SEC clamps down permanently on illegal "naked short-selling”

A temporary rule designed to cut down on “naked” short selling abuses has proven so effective that the SEC has decided to make it permanent.

Rule 204T, which was implemented last fall and was due to expire July 31, gave some real teeth to the SEC’s prohibitions on naked short selling by actually imposing penalties on firms that failed to deliver securities for settlement after selling them.

Short selling, a legal transaction that involves borrowing securities to sell them in anticipation that the price of the stock will fall, has come under fire from some critics in Congress and elsewhere, with claims that the practice exacerbated the financial crisis by pushing financial stocks lower.

Naked short selling, which is not legal, involves selling shares that the seller neither owns nor borrows. At the settlement three days after the trade, such a seller will generally “fail to deliver” the stock in question. Naked short selling has been blamed for driving numerous startups and small companies out of business when speculators gang up on a stock and force its price down. Lawmakers have put pressure on the SEC to stop the abuse.

Even after the SEC required broker-dealers to locate the shares that were going to be borrowed in a short sale, or rely on the seller to provide them, the abuses continued. The temporary rule required the clearing firm to borrow or purchase shares in order to close out a fail to deliver on the fourth day after the trade or face penalties.

The rule has had a significant impact, the SEC said. Since it went into effect last fall, fails to deliver in all equity securities has decreased by about 57 percent. What’s more, the daily list of so-called “threshold securities” – those with large and persistent fails to deliver, indicating widespread naked short selling – declined from its high of 582 securities in July 2008 to just 63 in March 2009.

The SEC also said it is working with self-regulatory organizations to get more disclosure of short sale volume and transactions to make the short selling market as a whole more transparent.
“Today's actions demonstrate the commission’s determination to address short selling abuses while at the same time increasing public disclosure of short selling activities that affect our markets,” said SEC chairman Mary Schapiro.

The agency will also hold a “roundtable” discussion on short selling on September 30. The SEC uses these roundtables, with several panels of experts, as a basis for further rulemaking.
At the September 30 roundtable, a topic that will be discussed is whether to launch a pilot program requiring short sellers to “pre-borrow” the shares to be sold, as well as other measures to foster transparency.