The U.S. Securities and Exchange Commission (the "SEC") took unprecedented emergency action last week in an attempt to help calm the U.S. financial markets in general, and temper the trading volatility of the securities of financial institutions in particular. The SEC measures follow the significant and unsettling events early last week surrounding Lehman Brothers, AIG, and Merrill Lynch, and culminating over the weekend in the action of the U.S. Federal Reserve to convert Goldman Sachs and Morgan Stanley into bank holding companies and Congress proposing a $700 billion financial bailout plan. The SEC, the Federal Reserve, and Congress all acted with the stated purpose of restoring confidence to U.S. financial markets and U.S. financial institutions.
Emergency Order Prohibiting Short Selling of Financial Firms
In SEC Release No. 34-58592, dated September 18, 2008, the SEC adopted rules to prohibit short selling with respect to certain "financial firms," including banks, insurance companies, and securities firms. The prohibition extends to approximately 800 financial firms identified in the SEC's Emergency Order. While the Emergency Order takes effect immediately, it is temporary and will end at midnight (EDT) on October 2, 2008, unless extended by the SEC.
According to the SEC, the measures are in the public interest and are intended to prevent sudden and excessive market fluctuations of securities prices of financial firms and to help restore confidence in the financial system. The SEC's emergency action to halt all short selling with respect to the securities of certain financial firms is taken in addition to new short selling rules the SEC instituted earlier last week with respect to "naked" short selling of all securities, as discussed below.
In a related move, the U.K. Financial Services Authority (the "FSA") on September 19, 2008 published Short Selling (No 2) Instrument 2008, which came into effect immediately. The Instrument prohibits short selling with respect to any U.K. financial sector company, including banks and insurance companies. The FSA has published a list of the U.K. banks and insurers (32 in total) to which the Instrument applies. The measures in the United Kingdom are to remain in force until January 16, 2009, although the FSA has stated it will keep this date under review in light of market conditions. Other countries, including Australia, Taiwan, and The Netherlands, have also enacted new rules to limit short selling.
Emergency Order Prohibiting "Naked" Short Selling
On September 17, 2008, the SEC adopted new short selling rules instituting a hard settlement requirement (three days after the sale transaction date, or T+3), and imposing penalties for failure to adhere to the new rules. In SEC Release No. 34-58572, the SEC is curbing the use of "abusive naked" short selling (i.e. selling a stock short without first borrowing the shares or ensuring that the shares can be borrowed). Unlike the SEC's July 15, 2008 and September 18, 2008 Emergency Orders that apply only to certain financial firms, the new naked short selling rules apply to the securities of all public companies, including companies in the financial sector.
The new naked short selling rules require that short sellers and their broker-dealers deliver securities by the close of business on the settlement date, T+3, and impose penalties for failure to do so. If a short sale violates this close-out requirement, then a broker-dealer acting on the short seller's behalf will be prohibited from further short sales in the same security unless the shares are not only located, but also pre-borrowed. This prohibition on broker-dealers will apply not only to short sales for the particular naked short seller, but to all short sales of that security for any customer. While these new rules go into effect immediately, the SEC has provided a 30 day comment period expiring October 17, 2008.
In addition, the SEC also adopted on September 17, 2008 new Rule 10b-21 under the Securities Exchange Act of 1934 (the "Exchange Act") entitled "Deception in connection with a seller's ability or intent to deliver securities on the date delivery is due." Rule 10b-21 states that short sellers who deceive broker-dealers or any other market participant regarding their intention or ability to deliver securities in time for settlement are engaging in conduct that constitutes a "deceptive or manipulative device or contrivance" - as such terms are used in Section 10(b) of the Exchange Act.
Emergency Order Requiring Disclosure of Short Positions
In yet another significant Emergency Order issued by the SEC on September 18, 2008, SEC Release No. 34-58591, the SEC will now require hedge funds and other large investors to disclose their short sale trading activity and positions.
The new reporting rules will require every institutional investment manager with investment discretion covering more than $100 million of "section 13(f) securities" that filed or was required to file Form 13F for the calendar quarter ended June 30, 2008 to begin reporting each week their daily short sale trading activity and positions for the previous week. This information is to be filed via EDGAR on new Form SH (instructions) and must include (i) the number and value of section 13(f) securities (excluding options) sold short during the day, (ii) daily opening and closing short positions (gross, not net), (iii) the largest intraday short position, and (iv) the time of the largest intraday short position - in each case for every security on each calendar day of the prior week in which the manager engaged in short sale transactions. Pre-existing short positions do not have to be reported.
There is, however, some relief from the new reporting rules. A manager does not have to report a short position otherwise reportable if (i) such position involves less than 0.25 percent of the class of securities issued and outstanding, and (ii) the value of the position is less than $1,000,000. This Emergency Order is also temporary and, unless extended by the SEC, will be short lived. It takes effect today, requires an initial Form SH to be filed on September 29, 2008, and will end at midnight (EDT) on October 2, 2008. Lastly, the SEC over the weekend indicated that the information reported on Form SH will remain non-public for two weeks following the reporting date.
Emergency Order Easing Issuer Repurchases
In a related Emergency Order issued to help stabilize the securities markets, SEC Release No. 34-58588, the SEC has temporarily relaxed the timing and volume restrictions on the repurchase of securities by their issuers.
When an issuer believes that its stock price is undervalued in the market, it will often engage in repurchases of its stock to reduce the number of shares outstanding, which will generally result in upward pressure on its stock price. There are, however, certain rules limiting the timing and volume of such issuer repurchases, and issuers generally rely on the safe harbor provisions of Exchange Act Rule 10b-18 to effect such repurchases.
By Executive Order, the SEC temporarily suspended Exchange Act Rules 10b-18(b)(2)(i)-(iii) related to the timing of repurchase transactions. Further, the SEC has modified Exchange Act Rule 10b-18(b)(4) related to the volume of securities repurchased, and has increased the repurchase limit from 25 percent of the average daily trading volume to 100 percent of the average daily trading volume of the particular security in question. The Emergency Order takes effect immediately and will end at midnight (EDT) on October 2, 2008, unless extended by the SEC.
Further Enforcement Efforts
In addition, Chairman Cox announced that the Division of Enforcement is expanding its ongoing investigations and undertaking a series of additional enforcement measures against market manipulation and abusive short selling. The Division of Enforcement will seek disclosure of additional information from significant hedge funds and other institutional traders relating to their past trading positions in certain securities. Chairman Cox explained that certain targeted hedge funds and institutional traders will be notified by the SEC and asked to immediately secure and preserve all of their communication records in anticipation of subpoenas for these records.
The SEC's investigations will likely focus on perceived abusive short selling and other forms of market manipulation, but will undoubtedly also include inquiries concerning whether the targeted hedge fund or institution has controls in place to identify and prevent abusive short selling and other forms of market manipulation. While this enforcement initiative appears focused on hedge funds, it is important to remember that the anti-fraud provisions of the federal securities laws, including the newly announced Rule 10b-21 discussed above, apply to all market participants and investment advisers - whether or not they are registered with the SEC.
In addition, the New York Attorney General, Andrew Cuomo, announced last week that the State of New York is launching an investigation into whether short sellers have engaged in illegal tactics while short selling the securities of several Wall Street firms. Mr. Cuomo stated that the investigation will focus on whether short sellers engaged in conspiracy or spread bad information to influence the stock prices of Lehman Brothers, AIG, and other firms that have suffered precipitous declines in their stock price during the ongoing financial crisis.