On July 15, 2008, the Securities and Exchange Commission (the "SEC") issued an emergency order restricting the use of "naked" short sales in the securities of nineteen major financial institutions. The SEC's order came in the wake of increased disclosure requirements implemented by the Financial Services Authority in England (the "FSA"). The FSA mandated that any trader short-selling 0.25% or more of a company's securities during a rights issuance disclose its position to the public.
While the new English regulations primarily affect the transparency of financial activities, the SEC's emergency order impacts the actual mechanics of short-selling. The order states in relevant part:
[N]o person may effect a short sale in these [nineteen] securities using the means or instrumentalities of interstate commerce unless such person or its agent has borrowed or arranged to borrow the security or otherwise has the security available to borrow in its inventory prior to effecting such short sale and delivers the security on settlement date.
The SEC further stated that "[s]hort sales to be effected as a result of a put options exercise are subject to this Order. In addition, we note that short sales used to hedge would also be subject to this Order." The order was issued pursuant to the SEC's power under Section 12(k)(2) of the Securities Exchange Act of 1934. It went into effect at 12:01 a.m. EDT on July 21, 2008 and will remain in force through 11:59 p.m. EDT on July 29, 2008. The SEC may extend the order to a maximum of 30 total calendar days upon a determination of continued threat to the public interest.
Prior to the issuance of the order, the SEC had adopted Regulation SHO to govern the short sales of securities. Regulation SHO imposes a "locate" requirement on broker-dealers such that they must have "reasonable grounds" for believing that they will be able to borrow the security in question prior to the delivery date. By contrast, the emergency order issued by the SEC requires that any person short-selling a security must have either borrowed, or arranged to borrow, the security before effecting the sale.
On July 18, 2008, the SEC issued an amendment to the emergency order, as well as a statement offering interpretive guidance for the new regulation. The amendment had four principal effects. First, it carved out an exception for Bona Fide Market Makers, provided that they are engaging in bona fide marketmaking and hedging activities. Second, it affirmed that provision of documentation confirming that the shortseller has borrowed or arranged to borrow a given security may follow the same processes that are used to document compliance with Regulation SHO. Third, it exempted individuals that effect short sales pursuant to Rule 144 of the Securities Act of 1933. Finally, it exempted short sales made by underwriters or members of a syndicate.
The guidance statement issued by the SEC clarified a number of ambiguities in the emergency order. The statement provided that a person effecting a short sale on behalf of a customer may rely on that customer's representation that he or she has arranged to borrow the securities as long as the person has "reasonable grounds" to believe the customer's representations. The guidance statement also reaffirmed that the emergency order applies to any short sale of the specified securities in which either the trade is agreed to in the United States, a customer is located in the United States, or any broker-dealer using the means or instrumentalities of interstate commerce in the United States.
The initial effect of the SEC's emergency order was a dramatic decline in short sales, as reported in The Wall Street Journal (July 23, 2008). Short sales in the securities of the nineteen specified financial institutions declined by roughly 70%, with short sales of Fannie Mae and Freddie Mac each declining by about 90%, even though these were easy-toborrow securities. The long-term effect of the new regulation remains ambiguous because of its transient nature. It is clear, however, that the SEC is concerned with the impact of shortselling on market stability. Should the SEC implement the new regulation on a permanent basis, or expand it to other securities, as SEC Chairman Cox indicated in testimony before the U.S. House of Representatives Financial Services Committee on July 24, 2008, it is likely that the volume of short sales will remain depressed, which can have adverse effects on the demand for securities borrowing.
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