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SEC proposes steps to control short-selling

The SEC voted unanimously on Wednesday to issue proposed curbs on short selling, including a return of the "uptick rule", for a 60-day public comment period.
/ Source: Reuters

Federal regulators opened a public debate Wednesday over ways to restrict trades that bet against a stock, as investors and lawmakers clamor for brakes on moves they say worsened the market’s downturn.

One option the Securities and Exchange Commission advanced is restoring a Depression-era rule that prohibits short sellers from making their trades until a stock ticks at least one penny above its previous trading price. The goal of the so-called uptick rule is to prevent selling sprees that feed upon themselves — actions that battered the stocks of banks and other companies over the last year.

Another approach would ban short-selling for the rest of the trading session in a stock that declines by 10 percent or more.

The five SEC commissioners, who voted unanimously to put forward five alternative short-selling plans, could settle on one and formally approve it sometime after a 60-day public comment period.

SEC Chairman Mary Schapiro said the agency was beginning “a thoughtful, deliberative process to determine what is in the best interests of investors.”

Short-selling is legal and widely used on Wall Street. But as the market has plunged, investors and lawmakers have pressed the SEC to reinstate the uptick rule. They say its absence since mid-2007 fanned market volatility, prompting bands of hedge funds and other investors to target weak companies with an avalanche of short-selling.

The SEC meeting marked the second time in less than a week that financial relief measures pressed by Congress were taken up by independent overseers. The Financial Accounting Standards Board on April 2 gave companies more leeway in valuing assets and reporting losses, a move that sent financial stocks and the broader market soaring.

Both sets of changes would especially benefit banks and other financial institutions, whose balance sheets have been battered in the financial crisis and whose stocks have been targeted by short sellers.

At the same time, the Obama administration has proposed to Congress a sweeping overhaul of the nation’s financial rule book meant to prevent a repeat of the banking crisis that toppled iconic institutions and wiped out trillions of dollars in investor wealth. It includes requiring big hedge funds and other private pools of capital to register with the SEC and open their books to federal inspection. Credit default swaps also would come under federal regulation for the first time.

Although many in the public blame short-selling for enflaming market volatility over the past 18 months, Schapiro said there is no “specific empirical evidence” that the absence of the uptick rule fueled it. Still, she acknowledged the SEC’s difficult task in striking a balance between stemming market abuses to bolster investors’ confidence and stifling the legitimate benefits of short-selling.

Other commissioners warned of possible unintended negative consequences of short-selling restraints. Troy Paredes said such restrictions could actually undermine investors’ confidence because they may be disappointed if the curbs don’t have the intended effect of stabilizing the market.

Another commissioner, Luis Aguilar, suggested that curbs on short-selling could push market players into other, unregulated areas — notably credit default swaps — as a way of trading to benefit from companies’ weakness.

The swaps, a form of insurance against loan defaults, are traded in a secretive market valued at around $60 trillion. They figured prominently in the credit crisis that brought the downfall of Lehman Brothers, a government bailout of insurer American International Group Inc. and the sale of Merrill Lynch & Co. to Bank of America Corp.

The short-selling move is the first major initiative under Schapiro, who was appointed by President Barack Obama and became SEC chairman in January.

The practice involves borrowing a company’s shares, selling them, then buying them back when the stock falls and returning them to the lender. The short seller pockets the difference in price.

Proponents of short-selling say it can make markets more efficient, bring in more capital and raise warning signs about weak or badly managed companies. Professional short sellers and some analysts also have warned that restricting short-selling could actually distort edgy markets.

“Rebuilding investor confidence should be the primary objective of any new regulatory effort and it is not clear that today’s proposals will meet that simple goal,” Jim Chanos, a prominent short seller and president of hedge fund Kynikos Associates, said in a statement.

But companies and regulators maintain the practice widened the scope of the financial crisis and contributed to the collapse in value last fall of a number of bank stocks and the demise of Lehman Brothers.

Another option floated by the SEC, besides reinstating the uptick rule, is a sort of “circuit breaker” for stock prices. That approach, in three variations, either bans short-selling outright for the rest of the trading session in a stock that declines 10 percent or more, or restricts short-selling of the stock for the rest of the session based on its previous sale price or highest bid.

The fifth alternative, known as an upbid rule, would allow short sellers to come in only at a price above the highest current bid for the stock.

The SEC repealed the uptick rule, which was established in 1938 during the Depression that followed the 1929 market crash, nearly two years ago when the stock market was near its peak. A test by the SEC earlier in 2007, removing the uptick rule for one-third of the stocks in the Russell 3000 index, found it could be eliminated without causing significant harm.