Summary

Last week, the SEC’s order limiting “naked” short selling in 19 securities went into effect. It appears that, despite some minor difficulties, firms were able to comply with the order. However, compliance with respect to 19 securities is much different than the prospect of complying with a larger scale limitation across the entire marketplace.

In a July 24 op-ed for The Wall Street Journal (“What the SEC Really Did on Short Selling”), SEC Chairman Christopher Cox indicated his desire to extend the coverage of the order’s “operational protections” to the broader marketplace. The SEC has already stated that it intends to extend the order from the July 29 end date to the full 30 days allowed under Section 12(k)(2) of the Securities Exchange Act of 1934. Further, Chairman Cox stated in his testimony before the House Financial Services Committee on July 24 that he ultimately intends to expand the orders restrictions in the form of a marketplace rule.

In addition to the expansion of the “borrow” obligations, the SEC indicated that it was weighing additional measures that may be imposed to limit certain short selling.

Analysis

The SEC has been unambiguous in expressing its intent to impose limitations on short selling beyond what is mandated by Regulation SHO. For example, Chairman Cox stated in his July 24 op-ed that the Commission needs to consider the elimination of the “reasonable grounds” provisions of Regulation SHO, which allows brokers to effect a short sale order without actually borrowing a security if they “reasonably” believe they can borrow the security. Chairman Cox stated in the same article that he believes this allows for “evasion of the rule’s purpose.”

Chairman Cox has confirmed that he intends to extend the “pre-borrow” mandate to all securities. This may cause large operational issues for the broker-dealers, as many of them are using manual processes to comply with the order. It may not be feasible for them to comply with a marketplace rule without the opportunity to implement significant automation.

The costs associated with a marketplace rule will be significant. First, there is the cost associated with building and maintaining the systems necessary to deal with a broad rule. Further, broker-dealers and/or their clients will have to bear the additional costs associated with borrowing securities (as opposed to the minimal costs involved in locating securities).

In addition to a broader borrow rule, Chairman Cox has indicated that the Commission is also looking into other measures to limit short selling. One such measure would be to require disclosure of significant short positions, much like the current requirement to disclose significant long positions.

In his House Financial Services Committee testimony, Chairman Cox stated that the SEC is reviewing the possibility of reinstituting the “tick test”, but indicated that the rule had proved to be ineffective when using a penny increment as the test. According to the Chairman, the SEC will be looking at the possibility of a tick test with a larger decimal increment.

Conclusion

It is unclear what rules will be introduced in the next month or two, but it is a near certainty that some additional short sale limitations will be imposed. SIFMA, STA, MFA and CPIC, among others, have weighed in on the SEC emergency order. Any new rules will surely invite great debate and comment.