September's upheaval in the financial markets prompted international securities regulators, led by the United States Securities and Exchange Commission (SEC), to adopt emergency restrictions on short selling of certain financial stocks. The SEC also enacted emergency measures that effectively banned "naked" short-selling of all equity securities. In support of the SEC's measures and to avoid regulatory arbitrage, the United Kingdom's Financial Services Authority and some Canadian regulators also implemented emergency restrictions on short selling of certain financial stocks. In October, the U.S. and Canadian emergency measures against short sales of financial stocks were allowed to expire, but the SEC took further action to extend its restrictions against naked short sales.

We described the September emergency measures in an article that is now available on our website.1 In this article, we describe the SEC's ban on naked short selling, which appears to be permanent.

What is Naked Short Selling?

Short selling is the practice of selling securities the seller does not own, with the intention of acquiring the securities (or "covering" the short position) at a lower price in the future. The short-seller traditionally borrows the securities from a dealer for a fee and makes a profit based on how far the price of the security declines before he must pay for the covered securities.

For those unfamiliar with it, short-selling has historically been seen as somewhat of a black art. More recently, it has been blamed for contributing to the recent crisis in financial stocks and institutions. For example, Morgan Stanley's John Mack complained that short sellers wrestled his company's stock to the ground. The second largest pension fund in the U.S. called short-sellers "piranhas" and refused to lend stock to them. New York's Attorney General Andrew Cuomo likened short-sellers to "looters after a hurricane."

In a "naked" short sale, the short seller does not formally borrow the security (i.e. obtain a positive confirmation that the dealer is in a position to lend the shorted securities) before shorting. Furthermore, the short-seller does not meet the standard requirement for settlement by delivery of shares within three days of the trade (T+3 Settlement).

The fact that the naked short seller does not borrow the security puts downward price pressure on the security through what is in effect an artificial increase in the supply of that security. In a naked short sale, the short seller is at immediate risk of a buy-in if delivery of the shares is insisted upon by the buyer of the securities sold short. For this reason, naked short selling is often done with a very short-term outlook where price declines are in progress.

SEC Action Against Naked Short Selling

On September 18, 2008, the SEC adopted temporary measures against naked short-selling. Unlike the SEC's restrictions against short sales of certain financial stocks, these measures were not allowed to lapse. On October 14, 2008, the SEC extended these measures by adopting an interim final temporary rule (Rule 204T), effective as of October 17, 2008.

To avoid exacerbating price declines in securities, the SEC's new rule effectively prevents naked short selling by requiring a T+3 Settlement. The ban applies to naked short selling in all stocks, not just financial ones.

Under the rule, short sellers and their broker-dealers must deliver shorted securities for clearance and settlement by the close of business within three days of the date of the short sale. If they have not delivered the shares by the settlement date, they must immediately purchase or borrow securities to close out the fail to deliver position no later than the beginning of regular trading hours on the next day. A participant or broker-dealer who fails to comply with this rule may not accept further short sales in that stock, unless it has previously arranged to borrow or has borrowed the security, until the fail to deliver position is closed.

The SEC also adopted a final rule that makes options market makers subject to the T+3 Settlement requirement.

As part of these efforts, on September 18, 2008, the SEC also adopted on a temporary basis a new anti-fraud rule under Section 10(b) of the Exchange Act to address deceptive short selling practices. On October 14, 2008, the SEC made this rule permanent, effective October 17, 2008.

New Rule 10b-21 provides that short sellers who make misrepresentations about their intent and ability to deliver equity securities in compliance with the T+3 Settlement requirements are in violation of the law when they fail to deliver the securities as represented. This rule is intended to flush out the situation where the short seller does not advise the broker that the shares are being sold short but rather directs the broker to sell shares which are not in the account on the basis of an implied promise by the seller to lodge the shares before settlement is required or buy them back and cover at that time.

Canadian Restrictions to Come?

The SEC coordinated some of its recent activity to stabilize markets with the United Kingdom's Financial Services Authority, which passed some similar measures. Canada's financial sector has not been rocked as severely by sub-prime loan related market turmoil and the imperatives for action have not appeared as compelling as they have in the U.S. and perhaps the U.K. With respect to short-selling specifically, Canadian short selling rules require that the short sale must occur at a price that is euqual to or higher than the previous trade, which inhibits short selling in a falling market. The SEC did away with its uptick rule last year, which likely exacerbated the current problem with short-selling in the U.S. Although possible, it is unlikely that Canadian regulators will pass significant, permanent restrictions on short selling, as the current rules appear to address the concerns that led to the restrictions in the United States.