The Securities and Exchange Commission issued an emergency order (the Order), on Tuesday, July 15, 2008, prohibiting the “naked” short sale of the securities of 19 financial service companies, including certain commercial and investment banks, as well as Fannie Mae and Freddie Mac. The Order requires that anyone who trades in the securities of these companies must actually borrow or arrange to borrow the securities prior to entering into the short sale and deliver the securities at the time of settlement. The Order supersedes the existing “locate” requirement that requires that the short seller have reasonable grounds to believe that the security can be borrowed to cover an open short position at the time of delivery.

The order goes into effect at 12:01 a.m. U.S. Eastern time on Monday, July 21 and terminates at 11:59 p.m. U.S. Eastern time on Tuesday, July 29, subject to further extension by the SEC.

The SEC stated that the purpose of the Order was to “stop the unlawful manipulation through ‘naked’ short selling that threatens the stability of financial institutions.” A “naked” short sale occurs when a seller does not borrow or arrange to borrow a security in time to deliver the security at the time the trade settles. The SEC declared that false rumors about certain financial service companies have led to a loss of confidence in the markets and fueled panic selling that has been aggravated by “naked” short sellers. These activities have caused disruptions in the markets and, according to the SEC, “there now exists a substantial threat of sudden and excessive fluctuations of securities prices generally and disruption in the functioning of the securities markets that could threaten fair and orderly markets.”

Under the Securities Exchange Act of 1934, effecting a short sale in contravention of SEC rules is unlawful. Even though the SEC did not identify the types of penalties that may be imposed for violations of the Order, it has a variety of remedies at its disposal, including cease and desist orders, injunctions and civil penalties, as well as the authority to refer violators for criminal prosecution.

In the short term, the Order likely will reduce short sales in the named securities, as well as increase transaction costs to short sellers, as short sellers will now have to hold, borrow or arrange to borrow the securities they wish to sell short, rather than relying on brokers to simply locate the securities prior to settlement. In the long term, the SEC has the authority to modify existing rules or issue additional rulemaking related to short sales. While the SEC did not indicate any intent to address the issue in this manner in the Order, there are reports that the SEC is considering whether to extend these short selling restrictions to all securities traded in the U.S. In addition, the New York Stock Exchange announced today that the SEC intends to grant limited relief for market makers; however, no additional guidelines have been released at this time.