The hedge fund industry faces growing opposition to its efforts to hold back restrictions on naked short selling.
The hedge fund industry faces growing opposition to its efforts to hold back restrictions on naked short selling.
Among the 300 investor comments filed over the past month with the Securities and Exchange Commission about naked short selling, most voiced opposition to the abusive version of it.
Adding to the cry against naked short selling is a new proposal that the SEC is slated to release this week protecting publicly traded companies from abusive naked short selling.
What's more, South Dakota voters will decide in November whether to approve an initiative that the state's securities director says would ban all short selling. The group sponsoring that action promises to get similar initiatives on ballots in 18 other states if the SEC doesn't put more restrictions on short sales.
The hedge fund industry is fighting restrictions on naked short selling, in which securities are sold short without borrowing the stock first. Abusive naked short selling is being blamed for depressing stock prices in financial services stocks as well as stock prices for other companies.
The practice could have played a role in the demise of The Bear Stearns Cos. Inc. of New York, which was taken over by JPMorgan Chase & Co. of New York in May.
The pressure to take protective action in the wake of these incidents is mounting. SEC emergency orders enacted July 15 require short sellers of stock in 19 major financial services firms to arrange to borrow the securities before the transaction so that buyers will receive the stock they purchase on time. Those orders expire tomorrow and will not be renewed. However, the new SEC rule will address the issue.
Treasury Secretary Henry Paulson, Federal Reserve Board Chairman Ben Bernanke and Robert Greifeld, chief executive of The Nasdaq Stock Market Inc. of New York, as well as the Financial Services Roundtable and the U.S. Chamber of Commerce, both of Washington, have all indicated support for the SEC's efforts to impose more restrictions on the practice.
Many financial firms have joined in calling on the SEC to take more-aggressive action to rein in abuses. The emergency order ought to be made permanent, and it should be extended to all publicly traded companies, said registered representative Keith Stucker, who was one of the commenters.
"Naked short selling has been abusing the markets for a decade," said Mr. Stucker, senior vice president and financial consultant in the Indianapolis office of RBC Wealth Management of Minneapolis. He manages about $100 million.
The proliferation of hedge funds during that time has contributed to the problem, Mr. Stucker said.
"When you couple naked short selling with the repeal of the uptick rule a year ago, it was like giving the keys to the henhouse to all of these hedge funds or sovereign wealth funds that wanted to take advantage of manipulation," he said.
The uptick rule, repealed by the SEC in 2007, required traders to wait for a stock's price to go up before it could be sold short.
In a July 21 letter filed with the SEC by the Managed Funds Association and the Coalition of Private Investment Companies, both in Washington, the two hedge fund groups urged the SEC not to extend the emergency order, which they said "will have the effect of discouraging legitimate short sales."
Current rules say short sellers only have to locate stock before they short, according to Peter Chepucavage, general counsel of Plexus Consulting Group LLC in Washington, which operates The International Association of Small Broker Dealers and Advisors. He is a commenter.
"That means you only have to look at a list" to locate a stock, Mr. Chepucavage said. "If the locate fails, you're better off. That leads to opportunistic short selling. If I can make a ton of money without the borrowing costs, that's the American way."
So far, the Securities Industry and Finan cial Markets Association has been silent on the SEC's emergency order, which ends this week. SIFMA, which has offices in New York and Washington, is "first and foremost focused on ... implementation issues," said spokesman Travis Larson.
"We're now in the process of gathering data about how that [July 15 emergency] order went forward ... When we have those facts in hand, we will ... work on ... a consensus position," Mr Larson said.
In 2006, SIFMA sued Utah over a law passed by the state's legislature that would have imposed severe penalties on brokerage firms that failed to deliver stock in a short sale. The Utah Legislature repealed the law after SIFMA won a preliminary injunction against it in a federal court in that state.
But SIFMA may face an even more difficult situation this year in South Dakota, where a measure is on the ballot in November that would effectively ban all short selling, according to that state's securities director, Gail Sheppick, whose office is in Pierre.
The initiative would ban selling securities not owned by the seller, or securities that a seller did not have a contract to purchase, said Mr. Sheppick, who opposes it. "It sounds like a simple resolutions, but it's not when you're trying to keep the markets liquid," he said. If the initiative is passed, it may be overturned in court for violating the commerce clause of the Constitution, Mr. Sheppick said. "But meanwhile, it will create a lot of turmoil in the market here."
Los Angeles-based American Entrepreneurs for Securities Re-form, which sponsored the South Dakota initiative, last week promised to organize similar campaigns in 18 other states if the SEC does not move to restrict naked short selling permanently for all companies.
The organization is backed by Overstock.com Inc., a Salt Lake City online retailer that has waged a campaign against naked short selling for several years, saying the practice has been used by hedge funds to depress its own stock. "Our goal is to stop abusive naked short selling," said Overstock.com president Jonathan Johnson, a commenter. "Before someone short-sells, they should have to borrow the stock."
Other companies also believe they have been harmed by naked short selling. One is Monroe Bank and Trust, a unit of MBT Financial Corp. of Monroe, Mich. The community bank's trust department manages $750 million. "A short sale as an investment strategy is appropriate," said Herb Lock, senior vice president and chief investment officer, and a commenter. "The concern is the naked short sale and whether there is an effort to manipulate price."
The SEC needs to act as quickly as possible to make its emergency order permanent for all stocks, said Wayne Jett, managing principal and chief economist with Classical Capital LLC of San Marino, Calif., which manages about $3 million. He is one of the commenters.
Naked short selling has allowed short-sellers "to create stocks that are unregistered and sell them as electronic entries and get the money for it," Mr. Jett said.
E-mail Sara Hansard at shansard@investmentnews.com.
