On June 13, 2007, the Securities and Exchange Commission (SEC) voted to eliminate Rule 10a-1 under the 1934 Securities Exchange Act, the uptick rule, which for 70 years had placed restrictions on short selling of exchange-listed stocks. In the months following the rule's withdrawal, some concerns arose that there might be a relationship between that action and a perceived heightening of stock market volatility. During part of September and October 2008, the SEC temporarily suspended all short selling in about 1,000 financial stocks. After the ban expired, attention shifted back to the issue of whether the agency should reinstate the uptick rule. In April 2009, the SEC put forth a number of proposals, including one that would involve a market-wide, modified uptick rule. On February 24, 2010, in a split vote, the SEC adopted an alternative uptick rule in which a security-specific circuit breaker would be triggered if a stock's price declines by 10% or more from the previous trading day's closing price, resulting in a temporary restriction on short selling in the stock. This report looks at the background, public policy considerations, and controversies surrounding the genesis of the uptick rule, its repeal, and legislative and administrative developments after the repeal, including the SEC's February 2010 adoption of an alternative uptick rule. Short selling involves selling a stock that the seller has borrowed. If the stock price goes down, the seller buys it back from the market and settles the transaction at a profit. To sell a stock short, an entity like a broker-dealer will lend stock to the prospective short seller, stock taken from the entity's inventory. At some point, the short seller closes the short position by buying back the same number of shares (called covering) and returns them to the broker. If the price drops, the trader can buy back the stock at the lower price and make a profit on the difference. But if the price of the stock rises, the trader must buy the stock back at the higher price, thus losing money. A frequent source of this borrowed stock is broker held margin stock. Short sellers are generally considered to be speculators seeking a profit or brokerage house employees such as market makers managing their positions. One measure of short selling is known as the short interest, the total number of shares of a particular stock that have been sold short by investors but have not yet been covered or closed out. When expressed as a percentage, it represents the number of shorted shares divided by the number of shares outstanding. For example, at the close of business on the settlement day of May 15, 2009, the NYSE Group reported that short interest equaled about 3.96%. In popular lore, short selling is often depicted as questionable and a form of stock market manipulation. Indeed, the history of the U.S. markets is fraught with various instances in which certain kinds of manipulative short selling appear to have had a problematic market impact. There have been instances of a particularly egregious form of stock manipulation known as a "bear raid." In a bear raid, a particular stock is sold short in an effort to drive down the price of the security by creating an imbalance of sell-side interest. The operatives then place themselves in a position to acquire the stocks at artificially deflated prices. In addition, unfettered short selling can exacerbate a declining market in a security by increasing seller-based pressure, thus reducing interest in bidding to acquire the stock, and thereby causing a further reduction in the price of a stock by creating an appearance that the security price is falling for fundamental reasons. Short selling can, however, also confer a number of economic benefits on markets, including providing them with the following: Greater Market Liquidity. Short selling by market professionals can offset temporary imbalances in the demand and supply for stock shares. Additionally, short sales can also add to the trading supply of stock that is available to prospective buyers and reduce the risk that the share prices paid by them are artificially high because of a temporary contraction in a given stock's supply. Greater Market Efficiency. Efficient markets require that prices fully reflect all buy and sell interests in traded securities. Investors who think that a given stock is overvalued may conduct short sales in an attempt to profit from a perceived divergence of stock prices from their actual values. These short sellers add to stock pricing efficiency because their transactions inform the market of their evaluation of future stock price performance, an evaluation that is reflected in the resulting market price. Arbitrageurs also contribute to pricing efficiency by utilizing short sales to profit from price disparities between a stock and a derivative security like a convertible security or an option on that stock. An arbitrageur may purchase a convertible security and sell the underlying stock short to profit from a current price differential between two economically similar positions. Rule 10a-1 under the 1934 Securities Exchange Act placed restrictions on short sales. The rule, which was adopted in 1938, provided that, subject to certain exceptions, an exchange-listed security (New York Stock Exchange and American Stock Exchange) can be sold short: (1) at a price higher than the preceding transaction in the same security (called the plus tick rule), or (2) if the price is the same as the previous transaction price but at a higher price than the last trade of a different price (the zero plus tick rule). Short sales, however, were not permitted (1) on the sale of a stock at a price that is less than the previous sale price (minus tick); and (2) at the same price as the previous price but at a lower price than the last different price (zero downtick). Collectively, these limitations were known as the tick test or the uptick rule. By eliminating both the prohibitions on minus ticks and zero downticks, the SEC's elimination of the tick test effectively lifted the proscriptions on selling stock short when its price is falling. In adopting Rule 10a-1, the SEC's declared goal was to prevent short sellers from manipulating stock prices, causing successively lower share prices. The rule was also seen as a way of stopping the practice of bear raids. Many observers at the time believed that bear raids were major contributors to the stock market declines of 1929 and in the late 1930s. In subsequent years, however, some of those assumptions have been challenged. In 2005, the SEC, as part of Regulation SHO, in an initiative aimed at updating short sale regulation in light of various market developments that had emerged since the initial 1938 regulation, began a pilot program to test the market impact of relaxing the uptick rule for a select group of 1,000 securities. The pilot lasted a year and then was extended into 2007. It was an attempt to test widespread industry, academic and regulatory perceptions that the uptick rule was no longer necessary. In an analysis of results from the pilot, the SEC's Office of Economic Analysis found that short trade restrictions had a limited effect on a stock price and that there appeared to be no association between manipulative short selling activities like "bear raids," and the presence of the tick test. It also found confirmation of the notion that the tick test appeared to have some potentially adverse market effects in discouraging short selling. The study also revealed little empirical justification for maintaining price test restrictions, especially for stock of companies with higher levels of market capitalization (larger cap stocks). Although it found some changes in the displayed liquidity, all the tested securities showed about the same level of liquidity and pricing efficiency with or without the tick test. When the differences between larger and smaller cap stocks were examined, one of the most counter-intuitive discoveries was that the short selling restrictions appeared to increase volatility in the larger capitalized securities while dampening it in the smaller ones. Overall, the SEC found little evidence suggesting that removal of the short selling restrictions would have a negative impact on market volatility, price efficiency, or liquidity. On December 7, 2006, the SEC commissioners voted to issue a policy proposal that, among other things, would eliminate Rule 10a-1's tick test. Prior to that decision, Chairman Cox observed: The core provisions of Rule 10a-1 have remained virtually unchanged since the 1930s. But a great deal else has changed in the marketplace over that very long time. Over the years, decimalization and changes in trading strategies have undermined the effectiveness of the price test. And at the same time, increased transparency and better means of surveillance appear to have lessened the need for the price test.... Through the pilot program, we sought to understand the effect of this particular regulation on our markets. The evidence gathered from the pilot suggests little empirical justification for maintaining short sale price test restrictions, at least for the exchange-traded stocks in the pilot.... In light of the results of the pilot program and the market developments that have occurred in the securities industry since Rule 10a-1 was first adopted, we will today consider proposals to remove the tick test of Rule 10a-1, and to prohibit the SROs from maintaining their existing price tests or adopting any new ones.... Among those who backed the lifting of the tick test were a number of individual traders, academics, broker-dealers, the Securities Industry and Financial Markets Association (an association of several hundred securities firms, banks, and asset managers), and the Securities Traders Association (STA, an association of individual professionals in the securities industry). Among the staunchest opponents of rescinding the restrictions were a number of individual investors who invoked the specter of a greater likelihood of bear raids. Qualified support came from the New York Stock Exchange, which expressed concerns over unrestricted short selling during periods of unusually rapid and large market declines. Exchange officials noted that the pilot did not gauge the effect of an unusually rapid and large market decline because such decline did not occur during the period. American Stock Exchange (AMEX) officials expressed related concerns. The exchange specializes in smaller stocks, and its officials stated that the removal of the tick test from smaller stocks was premature and needed further study.