SEC’s Restrictions on Short Selling in Melting Scrip

(The following post has been contributed by Ravichandra S. Hegde of J. Sagar Associates)

The Securities and Exchange Commission (“SEC”) in February 2010 has amended Rule 201 of the SHO Regulations[1] framed under the Securities Exchange Act of 1934 (“Act”) restricting abusive short sale in the falling scrip thereby retaining investor confidence.

The amendment effected to Rule 201 is primarily intended to protect the interest of the long term shareholders and to further protect the market stability of the scrip. In what may be termed as an additional measure of discouraging the making of a fast buck by market players, SEC has imposed certain restrictions on short selling of the securities which are experiencing significant downward price pressure. This measure can be called as a review by SEC of the existing “free trade” policies which began in July 2007 when SEC had eliminated all short sale price test restrictions. Prior to that time, short sale price test restrictions were included in Rule 10a-1 under the Exchange Act which was commonly known as the “uptick rule” or “tick test”. This Rule applied to exchange-listed securities, and the National Association of Securities Dealers, Inc.’s (“NASD”) bid test.

Short selling involves the selling of a security that an investor or a trader does not have in possession when placing the sale order in the system. A short seller sells the security in the market with an expectation that he can buy back the same security at a later date for a lower price than it was sold for. The difference in the selling price and the buying price would be the profit earned on short selling. In 2005, Regulation SHO was enacted which required the broker-dealer to have grounds to believe that shares will be available for a given stock transaction, and requiring that delivery take place within a limited time period. As part of its response to the crisis in the North American markets in 2008, the SEC issued a temporary order restricting short-selling in the shares of 19 financial firms deemed systemically important, by reinforcing the penalties for failing to deliver the shares in time. There has been speculation that naked short selling played a role in driving companies such as Washington Mutual and Lehman Brothers into bankruptcy. Effective September 18, 2008, amid claims that aggressive short selling had played a role in the failure of financial giant Lehman Brothers, the SEC extended and expanded the rules to remove exceptions and to cover all companies.

The amendments introduced to Rule 201 will discourage short sellers from selling at or below the current national best bid while the circuit breaker is in effect, the short sale price test restriction in Rule 201 will allow long sellers, who will be able to sell at the bid, to sell first in a declining market for a particular security. SEC says that the goal of such restrictions is to allow long sellers to sell first in a declining market. A short seller who is seeking to profit quickly from accelerated, downward market moves may find it advantageous to be able to short sell at the current national best bid. In addition, by making such bids accessible only by long sellers when a security’s price is undergoing significant downward price pressure, Rule 201 will help to facilitate and maintain stability in the markets and help ensure that they function efficiently.

Rule 201, which will be operative from May 2010, includes the following features:

Short Sale-Related Circuit Breaker: The circuit breaker would be triggered for a security any day in which the price declines by 10 percent or more from the prior day’s closing price.

Duration of Price Test Restriction: Once the circuit breaker has been triggered, the alternative uptick rule would apply to short sale orders in that security for the remainder of the day as well as the following day.

Securities Covered by Price Test Restriction: The rule generally applies to all equity securities that are listed on a national securities exchange, whether traded on an exchange or in the over-the-counter market.

Implementation: The rule requires trading centers to establish, maintain, and enforce written policies and procedures that are reasonably designed to prevent the execution or display of a prohibited short sale.

However, upon written application or upon its own motion, SEC may grant an exemption from the provisions of this Rule, either unconditionally or on specified terms and conditions to the extent that such exemption is necessary or appropriate, in the public interest, and is consistent with the protection of investors.

[1] The SEC enacted Regulation SHO in January 2005 to target abusive naked short selling by reducing failure to deliver securities, and by limiting the time in which a broker can permit failures to deliver.

– Ravichandra S. Hegde

About the author

Umakanth Varottil

Umakanth Varottil is an Associate Professor at the Faculty of Law, National University of Singapore. He specializes in corporate law and governance, mergers and acquisitions and cross-border investments. Prior to his foray into academia, Umakanth was a partner at a pre-eminent law firm in India.

Add comment

Top Posts & Pages


Recent Comments


web analytics

Social Media