United States: SEC Issues Emergency Order Suspending "Naked" Short Selling

Originally published July 24, 2008

Keywords: SEC, naked short selling, Fannie Mae, Freddie Mac, Rule 10b-21

On July 15, 2008, the Securities and Exchange Commission (SEC) issued an emergency order (the "Emergency Order") prohibiting anyone from engaging in the "naked" short selling of the securities of Fannie Mae, Freddie Mac and seventeen other financial firms identified in Appendix A to the Emergency Order (the "Appendix A Securities").¹ The Emergency Order is in effect between 12:01 a.m. ET, Monday, July 21, 2008, and 11:59 p.m. ET, Thursday, July 29, 2008, and can be extended by the SEC for up to 21 additional days. During this period, no one may effect a short sale in the Appendix A Securities unless they have those securities in inventory available to borrow, or they or their agent have borrowed, or arranged to borrow, the securities, and the securities are delivered on the settlement date.

Citing the "substantial threat of sudden and excessive fluctuations of securities prices generally and disruption in the functioning of the securities markets," the Emergency Order comes amid a backdrop of serious declines in the stock values of financial firms and the collapse of Wall Street trading firm Bear Stearns in March. During recent testimony before the Senate Banking Committee, SEC Chairman Christopher Cox indicated that the SEC is contemplating issuing an interim final rule that would expand the short selling restrictions to cover the "entire market." Industry reaction to the Emergency Order has been mixed. In a statement issued July 16, 2008, the Securities Industry and Financial Markets Association stated that it "supports [SEC] efforts both to enforce the law against illegal naked short selling and to root-out false rumors." However, Richard Baker, president of the Managed Funds Association, said the SEC's emergency action "is aberrant, it's unusual, and it may be without precedent."

On July 18, 2008, the SEC released another order amending the Emergency Order (the "Amendment Order") by exempting certain entities and market activities from the Emergency Order's short selling restrictions.² In particular, the Amendment Order allows registered market makers, block positioners and other market makers that are obligated to quote in over-the-counter markets, to engage in short selling in the Appendix A Securities as part of bona fide market making and hedging activities, as long as the Appendix A Securities are delivered by the settlement date.³ The Amendment Order also clarified that the Emergency Order does not apply to short sales of Appendix A Securities effected pursuant to Rule 144 of the Securities Act of 1933. In addition, the Amendment Order provides that, notwithstanding the Emergency Order, short sales are permitted for (a) underwriters, or for members of a syndicate or group that is participating in distributions of Appendix A Securities in connection with an over-allotment of such securities, or (b) any lay-off sale by such persons in connection with a distribution of such securities through a rights or a standby underwriting commitment.

It will be interesting to see how the Emergency Order and the Amendment Order interplay with the SEC's springtime proposal of new Rule 10b-21 under the Securities Exchange Act of 1934 (Exchange Act), which was described as an attempt generally to address problematic naked short selling.⁴ If adopted, proposed Rule 10b-21 would clarify that it is a violation of the antifraud provisions of Section 10(b) of the Exchange Act for any short seller, including a broker-dealer acting for its own account, to deceive others (e.g., broker-dealers, other participants of a registered clearing agency, or purchasers) about the seller's intention or ability to deliver the securities sold short in time for settlement, and to subsequently fail to deliver those securities on or before the date delivery is due. Although the comment period for this proposal ended on May 20, 2008, the SEC has not yet taken formal action on the proposal, thus begging the question of whether the SEC now believes that more focused and deliberate actions are required to combat perceived or actual short selling abuses.

Footnotes

^{1. Securities Exchange Act Release No. 58166 (July 15, 2008) available at http://www.sec.gov/rules/other/2008/34-58166.pdf . The following are the affected securities: BNP Paribas (BNPQF or BNPQY); Bank of America Corporation (BAC); Barclays PLC (BCS); Citigroup Inc. (C); Credit Suisse Group (CS); Daiwa Securities Group Inc. (DSECY); Deutsche Bank Group AG (DB); Allianz SE (AZ); Goldman, Sachs Group Inc (GS); Royal Bank ADS (RBS); HSBC Holdings PLC ADS (HBC); J. P. Morgan Chase & Co. (JPM); Lehman Brothers Holdings Inc. (LEH); Merrill Lynch & Co., Inc. (MER); Mizuho Financial Group, Inc. (MFG); Morgan Stanley (MS); UBS AG (UBS); Freddie Mac (FRE); and Fannie Mae (FNM).}

^{2. Securities Exchange Act Release No. 58190 (July 18, 2008) available at http://www.sec.gov/rules/other/2008/34-58190.pdf .}

^{3. The exemption also applies to short selling derivative securities based on the Appendix A securities, as well as exchange traded funds of which the Appendix A securities are a component.}

^{4. See Securities Exchange Act Release No. 57,511 (Mar. 17, 2008), 73 Fed. Reg. 15,376 (Mar. 21, 2008) available at http://www.sec.gov/rules/proposed/2008/34-57511fr.pdf .}

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