SEC Races Against Short Sellers

In an attempt to stanch the bloodletting on Wall Street, the Securities and Exchange Commission will rush to institute new rules as soon as this week to curb abusive short selling of stocks.

The rules — which are far less sweeping than restrictions the agency temporarily instituted in July on shorting shares of 19 financial firms — will make it fraudulent for traders to mislead brokers about whether they have located a stock they intend to short, and will no longer allow options traders to bet against a stock without borrowing it first. It will also require brokers to close out their short positions sooner.

The SEC had intended to release the new guidelines later this month, but is pushing forward the announcement in light of the current crisis, a person familiar with the plans said.

The SEC's moves come on the heels of a crushing day on Wall Street, with the Dow Jones Industrial Average tumbling 504 points — just four points fewer than the loss in the October 1987 crash and the worst point drop since the terrorist attacks of September 11, 2001. Driving much of the sell-off was concern over the solvency of one of the world's largest insurers, American International Group; Standard & Poor's downgraded the insurance giant yesterday evening by three notches.

Investors are bracing for a choppy market today, as they await the outcome of the Federal Reserve's policy meeting. Wall Street is expecting the Federal Open Market Committee to cut its key lending rate by one quarter of a percentage point, to 1.75%. Some economists, including Merrill Lynch's David Rosenberg, expect the Fed to go a step further and cut by half a percentage point.

If the Fed cuts by just one quarter of a percentage point "it will be viewed as too tepid a response to these epic contractionary events," Mr. Rosenberg wrote in a note to clients.

Market players are placing some of the blame for the recent drop-off in bank stocks — spurring Lehman Brothers's bankruptcy filing and Merrill Lynch's sale of itself to Bank of America — on so-called naked short sellers.

In a traditional short sale, a trader who believes a company's stock is about to fall must locate a share to borrow — it is not required that the trader actually borrow it — and sell that share, hoping to buy it back for a lower price and pocket the difference. In a naked short, the trader doesn't locate the share before selling it short, enabling throngs of traders to pile onto a short bet, amplifying the effect and causing the stock to topple.

"Bank stocks are a uniquely exposed industry to naked shorting," a professor of law at Columbia University, John Coffee, said. "In most other markets, if a company's stock price declines it doesn't have any operational impact. If I am a bank, however, and my stock price declines, the credit ratings agencies put me under review and counterparties who engage in trading with me back away." This leads to a loss of confidence by the markets and a possible liquidity crunch, much like the ones that felled Bear Stearns and Lehman Brothers, and might have toppled Merrill Lynch if not for the deal with Bank of America.

While naked short selling is not illegal, the SEC did move in July to lessen the havoc it was wreaking on the financial sector. For a handful of stocks, including Fannie Mae, Freddie Mac, and Lehman Brothers, traders were required not only to locate a share to borrow, but also execute a formal agreement to borrow the share.

The SEC will not reinstitute this rule because it prevented legitimate short selling, which is necessary for investors to hedge their bets and for a market to function properly, a person familiar with the SEC's thinking said.

Instead, the SEC will make it illegal for a trader who wants to short a stock to lie to their broker about whether they have located a share to borrow. This "increases the antifraud protections of the existing rules to make it explicit that it is fraudulent to transact without actually making a bonafide effort to locate the stock," the person said.

The SEC declined to comment.

The new rule that makes lying to a broker fraudulent confounded some market watchers, who said it would be difficult to investigate and enforce.

"I always thought it was plainly fraud to sell a stock without having to locate first, and I am puzzled by anyone who doubted that was so," a professor emeritus at New York University's School of Law, John Slain, said.

In a short sale, traders must also "cover" their short, or return their borrowed share within three business days. If more than one half of 1% of the company's outstanding shares aren't delivered for five consecutive days, the stock is placed on a list of "threshold" companies, and after 13 days the brokers are required to buy the shares in the open market and close out their positions. The SEC will change this so that brokers will have to close out their positions in as few as five days, the person said.

In addition, the futures market, which has been exempted from having to locate a share to borrow before a short sale can be complete, will now be subjected to these restrictions.

Some in the market had been hoping the SEC would reinstitute the "uptick rule" that was repealed over a year ago. The rule inhibited short selling by requiring that traders could short only those stocks where there was an uptick in their price.

The SEC is against bringing this back, arguing it is easy for traders to manipulate it by simply buying enough shares in the company to create a one-cent-a-share increase before shorting the stock. To increase the limit — so that a stock would have to increase by a nickel a share, for example, before it could be shorted — would eliminate legitimate short selling for some stocks that have a smaller bid-ask spread.