Review of the Policy Debate over Short Sale Regulation during the Market Crisis

I. INTRODUCTION This article summarizes the recent history of short sale regulation, and academic research on the subject. It then discusses the impact of the market crisis beginning in 2007 on short sale regulation, the current debate over the Securities and Exchange Commission's ("SEC") revisions to Regulation SHO, and a general issue of public perception of risk and regulatory policy in complex financial markets. II. OVERVIEW OF SHORT SALE REGULATION Short sales serve three purposes. First, traders use short sales to profit from anticipated declines in stock prices, selling borrowed shares at a high current price and hoping to repay the loan with shares purchased at a subsequent lower price. Second, market makers, responding to incoming buy orders for stocks they do not have in inventory, sell shares that they do not possess but can acquire within designated settlement periods as part of their market-making function. Third, short sales are an important component of complex electronic trading and hedging strategies; for example, to manage overall portfolio risk, participants combine long positions that increase in value as prices increase with short positions increasing in value as prices go down. Short sales in market making or complex trading and hedging strategies do not target anticipated declines in the price of stocks; they facilitate transactions by others, or are part of a broader technique based on the relative prices of different securities. These now constitute the largest share of short selling, especially as electronic trading comprises such a large share of market activity. For example, Credit Suisse notes that only 0.7 percent of hedge funds' short sales are "dedicated shorts," or designed to profit from anticipated declines in specific stock prices. (1) "Dedicated short" selling, however, generates the most attention in regulatory debates. Those defending short selling maintain that short sellers improve markets by investigating and disclosing information about over-valued stocks. (2) Corporate issuers, holders of particular stocks, or other parties maintain, however, that short sellers, by selling at progressively lower prices, spreading negative rumors about companies, and other manipulative methods, commonly induce stock price declines by concerted short selling rather than correct inflated prices. Market declines historically produce calls for tighter controls on short selling. In 1932 J. Edward Meeker reviewed how this debate was an important part of financial crises going back hundreds of years, (3) and Charles Jones discussed how the debate played out in the 1930s and in the market declines in 2008. (4) In 1938 the SEC issued Rule 10a-1 under the Securities Exchange Act, prohibiting short sales of exchange-listed securities at levels below the last sale price, or at the last sale price "unless that price was above the next preceding different price" (a zero-plus tick); the purpose was to prevent short sellers from driving prices down through sales at progressively lower prices. (5) The Securities and Exchange Commission reviewed recent history of short sale regulatory proposals in a 1999 concept release. (6) The SEC's Report of the Special Study of the Securities Markets in 1963 suggested that short sale regulation "did not prevent the harmful effects of short selling that the rules were designed to prevent," but acknowledged that the data to support such conclusions needed improvement. (7) In 1976, the SEC proposed temporary suspensions of short sale pricing rules to permit analysis of how the markets would function without them. (8) Eight of the twelve comments on the proposal, including those by the New York Stock Exchange ("NYSE") and Amex, opposed the suspensions, arguing that even temporary relaxation of short sale restrictions would damage the markets. The SEC withdrew the proposal in 1980. The House Committee on Government Operations issued a report on short selling in 1991. …