Capital Markets

SEC Declares War on Short-Selling, Rumors

All short-sellers of Fannie Mae and Freddie Mac must pre-borrow stock before shorting the shares of either of the mortgage-finance giants.
Vincent RyanJuly 15, 2008

The Securities and Exchange Commission is issuing an emergency order aimed at reducing short-selling in the stock of Fannie Mae and Freddie Mac and Wall Street brokerage firms and is considering extending those trading limits to the broader equity markets. SEC Chairman Christopher Cox revealed the order in testimony before the Senate Banking Committee on Tuesday.

Cox said that all short-sellers of Fannie Mae and Freddie Mac will be required to pre-borrow stock before shorting the shares of either company. The order, which will expire in 30 days, is designed to limit short-selling for the two mortgage-finance companies, whose share prices are plummeting even with the aid of a government backstop.

The SEC wants the order to “enhance protections” against “naked” short-selling. In a short sale, a trader sells a security which it does not own (usually by borrowing it) in the belief that the price of the stock will fall before the trader has to cover the sale. In a naked short, the trader sells a stock short without first borrowing the shares or even ensuring that the shares can be borrowed. Potentially, purveyors of naked shorts could continually sell shares to drive down the price of a stock without being constrained by the supply of a company’s shares available for borrowing.

Wall Street has been after securities regulators to curb the abuses of short-selling and rumor-mongering in the markets. Many executives believe such practices have contributed to the large sell-off in financial services stocks and the overall market’s volatility.

Short-selling on the New York Stock Exchange climbed to a record high in June. The portion of overall shares sold in anticipation that their price would drop rose nearly 11 percent, to 17.7 billion shares, from May 15 to June 13. That was the exchange’s highest level of such selling ever.

The SEC has had active investigations underway for several months targeting “the possible manipulation of securities prices through various combinations of manufacturing false rumors and short selling in a number of cases that may have contributed to the increase in market volatility that is impacting so many ordinary investors,” Cox said in prepared remarks.

For example, the SEC has sent subpoenas to several hedge funds seeking trading and communications data on short-selling and options trading in the shares of Bear Stearns and Lehman Brothers, according to news reports.

Together with New York Stock Exchange Regulation Inc. and the Financial Industry Regulatory Authority, the SEC is also conducting “sweep examinations” in the securities industry focused on preventing the spread of intentionally false rumors aimed at manipulating securities prices. That investigation is probing whether firms such as broker-dealers have controls in place to prevent the intentional creation of false information intended to affect securities prices.

In a Monday letter to the compliance directors of broker-dealer firms, the market surveillance division of NYSE Regulation asked for information on how compliance departments monitor the activities of personnel to ensure that false or misleading rumors aren’t being circulated in order to affect market conditions or for manipulative purposes. Specifically, the division wants to know how firms monitor E-mail, instant messages, and other electronic communications, as well as activity on Internet chat rooms and message boards.

The NYSE also requested details on internal policies and procedures that require sales and trading personnel to report instances of clients or other members of the broker-dealer community who are circulating false or misleading rumors. The letter gives broker-dealers a deadline of July 28 to provide the information.

In his testimony before the committee, Cox noted that in the SEC’s 75-year history, its has never before brought an enforcement action concerning market manipulation by a trader who was knowingly spreading false rumors. But recently the SEC successfully sued a trader who used instant messages to other brokerage firms and hedge funds to spread fake information about a pending acquisition, he noted.

“It is probably because of the difficulty in tracing where a false rumor starts, and proving that it was knowingly false, that these cases haven’t been brought in the past,” Cox said. “But now the same technology that instantly spreads market rumors across the globe is also helping law enforcement track down the culprits.”

If the SEC is successful in bringing future cases, Cox said the penalties “should be commensurate with the enormous amount of shareholder value that is destroyed by this kind of wantonness toward other people’s money.”

The statement echoed remarks made earlier this week by JPMorgan Chase chief executive Jamie Dimon during the Charlie Rose television program. Dimon called for jail sentences for short sellers of stock who make up rumors to drive share prices down.

‘I think if someone knowingly starts a rumor or passes on a rumor, they should go to jail,” he said. “This is even worse than insider trading. This is deliberate and malicious destruction of value and people’s lives.”

Understanding Which ERP Modules Your Business Needs – And When