On Tuesday July 15, 2008, the Securities and Exchange Commission (the “Commission”) issued an emergency order (the “Order”) requiring traders to borrow or arrange to borrow stock before shorting the securities of 19 specified financial services companies. The Order supplants existing “locate” requirements that currently require only that a short-seller receive reasonable assurances that stock will be available to cover an open short at the time of delivery. The new “pre-borrow” requirement reduces the amount of short selling possible in these securities, as shorting in any issuer will be limited by the amount of long inventory available to borrow. The Order will likely make short selling the specified securities more difficult and more expensive.

According to the Commission, there is a “substantial threat” of “disruption in the function of the securities markets” created by the spreading of false rumors and “naked” short selling. “Naked” short selling occurs when the short seller does not deliver the "located" stock at settlement. The Commission expressed concerns that “naked” shorting is occurring because multiple investors are sourcing the same inventory of stock for the purposes of meeting the existing “locate” requirements. According to the Commission, such “naked” shorting, in connection with the spreading of false rumors, together may artificially drive down the share price. Highlighting its sense of urgency in issuing the Order, the Commission stated that “[i]n recent days, false rumors have continued to threaten market disruption.”

The Order takes effect at 12:01 a.m. EST on Monday, July 21, 2008, and terminates at 11:59 p.m. Tuesday, July 29, 2008, and the Commission has the power to extend the Order up to 30 days from July 21. The stocks subject to the Order are listed at the bottom of this alert.

Press reports indicate that the Commission may supplement the Order with rulemaking that would replace existing short-selling requirements for all equities with a requirement that delivery stock be pre-borrowed prior to establishment of a short position. Such rulemaking may affect securities lending programs, as a “pre borrow” requirement would likely necessitate having securities in the inventories of investment banks, or with the investors who intend to short sell. Such rulemaking might also increase the demand for other financial instruments, such as credit default swaps, if investors look for other ways of profiting from declining securities. Finally, “short squeeze” scenarios are possible in any names where the short interest exceeds long inventory, as industry participants will have to buy into the market to cover, causing stock prices to rise.

Although the Commission did not specify the penalties that will stem from failures to comply with the Order, Section 10(a)(1) of the Securities Exchange Act of 1934 makes unlawful any short sale effected in contravention of SEC rules. The Commission has a wide array of potential remedies it can seek to redress alleged Exchange Act violations including: injunctions, cease and desist orders, civil penalties, disgorgement, and orders barring individuals from the securities industry. The Commission also has the ability to refer matters to the Department of Justice for potential criminal prosecution. There also may be private civil remedies and enforcement actions by the self-regulatory organizations.

The Order is part of a recent series of SEC initiatives regarding short-selling. In March, 2008, the SEC proposed a new antifraud rule which would apply to any short seller found to have misled its broker about the source of borrowable shares in connection with the “locate” requirements. In April, 2008, the SEC charged a trader with securities fraud and market manipulation for spreading false rumors about an issuer so he could profit by shorting the issuer’s shares. And on July 13, the Commission announced an immediate series of examinations of broker-dealers and investment advisers aimed at the prevention of the intentional spreading of false information intended to manipulate securities prices.

Stocks Subject to Emergency Order

  • BNP Paribas Securities Corp. (BNPQF/BNPQY) 
  • Bank of America Corp. (BAC) 
  • Barclays PLC (BSC) 
  • Citigroup Inc. (C) 
  • Credit Suisse Group (CS) 
  • Daiwa Securities Group Inc. (DSECY) 
  • Deutsche Bank Group AG (DB) 
  • Allianz SE (AZ)
  • Goldman Sachs Group, Inc. (GS) 
  • Royal Bank ADS (RBS) 
  • HSBC Holdings PLC ADS (HBC/HSI) 
  • J.P. Morgan Chase & Co., Inc. (JPM) 
  • Lehman Brothers Holdings Inc. (LEH) 
  • Merrill Lynch & Co., Inc. (MER) 
  • Mizuho Financial Group, Inc. (MFG) 
  • Morgan Stanley (MS) 
  • UBS AG (UBS) 
  • Freddie Mac (FRE) 
  • Fannie Mae (FNM)

For additional SRZ Alerts related to short selling, see:

Regulators Investigating Market Rumors

UK FSA Issues on New Short Selling Rule

UK FSA Rule on Short Selling in Rights Issues, Effective 20 June 2008