

On Tuesday, the SEC voted to seek public comment on proposed short sale and circuit breaker rules. Casting the new proposals as a product of the extreme market conditions, the Commission is offering alternate proposals. One approach is a market-wide, permanent approach. The other is a security-specific, temporary approach based on the notion of a circuit breaker.

The market-wide approach has two variations. One, called the proposed modified uptick rule, is a market-wide short sale price test based on the national best bid. The other, a proposed uptick rule, would be a market-wide short sale price test based on the last sale price or tick.

The alternative circuit breaker approach is security specific and temporary. The Commission is considering three possible variations here: 1) A circuit breaker halt rule which would ban short selling in a particular security for the day following a severe price decline; 2) A circuit breaker uptick rule that would impose a short sale price test based on the national best bid in a particular security for the remainder of the day following a severe price decline in that security; or 3) A circuit breaker uptick rule that would impose a short sale price test based on the last sale price in a particular security for the remainder of the day following a severe price decline.

These proposals are made against a backdrop of recent Commissions actions and statements which, at best, might be viewed as “mixed signals.” In 2007, the SEC abolished the 1930s era uptick rule, former Rule 10a-1. That rule essentially precluded short selling except following an uptick or higher bid for the security.

As the market crisis evolved in 2008 however, there was concern that short sellers were driving down the share price of financial institution stocks. In July 2008, the price of former Wall Street investment banking giant Bear Stearns’ shares tumbled from about $50 to $10 in one week despite reassurances from the firm and the SEC that it had more than adequate capital.

As Bear Stearns tumbled to its demise, Treasury was concerned with propping up the two giant GSE players in the mortgage backed securities market, Freddie Mac and Fanny Mae. There was also concern about the share price of other financial institutions, particularly those that could borrow from the Fed. Many believed that Bear Stearns and later Lehman Brothers, which slid into bankruptcy after the government refused to assist the firm, collapsed because of bear raids, that is traders who combined short selling with rumors to drove down the share price. The SEC opened investigations which are still in progress.

Those fears prompted the SEC to issue a ban on short selling in the shares of a limited number of securities. That ban was expanded in August 2008 and continued into October 2008 when it ended. During the same period regulators in the UK, Germany, Australia and Japan followed with short sale bans which ran longer than the one imposed by the SEC.

The SEC’s ban resulted in a storm of criticism. Many viewed it an unprecedented intervention into the markets. In a letter to then-Chairman Cox dated September 30, 2008 however, Congressman Markey requested the basis for the Commission’s approval of the repeal of NYSE Rule 80A, the so-called collar rule. That rule restricted certain program trading when there is an up or down movement of 2% from the previous day close.

Days before Congressman Markey’s letter, the SEC Inspector General issued a report which was highly critical of the actions of the Divisions of Trading and Markets and Corporation Finance regarding the collapse of Bear Stearns. Indeed, the report stated that the failure of Corp Fin to conduct a timely review of the investment firm’s most recent 10-K deprived investors of important information which may have helped quell the rumors which swirled about the firm as its share price tumbled.

Following the termination of the SEC’s short sale ban then Chairman Cox called the ban an egregious error undertaken only because of pressure from Treasury and the Fed. Now however, the SEC has come full circle — it is reconsidering rules which could limit the impact of short selling. If adopted, those rules will not become effective for months.