Yesterday the SEC took various emergency actions to address heightened concerns over market manipulation in light of the unprecedented turmoil in the financial markets. Over the course of the day:

  • First, the SEC issued an emergency order adopting new short selling rules aimed at strengthening investor protections against “naked” short selling. The new rules apply to the securities of all public companies, including all companies in the financial sector. The SEC’s actions are effective as of 12:01 a.m. ET on Thursday, September 18, 2008.
  • Later in the day, SEC Chairman Cox and SEC Enforcement Division Director Thomsen issued a statement regarding immediate SEC action to market manipulation, including calls for new disclosure rules applicable to hedge funds and other large investors with more than $100 million invested in securities that would require prompt public reporting of daily short positions (currently only long positions are reported).
  • Chairman Cox and Enforcement Director Thomsen also announced an expanded enforcement effort against market manipulation.

Emergency Order

The actions under the emergency order are the result of formal SEC rulemaking and go beyond the temporary short selling order issued last July, which applied only to the securities of certain financial institutions and expired on August 12, 2008.

Hard T+3 Close-Out Requirement; Penalties for Violation Include Mandatory Pre- Borrow

The new rules require that short sellers and their broker-dealers deliver securities and close out the short sale transaction no later than the close of business on the settlement date (three days after the transaction date, or T+3). These new rules effectively ban naked short selling.

If a broker-dealer violates this “close out” requirement, it will be prohibited from further short sales in the same security unless the shares are not only located but also pre-borrowed. This prohibition will apply to all short sales in the same security effected by the broker-dealer, not just future sales for the particular “naked” short seller.

The new “close out” requirement was adopted on an interim final basis, which means that the rules will be effective immediately and the SEC will seek public comments before adopting final rules.

Repeal of Exception for Market Makers from Short Selling Close-Out Provisions

The SEC also approved a final rule to eliminate the options market maker exception from the close out requirement of Rule 203(b)(3) in Regulation SHO. As a result, options market makers will be treated in the same way as all other market participants, and required to abide by the hard T+3 close out requirements. This rule change will become effective five days after publication in the Federal Register.

Short Selling Anti-Fraud Rule

In addition, the SEC adopted a new anti-fraud rule that expressly targets short selling transactions. New Rule 10b-21 will prohibit short sellers from deceiving their broker-dealers or other market participants about their intention or ability to deliver securities in time for settlement. The new rule will be effective immediately.

Further Action on Disclosure

Following the issuance of the emergency order, and in light of further significant concern over declining stock prices, Chairman Cox requested the SEC to consider on an emergency basis a new disclosure rule that would require hedge funds and other large investors to disclose their short positions. Managers with more than $100 million invested in securities would be required to promptly begin public reporting of their daily short positions. Such managers currently report their long positions to the SEC.

Further Enforcement Measures

In addition, the Division of Enforcement will expand its ongoing investigations by undertaking additional enforcement measures against market manipulation. As stated by Chairman Cox, the Division of Enforcement “will obtain disclosure from significant hedge funds and other institutional traders of their past trading positions in specific securities” and such institutions “will also be required immediately to secure all of their communication records in anticipation of subpoenas for these records.”

Next Steps

We are monitoring the situation closely. Further action in the United States is likely on the initiatives announced later in the day yesterday, and there continue to be calls for the SEC to reinstate the “uptick” rule eliminated in June 2007, as well as calls to impose a temporary ban on short selling of stocks of financial institutions. The SEC has not chosen, at this point, to go that far.

Enforcement action may also follow. The tools to combat market abuse have been in place and remain unchanged as the U.S. regulators have a range of bases on which to purse market manipulation. The key will be access to information by regulators through greater transparency.

The SEC announced in July that it and other securities regulators would undertake examinations aimed at preventing the intentional spreading of false information to manipulate the prices of traded securities. That followed a March 31 notice by FINRA, NYSE Regulation and participants of the Options Regulatory Surveillance Authority reminding industry participants of the prohibition against the circulation of rumors that might reasonably be expected to affect market conditions and advising such participants to review internal controls and procedures in respect of such activity. An enforcement action in April was brought against a trader for securities fraud and market manipulation for intentionally disseminating false rumors. The SEC had, the previous month, reminded investment professionals, through a Section 21(a) report of investigation of an unregulated money manager, of their responsibilities under the federal securities laws and highlighted the risks of operating without an effective compliance program.

In light of the global nature of the markets and the near uniform effects across the markets of the developments over the past week, it remains to be seen what action will be take by regulators outside the United States to address possible market manipulation.