Short selling and the SEC

June 23, 2009

The subject of short selling can always be counted on to generate a lot of heat. And a proposed Securities and Exchange Commission rule that would put limits on the ability to short a stock–especially in a severe market downturn–is no different.

In all, some 3,700 people submitted comments to the SEC, which officially stopped taking public input on the proposal on June 19. (The comments, however, are still coming in).

And that doesn’t include the 5,000 people, who signed a petition drafted by Jim Cramer, the CNBC television personality and founder of TheStreet.com. Cramer and his many friends strongly support the SEC proposal to reinstate the ”uptick rule,” which would prevent traders from shorting a stock on downward movement in price.

Not suprisingly, the vast majority of comments are from individual investors who favor limits on short selling. The industry, for the most part, is opposed to the SEC proposal.

This comment from Goldman Sachs pretty much sums up Wall Street’s view:

While we share the Commission’s interest in restoring investor confidence, we do not think that the available evidence demonstrates that short selling caused last fallt’s severe price declines or supports the need for new short sale practices.

I think short sellers were wrongly accused for fueling the flames last year and hastening the collapse of Bear Stearns and Lehman Brothers. While the shorts no doubt made giant profits by betting against those firms, the investment banks ultimately collapsed because of their own recklessness. No short seller forced Bear and Lehman to lever their themselves 30 to 1. And no one forced the investment banks to use short-term overnight borrowings to finance investments in longer dated risky real estate-related assets.

So the SEC proposal for instituting a market circuit breaker, which would limit trading in a stock that declines too sharply, strikes me as unnecessary and unwise.

But I see no harm in putting the uptick rule back in place.  The market operated just fine with that limited prohibition on shorting for decades until it was repealed by the SEC in 2007.

And while there’s ample evidence that the uptick rule had little actual impact on stock prices. It probably couldn’t hurt to go back to the way business used to operate on Wall Street.

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