NEW YORK/WASHINGTON (Reuters) - A steep sell-off in shares of struggling investment bank Lehman Brothers Holdings Inc has revived questions about whether the U.S. Securities and Exchange Commission is doing enough to fight short-selling abuses.
During late July and early August, Lehman was under the protection of an emergency SEC rule to curb abusive short-selling. The SEC also said in July it was boosting efforts to stop the spread of false rumors that threaten financial institutions.
But the emergency rule expired August 12 with a promised permanent rule still to come.
“It is no coincidence that the bottom of the market in July was the exact day that the SEC announced the rule to restrict naked short selling, and the top of the rally was the day when the SEC announced they would end the rule,” said Dylan Wetherill, president of short interest tracking service ShortSqueeze.com.
This week, Lehman shares dropped 45 percent on Tuesday after reports of a collapsed deal with a Korean bank, and fell 42 percent on Thursday as investors doubted its plan to sell assets to cover trouble real estate investments.
“If the SEC has an interest in helping to save the market from the powerful short sellers, it will reinstate (the rule to curb illegal shorting,)” Wetherill said.
But it isn’t clear how short sellers were involved in the drop in Lehman shares this week. About 11 percent of Lehman’s shares outstanding were held short in late August, according to the latest New York Stock Exchange data.
SEC spokesman John Nester said agency staff expect to present recommendations for commission consideration as early as this month to provide additional protections against abusive naked short selling.
As the markets swooned in mid-July, driven by fears that mortgage giants Fannie Mae and Freddie Mac would collapse, the SEC issued an emergency rule requiring short sellers to pre-borrow stock when shorting 19 major financial stocks, including the mortgage titans and Lehman.
It was greeted with skepticism from short sellers, who said they were being unfairly targeted, and anger from companies wanting the same protections.
Short sellers arrange to borrow shares they consider overvalued and sell them in hopes of buying them back at a profit when the price drops. Naked shorting is when an investor sells stock that has not yet been borrowed. It is illegal if done intentionally.
While often criticized by companies and shareholders, the short sellers say they stop shares from being overvalued.
James Chanos, a well known short seller, has said short selling plays a vital role in market stability. Similarly, the SEC has been quick to say that short selling is legitimate.
“Short sellers are really the people you want at the bottom to be able to get in and out of a stock,” said Bill Rhodes, president of Rhodes Analytics, noting how Malaysia’s stock market suffered from liquidity problems after it banned short-selling in 1997 during the Asian financial crisis.
”You want to shut down the abuses and you want to shut down the sloppiness, but you don’t want to throw the baby out with the bathwater.
During the emergency rule, traders were required to pre-borrow stock in the 19 companies before executing a short sale. Short sellers were also required to deliver those securities by the settlement date. Market makers were exempted from the pre-borrow requirement.
From mid-July to late July, short interest in 17 of the stocks listed on the New York Stock Exchange dropped an average 5.3 percent, but it wasn’t clear how much of that decline came from legitimate short selling or illegal naked shorting.
Two studies reported that the emergency rule had little impact on the stock prices of the protected financial firms and may have backfired.
Finance professor Arturo Bris, at the IMD business school in Lausanne, Switzerland, found market efficiency had deteriorated for the 19 stocks, and the firms lost about 3.8 percent of their value, while the rule was in effect, compared to their peers.
Now, the SEC is back at the drawing board and expected to go through its regular rulemaking process to strengthen rules against abusive illegal shorting.
“There’s strong political pressure to curb short selling and there is little support for naked short selling,” said John Coffee, a professor at Columbia University Law School.
“They should follow up fairly promptly. Before the end of the summer... is appropriate for them to come up with proposed rules.”
SEC Chairman Christopher Cox has said he wants a market-wide solution and is considering proposing that investors be required to publicly disclose substantial short positions in stocks, as investors already do for substantial long positions.
The American Bankers Association, a trade group representing banks of all sizes, has pushed the SEC to extend the emergency rule to all stocks.
The SEC has already proposed a rule that would no longer allow option market makers to short stock without pre-borrowing the security. Currently, option and equity market makers are not required to locate a source of shares ahead of time to ensure markets remain liquid.
The SEC is also expected to strengthen its current short selling rule, also known as Regulation SHO, which requires investors to locate a share to borrow before executing a short sale and to deliver those securities by settlement date.
Editing by Tim Dobbyn