US short sellers weigh challenges to trading ban

By Martha Graybow

NEW YORK (Reuters) - Short-sellers unhappy about an emergency U.S. rule restricting their activity are weighing possible legal action to challenge it, though legal experts said it was unclear what chance of success they would have.

Hedge funds and short sellers -- accused by some bank executives and politicians of trying to destabilize markets and drive down stocks -- expressed dismay on Friday over the new rules handed down by the Securities and Exchange Commission.

The emergency order temporarily bars short sales of nearly 800 financial stocks.

A hedge fund lobbying group, the Managed Funds Association, has been discussing possible litigation spurred by the SEC ban, said Richard Baker, the group's president. But no decisions have yet been made, he said.

Short sellers sell borrowed shares in hope the stock falls. They record profits when they return the shares, purchased at the lower price.

As a result of the new rules, short sellers may have to buy shares -- at a loss -- to cover their trading positions after having bet that stock prices would drop. Financial stocks covered by the new rule soared on Friday.

Short sellers say that far from causing the current crisis, they've been sounding the alarms about credit market problems for months and should not be blamed for the Wall Street turbulence.

Legal experts say that they would not be surprised if the SEC's move ultimately draws legal challenges.

But they say that the 1934 securities law that the SEC drew on to impose the ban gives regulators wide powers and that the commission was clearly trying to quell market turmoil.

"Obviously we are seeing things happen in the marketplace we have never seen before," said Orlan Johnson, a partner at law firm Saul Ewing LLP. "For the commission to sit idly by and not make any adjustment in any way would be considered irresponsible."

Bruce Hiler, head of the securities enforcement group at law firm Cadwalader Wickersham & Taft LLP, said that legal challenges to the new restrictions were certainly possible, though it's unclear on what basis opponents would seek to overturn the ban. Time is also a factor, he said.

"The SEC clearly has broad authority to regulate the securities markets," he said. "I can't tell you that somebody couldn't come up with a challenge to it. Right now it's in effect for 10 days. I guess someone could get in court very quickly."

The short-selling ban runs through Oct. 2 and could be extended by 10 days at the discretion of the SEC, but the order will not be extended for more than 30 calendar days in total, according to the commission.

D. Roger Glenn, a partner at law firm Edwards Angell Palmer & Dodge LLP and expert in securities law, said that he also thinks there is little time for short-sellers to mount a court challenge.

One scenario to test the legality of the ban would come if traders defy the order, and the SEC seeks to bring an enforcement action against them.

Glenn said that a court case could pose interesting legal issues, given that while the SEC has broad powers to govern markets it also has said in the past that short selling is a legitimate trading strategy.

"The SEC's real function is to prevent fraud and manipulation in the market," he said, "and there is nothing per se fraudulent or manipulative about short selling."

(Additional reporting by Rachelle Younglai in Washington, editing by Brad Dorfman)