(Adds groups urging SEC against extending short sale rule,
By Rachelle Younglai
WASHINGTON, July 21 An emergency rule to curb
abusive short selling will likely be extended beyond 19 major
financial firms as pressure mounts on the U.S. Securities and
Exchange Commission to broaden the measure.
The impact of the SEC's rule is being closely monitored as
brokers and dealers are now required to borrow stock before
executing a short sale in 17 major Wall Street firms and
mortgage finance giants Freddie Mac FRE.N and Fannie Mae
The rule, which went into effect on Monday and can last up
to 30 days, also requires investors to deliver securities on
the settlement date.
The SEC announced its rule July 15, after bank regulators
seized IndyMac July 11 and the Federal Reserve and Treasury
Department announced emergency support on July 13 to ensure
Freddie and Fannie would have access to capital if needed.
Although short selling is a legitimate investment strategy
and can prevent stocks from becoming overvalued, lawmakers and
corporate executives have called for a probe of short sellers
since the demise in March of investment bank Bear Stearns.
The SEC has already said it will consider rules to address
abusive short selling issues across the entire stock market.
But it is unknown how the agency will craft that rule.
"We cannot have a segregated market where only the large
and connected get protected by the SEC," said former SEC
commissioner Roel Campos, now a partner at law firm Cooley
The American Bankers Association is lobbying the SEC to
include all publicly traded banks and bank holding companies
such as Washington Mutual Inc (WM.N) and Wachovia Corp WB.N,
which have been under pressure.
But the Coalition of Private Investment Companies and the
Managed Funds Association said they sent a letter to SEC
Chairman Christopher Cox on Monday urging against extending the
order in either duration or the securities currently covered.
"Such action would severely burden short selling activity,
which the SEC itself repeatedly has acknowledged plays a vital
role in the stability of securities markets," said James
Chanos, a well known short seller, who chairs the coalition.
The SEC's order only covers the primary dealers that have
access to the Federal Reserve's discount window and many of
those firms are foreign-based such as Swiss-based UBS AG
UBSN.VX and London-based HSBC Holdings (HSBA.L).
"I don't think you could limit it to those 19 names pushed
on the SEC by the Federal Reserve, to protect all dealers in
government securities," said John Coffee, professor at Columbia
Under pressure from the exchanges and the Securities
Industry and Financial Markets Association, the SEC on Friday
granted a partial exemption for market makers, or those who
facilitate trading in certain stocks.
Market makers don't have to pre-borrow stock before
executing a short sale in the 19 financial companies but must
deliver the stocks within the settlement period.
"I do think they will extend it (past the 30 days), because
the exemption... will largely nullify its effect," said
Short sellers arrange to borrow shares they consider
overvalued and sell them in hopes of making a profit when the
price drops. When an investor does not pre-borrow the shares
before shorting the stock, it's called a "naked" short sale,
which is illegal if done intentionally.
The SEC's rule is designed to end July 29, but can be
extended for a total of 30 days if the commission deems it
necessary to protect investors.
Within that time frame -- which is seen as a trial period
by some -- the agency will most likely have to prove that this
action has had some kind of impact on abusive short sales.
"The SEC will have to have better evidence that this is a
useful thing to do," said Jay Brown, a securities professor at
University of Denver Sturm College of Law. "What they can't do,
is do the same thing over again. They will either have to
expand the number of companies or kill it," Brown said.
Henry Klehm, a partner at Jones Day representing financial
institutions and others, said he would be surprised if the SEC
developed a permanent rule for specific stocks.
"They have to consider these things on a broader basis,"
Klehm said. I don't think they want to go with a specific class
of securities in the long run."
The SEC's emergency rule rattled the trading community,
which scrambled to understand how the rule would be enforced.
The unprecedented rule came after the SEC announced plans to
crackdown on rumormongering and has started examining whether
broker dealers and investment advisers have controls in place
to prevent market manipulation.
Others have been calling on the SEC to reinstate the
so-called tick test rule -- a rule that was adopted after the
1929 stock market crash.
The tick test, which was repealed June 2007, only allowed
short sales when the last sale price was higher than the
previous price. That meant a trader could not short a stock if
the movement prior to the short sale was down. One lawmaker,
Rep. Gary Ackerman, a Democrat from New York, has introduced
legislation to reinstate the rule but there is little time left
in the legislative year.
The SEC has pointed to studies that said the tick test did
not really make a difference to volatility or to how the market
performed and some think reversal unlikely.
"The whole process of eliminating the tick test was a long
regulatory debate," said Klehm, the securities lawyer.
Dylan Wetherill, president and founder of short interest
tracking service ShortSqueeze.com said the SEC's action on
rumors and short sales are speaking pretty clearly on what they
are trying to achieve.
"The rule extends protection to the downside," he said.
"They are testing it out, wanting to see the market's reaction.
If it does what they want it to do, they will continue it."
(Reporting by Rachelle Younglai; Editing by Tim Dobbyn)