Ban on Naked Short-Selling in the U.S. 


Spring 2009 - (InBrief Spring 2009)

InBrief Spring 2009

It appears that the ban imposed by the United States Securities and Exchange Commission on naked short-selling will be permanent. It is unlikely that Canadian regulators will alter the rules with respect to short-selling because the imperatives for further regulatory action do not appear as compelling in Canada. What is the Essence of Naked Short-selling?

Short-selling is the practice of selling securities the seller does not own, with the intention of acquiring the securities (or "covering" the short position) at a lower price in the future. The short-seller traditionally borrows the securities from a dealer for a fee and makes a profit based on how far the price of the security declines before he must pay for the covered securities.

For those unfamiliar with it, short-selling has historically been seen as something of a black art. More recently, it has been blamed for contributing to the recent crisis in financial stocks and institutions. For example, Morgan Stanley's John Mack complained that short-sellers wrestled his company's stock to the ground. The second largest pension fund in the U.S. called short-sellers "piranhas" and refused to lend stock to them. New York's Attorney General Andrew Cuomo likened short-sellers to "looters after a hurricane."

In a "naked" short sale, the short-seller does not formally borrow the security (i.e., obtain a positive confirmation that the dealer is in a position to lend the shorted securities) before shorting. Furthermore, the short-seller does not meet the standard requirement for settlement by delivery of shares within three days of the trade ("T+3 Settlement").

The fact that the naked short-seller does not borrow the security puts downward price pressure on the security through what is, in effect, an artificial increase in the supply of that security. In a naked short sale, the short-seller is at immediate risk of a buy-in if delivery of the shares is insisted upon by the buyer of the securities sold short. For this reason, naked short-selling is often done with a very short-term outlook where price declines are in progress.

SEC Action Against Naked Short-Selling

On September 18, 2008, the SEC adopted temporary measures against naked short-selling. Unlike the SEC's restrictions against short sales of certain financial stocks, these measures were not allowed to lapse. On October 14, 2008, the SEC extended these measures by adopting an interim final temporary rule ("Rule 204T"), effective as of October 17, 2008.

To avoid exacerbating price declines in securities, the SEC's new rule effectively prevents naked short-selling by requiring a T+3 Settlement. The ban applies to naked short-selling in all stocks, not just financial ones.

Under the rule, short-sellers and their broker-dealers must deliver shorted securities for clearance and settlement by the close of business within three days of the date of the short sale. If they have not delivered the shares by the settlement date, they must immediately purchase or borrow securities to close out the fail to deliver position no later than the beginning of regular trading hours on the next day. A participant or broker-dealer who fails to comply with this rule may not accept further short sales in that stock, unless it has previously arranged to borrow or has borrowed the security, until the fail to deliver position is closed.

The SEC also adopted a final rule that makes options market makers subject to the T+3 Settlement requirement.

As part of these efforts, on September 18, 2008, the SEC also adopted, on a temporary basis, a new anti-fraud rule under Section 10(b) of the Exchange Act to address deceptive short-selling practices. On October 14, 2008, the SEC made this rule permanent, effective October 17, 2008.

New Rule 10b-21 provides that short-sellers who make misrepresentations about their intent and ability to deliver equity securities in compliance with the T+3 Settlement requirements are in violation of the law when they fail to deliver the securities as represented. This rule is intended to flush out the situation where the short-seller does not advise the broker that the shares are being sold short, but rather directs the broker to sell shares that are not in the account on the basis of an implied promise by the seller to lodge the shares before settlement is required or buy them back and cover at that time.

Canadian Restrictions to Come?

The SEC coordinated some of its recent activity to stabilize markets with the United Kingdom's Financial Services Authority, which passed some similar measures. Canada's financial sector has not been rocked as severely by sub-prime loan related market turmoil and the imperatives for action have not appeared as compelling as they have in the U.S. and perhaps the U.K. Although possible, it is unlikely that Canadian regulators will pass significant, permanent restrictions on short-selling, as the current rules appear to address the concerns that led to the restrictions in the United States.

by Daniel Dex

This article appeared in the Lang Michener LLP InBrief Spring 2009.