UPDATE 2-SEC to grant market makers leniency on short sales

(Recasts, adds SEC statement and comments from hedge fund lobby group's head)

By Svea Herbst-Bayliss and Rachelle Younglai

BOSTON/WASHINGTON, July 17 (Reuters) - U.S. regulators said they would grant some leniency to certain market makers who sell stocks short, responding to pressure from fund managers and brokerages to clarify how new restrictions on the practice would work.

The guidance came from the Securities and Exchange Commission late on Thursday after it stunned financial markets by announcing unprecedented restrictions on short-selling two days before.

The rule, which takes effect on Monday and is expected to last at least 30 days, is designed to restrict improper short selling of shares in 19 financial firms, including recently battered Fannie Mae (FNM.N), Freddie Mac (FRE.N) and Lehman Brothers Holdings Inc LEH.N.

"The staff is recommending exceptions to the short sale order for market makers of the 19 stocks and their derivatives from arranging to borrow in advance for short sales in their marketmaking and related hedging activities, to avoid constraining the market makers' provision of liquidity," SEC spokesman John Nester said by e-mail.

Separately, the SEC announced plans to crack down on people who may be spreading rumors to manipulate stock prices and dozens of hedge funds and brokerages received requests to turn over e-mails to regulators as they probe the collapse of Bear Stearns and a sharp decline in Lehman's share price.

More than 50 hedge funds and brokerages began receiving subpoenas in recent days, managers and their lawyers said.

Loosely regulated hedge fund managers, who often rely on selling stocks short to make money, complained that the rule would make their work more difficult and expensive.

"This ties both hands behind their backs," Perrie Weiner, co-chairman of the securities group at law firm DLA Piper, said of the new measure. "It has caused an uproar because the government is telling you that an otherwise legal practice is being restrained. It is Big Brother looking over your shoulder."

Short selling occurs when investors borrow securities and then sell them in the hopes their price will drop so they can repay the loan for less later and pocket the difference.

Corporate executives and politicians have blamed short sellers for recent sharp drops in financial stocks and many hedge fund managers now view the SEC's move as a last-ditch effort to try to stabilize financial stocks since the United States is already grappling with record-high energy prices, job losses and sluggish economic growth.

From Monday, regulators will be cracking down on so-called naked short selling where investors do not actually have the shares before selling them. Now people will have to make arrangements to have the shares in hand before selling them.

Because naked short selling is not considered to be widespread, hedge fund managers and the Managed Funds Association, one of the $2 trillion industry's trade lobby groups, called the move unnecessary as well as confusing.

SEC staff met with representatives from the MFA on Wednesday to discuss the logistics, said Richard Baker, a former congressman and the group's new chairman and CEO.

"Short selling is a legitimate and valuable trading strategy as well as a vital component of providing price discovery and promoting efficient markets," Baker said by e-mail, adding that since regulations already stipulate a three-day settlement, "it is not clear why this extreme measure is warranted."

The group expects the SEC to release a response to frequently asked questions by the end of the week, Baker said. (Editing by Tim Dobbyn and Braden Reddall)