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E-MailThis post comes to us from Lanny A. Schwartz and Gerard Citera of Davis Polk & Wardwell. A memorandum, issued after this post was published, describing amendments to the temporary banning order is available here.
Yesterday the SEC issued an order temporarily banning all persons from short selling publicly traded securities of any issuers that are included in a list of financial companies attached to the order. The order, which is currently effective, expires at 11:59 p.m. (Eastern) on October 2, 2008.
There are several narrow exceptions to the blanket short selling ban, including:
• Registered market makers, block positioners, or other market makers obligated to quote in the over-the-counter market that are selling short as part of bona fide market making in a security;
• short sales that occur as a result of automatic exercise or assignment of an equity option held prior to the effectiveness of the order; and
• until 11:59 p.m. on September 19, 2008, short selling as part of bona fide market making and hedging activity related directly to bona fide market making in derivatives on the publicly traded securities of a covered issuer.
The SEC stated that it took this extreme action because of its belief that fair and orderly markets were threatened by the sudden and excessive fluctuations in prices of financial institution securities, which may have been fueled by short selling. In the SEC’s view, such conditions have contributed to a crisis of confidence without an underlying basis.
Unlike a similar action taken by the U.K. Financial Services Authority on September 18th, the prohibition is not limited to the active creation or increase of net short positions. Without this exception, it would appear that financial institutions (including those the SEC is trying to protect) and other market participants who hold convertible securities, options and other equity derivatives, cannot adjust their delta hedge positions in the underlying common stock that hedge their risk of owning the equity derivatives. Therefore, contrary to its intent, the SEC action may significantly limit the ability of the indentified financial institutions to access the convertible and equity derivative markets.
The SEC has been addressing a number of specific questions and concerns that have been noted. For example, we understand that the SEC staff has informally advised market participants that, despite the reference to “publicly traded security” in the order, the order is not intended to cover debt securities. Also, a number of issuers believe that they have been inadvertently omitted from the list of financial institutions whose stock is covered by the order, and Davis Polk has been in contact with the SEC staff concerning revising the list.
At the same time as it issued this emergency order, the SEC also took two further actions, including the issuance of emergency orders to establish short sale and short position reporting requirements for institutional investment managers and a liberalization of certain requirements under Rule 10b-18 under the Securities Exchange Act of 1934 concerning securities repurchases by issuers.
The SEC press release on these actions is available here. The list of companies covered by the SEC’s short sale ban is in Appendix A to the order, which is available here.
One Comment
I am reminded of a “Jackass” episode in which they rent a car, take it to a demolition derby, and then return the destroyed car to the rental agency on the following day. When the agency informs the driver that he will have to pay for the damages, he responds with a kind of “What’s your problem? I paid the rental fees, so I don’t owe you anything more” attitude.
I don’t remember anyone asking my permission to loan them my 500 shares of AIG stock so that they could short-sell them. If they had, I would have asked “Why would I want to loan you my shares? What’s in it for me?”.
Of course, someone short-selling my 500 shares can hardly move the market, but the larger question is why ANYONE who holds a long position would willingly give their shares to someone else only to have the shares returned a few days later damaged (or even destroyed).
In the worst case (as with AIG), the borrower uses my shares to profit from driving down the price. I get back shares that are now worth much less than they were before. This is obviously not to my benefit.
In the “best” case, the person shorting the shares misjudges the market and has to buy them back at a higher price, presumably to my benefit because I now get back shares that are worth more. But the increase in price isn’t based on AIG’s performance, it is based on speculative return. Such returns can evaporate just as easily as they have been created, and I fail to see how this type of trading adds any stability to market pricing (particularly for fundamental investors such as myself).
Bearish investors and speculators can achieve the same type of short-selling results by purchasing Put options or selling naked Calls. It seems to me that speculators and hedgers should be confined to the derivatives arena where their actions can not be construed as having anything to do with INVESTOR confidence (or lack of confidence) in the underlying equity price.
In my view, only long positions should be allowed for equities; speculators can play in the derivatives sandbox. I further submit that such segregation would make it easier to discern whether prices are being influenced by INVESTORS or by SPECULATORS.
Given the ability to achieve the same results through the use of derivatives, my question is why don’t we simply disallow ALL shorting of equities? Given the events of the past few weeks, I doubt that anyone can any longer make the case that shorting is healthy for stable and liquid markets…