June 18, 2009
Additional comments on Short Selling Regulation
At the May 5 roundtable addressing the current SEC proposed limitations on short selling, the Chairwoman kept asking what the Commission needed to do to restore investor confidence in the markets. She posed the right question but to the wrong audience. The roundtable participants included everyone interested in the markets except individual investors. She needed to ask investors directly. Many of the participants on the panels make their living based on the volume of trading in the markets, not the viability of the investments they trade. Others are academics. Still others are interested in their ability to raise capital in the markets. While they all have a fundamental interest in the markets, they do not speak for investors.
I am sure that the Commission is cognizant that each interested community has a different perspective on the uptick rule:
Market makers profit from volume and since short selling increases volume, prefer few restrictions. Additionally, rules, such as the uptick rule, cost them money to implement and follow.
Traders in the market say short selling is healthy for the markets and want no restrictions.
Firms traded in the markets (other than those that themselves trade the market) prefer limits on short selling, so they can more easily raise capital.
Academics argue that the uptick rule simply slows an inevitable fall in prices that would have occurred anyway.
But Investors, those whom the Commission is chartered to protect, see the uptick rule as protecting their investment. Under the former uptick rule, only investors could sell their stock when the price was falling. Outside short sellers could not jump in and sell stock short (and profit) once the price was falling. In effect, short selling steals the investors value because it drives the price down. Hence, a strong uptick rule not only slowed the fall in prices of stocks (which gives investors and the firms they invested in, time to address whatever is causing the selling), it limited selling to those that held the investment originally.
I am a small individual investor and here are some comments for the record concerning actions the Commission needs to take to restore my and other investors confidence in the markets:
1. Publicize the SECs analysis of what led to major financial institution failures or forced mergers in 2008
2. Fix regulations concerning short selling so they preclude bear raids and are fair to long term investors in stock.
3. Never issue short term interim trading regulations without a commensurate long term proposal that will be put in place at the end of the interim.
4. Prosecute those who profited from naked short selling.
5. If bear raids were perpetrated, seek enforcement actions against those who manipulated the markets.
1. Publicize the SECs analysis of what led to major financial institution failures or forced mergers in 2008.
Until investors know what really happened in the stock markets leading up to the collapse of Bear Sterns as well as each of the other major financial institutions that failed or were forcibly merged into other banks last year, investor confidence will remain tenative. Investors widely believed that bear raids on the stock of financial institutions by short sellers was the major cause of the failures. It worked as follows:
A large fund quickly sells a significant amount stock of a bank short, driving its price down.
The fund also purchases a substantial number of put options on the stock of the bank, raising the option price.
The fund also buys a significant amount of credit default swaps driving the price of those up as well.
These price changes/actions begin to raise questions about what is happening at the company and its stock falls farther.
Rumors spread (or are spread) creating more uncertainty.
The price of the stock falls farther.
When the price reaches certain triggers, more shares are automatically sold by holders, putting even more stock on the market for sale, and the price falls even farther.
Panic selling sets in. At this point the original fund buys back in and profits handsomely.
In some cases, these bear raids were so effective that the company, unable to raise capital, went out of business.
There is considerable circumstantial evidence to support this belief. There was a huge amount of short selling in financial stocks, and it accelerated as the price of the stocks fell. When bad news about a financial firm was announced last year, it felt like sharks were circling in the water around the firm. The price of such a stock would often plummet in a matter of minutes. What sketchy information is available about the amount of shorts outstanding showed dramatic increases as the price was falling.
There were instances where the volume of stock traded in a single day was well over half of all of the outstanding shares. This begs the question: Did that many holders of the stock decide to sell it that day or was it outsiders shorting the stock and profiting from its fall? We know that many holders could not sell in one day, such as employees that held shares in their retirement accounts, or shares held by fixed index funds and many mutual funds. Without more information, one can only conclude that it was short sellers, not investors, driving the price down.
My point is that it is widely believed that bear raids happened. And unless the SEC publishes its analysis of events that shows something different, investors will not embrace any remedy put forward by the SEC that does not adequately address this scenario. As an investor, I assume that the SEC has studied the market activity around each of these events, given the anomaly they were, and I anticipate the release of the kind of thorough analysis that only the SEC is capable of, given their access to market data and expertise.
2. Fix the regulations concerning short selling so they preclude bear raids and are fair to long term investors in stock
Stock markets exist so that companies can raise capital to innovate, grow, and hire. Investors invest in those companies via purchasing company stock in the stock markets. The Federal government has long recognized that investing in the stock markets, as opposed to gambling at a casino, is beneficial to society. Tax laws provide benefits for long term stock investments. Retirement laws allow and encourage long term investments in stock (but do not incidentally allow short selling).
The SECs own charter is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation. Without effective constraints on short selling, none of these objectives can be fulfilled:
Protect investors. Unless there are constraints on short selling, investors in stock are at risk of bear raids on their stock. As I noted earlier, it is widely believed that such raids occurred last year. As recently as the May meeting, the NASDAC representative seemed to say that a recent sharp decline of a stock in his market was the result of a bear raid. Preventing such raids is an essential component of protecting and reassuring investors.
Maintain fair, orderly, and efficient markets. Last year the stock markets were anything but fair, orderly and efficient. We saw the widest daily market value swings in history, the biggest fall in market value since the great depression, and the highest market volatility in history. It is useful to recall that as recently as January 2009 no firms could raise capital in the markets. Was it coincidental that the markets began this wild activity shortly after the uptick rule was eliminated in July 2007 and that it has returned to more normal trading beginning in March of this year, when the SEC announced that it was undertaking this rulemaking?
Facilitate capital formation. Short selling is a mechanism to provide liquidity to the markets and also help in price discovery as it provides rewards for doing research about particular companies. However, it does not contribute to capital formation. If I have $1000 and invest it in company x, I have contributed to capital formation of the company by raising its price and so allowing it to borrow against the market capital of its stock (or issue more stock at a higher price). If I use the $1000 to sell the stock of company x short, under current rules I can lower the price of the stock and so may actually impede its ability to borrow funds (or issue more stock). I am not arguing for eliminating short selling altogether, rather that for the purposes of the markets, short selling is not equivalent to investing and regulations should favor and protect investors over short sellers in order to promote capital formation. The current rules do not.
The SEC has proposed several alternatives for limiting short selling. I urge the SEC to adopt a strong, easy to understand and enforce, uptick rule. It may take a combination of the alternatives proposed:
It must be a market-wide permanent approach.
It needs to pre-empt bear raids, like the original uptick rule, not require specific stock intervention to be effective. After the fact enforcement simply has not and will not work in preventing such raids.
It needs to reinstate investors ability to sell shares in a falling market before short sellers can sell them. Having protection only after short sellers have pushed the price of an investment down a significant amount (e.g. 10 or 20 percent) would not protect nor re-assure investors that the market is fair.
In my earlier comments, I commented that individually none of the proposed alternatives is adequate to address the problem. However, I propose adopting an Up-Day alternative, which incorporates a combination of the proposals, and provides stronger investor protections, while giving short sellers more potential to participate as well. Under the proposal:
A market-wide permanent circuit breaker is set at zero percent. That is, not allowing short selling of a stock when its price falls below its opening price of the session. Circuit breakers greater than 0 percent in effect tell long term investors that it is OK for short sellers to drive your stock down that percentage before we will protect you. Why is that fair to me as an investor that holds stock and how would it re-assure me?
Allow short selling to resume after a period of time, but make that time variable with the price of the stock. That is when the price of the stock rises back to its opening level for the session, short selling is allowed again. This will allow short sellers to participate in the market during the same trading session – as long as the price of the stock is higher. It is more flexible than a permanent session or several session freeze on short selling.
An Up-day rule has significant advantages over any of the other proposals:
Simpler: It is simple to understand by everyone in the marketplace – and so will go a long way to restore investor confidence and also be easy to enforce in trading.
Easier: It should be easy to implement, since the opening price of each sessions trading is widely available whenever a trade is ordered.
Allows Real Research: It allows short selling to occur when it is the result of real research about a stock, since most stock normally trades up and down from its opening price during a normal trading session.
Restricts Short Selling on Bad News: It precludes short selling from driving a stocks price down based on widely available news about a stock, which is exactly the time that fairness argues that short selling should be restrained (and the original uptick rule limited such selling). It simply is not fair for a short seller (who has no money on the table) to be able to sell my stock short and drive its price down when he hears bad news about it, while I (who have money on the table in the form of owning the stock long term) am busy working for a living and so am not able to monitor my investments every minute. Why should a short seller be able to profit simply from hearing general news first and being able to trade fast?
Reduces Panic: It will calm long term investors who will not have to react quickly to bad news about their stock for fear short sellers will drive its price down quickly.
The SEC should adopt a strong investor protection, such as an up-day rule.
3. Never issue short term interim trading regulations without a commensurate long term proposal that will be put in place at the end of the interim.
Unfortunately, the SECs actions last year, while well intentioned, contributed to the market turmoil. In an effort to calm markets, the SEC issued two temporary regulations: One banned naked short selling and one stopped all short selling of stock in certain financial institutions. As an investor, I can tell you these contributed to loss of confidence in the markets.
Naked Short Selling: The temporary ban on naked short selling raised red flags for me as a long term investor. It begged the question: Why? I had always believed (as do most long term investors) that naked short selling was and is, illegal. As I said in my earlier comments, selling something that one does not have a right to is a form of fraud. Yet here was the SEC taking the extraordinary action of issuing a temporary rule banning this activity. At first it was simply confusing. Than I realized that the SEC must be detecting widespread naked short selling – which to me meant widespread fraud – in the markets. Do I want to keep my retirement or other long term investments in a market where there is widespread fraud? Certainly not if they are only taking TEMPORARY action to stop it – and that action is to say stop doing that
Short Selling of Financial Institutions: The second temporary rule was not much more re-assuring to me as a long term investor. In it, the SEC temporarily banned all short selling of certain financial institutions while the TARP was put into place. Again this was done without proposing any substantial long term solution to short selling (there was a reporting requirement, but it was for secret reports to the SEC and it was not clear what the SEC would do with those). It begged the question: As a long term investor, should I commit funds to new stock purchases or hold onto my investments when it is apparent that the SEC itself fears what short sellers will do to financial stocks immediately, but provides no substantive fix to prevent that from happening a few weeks later? Not likely
It is also worth noting that short sellers often refer to these bans and the fall in prices while they were in effect as evidence that short selling was not a cause of last years market collapse. This is wrong. What caused the market to fall while these bans were in effect was a loss of confidence in the fairness of the markets themselves and in the SEC as a protector of investors and the markets.
4. Prosecute those who profited from naked short selling.
As I noted earlier, it is widely believed that naked short selling is illegal. Last years SEC temporary rule is evidence that SEC must have detected widespread naked short selling. I note that at the meeting there was a brief discussion about the large number of fail to delivers -- which was indicative that a large amount of naked short selling had taken place. Yet to date the SEC has not taken any visible action to enforce rules against such activity. I would suggest that the SEC undertake some very visible enforcement actions against naked short sellers. If need be, the SEC should join with other law enforcement agencies (e.g. FBI, Secret Service, IRS, etc.) to undertake some well publicized, high profile prosecutions of people who widely abused naked short selling.
5. If bear raids were perpetrated, seek enforcement actions against those who manipulated the markets.
Market manipulation is a crime. If the SECs analysis of events around the collapse of certain stocks shows that bear raids indeed occurred, the SEC should seek enforcement actions against those that manipulated the markets. While removal of the up-tick rule allowed short sellers to sell short while the market was falling, bear raids were not made legal. Those that manipulated the market should be held liable for market manipulation. And, as in the case of enforcement of naked shorting, this should be done visibly and with the assistance of other law enforcement agencies as needed. After all, that is what the SEC promised – strong enforcement -- when the up-tick rule was eliminated in July of 2007.
Thank you for undertaking this critical rulemaking. I believe it is essential to the viability of our stock markets and to the ability of our industry to raise capital, grow and hence hire. And I trust that the Commission will arrive at a strong, viable solution that protects and reassures me as an investor, while facilitating the markets in raising capital.