SEC Order On Naked Short Selling Takes Effect

By Christopher Twarowski
Washington Post Staff Writer
Tuesday, July 22, 2008

An order from the Securities and Exchange Commission aimed at protecting some of the country's largest financial companies against a form of short selling took effect yesterday, provoking complaints from smaller firms that they have been left vulnerable to the practice.

Shares of the 19 large companies in the SEC's order have been rising since the commission announced last week that it would shelter them from the practice, known as naked short selling, while organizations representing banks and investment firms excluded from the list have been pressing to have the protection extended to them.

Edward L. Yingling, president of the American Bankers Association, said yesterday that executives of small banks around the country say they are now being targeted.

"They believe that the short sellers moved to their stocks," said Yingling. "They're not that big, and they don't have that many shareholders, so that if there is a short sell attack on one of these institutions, it really can be very harmful because they could move the stock price a lot, without much effort."

In regular short selling, which is legal, a seller borrows shares of a security, such as a stock, from a broker and then sells it in the hope that the security will decrease in value. The seller buys it back later and returns it to the lender, profiting if the price has in fact dropped.

In naked short selling, the seller doesn't actually borrow the security but conducts the rest of the transaction as if he had. Since the seller is not constrained by the number of available shares, he can sell an unlimited number of securities that may not even exist. In large volumes, naked short selling can depress a company's stock by creating sustained downward pressure and ultimately destroy it, driving down the price until it is worthless, critics say.

The SEC's order, issued last Tuesday, provides further protection against abusive naked short selling -- which was already barred by securities law with only a few exceptions -- to 19 companies, including mortgage giants Fannie Mae and Freddie Mac and leading Wall Street investment banks Goldman Sachs, Merrill Lynch and Lehman Brothers, among others.

The commission required that traders get a commitment from a lender to supply the securities before selling them short. The order differs from existing law, which applies to all securities and requires only that sellers identify actual shares available to be borrowed before proceeding with a short sale.

The order is set to expire July 29, but the SEC may extend it for a full month and could broaden it to cover more companies.

The ABA, which represents 8,500 banks, last week wrote a letter to SEC Chairman Christopher Cox expressing fear that naked short sellers would turn their attention to the banks and bank holding companies not on the list. The Financial Services Roundtable, which represents 100 of the largest financial services companies in the country, sent a similar letter.

Yingling said firms were especially vulnerable because of the repeal last year of the SEC's uptick rule, which restricted short selling if the price of the stock being sold was less than the previous trade. That meant only securities whose prices were rising could be shorted. Now, short sales can have a cascading effect on stocks, driving their share prices continuously downward.

In the current financial environment, short selling can be especially harmful to banks and brokerage firms because customers and investors may view sinking stock prices as a sign of trouble and react by withdrawing deposits, Yingling said.

But the SEC's action could create severe difficulties for regular short selling, which is used by investors to profit on the negative performance of a security, according to the Coalition of Private Investment Companies and the Managed Funds Association. In a letter to Cox yesterday, the groups urged him not to extend the order beyond July 29.

"Restrictions on short sales distort the fundamentals that drive market prices and are, in the long run, counterproductive because they remove liquidity and healthy skepticism from the marketplace," CPIC Chairman James S. Chanos said.

Naked and abusive short selling are not new. Robert J. Shapiro, a former undersecretary of commerce for economic affairs, testified before the SEC's rules committee in 2003 about the then-growing problem. He noted that one form of manipulative short selling that was widespread in the 1990s, called death-spiral financing, created "strong incentives for large-scale naked short sales focused on small and medium-size public companies." His research found that a sample of 200 companies victimized by the technique posted a combined market loss of more than $105 billion.

Shapiro, who is chairman of Sonecon, a District economic advisory firm, said in an interview yesterday that the troubled financial market had made it possible for naked short sellers to affect much larger companies than before, including the major firms covered by the SEC order.

"Finally, the real concern has arisen because the target of it is a financial institution whose failure could pose a systemic risk to the capital markets," Shapiro said. "That's why they're concerned. But the phenomenon has been around in significant scale, and cost thousands, maybe millions, of investors money, who have been in stocks that have been driven down by naked short sellers for years now."

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