Federal regulators on Wednesday took measures aimed at reining in aggressive forms of short-selling that were blamed in part for the demise of Lehman Brothers and which some feared could be used against other vulnerable companies in a turbulent market.
The Securities and Exchange Commission adopted rules it said would provide permanent protections against abusive "naked" short-selling. Unlike the SEC's temporary emergency ban this summer covering naked short-selling in the stocks of mortgage finance giants Fannie Mae and Freddie Mac and 17 large investment banks, the new rules apply to trading in the broader market.
The new rules remove an exception for market makers in options on stocks from rules restricting naked short-selling and tighten anti-fraud regulations related to that activity. The changes make clear that anyone who lies about their intention or ability to deliver the stocks underlying a short-sale transaction in time for settlement violates the law if they fail to deliver them.
Short sellers bet that a stock's price will fall so that they can profit from it. They borrow shares of the stock and sell them. If the price drops, they buy cheaper actual shares to cover the borrowed ones, pocketing the difference.
Naked short-selling occurs when sellers don't even borrow the shares before selling them, and then look to cover positions immediately after the sale.
Another new rule will require short sellers and their brokers to deliver underlying stocks in the transactions by three days after the date of the short sale, or face penalties for failing to do so. That rule takes effect Thursday but was adopted on an interim basis and the SEC is seeking public comment on it for 30 days.
"These several actions today make it crystal clear that the SEC has zero tolerance for abusive naked short- selling," SEC Chairman Christopher Cox said in a statement. The agency's divisions, including enforcement attorneys and market inspectors, "will now have these weapons in their arsenal in their continuing battle to stop unlawful manipulation," he said.
The new rules take effect at 12:01 a.m. EDT on Thursday.
Critics say the SEC action comes too late to stem a tide of short-selling attacks that have felled huge, venerable companies. They want a prohibition on all naked short-selling similar to the emergency ban this summer covering the stocks of the 19 big financial companies.
Some investors contend that naked short-selling, if left unchecked, would have given hedge funds and other aggressive short sellers an unfair advantage to attack other victims after Lehman Brothers Holdings Inc., which made the biggest bankruptcy filing in U.S. history on Monday.
Merrill Lynch & Co. — being bought by Bank of America Corp. in a $50 billion shotgun deal — or giant insurer American International Group Inc., rescued with an $85 billion cash injection from the Federal Reserve, were said to be among the likely targets.
Shares of regional banks and investment firms nationwide continued to be targeted by aggressive short sellers after the SEC's emergency ban took effect, according to the American Bankers Association and other industry advocates.
The banking industry organization said Wednesday it supported the SEC's new measures, calling them "aggressive" because they take effect right away.