SEC Limits Short Sales of Major Financial Firms

U.S. securities regulators issued an emergency rule Tuesday to limit certain types of short selling in major financial firms, including Fannie Mae and Freddie Mac.

The rule is the latest effort by the U.S. Securities and Exchange Commission to clamp down on market manipulation that some blame for the sharp declines in financial stocks and the demise of investment bank Bear Stearns in March.

CNBC

The rule will go into effect on Monday, July 21, and last through July 29, although it could be extended to last up to 30 days.

The SEC said it will consider rules to address short selling issues across the entire stock market.

The emergency rule applies to 19 financial firms including Lehman Brothers , Goldman Sachs , Merrill Lynch , Morgan Stanley , JPMorgan Chase and Citigroup .

The SEC said that a loss of confidence in markets can lead to panic selling, which may be further exacerbated by certain types of short selling.

"As a result, the prices of securities may artificially and unnecessarily decline well below the price level that would have resulted from the normal price discovery process," the SEC said.

"If significant financial institutions are involved, this chain of events can threaten disruption of our markets." Short sellers arrange to borrow shares they consider overvalued and sell them in hopes of making profit when the price drops.

With financial stocks dropping dramatically over the year, lawmakers have been calling on the SEC to investigate whether short sellers and speculators are behind the move.

Over the weekend, the SEC announced plans to crack down on false rumors and said it is examining whether broker dealers and investment advisers have controls in place to prevent market manipulation.

The agency's rule change would prevent investors from making "naked" short sales of the biggest financial stocks. A "naked" short sale occurs when an investor sells stock that has not yet been borrowed.

Broker-dealers will sometimes accidentally fail to deliver stocks to investors who have arranged to borrow a stock. If it is done intentionally, it is illegal.

"Today's commission action aims to stop unlawful manipulation through naked short selling that threatens the stability of financial institutions," SEC Chairman Christopher Cox said in a statement.

The emergency rule would require a short seller to borrow the securities before executing the sale. It would also require the investor to deliver the securities on the settlement date.

"The new rule will benefit the investment community and help bring more stability to the market," said Dylan Wetherill, president and founder of short interest tracking service ShortSqueeze.com. "This rule would help relieve the extreme downward pressure on stocks that has helped fuel the market down to these levels," he said.

As of June 30, short sellers held about 14 percent of Fannie's outstanding stock, up from around 3 percent last August. For the same period, shorts held almost 12 percent of Freddie's outstanding stock, up from about 2.7 percent. They also held about 10 percent of Lehman's stock, up from 4.5 percent.

Short sellers say they prevent stocks from becoming overvalued and are an essential feature of the market.

"While no one in Washington did their job, now they are trying to blame short sellers," said William Fleckenstein, president of Fleckenstein Capital, which manages a Seattle-based hedge fund. "Short sellers don't make stocks go down. If a short seller was trying to push a stock to a price where it didn't belong, it would come back right away," said Fleckenstein, who is not currently short the investment banks or Fannie or Freddie. He had a short position on Fannie, which he covered on Tuesday.

Earlier, Cox told a Senate Banking Committee hearing that the emergency rule would be more effective than the so-called tick test rule, which was repealed June 2007. The tick test rule only allowed short sales when the last sale price was higher than the previous price. That meant a trader could not short a stock if the movement prior to the short sale was down.

Cox said the SEC is going to look at whether some other kind of a price test might be useful for "circumstances such as those we find ourselves in now." "We are very open to that," said Cox.

The tick test rule, adopted a decade after the 1929 stock market crash, was designed to prevent short sellers from adding to the downward pressure on a stock that is already falling sharply.

The SEC has already proposed another rule to curb naked short selling abuses and prevent market price manipulation. It is not known when the SEC will adopt this rule.

Here is the full list of securities affected by its order: BNP Paribas Securities, Bank of America , Barclays, Citigroup, Credit Suisse Group , Daiwa Securities Group, Deutsche Bank Group , Allianz ,  Goldman Sachs Group, Royal Bank ADS , HSBC Holdings , JPMorgan Chase, Lehman Brothers, Merrill Lynch, Mizuho Financial Group , Morgan Stanley, UBS , Freddie Mac and Fannie Mae.

Copyright 2009 Reuters. Click for restrictions.