An emergency SEC rule that will go into effect on Monday prohibits naked short selling of 19 financial companies including Freddie Mac and Fannie Mae. The SEC expects the rule to curb illegal shorting practices that several financial firms claim are causing unnecessary panic and capital market dysfunction.

Short selling is the process of borrowing shares, selling the shares immediately, and then buying the shares back in the open market after the price has gone down (in order to return the shares to the lender). The borrower pays a fee to the lender and earns the difference between the sale price and the purchase price (minus transaction costs). Short selling is a prediction that a stock is overvalued and will decrease in value, and proponents argue that it is an important check on inflated stock prices.

Naked short selling occurs when short sellers and the entities loaning the shares (market makers and brokerages) do not identify whether shares are available to be borrowed. Because actual share certificates do not necessarily change hands, and transactions are settled days after the sale occurs, shares can be shorted without ever being borrowed in the first place. This practice creates opportunities for abuse, and there have been allegations of the same shares being lent to different short sellers resulting in shares being sold that do not exist and more shares shorted than are available in the public float.

Short selling does not work unless the stock price goes down, and the stock price (in theory) does not go down unless unfavorable information about a company is introduced into the market place. Fraud occurs when the unfavorable information is intentionally false, and fraud has been illegal long before short selling rules were in place.

The emergency rule will only last 8 days, but the SEC is considering a more permanent resolution and has the power to expand the emergency rule for a total of 30 days if necessary.

The complete list of firms for which there can be no naked short selling follows:

  • BNP Paribas Securities Corp.
  • Bank of America Corporation
  • Barclays PLC
  • Citigroup Inc.
  • Credit Suisse Group
  • Daiwa Securities Group Inc.
  • Deutsche Bank Group AG
  • Allianz SE
  • Goldman, Sachs Group Inc.
  • Royal Bank ADS
  • HSBC Holdings PLC ADS
  • J. P. Morgan Chase & Co.
  • Lehman Brothers Holdings Inc.
  • Merrill Lynch & Co., Inc.
  • Mizuho Financial Group, Inc.
  • Morgan Stanley
  • UBS AG
  • Freddie Mac
  • Fannie Mae