SIFMA to sue if short-sale vote wins

The Securities Industry and Financial Market Association will file a lawsuit against South Dakota if voters there approve a ballot initiative tomorrow that the group claims would effectively ban all short selling. South Dakota voters will become the first in the nation to vote on whether to ban "naked short selling" — an indication of growing pressure on the hedge fund industry to curb short-selling practices. Backers of the initiative are looking to bring the matter to a vote in other states as well. More pressure is coming from NYSE Euronext Inc. of New York, which is citing the concerns of companies listed on both the New York Stock Exchange and the Nasdaq Composite Index to push for a return of the so-called uptick rule. In order to profit from an expected decline in share prices, short-sellers borrow shares, sell them and then buy the shares back later, hopefully at a lower price. Naked short selling is based on the same principle, except that the seller does not borrow the necessary shares or even ensure that they can be borrowed. Critics charge that despite regulations against the practice, naked short selling is widespread and threatens companies whose shares are targets of speculators. The South Dakota initiative is an attempt to duplicate NYSE rules, "but put them into state law so we could have a state law action here in South Dakota," said Mark Meierhenry, a partner with Sioux Falls, S.D., law firm Meierhenry Sargent LLP. Mr. Meierhenry, who sponsored the initiative, was attorney general of South Dakota from 1979 to 1986. "We don't want to have to rely on regulators on Wall Street and courts in New York City because of cost," he said. Financial services companies that operate in South Dakota would be required to have a contract to purchase a stock before they shorted it under the initiative, Mr. Meierhenry said. SIFMA thinks that if the initiative passes, it would effectively ban all short sales, said Travis Larson, a spokesman for the association, which has offices in New York and Washington. "The ballot has been crafted in such a way as to make illegal any short selling, naked or others, for firms registered to do business in South Dakota, which is every major national firm, almost all the regionals and many others," he said. SIFMA would "immediately" take the issue to court to have the initiative overturned if it wins approval, Mr. Larson said. Mr. Meierhenry denies SIFMA's contention that the South Dakota initiative would prevent all short sales. A SIFMA lawsuit to have the law overturned would be controversial because it would mean that the association would have to "align themselves with the crooks" in short-selling cases, he said. In 2006, the Utah legislature repealed a law that would have imposed severe penalties on brokerage firms that failed to deliver stock in short sales after SIFMA won a preliminary injunction in federal court against the state law. American Entrepreneurs for Securities Reform, based in Union, Mo., plans to offer initiatives similar to the South Dakota initiative in 18 other states that allow voter initiatives on the ballot, said Tim Mooney, a spokesman for the group. AESR is backed by Patrick Byrne, president, chief executive and chairman of Salt Lake City-based Internet retailer Overstock.com Inc., who has been a prominent critic of short-selling practices. "We'd prefer to do none of this if the SEC would simply enforce the law," against naked short selling, Mr. Mooney said. More than 4,000 companies, including Overstock.com, have been listed by the SEC as not having their stock delivered on short sales, he said. These "fails to deliver" are an indication that traders shorted shares without having made the necessary borrowing arrangements.
Meanwhile, an Oct. 21 NYSE Euronext survey found that 60% of executives of publicly traded companies polled think that short selling harms their companies' stock and stockholders. Conducted in mid-October, the stock exchange got responses from 438 executives of companies traded on the New York Stock Exchange and Nasdaq. "I don't think at the New York Stock Exchange we're advocating a total ban on short selling," said Scott Cutler, senior vice president of the global corporate client group at NYSE Euronext. "We conducted the study to be clear and give our issuers the opportunity to voice their opinion on the issue."

WARNING SIGN

But the report could be a warning sign that the powerful exchange will push for more restrictions, some say. "The nature of the report is a concern," said Richard Baker, president and chief executive of the Managed Funds Association of Washington, The MFA, which represents hedge funds, is the group associated most with short selling. The MFA is evaluating the survey findings, Mr. Baker said. "We do want to formally engage the exchange to have a better understanding about the findings," he said. But it isn't surprising that executives of companies whose stocks may be shorted would want more restrictions on the practice, Mr. Baker said. Hedge funds and other short-selling traders argue that the two Securities and Exchange Commission emergency orders that banned short sales of financial stocks in September and October didn't stop market volatility. According to an Oct. 13 report from Credit Suisse North America of New York, a unit of Credit Suisse Group of Zurich, Switzerland, stocks that were restricted under the SEC ban performed better than the rest of the market prior to the restrictions. The market dropped far more after the restriction was put in place than before, and stocks subject to the short-selling restriction fell along with the rest of the market when the restriction was in place, according to the report.

UPTICK RULE

NYSE Euronext primarily wants the SEC to reinstate the uptick rule, Mr. Cutler said, noting that 85% of the respondents to survey favored that approach. The rule, which was eliminated by the SEC last year, generally required that short sales be transacted above the price of immediately preceding sales. The rule was intended to reduce market volatility. "We have attempted to lead the industry to a broader, marketwide solution centered around the reinstitution of the uptick rule," he said. Seventy-five percent of the respondents to the NYSE survey said that they want to prohibit short sales when markets are volatile. "It was pretty clear that corporate issuers, generally speaking, favor rules limiting short selling," Mr. Cutler said. "The SEC has tightened its rules regarding short selling and increased liability for those who engage in short selling," said SEC spokesman John Nester. SEC Chairman Christopher Cox has said he would be open to a price test for instituting circuit breakers that restrict short selling, but the commission hasn't received a recommendation from the agency staff yet, Mr. Nester said. E-mail Sara Hansard at shansard@investmentnews.com.