The Securities and Exchange Commission (“Commission”) recently voted to amend Regulation SHO, the short selling rule under the Securities Exchange Act of 1934 (“the Rule”). The effective date of the rule is May 10, 2010 and the compliance date is November 10, 2010. The amendments, and the process leading up to the vote itself, were not without significant debate, controversy and consternation among market participants.
In “short”, the Commission voted to adopt a type of circuit breaker that imposes “a restriction on the prices at which securities may be sold short, according to the 334-page Rule release (a substantial portion of which is for discussion of the rule’s cost-benefit analysis and its Paperwork Reduction Act impact).
The Rule provides for a “short sale price test” with respect to national market system securities (NMS stocks), i.e., those traded on a national securities exchange. The Rule does not cover options and does not cover non-NMS stocks such as those quoted on the over-the-counter (“OTC”) bulletin board. If a security’s price drops by 10 percent during a single trading day from the prior day’s closing price, the circuit breaker is activated. This remains in effect for the rest of the trading day and the following day. The amended rule, of course, has exceptions. For example, a short sale may be designated as “short exempt” where at the time the order was placed it was priced above the current national best bid. Riskless principal transactions are also exempt.
Commission Goals and Public Comment
The Commission noted in the release that the Rule was being amended to prevent short selling from further driving down the price of a security that has already experienced a significant “intraday” price decline including through “potentially manipulative or abusive short selling”. Rather than imposing a more wide-ranging, permanent restriction, the Commission imposed what it describes as a “narrowly-tailored Rule” in keeping with the fast pace of modern electronic trading. Part of the goal expressed by the Commission in amending the Rule, was to allow for long sellers to sell first in a declining market.
As background, during the height of the market crisis, the Commission had taken emergency action to curtail short selling. In light of those actions and other factors, interest among industry participants and investors was high with respect to any additional changes to regulations affecting short sales. During the comment periods, the Commission received over 4,300 letters with respect to the proposed amendment of the Rule. Those commenting disagreed regarding whether the amendments would have a positive or negative effect on the markets and whether they would serve to lessen volatility. Many questioned the need for, or the potential effectiveness of, any amendments to the rule. One study noted that during periods of price declines, much of the sales pressure came from long, rather than short sellers. The release notes that several comments were favorable to imposing short selling restrictions, supporting an effort to solidify or restore investor confidence in the markets.
In the Rule release, the Commission expressed multiple times, its desire to maintain investor confidence and trust with respect to the financial markets and to maintain “smooth functioning of the markets.” This is a notable example of how the Commission has reacted to the market crisis and economic conditions, as well as how seriously it considers the impact the market crisis and economy have had on investor trust in the markets. The Commission noted that despite recently improved stability in the markets, future downward pressure and fears of unrestricted short selling could erode investor confidence in the markets and increase market turmoil.
Impact on Investment Advisers
The impact on broker-dealers is discussed widely throughout the rule release. What is interesting, however, is that not once in the release is the term “investment adviser” used. That notwithstanding, the Rule could have an impact on investment advisers who engage in short selling. Although, as mentioned above, a study indicated that short selling represents a relatively small amount of overall volume, many investment advisers engage in short selling and some have aggressive trading strategies that involve short selling and taking advantage of quick changes in market activity by making trades based on certain trigger points or quantitative models. This type of activity is undertaken not only by Commission-registered investment advisers but also by unregistered firms including those that manage private funds. It is worth acknowledging that the release also does not mention the terms “private fund”, “pooled investment vehicle”, “hedge fund” or even “mutual funds”. The term “investment company” is only used in footnotes in reference to organizations such as the Investment Company Institute. Despite that, these market participants are significant actors in respect to short selling, and the restrictions can have an effect on their trading strategies and perhaps their business in general. The Rule could also have an impact on dually-registered investment adviser/broker-dealers or investment advisers affiliated with broker-dealers especially if advisory client trades are effected through the broker-dealer “side”. Dually-registered advisers/broker-dealers should ensure that their broker-dealer policies, procedures and practices are revised so as to be designed to comply with the amended Rule as the amendments are largely based on maintenance of policies and procedures.
Although market volatility has eased and stability appears to have returned to the markets, some investors are still wary of the markets, distrust financial institutions and are not appreciative of actions taken by the federal government, including the Commission, with respect to the economic and market crisis. The amendments to the Rule may help, in part, further the Commission’s stated goal of restoring and maintaining investor confidence and trust. However, short selling is not an activity in which many individual “non-sophisticated” investors engage, and the impact of these amendments will likely not be of much relevance to these investors. Therefore, this move will likely only represent a small part of the efforts the Commission and other regulators take in order to fully restore individual investor confidence in the markets. While sophisticated investors and market participants, such as investment advisers and broker-dealers, will quickly adjust to the new provisions (perhaps with some ranting and raving along the way), the individual investor will insist that regulators and major market participants first demonstrate reliability and stability before any trust is earned back.