The order, effective July 21, 2008, imposes strict prohibitions on effecting short sales in the shares of specified financial institutions if the short seller has not first borrowed or arranged to borrow the securities being sold short.

As has been widely reported, on Tuesday, July 15, 2008, the U.S. Securities and Exchange Commission (SEC) issued an emergency 30-day order (Order), to become effective on Monday, July 21, imposing strict prohibitions on effecting short sales in the shares of specified financial institutions if the short seller has not first borrowed or arranged to borrow the securities being sold short. Click here to view the Order. While these prohibitions do not radically differ from requirements already in effect (and that will continue to be in effect) with respect to all stocks, they combine with actions to root out market manipulation that might have a significant effect on certain kinds of short selling practices. The financial institutions in question are listed in the Order.

The explanation accompanying the Order concentrates on the ill-effects of rumor mongering and the possibility that stock prices of financial institutions have been manipulated to the downside, all of which the SEC says it is vigorously investigating. From a technical perspective, however, the changes wrought by the Order could be seen as small. Regulation SHO under the Securities Exchange Act of 1934 (Exchange Act rules 200-203) provides that a broker-dealer may not accept or effect a short sale order on an equity security unless it either (1) has borrowed or entered into a bona fide arrangement to borrow the shares for its own account or (2) has “reasonable grounds” to believe (e.g., on the basis of adequate client assurances) that the shares can be borrowed so that they can be delivered on the date delivery is due. The Order in effect provides that “no person” (whether or not a broker-dealer) may engage in a short sale of the designated securities unless it has complied with the first of these requirements or “otherwise has the security available to borrow in its inventory” and actually delivers the securities on the short sale settlement date.

In effect the Order therefore straightforwardly prohibits naked short selling, which is already illegal if engaged in deliberately and is the subject of a proposed explicit antifraud rule under section 10(b) of the Exchange Act that the SEC noticed for adoption in March (Exchange Act Release 34-57511 (March 17, 2008)). The Order is also consistent with modifications of Regulation SHO adopted in 2007 that tightened requirements to promptly close out failed short sale deliveries in the case of “threshold securities” (i.e., securities that have experienced a defined level of delivery failures) by removing an exemption for “grandfathered” failures that occurred before the security in question became a threshold security. The SEC has taken those actions in response to criticisms of short selling by issuers and in the political arena, and is also considering whether to remove a grandfathering exemption that currently applies to options market makers when a security is classified as a threshold security (Exchange Act Release 34-58107 (July 7, 2008)).

As noted in the SEC’s proposing release for the antifraud rule, failure to deliver in a short sale in effect turns a sale transaction for a security into a futures contract (since the seller’s obligation to deliver to the buyer persists) and can deprive buyers of rights of ownership. Systematic engagement in failed transactions could also accentuate downside pressure on a stock that is the subject of manipulation through the dissemination of adverse rumors. Because such practices are already illegal, however, it is not clear how often they occur. Furthermore, in promulgating the Order the SEC did not cite evidence of unusual levels of failed deliveries in the named stocks or imply that they might be approaching threshold security status. As a result, it may be that the Order will have little actual effect on most short transactions executed in the market other than to mildly retard short selling in these stocks and send a shot across the bow of traders perceived to be acting on the basis of potentially manipulative rumors. According to press reports certain practical issues are also being hashed out, including the effect of the Order on options market makers. The effect of the SEC’s actions in this circumstance will bear watching and could presage other more general modifications in Regulation SHO.