An emergency rule to curb abusive short selling will likely be extended beyond 19 major financial firms as pressure mounts on the U.S. Securities and Exchange Commission to broaden the measure.
The impact of the SEC's rule is being closely monitored as brokers and dealers are now required to borrow stock before executing a short sale in 17 major Wall Street firms and mortgage finance giants Freddie Mac and Fannie Mae .
The rule, which went into effect Monday and can last up to 30 days, also requires investors to deliver securities on the settlement date.
The SEC announced its rule July 15, after bank regulators seized IndyMac July 11 and the Federal Reserve and Treasury Department announced emergency support on July 13 to ensure Freddie and Fannie would have access to capital if needed.
Although short selling is a legitimate investment strategy and can prevent stocks from becoming overvalued, lawmakers and corporate executives have called for a probe of short sellers since the demise in March of investment bank Bear Stearns.
The SEC has already said it will consider rules to address abusive short selling issues across the entire stock market.
But it is unknown how the agency will craft that rule.
"We cannot have a segregated market where only the large and connected get protected by the SEC," said former SEC commissioner Roel Campos, now a partner at law firm Cooley Godward Kronish.
The American Bankers Association is lobbying the SEC to include all publicly traded banks and bank holding companies such as Washington Mutual and Wachovia , which have been under pressure.
The SEC's order only covers the primary dealers that have access to the Federal Reserve's discount window and many of those firms are foreign-based such as Swiss-based UBS AG and London-based HSBC Holdings.
"I don't think you could limit it to those 19 names pushed on the SEC by the Federal Reserve, to protect all dealers in government securities," said John Coffee, professor at Columbia Law School.
Under pressure from the exchanges and the Securities Industry and Financial Markets Association, the SEC on Friday granted a partial exemption for market makers, or those who facilitate trading in certain stocks.
Market makers don't have to pre-borrow stock before executing a short sale in the 19 financial companies but must deliver the stocks within the settlement period.
"I do think they will extend it (past the 30 days), because the exemption...will largely nullify its effect," said Coffee.
Short sellers arrange to borrow shares they consider overvalued and sell them in hopes of making a profit when the price drops.
When an investor does not pre-borrow the shares before shorting the stock, it's called a "naked" short sale, which is illegal if done intentionally.
The SEC's rule is designed to end July 29, but can be extended for a total of 30 days if the commission deems it necessary to protect investors.
Within that time frame -- which is seen as a trial period by some -- the agency will most likely have to prove that this action has had some kind of impact on abusive short sales.
"The SEC will have to have better evidence that this is a useful thing to do," said Jay Brown, a securities professor at University of Denver Sturm College of Law. "What they can't do, is do the same thing over again. They will either have to expand the number of companies or kill it."
Henry Klehm, a partner at Jones Day representing financial institutions and others, said he would be surprised if the SEC developed a permanent rule for specific stocks.
"They have to consider these things on a broader basis," Klehm said. I don't think they want to go with a specific class of securities in the long run."
The SEC's emergency rule rattled the trading community, which scrambled to understand how the rule would be enforced.
The unprecedented rule came after the SEC announced plans to crackdown on rumor-mongering and has started examining whether broker dealers and investment advisers have controls in place to prevent market manipulation.
Others have been calling on the SEC to reinstate the so-called tick test rule—a rule that was adopted after the 1929 stock market crash.
The tick test, which was repealed June 2007, 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.
One lawmaker, Rep. Gary Ackerman, a Democrat from New York, has introduced legislation to reinstate the rule but there is little time left in the legislative year.
The SEC has pointed to studies that said the tick test did not really make a difference to volatility or to how the market performed and some think reversal unlikely.
"The whole process of eliminating the tick test was a long regulatory debate," said Klehm, the securities lawyer.
Dylan Wetherill, president and founder of short interest tracking service ShortSqueeze.com said the SEC's action on rumors and short sales are speaking pretty clearly on what they are trying to achieve.
"The rule extends protection to the downside," he said. "They are testing it out, wanting to see the market's reaction. If it does what they want it to do, they will continue it."