U.S. SEC under pressure to extend short sale ban

BOSTON/WASHINGTON, Sept 30 (Reuters) - Dizzying drops like the Dow Jones industrial average’s 7 percent plunge on Monday may prompt U.S. securities regulators to extend a short selling ban beyond Thursday.

Hedge fund managers and large institutional investors bitterly oppose the restriction imposed by the U.S. Securities and Exchange Commission, saying it has contributed to sharp market swings. But securities experts say the SEC is under pressure to take whatever action it can to help calm financial markets rattled by the uncertain legislative fate of a $700 billion federal bailout plan.

“I suspect they will extend it, given what is going on in markets,” said Keith Miller, a former SEC enforcement lawyer who now advises broker dealers, investment banks and financial firms as a partner at law firm Paul Hastings.

On Tuesday, markets swung sharply in the other direction, recording its best day in six years with the Dow industrials up 485 points.

About two weeks ago, the SEC ordered traders, including hedge funds, to stop short selling nearly 800 financial stocks such as financial titans Goldman Sachs Group Inc GS.N and Citigroup Inc C.N.

Since then, regulators have expanded the list to more than 950 companies, including General Electric Co GE.N and other less obvious candidates such as drug store chain CVS Caremark Corp CVS.N.

The emergency measure also required large managers to disclose what stocks they are selling short, or betting on a price drop.

The order is set to expire on Thursday at midnight unless SEC commissioners decide to extend it.

If the agency decides to extend the ban, it can do so only for a maximum of 30 days in total.

Other regulators in the United Kingdom, Canada, Australia and Germany have imposed similar bans on short selling, increasing the pressure on the SEC to remain in lock-step with them.

“The markets continue to be very fragile. Investors and all players must believe that all measures are being used to protect financial institutions from improper shorting,” said former SEC commissioner Roel Campos.

“It is not acceptable for the SEC to be protecting its markets less than other countries, like the U.K. and Australia, where shorting is currently banned,” added Campos, now in private practice at Cooley Godward Kronish.

Regulators around the world argued that short selling bans would help stabilize trading by keeping financial companies such as Morgan Stanley, whose share price plunged two weeks ago, from falling victim to so-called short sellers. Some executives blamed these traders, mostly hedge funds, for bringing down Lehman Brothers Holdings Inc LEHMQ.PK.

In mid July, the SEC issued a temporary emergency order to crack down on illegal naked short selling in 19 financial firms such as Fannie Mae FNM.N and Freddie Mac FRE.N. That order was also deeply unpopular. Other companies wanted to be included and short sellers were furious they were being singled out.

Like the July order, which was first issued for just over a week and then extended for another 10 trading days, SEC watchers expect the agency to do the same.

“I predict another 10 days under the SEC’s emergency authority with some possible adjustment to the list of companies involved. It is hard to say that it’s doing any good, but the SEC will not want to seem uninvolved in the current turmoil,” said Jay Brown, a securities professor at University of Denver Sturm College of Law.

“The SEC put the ban in place, without, in my opinion, good evidence that short sales were contributing to market instability.”

Managers in the $1.9 trillion hedge fund industry argue the rules are attacking them and putting dozens of these loosely- regulated portfolios out of business.

Hedge funds, unlike mutual funds, routinely rely on selling stocks short, or betting their price will drop, to hedge their portfolios. Under the ban, many managers said they have not been able to trade effectively, have suffered heavy losses and had investors hastily pull out millions of dollars.

In September, the average hedge fund lost about 5 percent, according to preliminary data from Hedge Fund Research, leaving the industry with losses of roughly 10 percent this year, the biggest ever declines.

“Certainly a lot of hedge funds would like the orders to expire, particularly the disclosure rule because that is what is keeping them from trading,” said Laurel FitzPatrick, a partner who heads the hedge fund practice at law firm Ropes & Gray.

Hedge fund managers have said they are urging regulators to drop the rules, but are getting no clear indication of what may happen next after Congress voted down a proposed government bailout plan on Monday.

Several managers said they have asked the Managed Funds Association, the industry lobby group, to appeal to regulators on their behalf, saying they want MFA lawyers to underscore just how debilitating the bans really are. (Editing by Andre Grenon)