Short sale rule change sparks confusion on Wall St.

By Emily Chasan

NEW YORK (Reuters) - The U.S. Securities and Exchange Commission's emergency rule to curb abusive short selling in major financial stocks has ignited confusion on Wall Street about how it will be enforced.

On Tuesday, the SEC issued an emergency rule to prevent investors from making "naked" short sales of some of the biggest financial stocks.

The rule takes effect on Monday, and could last up to 30 days. But while the rule says what will not be allowed, Wall Streeters are scrambling to clarify how the rules will work to make sure they will be ready to trade next week.

"Right now, market participants are trying to get clarity on the many implementation and interpretative issues," said Susan Grafton, a lawyer at Gibson, Dunn & Crutcher who represents broker-dealers and investment managers.

The Securities Industry and Financial Markets Association has already approached the SEC about the rule.

"We hope to solicit clarification on several important issues to ensure the market continues to operate smoothly and with the necessary liquidity," Ira Hammerman, general counsel and senior managing director at SIFMA, said in a statement.

SIFMA declined to elaborate further on the clarifications it was seeking.

Among the top concerns may be whether the SEC will grant an exemption for options market makers, who often sell shares short to keep their markets running smoothly.

Short sellers arrange to borrow shares they consider overvalued and sell them in hopes of making a profit when the price drops. Short selling, on its own, is a legitimate investment strategy, but the SEC is seeking to curb abusive "naked" short selling, where investors sell shares they have not actually borrowed.

Under the SEC's emergency rule, short sellers would have to prove, for 19 financial institutions on the SEC's list including Citigroup Inc (C.N), Lehman Brothers Holdings Inc LEH.N, Fannie Mae (FNM.N) and Freddie Mac (FRE.N), that they have borrowed shares before executing the short sale.

The concern, some say, is that naked short sales often occur due to accidents, like an account suddenly being transferred to another broker, or a paperwork snafu, and short sellers sometimes find themselves unintentionally "naked."

"If nobody did anything they weren't supposed to do and nobody broke the rules, you could still end up with an accident, and the question is, what do you do?" said Bill Rhodes, chief investment strategist at Rhodes Analytics, an independent research firm.

"The tone of the order would indicate that if you don't do what you've been asked to do, the consequences would be very serious, but it doesn't say what those consequences are."

Engaging in certain types of naked short selling is already illegal and SEC Chairman Christopher Cox said on Wednesday that the emergency rule is not expected to slow down proper short trading.

But some worry that uncertainty about what the rule means could slow down normal trading in financial stocks, and even other areas of the market.