Continued........
his or her broker is required to return shares that were borrowed at the time of the short sale, as described in the next section.
2. Securities borrowing and lending
Short selling normally requires that the short sellers broker must borrow securities. The purchaser of the shares in a short-sale transaction expects to receive delivery of the purchased shares, or at least the purchasers broker must receive them in order to hold them for the purchaser, but the seller does not have them to start with. The sellers broker must therefore borrow shares to complete the transaction.
Securities lending for this purpose is highly organized, and usually the sellers broker has no problem borrowing the necessary shares, either from other customers margin accounts or from another broker. Occasionally, however, the shares cannot be borrowed, in which case the broker is supposed to refuse to execute the customers order to sell short.
The sellers broker does not actually borrow the necessary shares when the short-sale trade is executed, however. The shares are not borrowed until settlement of the transaction occurs, which is normally five business days later, and this time lag can allow a problem to develop. On the settlement date, the sellers broker may discover that shares are no longer available to be borrowed from the source that seemed to have shares available five days earlier.
If the sellers broker cannot borrow the shares on settlement day, then no shares are delivered to the buyers broker. If the trade is processed through one of the major stock clearing organizations , as most now are, then no shares are delivered to the clearing organization. The short-sale trade is still a valid trade, but the sellers broker is merely late in delivering shares to complete the trade. This appears as a "fail-to-deliver" on the books of the selling broker.
3. Expansion of total beneficial ownership
Short sales of equity shares generally have the effect of increasing the total number of shares of that companys stock owned beneficially by investors. In a short-sale transaction, the buyer adds to his or her holdings of this stock, while no other investor has sold shares he or she owned.
Of course, there is no increase in the shares outstanding shown on the records of the issuing corporation. As a consequence, the short sale creates a situation in which the total number of shares owned beneficially by investors exceeds the number of shares issued by the issuing corporation.
Securities lending by brokerage firms makes this possible. Brokers normally hold shares in custody for their customers, and the customers investment holdings are reported to them on paper account statements from their brokers. When investors borrow money from their brokers on margin, as many investors do, they must sign an authorization permitting the broker to lend their shares or otherwise to pledge them as collateral for bank loans to finance the brokers lending. When a broker uses this lending authority to lend some customers margin shares to a short seller, the broker ends up holding fewer shares of that stock in custody than the number of shares the customers own, as shown on their paper account statements.
The result of such short selling and securities lending, in the aggregate, is that brokers as a group do not hold record ownership of as many shares of such a stock as they and their customers own beneficially. This may be described as a situation of fractional reserve brokerage, where the "reserves" of record shares, of issued shares shown on the records of the issuing corporation, are only a fraction of the beneficially owned shares shown on the account statements of customers and in the brokers own proprietary accounts.
This process of nominal share expansion through securities lending and short sales is very similar in its mechanics to the process of money expansion through bank lending, which is familiar to students of economics. In both cases the public holds a major part of its holdings, its money balances and its securities, in book entry form only, in accounts with intermediary institutions.
In the case of banks, these book entry holdings, the bank checking and savings accounts, show more money in total belonging to the depositors than the banks hold in their vaults or on deposit with the Federal Reserve Banks. The bank reserves are only a small fraction of depositors total bank balances on paper.
The same thing is now happening in securities brokerage firms. The total shares belonging to investors on paper, in their brokerage accounts, exceed the total reserves of registered or issued shares in the custody of the brokers when short sales have occurred.
It is not possible, however, for all investors to convert their shareholdings, as shown in their brokerage accounts, into stock certificates when such a share expansion has occurred. If all investors holding shares of a particular stock in their brokerage accounts tried to convert their holdings into stock certificates, brokers who had loaned out shares to short sellers would be forced to recall the loans to get the shares back. This, in turn, would force the short sellers who had borrowed the shares to buy back the shares in order to return the borrowed shares.
If the short sellers are able to buy back enough shares that is, if enough investors who first wanted stock certificates are willing to sell their shares instead then the remaining investors who do not sell can get stock certificates. In this case, the total shares held by investors will have contracted enough so that it matches the brokers reserves of issued shares in their custody.
However, sometimes short sellers are not able to buy back the necessary shares at a reasonable price, and a short squeeze results. All investors holding this stock are refusing to sell except possibly at a very high price, and when this happens regulatory intervention or court action may be needed to resolve the situation. As long as this short squeeze remains in effect, however, it is not possible for all the investors holding this stock in their accounts to obtain stock certificates for their holdings.
4. Expansion of tradeable shares
The expansion of book entry holdings of shares by investors when short selling has occurred also represents an expansion of tradeable shares in the market. Every investor whose brokerage account shows that he holds a certain stock may sell that stock immediately, regardless of whether his or her broker is holding enough shares in custody on that day to make delivery of all the shares sold by customers from their accounts. The rules of the stock exchanges and of the National Association of Securities Dealers (NASD), which regulates over-the-counter trading, do not place any limits on the entry of sell orders just because a brokers reserves of shares in custody are less than what that brokers customers want to sell.
5. Statistics on short interests in stocks
The New York and American Stock Exchanges and the NASD compile monthly statistics on the aggregate short security positions reported by brokers and dealers. These statistics, which are released to the press and the public, list hundreds of companies whose stock has been sold short in significant volume by investors. Short selling, and the resulting share expansion, are thus very widespread phenomena.
To provide further information on the scale of short selling and share expansion, the subcommittee has compared the short interest statistics reported monthly by the exchanges and NASD with the individual companies total shares outstanding. The purpose of this analysis was to identify cases in which the share expansion through short selling was at least 5 percent of a companys shares. The appendix contains a listing compiled by the subcommittee showing 695 companies for which the short interest in their stock was at least 5 percent of the companys total shares outstanding at some time during the years 1986-90 .
For 280 of these companies the short interest exceeded 10 percent of shares outstanding at its maximum, and for a smaller but still significant number the share expansion through short selling was over 20 percent.
B. Regulation of Short Selling
Short selling is regulated under both Federal agency regulations and under certain rules of the stock exchanges and the NASD.
As described above, the Federal Reserves margin regulations require a short seller to post a certain amount of additional cash margin, and to maintain afterward an appropriate amount of cash margin. This limits the amount of short selling an individual investor can do, based on his or her financial resources.
Certain Securities and Exchange Commission rules set important limits on short selling. SEC Rule 10a-1 (the "uptick rule") prohibits short sales of exchange-listed stocks except on or after a price "uptick." That is, the short seller must find a buyer who will pay at least one-eighth point more than the last sale price, or who will pay the same as the last sale price if the last change in the sale price of this stock was an increase. In theory, this rule is intended to prevent short selling from continually driving down the price of a stock, but evasion of this rule is possible, especially through overseas trading in stocks that can be traded in London, Tokyo, or other overseas markets. Moreover, this rule does not apply to stocks that are traded over-the-counter or in the NASDAQ system of the National Association of Securities Dealers. The NASD has proposed a similar uptick rule for NASDAQ trading, but has not taken final action to implement such a rule.
SEC Rule 15c3-3 sets important limits on the extent of securities lending. Except under special written agreements applicable to a particular stock, a broker may lend out only those customer shares that serve as collateral for the money the customers have borrowed from the broker on margin. The rule limits this to stocks having a value of no more than 140 percent of the amount borrowed. Therefore, if few brokerage customers are holding a particular stock in margin accounts that is, if most investors have paid in full for their holdings of this stock and are holding it in cash accounts or in certificate form then it may be difficult or impossible for brokers to borrow this stock. In this case normal short sales of this stock, in which borrowed shares are delivered to the buyer, may not be possible.
SEC Rule 10b-21 prohibits short sellers from closing out a short position with shares received in a secondary offering of shares by the company. This does not directly regulate short selling itself, but it seeks to control a short-selling abuse in which investors would use short sales to drive down the price of a stock just prior to a new offering of shares, and would then close out their short position with shares obtained in the offering at the lower price they had forced the company to accept.
The New York and American Stock Exchanges and the NASD have rules that require a broker to determine, at the time a customer enters a short-sale order, that the appropriate number of shares are available to be borrowed to cover the short sale. The broker must locate the required shares before executing the short sale for the customer.
The NASD also has recently received final SEC approval of a "buy-in" rule, which provides that a broker whose customer requests a certificate for NASDAQ securities that he or she has purchased must force a buy-in of the necessary shares for cash or guaranteed delivery, at the expense of the sellers broker, if the customers shares are not otherwise received through normal trade settlement procedures. Such a buy-in would typically only become necessary in cases where the broker handling a short sale is unable to borrow the necessary shares for delivery to the purchaser.
The NASD has also proposed, but has not received final SEC approval to implement, a "closeout" rule for short sales. This rule, if implemented, will require brokers, under certain circumstances, to close out customer short positions if delivery of the shares sold short has not been made by a certain number of days after the normal settlement date. There is no similar rule governing the delivery of shares sold short on the New York or American Stock Exchanges.
These rules typically provide blanket exceptions for short selling by exchange specialists and over-the-counter market makers. Specialists and market makers are generally permitted to engage in short selling on substantially more liberal terms than other investors.
C. Subcommittee Investigation and Hearings
1. Company and investor complaints
For years, investors and company executives (who are often major shareholders also) have complained about short-selling abuses. Many recent press reports of abuses, as well as other press features that dispute the reports of abuse, are reprinted in Appendix 9 of the printed subcommittee hearing record.
Many of the complaints have alleged that short sellers, after establishing a major short position in a particular stock, have aggressively circulated false rumors about the companys financial condition, problems with its products, or the health or integrity of its officers in an effort to drive down the stock price. It has also been frequently alleged that some elements of the press assist and cooperate with short sellers by printing very negative stories about the companies the short sellers have targeted.
In many cases short sellers are alleged to have contacted directly a companys major suppliers, customers, lenders, and institutional shareholders, often anonymously or under false pretenses, to aggressively suggest false or misleading "facts" about the company.
Other complaints have alleged that "naked" short selling has been employed to manipulate and drive down the price of a stock improperly. Short selling in which shares are not borrowed and are not delivered to the buyer is called naked short selling. This practice was described in a Forbes article in February 1988 .
Some complaints have been directed at the SEC. The SEC, it is alleged, is "soft" on short-seller abuse and fails to pursue cases of false rumors, even when the purpose of the false rumors is price manipulation. Some complaints have even alleged that the SEC actively assists short sellers by conducting investigations of companies in the stock of which short sellers have accumulated large short investments. These investigations assist short sellers because public announcement of such an investigation often causes other investors to sell such a stock, thereby driving down the price.
2. Survey of companies
In May and June 1989 the subcommittee mailed a questionnaire letter to approximately 200 companies that had had the short interest in their stock reach a ratio of at least 10 percent of their public float of shares at some time in the period from December 1986 through April 1989. (In the case of New York Stock Exchange listed companies, the subcommittee could not obtain float data and therefore compared the short interest of each company to its total shares outstanding.) The letter contained a series of questions asking what practical effect the short selling and the related activities of short sellers had had on the company, whether the company had experienced any disruptions or distortions of the proxy voting process, and how the company felt about three suggested changes in the regulation of short selling. The three regulatory ideas proposed in this letter were (i) mandatory public reporting of their short positions by short sellers if their positions exceed some percentage of a companys outstanding shares; (ii) an uptick rule for short sales of NASDAQ stocks; and (iii) a mandatory buy-in rule to reduce naked short selling.
The subcommittee received a total of 68 responses, for a response rate of about 34 percent. Thirty companies reported no problems or complaints arising from short-selling activity, while 38 reported problems of various sorts. Several of those reporting no problems had very substantial short positions arising from hedging or arbitrage transactions involving convertible securities, but did not feel there was any need to complain.
Widespread circulation of false rumors around the time of heavy short-sale activity was cited by 21 companies as a serious problem. They generally reported that these rumor problems, at the very least, made it necessary for company officials to devote inordinate amounts of time to reassuring stockholders, regulators, customers, and sources of debt financing, who were often seriously unsettled by the reports being circulated.
Thirteen companies characterized the short-sellers activities as involving improper interference with their relationships with customers, major shareholders, suppliers, banks, etc. Generally they complained of numerous phone calls, often anonymous, to these parties from "analysts" attempting to suggest very negative, frequently false, conclusions.
Only a small number of companies asserted that naked short selling was a significant problem. Most companies responded that they had no factual basis for determining whether naked short selling was a problem because they could not obtain the necessary data from their exchange or the NASD.
No companies reported any complaints related to shareholder proxies.
Many companies that reported specific complaints also expressed the view that short selling is a legitimate market practice and that the only need is to curb specific abuses.
Out of the 68 substantive replies received, 37 commented in some manner on one or more of the three policy ideas suggested in the letter. Public reporting of large individual short positions was supported in 32 of the responses and opposed in 2. Imposing an uptick rule for short sales of NASDAQ stocks was supported in 22 responses (13 from OTC companies), and opposed in 3. A mandatory buy-in rule or some other step to prohibit naked short selling was supported in 34 responses and opposed in 2.
In addition, various rule changes to assure informed consent by investors whose shares are lent to short sellers were suggested by seven companies.
3. Subcommittee hearings
In order to hear testimony on the allegations of short-seller abuse and on the programs of the SEC and the self-regulatory organizations (SROs) for controlling abusive practices, the Commerce, Consumer, and Monetary Affairs Subcommittee held three days of hearings in November and December 1989. On November 28, the subcommittee heard testimony from three company executives whose companies had been the targets of short selling and who reported abusive practices by short sellers. The subcommittee also heard testimony from two industry experts who gave a broader overview of short selling and its abuses, and it received for the record a statement from Joseph Feshbach of Feshbach Brothers, a major short-selling investment partnership, commenting on the issues the subcommittee had raised.
On December 29, the subcommittee heard testimony from John Guion, of the National Association of OTC Companies, and from the New York and American Stock Exchanges and the National Association of Securities Dealers (NASD). Mr. Guion reported on a survey his organization had conducted among 1,000 public companies concerning their experience with short-selling abuses and their views regarding possible regulatory improvements, from which he concluded that there is very widespread support among public companies for fuller disclosure of short-selling activity. He reported the intention of his organization to recommend to the SEC a new public reporting rule applicable to any individual short seller who accumulates a short position equal to 5 percent or more of a companys total shares outstanding.
Edward Kwalwasser, representing the New York Stock Exchange, and Stephen Lister, representing the American Stock Exchange, described the role of the SECs uptick rule in suppressing "bear raids" by short sellers and the manner in which the Exchanges, through various rules, control the spreading of misleading rumors and prohibit naked short selling. They both expressed skepticism regarding the subcommittees concern that shareholders might lose proxy voting rights when broker-dealer firms lend customers shares to short sellers. Mr. Lister also expressed concern that there might be unintended adverse effects from requiring public reporting of large individual short positions.
John Pinto and Gene Finn, testifying for the NASD, described the NASDs recent and proposed rule changes for strengthening their controls over naked short selling and other short-selling abuses. They opposed the extension of the SECs uptick rule to NASDAQ trading, basing their analysis in part of a major study of short-selling regulation that had recently been completed by Irving Pollack, a former SEC Commissioner and senior regulatory official. They also commented briefly on several other regulatory issues related to short selling.
Richard Ketchum, Director of the SECs Division of Market Regulation, and John Sturc, Associate Director of the SECs Division of Enforcement, presented the testimony of the Securities and Exchange Commission on December 6. They described at length the regulatory and enforcement programs of the SEC as they apply to short selling, and their prepared testimony also included detailed responses to a number of questions the subcommittee had submitted in advance. On the question of extending the uptick rule to NASDAQ securities, the SEC position was that they did not believe a need for this rule change had been demonstrated, but the SEC would continue to study the merits of this proposal. Regarding the proposal for public reporting of large individual short positions, they stated that the SEC does not favor public reporting that reveals potentially sensitive trading strategies, and furthermore that the SEC lacks authority to impose such a requirement without legislation.
4. Analysis of American Stock Exchange surveillance report
In 1987 the American Stock Exchange (ASE) investigated company allegations of possible manipulative activity in connection with short selling in the securities of three ASE-listed companies. The Exchange prepared and submitted to the SEC a lengthy surveillance report dated November 6, 1987, in which the Exchange reported finding no evidence of manipulation but recommended further inquiry by the SEC. The SEC provided a copy of this report to the subcommittee immediately prior to the 1989 hearings, with a request that it be treated as a confidential document because of its detailed data on individual security trades by certain individuals.
Following the hearings the subcommittee analyzed the surveillance report in substantial detail in order to evaluate the thoroughness of the American Exchange investigation.5. Study of SEC investigations of short-sale target companies
Following the hearings the subcommittee inquired of the SEC by letter what percentages of formal investigations and informal inquiries opened by the SEC to investigate companies for accounting fraud or other fraudulent public disclosures involved companies where a short interest existed, at the time the Commission began its inquiry, of at least 5 percent of the companys total shares outstanding. The purpose of the subcommittee inquiry was to attempt to verify company complaints that the SEC often assisted short sellers by investigating companies that the short sellers had identified as targets.
The SEC responded that they did not have the necessary information in their possession to respond to this inquiry. The SEC did offer, however, to permit subcommittee staff to view listings of SEC formal and informal investigations opened regarding suspected cases of the sort specified by the subcommittee.
A subcommittee staff person therefore compiled from these SEC listings and from the published monthly short interest reports released by the NASD the necessary data to prepare a partial answer to the question. The compilation prepared by the subcommittee covers SEC investigations of NASDAQ companies opened between March 1988 and March 1989.
6. Analysis of NSCC fails data, December 1990
In order to investigate company allegations of naked short selling, the subcommittee requested from the National Securities Clearing Corporation daily tabulations of clearing shorts (failures to deliver securities by settlement date) and clearing longs (failures to receive securities by settlement date) for every trading day in December 1990. The subcommittee received daily data from NSCC showing clearing shorts that aggregated at least 10,000 shares in a given equity issue and that were due from selling brokers who had been short in that issue for at least 5 trading days. The subcommittee also received data showing daily clearing longs on a comparable basis.
The subcommittee then prepared summary tabulations from the data provided by NSCC. These tabulations show individual stocks in which the clearing short position at NSCC that was due from brokers who had been continuously short for at least 10 days averaged at least 20,000 shares throughout the entire month of December. The subcommittee compared these cases of substantial and persistent clearing shorts with the publicly reported investor short interest statistics for December 1990.
In these tabulations the subcommittee identified 31 New York Stock Exchange issues, 28 American Stock Exchange issues, 129 NASDAQ issues, and 54 issues the subcommittee could not identify as to market but which appeared to be non-NASDAQ over-the-counter issues. Many of the issues shown in these tabulations also were reported as having substantial investor short positions in the monthly statistical reports as of December 15, and several were issues that had been reported in the press as the targets of professional short sellers. Several others were the stocks of companies that have expressed complaints about short-selling abuse.
The subcommittee then, in March 1991, requested evaluations from the SEC, the New York and American Stock Exchanges, and the NASD as to whether the persistent clearing fails shown in the tabulations reflected naked short selling, and if not what other factors accounted for such persistent and substantial clearing fails.
The SEC has not responded to this inquiry. The New York Exchange has tentatively reported apparent rule violations in three cases but has not completed its review of the matter. The American Exchange reported finding instances of failure to deliver shares after both long sales and short sales but determined that most of the cases examined did not represent rule violations or naked short selling. The NASD did not find significant rule violations or naked short selling.
The subcommittee has not completed its investigation of these findings of substantial and persistent clearing fails in issues subject to active short selling but expects to be able to report on this investigation in 1992.
7. Investigation of New York Stock Exchange proxy voting rules
The subcommittee has been concerned from the beginning of its short-selling investigation that legitimate short selling might have unintended and potentially adverse effects on investors proxy voting rights. The SEC and the SROs expressed the judgment in their hearing testimony that the subcommittees concerns were unfounded. The subcommittee determined, nevertheless, to investigate this question more deeply in late 1990, and in conducting this aspect of its investigation the subcommittee has corresponded at length with the New York Stock Exchange during 1990 and 1991.
In this correspondence the NYSE has confirmed the subcommittees basic supposition that short selling may occasionally lead to an inability on the part of brokerage firms to honor the proxy voting instructions of their customers. The subcommittees analysis of this issue appears in Section VI.
II. The Functional Role of Short Selling
The committee finds that short selling has an important and constructive functional rule in the equity market.
As an investment opportunity, short selling enables investors with negative evaluations of particular individual stocks to invest their funds so as to profit if their evaluations prove to be correct. In doing this, short sellers bring into the pricing structure of the market a balancing influence. Their negative evaluations of stocks then play a role, along with the positive evaluations of other investors who hold the same stock long in their portfolios, in determining the market price of this stock. This participation by short sellers thereby tends to enhance the efficiency of the market pricing mechanism.
The committee finds it highly significant that, among the many market participants and issuers who have complained of short-seller abuse, virtually none have held the position that short selling as an investment practice is bad or should be stopped. On the contrary, many emphasized to the subcommittee their conviction that short selling, per se, is entirely legitimate and constructive, if done according to the rules. The committee shares this conviction.
his or her broker is required to return shares that were borrowed at the time of the short sale, as described in the next section.
2. Securities borrowing and lending
Short selling normally requires that the short sellers broker must borrow securities. The purchaser of the shares in a short-sale transaction expects to receive delivery of the purchased shares, or at least the purchasers broker must receive them in order to hold them for the purchaser, but the seller does not have them to start with. The sellers broker must therefore borrow shares to complete the transaction.
Securities lending for this purpose is highly organized, and usually the sellers broker has no problem borrowing the necessary shares, either from other customers margin accounts or from another broker. Occasionally, however, the shares cannot be borrowed, in which case the broker is supposed to refuse to execute the customers order to sell short.
The sellers broker does not actually borrow the necessary shares when the short-sale trade is executed, however. The shares are not borrowed until settlement of the transaction occurs, which is normally five business days later, and this time lag can allow a problem to develop. On the settlement date, the sellers broker may discover that shares are no longer available to be borrowed from the source that seemed to have shares available five days earlier.
If the sellers broker cannot borrow the shares on settlement day, then no shares are delivered to the buyers broker. If the trade is processed through one of the major stock clearing organizations , as most now are, then no shares are delivered to the clearing organization. The short-sale trade is still a valid trade, but the sellers broker is merely late in delivering shares to complete the trade. This appears as a "fail-to-deliver" on the books of the selling broker.
3. Expansion of total beneficial ownership
Short sales of equity shares generally have the effect of increasing the total number of shares of that companys stock owned beneficially by investors. In a short-sale transaction, the buyer adds to his or her holdings of this stock, while no other investor has sold shares he or she owned.
Of course, there is no increase in the shares outstanding shown on the records of the issuing corporation. As a consequence, the short sale creates a situation in which the total number of shares owned beneficially by investors exceeds the number of shares issued by the issuing corporation.
Securities lending by brokerage firms makes this possible. Brokers normally hold shares in custody for their customers, and the customers investment holdings are reported to them on paper account statements from their brokers. When investors borrow money from their brokers on margin, as many investors do, they must sign an authorization permitting the broker to lend their shares or otherwise to pledge them as collateral for bank loans to finance the brokers lending. When a broker uses this lending authority to lend some customers margin shares to a short seller, the broker ends up holding fewer shares of that stock in custody than the number of shares the customers own, as shown on their paper account statements.
The result of such short selling and securities lending, in the aggregate, is that brokers as a group do not hold record ownership of as many shares of such a stock as they and their customers own beneficially. This may be described as a situation of fractional reserve brokerage, where the "reserves" of record shares, of issued shares shown on the records of the issuing corporation, are only a fraction of the beneficially owned shares shown on the account statements of customers and in the brokers own proprietary accounts.
This process of nominal share expansion through securities lending and short sales is very similar in its mechanics to the process of money expansion through bank lending, which is familiar to students of economics. In both cases the public holds a major part of its holdings, its money balances and its securities, in book entry form only, in accounts with intermediary institutions.
In the case of banks, these book entry holdings, the bank checking and savings accounts, show more money in total belonging to the depositors than the banks hold in their vaults or on deposit with the Federal Reserve Banks. The bank reserves are only a small fraction of depositors total bank balances on paper.
The same thing is now happening in securities brokerage firms. The total shares belonging to investors on paper, in their brokerage accounts, exceed the total reserves of registered or issued shares in the custody of the brokers when short sales have occurred.
It is not possible, however, for all investors to convert their shareholdings, as shown in their brokerage accounts, into stock certificates when such a share expansion has occurred. If all investors holding shares of a particular stock in their brokerage accounts tried to convert their holdings into stock certificates, brokers who had loaned out shares to short sellers would be forced to recall the loans to get the shares back. This, in turn, would force the short sellers who had borrowed the shares to buy back the shares in order to return the borrowed shares.
If the short sellers are able to buy back enough shares that is, if enough investors who first wanted stock certificates are willing to sell their shares instead then the remaining investors who do not sell can get stock certificates. In this case, the total shares held by investors will have contracted enough so that it matches the brokers reserves of issued shares in their custody.
However, sometimes short sellers are not able to buy back the necessary shares at a reasonable price, and a short squeeze results. All investors holding this stock are refusing to sell except possibly at a very high price, and when this happens regulatory intervention or court action may be needed to resolve the situation. As long as this short squeeze remains in effect, however, it is not possible for all the investors holding this stock in their accounts to obtain stock certificates for their holdings.
4. Expansion of tradeable shares
The expansion of book entry holdings of shares by investors when short selling has occurred also represents an expansion of tradeable shares in the market. Every investor whose brokerage account shows that he holds a certain stock may sell that stock immediately, regardless of whether his or her broker is holding enough shares in custody on that day to make delivery of all the shares sold by customers from their accounts. The rules of the stock exchanges and of the National Association of Securities Dealers (NASD), which regulates over-the-counter trading, do not place any limits on the entry of sell orders just because a brokers reserves of shares in custody are less than what that brokers customers want to sell.
5. Statistics on short interests in stocks
The New York and American Stock Exchanges and the NASD compile monthly statistics on the aggregate short security positions reported by brokers and dealers. These statistics, which are released to the press and the public, list hundreds of companies whose stock has been sold short in significant volume by investors. Short selling, and the resulting share expansion, are thus very widespread phenomena.
To provide further information on the scale of short selling and share expansion, the subcommittee has compared the short interest statistics reported monthly by the exchanges and NASD with the individual companies total shares outstanding. The purpose of this analysis was to identify cases in which the share expansion through short selling was at least 5 percent of a companys shares. The appendix contains a listing compiled by the subcommittee showing 695 companies for which the short interest in their stock was at least 5 percent of the companys total shares outstanding at some time during the years 1986-90 .
For 280 of these companies the short interest exceeded 10 percent of shares outstanding at its maximum, and for a smaller but still significant number the share expansion through short selling was over 20 percent.
B. Regulation of Short Selling
Short selling is regulated under both Federal agency regulations and under certain rules of the stock exchanges and the NASD.
As described above, the Federal Reserves margin regulations require a short seller to post a certain amount of additional cash margin, and to maintain afterward an appropriate amount of cash margin. This limits the amount of short selling an individual investor can do, based on his or her financial resources.
Certain Securities and Exchange Commission rules set important limits on short selling. SEC Rule 10a-1 (the "uptick rule") prohibits short sales of exchange-listed stocks except on or after a price "uptick." That is, the short seller must find a buyer who will pay at least one-eighth point more than the last sale price, or who will pay the same as the last sale price if the last change in the sale price of this stock was an increase. In theory, this rule is intended to prevent short selling from continually driving down the price of a stock, but evasion of this rule is possible, especially through overseas trading in stocks that can be traded in London, Tokyo, or other overseas markets. Moreover, this rule does not apply to stocks that are traded over-the-counter or in the NASDAQ system of the National Association of Securities Dealers. The NASD has proposed a similar uptick rule for NASDAQ trading, but has not taken final action to implement such a rule.
SEC Rule 15c3-3 sets important limits on the extent of securities lending. Except under special written agreements applicable to a particular stock, a broker may lend out only those customer shares that serve as collateral for the money the customers have borrowed from the broker on margin. The rule limits this to stocks having a value of no more than 140 percent of the amount borrowed. Therefore, if few brokerage customers are holding a particular stock in margin accounts that is, if most investors have paid in full for their holdings of this stock and are holding it in cash accounts or in certificate form then it may be difficult or impossible for brokers to borrow this stock. In this case normal short sales of this stock, in which borrowed shares are delivered to the buyer, may not be possible.
SEC Rule 10b-21 prohibits short sellers from closing out a short position with shares received in a secondary offering of shares by the company. This does not directly regulate short selling itself, but it seeks to control a short-selling abuse in which investors would use short sales to drive down the price of a stock just prior to a new offering of shares, and would then close out their short position with shares obtained in the offering at the lower price they had forced the company to accept.
The New York and American Stock Exchanges and the NASD have rules that require a broker to determine, at the time a customer enters a short-sale order, that the appropriate number of shares are available to be borrowed to cover the short sale. The broker must locate the required shares before executing the short sale for the customer.
The NASD also has recently received final SEC approval of a "buy-in" rule, which provides that a broker whose customer requests a certificate for NASDAQ securities that he or she has purchased must force a buy-in of the necessary shares for cash or guaranteed delivery, at the expense of the sellers broker, if the customers shares are not otherwise received through normal trade settlement procedures. Such a buy-in would typically only become necessary in cases where the broker handling a short sale is unable to borrow the necessary shares for delivery to the purchaser.
The NASD has also proposed, but has not received final SEC approval to implement, a "closeout" rule for short sales. This rule, if implemented, will require brokers, under certain circumstances, to close out customer short positions if delivery of the shares sold short has not been made by a certain number of days after the normal settlement date. There is no similar rule governing the delivery of shares sold short on the New York or American Stock Exchanges.
These rules typically provide blanket exceptions for short selling by exchange specialists and over-the-counter market makers. Specialists and market makers are generally permitted to engage in short selling on substantially more liberal terms than other investors.
C. Subcommittee Investigation and Hearings
1. Company and investor complaints
For years, investors and company executives (who are often major shareholders also) have complained about short-selling abuses. Many recent press reports of abuses, as well as other press features that dispute the reports of abuse, are reprinted in Appendix 9 of the printed subcommittee hearing record.
Many of the complaints have alleged that short sellers, after establishing a major short position in a particular stock, have aggressively circulated false rumors about the companys financial condition, problems with its products, or the health or integrity of its officers in an effort to drive down the stock price. It has also been frequently alleged that some elements of the press assist and cooperate with short sellers by printing very negative stories about the companies the short sellers have targeted.
In many cases short sellers are alleged to have contacted directly a companys major suppliers, customers, lenders, and institutional shareholders, often anonymously or under false pretenses, to aggressively suggest false or misleading "facts" about the company.
Other complaints have alleged that "naked" short selling has been employed to manipulate and drive down the price of a stock improperly. Short selling in which shares are not borrowed and are not delivered to the buyer is called naked short selling. This practice was described in a Forbes article in February 1988 .
Some complaints have been directed at the SEC. The SEC, it is alleged, is "soft" on short-seller abuse and fails to pursue cases of false rumors, even when the purpose of the false rumors is price manipulation. Some complaints have even alleged that the SEC actively assists short sellers by conducting investigations of companies in the stock of which short sellers have accumulated large short investments. These investigations assist short sellers because public announcement of such an investigation often causes other investors to sell such a stock, thereby driving down the price.
2. Survey of companies
In May and June 1989 the subcommittee mailed a questionnaire letter to approximately 200 companies that had had the short interest in their stock reach a ratio of at least 10 percent of their public float of shares at some time in the period from December 1986 through April 1989. (In the case of New York Stock Exchange listed companies, the subcommittee could not obtain float data and therefore compared the short interest of each company to its total shares outstanding.) The letter contained a series of questions asking what practical effect the short selling and the related activities of short sellers had had on the company, whether the company had experienced any disruptions or distortions of the proxy voting process, and how the company felt about three suggested changes in the regulation of short selling. The three regulatory ideas proposed in this letter were (i) mandatory public reporting of their short positions by short sellers if their positions exceed some percentage of a companys outstanding shares; (ii) an uptick rule for short sales of NASDAQ stocks; and (iii) a mandatory buy-in rule to reduce naked short selling.
The subcommittee received a total of 68 responses, for a response rate of about 34 percent. Thirty companies reported no problems or complaints arising from short-selling activity, while 38 reported problems of various sorts. Several of those reporting no problems had very substantial short positions arising from hedging or arbitrage transactions involving convertible securities, but did not feel there was any need to complain.
Widespread circulation of false rumors around the time of heavy short-sale activity was cited by 21 companies as a serious problem. They generally reported that these rumor problems, at the very least, made it necessary for company officials to devote inordinate amounts of time to reassuring stockholders, regulators, customers, and sources of debt financing, who were often seriously unsettled by the reports being circulated.
Thirteen companies characterized the short-sellers activities as involving improper interference with their relationships with customers, major shareholders, suppliers, banks, etc. Generally they complained of numerous phone calls, often anonymous, to these parties from "analysts" attempting to suggest very negative, frequently false, conclusions.
Only a small number of companies asserted that naked short selling was a significant problem. Most companies responded that they had no factual basis for determining whether naked short selling was a problem because they could not obtain the necessary data from their exchange or the NASD.
No companies reported any complaints related to shareholder proxies.
Many companies that reported specific complaints also expressed the view that short selling is a legitimate market practice and that the only need is to curb specific abuses.
Out of the 68 substantive replies received, 37 commented in some manner on one or more of the three policy ideas suggested in the letter. Public reporting of large individual short positions was supported in 32 of the responses and opposed in 2. Imposing an uptick rule for short sales of NASDAQ stocks was supported in 22 responses (13 from OTC companies), and opposed in 3. A mandatory buy-in rule or some other step to prohibit naked short selling was supported in 34 responses and opposed in 2.
In addition, various rule changes to assure informed consent by investors whose shares are lent to short sellers were suggested by seven companies.
3. Subcommittee hearings
In order to hear testimony on the allegations of short-seller abuse and on the programs of the SEC and the self-regulatory organizations (SROs) for controlling abusive practices, the Commerce, Consumer, and Monetary Affairs Subcommittee held three days of hearings in November and December 1989. On November 28, the subcommittee heard testimony from three company executives whose companies had been the targets of short selling and who reported abusive practices by short sellers. The subcommittee also heard testimony from two industry experts who gave a broader overview of short selling and its abuses, and it received for the record a statement from Joseph Feshbach of Feshbach Brothers, a major short-selling investment partnership, commenting on the issues the subcommittee had raised.
On December 29, the subcommittee heard testimony from John Guion, of the National Association of OTC Companies, and from the New York and American Stock Exchanges and the National Association of Securities Dealers (NASD). Mr. Guion reported on a survey his organization had conducted among 1,000 public companies concerning their experience with short-selling abuses and their views regarding possible regulatory improvements, from which he concluded that there is very widespread support among public companies for fuller disclosure of short-selling activity. He reported the intention of his organization to recommend to the SEC a new public reporting rule applicable to any individual short seller who accumulates a short position equal to 5 percent or more of a companys total shares outstanding.
Edward Kwalwasser, representing the New York Stock Exchange, and Stephen Lister, representing the American Stock Exchange, described the role of the SECs uptick rule in suppressing "bear raids" by short sellers and the manner in which the Exchanges, through various rules, control the spreading of misleading rumors and prohibit naked short selling. They both expressed skepticism regarding the subcommittees concern that shareholders might lose proxy voting rights when broker-dealer firms lend customers shares to short sellers. Mr. Lister also expressed concern that there might be unintended adverse effects from requiring public reporting of large individual short positions.
John Pinto and Gene Finn, testifying for the NASD, described the NASDs recent and proposed rule changes for strengthening their controls over naked short selling and other short-selling abuses. They opposed the extension of the SECs uptick rule to NASDAQ trading, basing their analysis in part of a major study of short-selling regulation that had recently been completed by Irving Pollack, a former SEC Commissioner and senior regulatory official. They also commented briefly on several other regulatory issues related to short selling.
Richard Ketchum, Director of the SECs Division of Market Regulation, and John Sturc, Associate Director of the SECs Division of Enforcement, presented the testimony of the Securities and Exchange Commission on December 6. They described at length the regulatory and enforcement programs of the SEC as they apply to short selling, and their prepared testimony also included detailed responses to a number of questions the subcommittee had submitted in advance. On the question of extending the uptick rule to NASDAQ securities, the SEC position was that they did not believe a need for this rule change had been demonstrated, but the SEC would continue to study the merits of this proposal. Regarding the proposal for public reporting of large individual short positions, they stated that the SEC does not favor public reporting that reveals potentially sensitive trading strategies, and furthermore that the SEC lacks authority to impose such a requirement without legislation.
4. Analysis of American Stock Exchange surveillance report
In 1987 the American Stock Exchange (ASE) investigated company allegations of possible manipulative activity in connection with short selling in the securities of three ASE-listed companies. The Exchange prepared and submitted to the SEC a lengthy surveillance report dated November 6, 1987, in which the Exchange reported finding no evidence of manipulation but recommended further inquiry by the SEC. The SEC provided a copy of this report to the subcommittee immediately prior to the 1989 hearings, with a request that it be treated as a confidential document because of its detailed data on individual security trades by certain individuals.
Following the hearings the subcommittee analyzed the surveillance report in substantial detail in order to evaluate the thoroughness of the American Exchange investigation.5. Study of SEC investigations of short-sale target companies
Following the hearings the subcommittee inquired of the SEC by letter what percentages of formal investigations and informal inquiries opened by the SEC to investigate companies for accounting fraud or other fraudulent public disclosures involved companies where a short interest existed, at the time the Commission began its inquiry, of at least 5 percent of the companys total shares outstanding. The purpose of the subcommittee inquiry was to attempt to verify company complaints that the SEC often assisted short sellers by investigating companies that the short sellers had identified as targets.
The SEC responded that they did not have the necessary information in their possession to respond to this inquiry. The SEC did offer, however, to permit subcommittee staff to view listings of SEC formal and informal investigations opened regarding suspected cases of the sort specified by the subcommittee.
A subcommittee staff person therefore compiled from these SEC listings and from the published monthly short interest reports released by the NASD the necessary data to prepare a partial answer to the question. The compilation prepared by the subcommittee covers SEC investigations of NASDAQ companies opened between March 1988 and March 1989.
6. Analysis of NSCC fails data, December 1990
In order to investigate company allegations of naked short selling, the subcommittee requested from the National Securities Clearing Corporation daily tabulations of clearing shorts (failures to deliver securities by settlement date) and clearing longs (failures to receive securities by settlement date) for every trading day in December 1990. The subcommittee received daily data from NSCC showing clearing shorts that aggregated at least 10,000 shares in a given equity issue and that were due from selling brokers who had been short in that issue for at least 5 trading days. The subcommittee also received data showing daily clearing longs on a comparable basis.
The subcommittee then prepared summary tabulations from the data provided by NSCC. These tabulations show individual stocks in which the clearing short position at NSCC that was due from brokers who had been continuously short for at least 10 days averaged at least 20,000 shares throughout the entire month of December. The subcommittee compared these cases of substantial and persistent clearing shorts with the publicly reported investor short interest statistics for December 1990.
In these tabulations the subcommittee identified 31 New York Stock Exchange issues, 28 American Stock Exchange issues, 129 NASDAQ issues, and 54 issues the subcommittee could not identify as to market but which appeared to be non-NASDAQ over-the-counter issues. Many of the issues shown in these tabulations also were reported as having substantial investor short positions in the monthly statistical reports as of December 15, and several were issues that had been reported in the press as the targets of professional short sellers. Several others were the stocks of companies that have expressed complaints about short-selling abuse.
The subcommittee then, in March 1991, requested evaluations from the SEC, the New York and American Stock Exchanges, and the NASD as to whether the persistent clearing fails shown in the tabulations reflected naked short selling, and if not what other factors accounted for such persistent and substantial clearing fails.
The SEC has not responded to this inquiry. The New York Exchange has tentatively reported apparent rule violations in three cases but has not completed its review of the matter. The American Exchange reported finding instances of failure to deliver shares after both long sales and short sales but determined that most of the cases examined did not represent rule violations or naked short selling. The NASD did not find significant rule violations or naked short selling.
The subcommittee has not completed its investigation of these findings of substantial and persistent clearing fails in issues subject to active short selling but expects to be able to report on this investigation in 1992.
7. Investigation of New York Stock Exchange proxy voting rules
The subcommittee has been concerned from the beginning of its short-selling investigation that legitimate short selling might have unintended and potentially adverse effects on investors proxy voting rights. The SEC and the SROs expressed the judgment in their hearing testimony that the subcommittees concerns were unfounded. The subcommittee determined, nevertheless, to investigate this question more deeply in late 1990, and in conducting this aspect of its investigation the subcommittee has corresponded at length with the New York Stock Exchange during 1990 and 1991.
In this correspondence the NYSE has confirmed the subcommittees basic supposition that short selling may occasionally lead to an inability on the part of brokerage firms to honor the proxy voting instructions of their customers. The subcommittees analysis of this issue appears in Section VI.
II. The Functional Role of Short Selling
The committee finds that short selling has an important and constructive functional rule in the equity market.
As an investment opportunity, short selling enables investors with negative evaluations of particular individual stocks to invest their funds so as to profit if their evaluations prove to be correct. In doing this, short sellers bring into the pricing structure of the market a balancing influence. Their negative evaluations of stocks then play a role, along with the positive evaluations of other investors who hold the same stock long in their portfolios, in determining the market price of this stock. This participation by short sellers thereby tends to enhance the efficiency of the market pricing mechanism.
The committee finds it highly significant that, among the many market participants and issuers who have complained of short-seller abuse, virtually none have held the position that short selling as an investment practice is bad or should be stopped. On the contrary, many emphasized to the subcommittee their conviction that short selling, per se, is entirely legitimate and constructive, if done according to the rules. The committee shares this conviction.
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