On July 15, 2008, the US Securities and Exchange Commission (the “SEC”) issued an emergency order (the “Emergency Order”) to protect against “naked” short sales1 in the securities of certain financial institutions2 by requiring short sellers to borrow or arrange to borrow the stock at the time of the sale. Currently, under Regulation SHO, such sellers are only required to “locate” the stock and reasonably believe it will be available for borrowing.

The SEC is particularly concerned with the negative effects of unsubstantiated rumors and naked short selling on the securities of certain financial institutions and is investigating the possible contributions of such conduct to the demise of Bear Stearns. Recent downward movement in the price of shares of Fannie Mae, Freddie Mac3 and Lehman Brothers have added to the concern. Although the SEC’s adoption of Regulation SHO, which imposed more stringent locate requirements on short sales and buy in rules in connection with ongoing fails in the delivery of certain “threshold securities,” was intended to address abusive short sale practices, the SEC continues to be concerned that concerted short selling activity, combined with the dissemination of unsubstantiated rumors, may be artificially driving down prices.

The Emergency Order is the latest of a number of SEC initiatives that have significantly impacted the regulation of short sales. With the adoption of Regulation SHO in 2005, the SEC instituted a pilot program under which the “uptick rule” was eliminated for certain highly liquid securities. This program led to the ultimate elimination of the rule, which required that a short sale could only be done on a “plus tick” or “zero-plus tick,” as to all equities. The uptick rule was regarded as the primary mechanism through which issuers could be protected against short sellers creating a downward spiral in their stock. The SEC, however, concluded that the elimination of the rule would have minimal impact on the overall market, particularly since the development of more sophisticated alternative instruments, such as equity swaps and single stock futures, allowed traders to effectively short securities without using a traditional short sale. Many market observers, however, believe that the elimination of the rule has increased market volatility and have advocated the reinstatement of the uptick rule.

The Emergency Order takes effect on Monday, July 21, 2008 and will terminate on July 29, 2008, unless extended by the SEC. The action marks an unusual action by the SEC in connection with a short-term market disruption. Although recent market events have suggested that financial stocks may be a particular focus of short sellers and unsubstantiated rumors, it is difficult to rationalize the SEC’s limiting the Emergency Order to that sector. The SEC has indicated that it may extend the Emergency Order to all equities, and that it will consider making the conditions of the Order part of a permanent rule.

Given the timing of the effectiveness of the Emergency Order, broker-dealers, particularly those acting as prime and clearing brokers, will have to quickly modify their systems and procedures to facilitate compliance with the Order. On July 18, 2008, the SEC amended the Emergency Order to allow registered market makers, block positioners and the OTC market makers to sell short in connection with bona fide market making activities without borrowing or arranging to borrow the securities subject to the Order. These persons are still required to make delivery.