Short Selling Under SEC Scrutiny

Short sellers have been vulnerable to attack on the claim that they’re spreading rumors or are out to destroy a company. Companies have mounted public-relations campaigns against them. In a short sale, investors borrow shares and immediately sell them, hoping to profit by replacing them later at a lower price – a sell-high, buy-low strategy.

There have been concerns that short sales are behind the big price slides. Short sellers seek to profit from a stock’s decline by selling borrowed shares and replacing them at a lower price. Short sellers have been blamed for the declines in stocks including Fannie Mae and Freddie Mac which were taken over by the Federal government last month.

Concerned about the possible unnecessary or artificial price movements based on unfounded rumors regarding the stability of financial institutions and other issuers exacerbated by short selling, the U.S. Securities and Exchange Commission (SEC) has come out with a new set of rules. The SEC also banned the short selling of nearly 1000 stocks until three days after the $700 billion rescue package is enacted into law.

The new rules require money managers with at least $100 million under management to report short selling if it exceeds a certain percentage of the shares outstanding and is greater than $1 million in value. Short sellers who haven’t added to their positions since the rule went into effect won’t have to report. Mutual funds and exchange-traded funds that short stocks also are subject to the disclosure rules. The disclosures would be made public by the SEC with a two-week delay – due to start in mid-October.

The new rules bring an end to secrecy which short sellers have long held to be one of their dearest tools. Short sellers will have to report which stocks they are short and how their exposure to those stocks changes during the day. The new rules have been welcomed by some who feels that since investors who own 5% of a company’s outstanding shares have to report their stakes, there is no reason for short sellers not to.

The new set of rules has been criticized by many. Forcing such public disclosure would be like asking Coca-Cola to reveal the super-secret formula for its popular fizzy beverage. It could lead to variety of consequences, some of them unintended. Short sellers are already plotting changes in strategy. Short sellers represent a supply of shares when the market is rising and demand for shares when markets are falling. It could affect the liquidity of some stocks if short sellers retreat fearing companies will cut off information flow, investment firms will lock them out of investor conferences and competitors will see who has built what positions. Stocks exposed as targets of well-known shorts could suffer if other investors piggyback on the same companies.

The SEC subsequently modified the disclosure requirement stating that the disclosure will not be made public. This came as a relief to short sellers and other hedge-fund managers worried that public disclosure of their bearish bets might expose them to pressure from the companies they target.

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