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.