The Securities and Exchange Commission on Tuesday stepped up its war against what it believes is manipulation of stocks by "short sellers" -- traders who bet on falling share prices.
SEC Chairman Christopher Cox surprised Wall Street with a plan to curb illegal short selling in 19 major financial company shares, including embattled mortgage titans Fannie Mae and Freddie Mac. Shares of Fannie and Freddie have been big targets of bearish traders this year.
With the nation's financial system under enormous strain and the stock market in its worst slump since 2000-02, federal regulators are facing pressure to show they're on top of the situation. Cox unveiled the agency's plan to limit short selling at a Senate Banking Committee hearing on financial market concerns.
The SEC chief said the agency was taking action to stop what he said was stock manipulation "that threatens the stability of financial institutions."
In a short sale, a trader borrows stock, usually from a brokerage's inventory, and sells it, expecting the price to decline. If the bet is correct, the trader can buy new shares later at a lower price, repay the borrowed stock and pocket the difference between the sale price and the repurchase price.
Shorting is legal -- unless traders are ordering stock sales without having arranged to borrow actual shares. That would be "naked" shorting, which is illegal, says John Coffee, a securities-law professor at Columbia Law School.
But the rule against such stock plays hasn't been enforced much, Coffee said.
The SEC's new plan is a crackdown on naked shorting of major financial stocks amid what has been a severe hammering of the shares -- to the point where investors are beginning to question the firms' survival.
Beginning on Monday, the SEC will require that "anyone effecting a short sale in these securities arrange beforehand to borrow the securities and deliver them at settlement." The emergency rule will be in effect through July 29, but could be extended until Aug. 21, the SEC said.
What's more, Cox said the agency eventually expects to cover the entire stock market with the new rule.
For the 19 stocks on the list, the change means that brokerages no longer will be able to take a short seller's word that he actually has borrowed the shares he wants sold. And that, in turn, could curb situations in which multiple short sellers are expecting to borrow the same shares for sale -- similar, say, to five different people putting the same car up for sale, knowing that only one of them can deliver the vehicle.
The SEC suspects that some short sellers are ganging up on financial stocks, engaging in naked shorting while spreading rumors that the companies are in dire straits.
The first salvo in the agency's offensive came Sunday when it announced that it would "immediately conduct examinations aimed at the prevention of the intentional spread of false information intended to manipulate securities prices."
That move and Tuesday's announcement by Cox were cheered by the U.S. Chamber of Commerce, which said in a letter to the SEC that "rumor-mongering" by short sellers "has been a significant problem for targeted companies for years."
On Wall Street, short sellers were widely blamed for the plunge in shares of brokerage Bear Stearns Cos. in March that hastened the company's demise. The jump in the number of shorted shares of Fannie Mae and Freddie Mac this year also has triggered accusations that short sellers were trying to drive the companies into ruin.
But veteran short sellers say regulators are looking for scapegoats for the problems financial companies have brought on themselves through bad investments and massive borrowing.
"Now that it's all collapsing, they're trying to blame it on short sellers," said Bill Fleckenstein, head of Fleckenstein Capital in Issaquah, Wash.
Legitimate short sellers bet against companies whose shares they believe are overvalued. That makes the shorts an important element of what academics call "price discovery" in the market. Short sellers find out things companies often would rather that shareholders didn't know.
For the long-term health of the market, "you don't want to restrict people's ability to invest on negative information," warns Jill Fisch, a securities law professor at Fordham University.
Columbia's Coffee said the risk the SEC faced in targeting illegal short selling in a specific set of stocks was that the move could appear to be panic driven, which might heighten investors' concerns that the market decline was spiraling out of control.
The Dow Jones industrial average fell 92.65 points, or 0.8%, to 10,962.54 on Tuesday, its lowest closing value in two years.
Besides Fannie Mae and Freddie Mac, the other 17 stocks covered under the SEC's plan are: Allianz, BNP Paribas Securities, Bank of America Corp., Barclays, Citigroup Inc., Credit Suisse Group, Daiwa Securities Group Inc., Deutsche Bank Group, Goldman Sachs Group Inc., HSBC Holdings, JP Morgan Chase & Co., Lehman Bros. Holdings Inc., Merrill Lynch & Co., Mizuho Financial Group Inc., Morgan Stanley, Royal Bank of Scotland and UBS.
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