SEC Short Selling Rules - Fallout for 130/30 and Hedge Funds?

Trading today may be wild as Wall Street back office staff and short sellers scramble to comply with new rules, imposed via emergency order by the U.S. Securities and Exchange Commission ("SEC"). By way of background, on July 15, 2008, the SEC issued "Securities Exchange Act of 1934, Release No. 58166/July 15, 2008," prohibiting naked short sales for 19 identified financial company stocks. (The company names and ticker symbols are shown below.)

The official stated goal is to avoid panic selling as a result of outright short trading and discourage false rumors. (A naked short contrasts with the situation whereby an individual borrows shares and then sells them at the prevailing market price. The short can be closed at a profit when the trader buys shares back at a lower price, assuming that prices do eventually fall).

Only a few days later, the SEC issued "Securities Exchange Act of 1934, Release No. 58190/July 18, 2008," amending its earlier emergency order and exempting certain parties such as "registered market makers, block positioners, or other market makers obligated to quote in the over-the-counter market, that are selling short as part of bona fide market making and hedging activities related directly to" the identified securities and related derivative instruments and exchange traded funds. The order is set to terminate at 11:59 p.m. EDT on July 29, 2008 "unless further extended by the Commission."

According to "SEC Short-Sale Rule Gets Negative Reviews," Wall Street Journal reporter Kara Scannell (July 19-20, 2008) reports that certain companies did not make the list but have nevertheless seen their stocks come under recent "selling pressure." Some firms complain that SEC list inclusion will add to jitters and thereby exacerbate woes for existing shareholders, big and small.

Important questions remain unanswered, notably the impact on non-exempted parties and their institutional investors. Take 130/30 managers. By their very nature, they short stocks they deem "over-valued." How will this SEC mandate impact quarterly 130/30 fund performance and beyond, especially if trading costs mount as a result of compliance? What about those pension plans that have allocated monies to 130/30 managers who are adversely impacted by the SEC order? Could their funding status be in jeopardy? The same concerns extend to hedge fund managers whose specified strategy requires short-selling in any or all of the SEC "specified" stocks. Additionally, will the regulatory effect be materially different if shorted shares already represent a large percentage of outstanding common equity?

Will the SEC emergency order solve one problem but create others?

Financial Services Firm Name (Ticker Symbols) Covered by the Order and Amendment:

  • BNP Paribas Securities Corp. (BNPQF or BNPQY)
  • Bank of America Corporation (BAC)
  • Barclays PLC (BCS)
  • Citigroup Inc. (C)
  • Credit Suisse Group (CS)
  • Daiwa Securities Group Inc. (DSECY)
  • Deutsche Bank Group AG (DB)
  • Allianz SE (AZ)
  • Goldman, Sachs Group Inc (GS)
  • Royal Bank ADS (RBS)
  • HSBC Holdings PLC ADS (HBC and HSI)
  • J. P. Morgan Chase & Co. (JPM)
  • Lehman Brothers Holdings Inc. (LEH)
  • Merrill Lynch & Co., Inc. (MER)
  • Mizuho Financial Group, Inc. (MFG)
  • Morgan Stanley (MS)
  • UBS AG (UBS)
  • Freddie Mac (FRE)
  • Fannie Mae (FNM)