SEC tightens rules on short sales

WASHINGTON/GREENWICH, Connecticut Wed Sep 17, 2008 10:07pm EDT

Traders work on the floor of the New York Stock Exchange September 15, 2008. REUTERS/Brendan McDermid

Traders work on the floor of the New York Stock Exchange September 15, 2008.

Credit: Reuters/Brendan McDermid

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WASHINGTON/GREENWICH, Connecticut (Reuters) - U.S. securities regulators tightened rules on traders who profit from stock declines as shares plummeted Wednesday on fears of a global credit crunch.

The U.S. Securities and Exchange Commission action follows a brief emergency rule this summer that was aimed at curbing abusive naked short selling in 19 major financial stocks.

Under a measure that takes effect Thursday, short sellers and their broker dealers must deliver securities by the close of business on the settlement date, three days after the sale.

But with stocks falling, lawmakers and banking executives kept up their pressure on the investor protection agency to further curb short selling.

SEC Chairman Christopher Cox issued a statement late on Wednesday saying he had additionally asked the commission to consider requiring hedge funds and large investors to disclose their short trade positions, as long positions already are.

He also said the SEC's enforcement division would obtain data from large hedge funds and other institutional traders on their past trading positions in specific securities.

Broker-dealers failing to comply with the new delivery requirement will be prohibited from further short sales in the same security unless the shares are pre-borrowed.

The SEC also adopted a rule that makes it fraudulent for customers to deceive broker-dealers about the intention or ability to deliver securities in time for settlement.

A third rule requires option market makers to deliver securities by the settlement date.

"These several actions today make it crystal clear that the SEC has zero tolerance for abusive naked short selling," Cox said in a statement.

The SEC action follows two turbulent days in which investment bank Lehman Brothers Holdings LEH.N filed for bankruptcy and U.S. authorities organized an $85 billion rescue plan for insurer American International Group (AIG.N).

LOBBYING FOR MORE

The SEC announcement of its rule changes, as trading opened Wednesday, appeared to have no immediate impact on share prices. Major U.S. stock indexes closed down more than 4 percent.

Morgan Stanley (MS.N) Chief Executive John Mack, whose saw his bank's shares lose 24 percent Wednesday, blamed the fall on short sellers and said he had talked with Cox.

"It's very clear to me -- we're in the midst of a market controlled by fear and rumors, and short sellers are driving our stock down," Mack said in a memo to employees obtained by Reuters.

Lawmakers such as New York Democratic Sen. Hillary Clinton also implored the SEC to do more. She said the SEC should consider reinstating the uptick rule, abandoned last year, which only allowed short sales when the last sale price was higher than the previous price.

But the new rules drew complaints from hedge funds, Wall Street banks and law offices, as investors and their advisors tried to comprehend the changes. No official text of the rules was immediately available.

"This is nonsense," fumed one manager who asked not to be identified because he often relies on shorting to make money. "This is the SEC trying to play political catch up and blame us for having uncovered problems at some big Wall Street banks that eventually went bust."

Columbia Law School professor John Coffee said the rules were a far bolder step than the SEC was willing to take last week. "Lehman and AIG seem to have given (the SEC) religion on this topic," he said.

Short sellers arrange to borrow shares they consider overvalued and sell them in hopes of making a profit when the price drops. It is a legitimate form of trading that can prevent stocks from being overvalued, but often blamed when a company's shares fall.

A "naked" short sale occurs when an investor sells stock that has not yet been borrowed.

Broker-dealers will sometimes accidentally fail to deliver stock to investors who have arranged to borrow it. If this is done intentionally it is already illegal.

In July, amid sharp market declines, the SEC issued a temporary rule to curb illegal naked short selling in 19 major finance stocks, including Lehman Brothers, and mortgage finance giants Freddie Mac FNM.N and Fannie Mae FRE.N, which have since been seized by the government.

The rule ended mid-August and was also criticized by hedge funds, short sellers and the broker-dealer community.

Bill Rhodes, president of Rhodes Analytics, was critical of the SEC's new rule concerning deception of broker-dealers saying it could catch honest investors.

He was also warned that the idea of requiring disclosure of short positions was ill-considered. "It's one thing to say you don't want the short sellers abusing the longs... but if you shut the short sellers down you'll destroy the market."

But some investors were confident that shorting would go on as usual when the rule takes effect on Thursday.

"It won't make much of a difference because the SEC is making something illegal that is already illegal," Mark Yusko, who invests billions in hedge funds as chief investment officer at Morgan Creek Capital Management.

Although effective on Thursday, the SEC will open a 30-day public comment period for the rule on delivery of securities.

(Additional reporting by Emily Chasan in New York; Editing by Tim Dobbyn)