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2nd UPDATE: SEC Tightens Short-Sale Rules With Firm Close-Out
09/17 02:22 PM

(Adds details on restrictions in third paragraph, and background on previous tick-test restrictions and the SEC's emergency order in the tenth and 11th paragraphs. Also adds reaction from bankers' group in eighth and ninth paragraphs and from hedge fund group at end.)
By Judith Burns
Of DOW JONES NEWSWIRES
WASHINGTON ()--The Securities and Exchange Commission announced measures Wednesday to curb abusive "naked short sales" by imposing a firm close- out requirement on short sellers and their brokers.
Short sellers and brokers must deliver securities borrowed for short sales on the trade settlement date, three days after the transaction, or face penalties if they do not, the SEC said.
The tighter delivery requirement was adopted by the SEC as an interim final rule, an unusual step for federal regulators, and will take effect for all public-company securities starting at 12:01 a.m. EDT Thursday. Brokers acting on behalf of customers who violate the new close-out requirement will be barred from further short sales in the affected stock for any customer unless the shares are located and borrowed in advance, the SEC said.
Additionally, the SEC finalized two other changes it previously proposed. One eliminates an exception from the close-out requirements for options market makers, making them subject to the same rules as everyone else. Regulators said that change will take effect five days after it is published in the Federal Register.
The SEC also approved a new anti-fraud rule targeted to short sellers who lie about their ability to deliver borrowed securities, which the SEC said takes effect immediately.
Short sellers aim to profit from declining stock prices by borrowing shares to sell and replacing them later at a lower price. So-called "naked" short sellers do not borrow shares before engaging in short sales and may never do so, a practice that can have punishing effects on a stock's price.
SEC Chairman Christopher Cox said in a statement that the changes "make it crystal clear that the SEC has zero tolerance for abusive naked short selling."
The American Bankers Association said it strongly supports the SEC's actions and the "aggressive" timetable for stricter delivery requirements, saying it has advocated for such changes since early July.
"In recent weeks, this unlawful manipulation of stock prices has resulted in precipitous drops in stock prices, extremely high trading volumes, and huge spikes in failures to deliver among our publicly traded member banks and bank holding companies," the ABA said in a statement.
SEC critics may not be satisfied with the changes, which do not call for reviving "tick test" restrictions outlawed by the SEC last year after a lengthy experiment. The Depression-era restrictions ban short sales unless prices are moving higher; the SEC concluded that they had little effect and weren't needed any longer. Wachtell, Lipton, Rosen & Kaz, a New York law firm, has called for the SEC to reimpose the uptick rule, and did so again this week.
The changes are the latest in a series of actions the SEC has taken to attack short-selling abuses. A temporary emergency order issued this summer required borrowing shares in advance of short sales in 19 financial stocks, including federal housing-finance giants Fannie Mae (FNM) and Freddie Mac (FRE), and U.S. Treasury securities dealers, chiefly Wall Street firms. After the order expired, Cox promised the SEC would look to extend similar protections market-wide.
The SEC's short-sale initiatives predate the current market turmoil. The agency adopted a package of reforms known as Regulation SHO in 2004 to tighten delivery requirements for short-sale trades. Among other things, the rule requires delivery failures in hard-to-borrow "threshold" securities to be closed out within 13 days. Option market makers were excluded from the stricter delivery requirements, however.
Option market makers balked at a 2007 SEC proposal to eliminate the exception, but the SEC reissued it in July after its economists found that many failures to deliver borrowed stocks were due to the option-market maker exception.
Although option market makers have warned that market liquidity could suffer if they are subject to stricter stock delivery requirements, SEC commissioners appear to have put those concerns aside and opted to treat option market makers like other market participants.
The new anti-fraud rule, proposed in March, expressly targets fraudulent short sales. Since the SEC already has broad anti-fraud powers, "whether they actually needed to do a rule is debatable," said Larry Bergmann, a special counsel at the law firm of Willkie, Farr & Gallagher LLP, in Washington, D.C., and former senior associate director in the SEC division that oversees trading and markets.
The Coalition of Private Investment Companies, whose members include hedge funds, praised the new anti-fraud rule, saying it sends "a strong signal to market participants that providing false information about stock borrowing will be dealt with harshly."
In a prepared statement, CPIC Chairman James Chanos, founder and president of Kynikos Associates, a New York firm known for short selling, called the changes "tough and balanced."
While Chanos endorsed having stock deliveries occur within three days of a trade settlement, he expressed concern that the change could have "unintended consequences" and urged the SEC to carefully monitor any fallout. Chanos also questioned the need to have the new rule take effect without any advance notice or public comment period.
-By Judith Burns, Dow Jones Newswires, 202-862-6692; [e-mail]