Thought Winter 2008

SEC's Temporary Ban on Short Sales Falls Flat

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In September, the SEC undertook emergency measures pertaining to its regulation of short selling in light of the ongoing credit crisis. Unfortunately, it proved to deliver only a short-term, hollow boost to troubled markets.

In late September 2008, the Securities and Exchange Commission (SEC) issued an emergency ban on the short selling of financial stocks. The move came nearly in lock-step with a similar initiative by the Commission's UK counterpart, the Financial Services Authority (FSA), whose temporary four-month ban also targets the short selling of financial stocks.

The SEC's orders, which aimed to halt the rapid decline in value of banking stocks, were part of a larger government intervention effort to stem the damage of the ongoing credit crisis. While the short-term goal of the ban was to restore a sense of equilibrium to turbulent markets, it appears that the measure did little to accomplish this.

What the Ban Intended
Essentially, the SEC temporarily prohibited all short sales of publicly traded common equity securities ("covered securities") of 799 financial stocks, as prepared by the national securities exchanges, also called the Financial Firms Order. The Order contained exceptions, however: (1) bona fide market makers; (2) short sales resulting from automatic exercise or assignment of an equity option, or, short sales in connection with the settlement of an expiring futures contract (entered into prior to September 28, 2008, the Order's effective date); and (3) writers of call options that effect short sales in covered securities. In addition, the ban did not apply to preferred stocks or debt securities, including convertible preferred and debt. At the time it was issued, a primary concern for the fund industry was whether the ban would impede the operation of registered 130/30 funds, and what disclosures would be necessary to investors as a result.

Awaiting the Results

Such concerns dissipated after October 8, however, when it became clear that the ban had had little effect on the troubled financials sector. According to Columbia Business School Professor Charles Jones, the ban gave financial stocks a temporary boost, which proved to be short-lived.¹

In fact, some market watchers believe that the ban did more harm than good.² Early evidence shows the ban was counterproductive, according to Arturo Bris, a finance professor at IMD, a business school based in Switzerland. Says Bris, "by not allowing shorting, the market has dropped even more. Short sellers act as a cushion," likely referring to the fact that typically, in falling markets, short sellers often step in as buyers to cover their positions.

SEC economists are now studying the impact of the short-sale ban. And, some large institutional investors say that they will work to keep certain shares out of the hands of short sellers.³

With regulators, policymakers and legislators moving at unprecedented speed in acting to stem the mortgage crisis, fund advisers are well advised themselves to stay current regarding the SEC's moves in the wake of the ban's expiration. Whatever the outcome, rapidly changing conditions and a highly volatile market environment call for vigilance in keeping abreast of SEC activity during the months ahead.

To stay current regarding the SEC's activity on this and related subjects, visit their Web site for regular updates at: http://www.sec.gov/spotlight/ emergencyactions.htm .

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¹ WSJ.com, "Short-Sale Ban Ends to Poor Reviews," by Kara Scannill and Craig Karmin, October 9, 2008. http://online.wsj.com/article/SB122351280409217645.html?mod=googlenews_wsj

²Ibid.

³Ibid.

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