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January 1, 2002

No More Shorting On Wall Street? SEC Takes Another Look at the Rules

By Tom Taulli

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  • No More Shorting On Wall Street? SEC Takes Another Look at the Rules

Some pundits are predicting dire consequences for Wall Street if the SEC adapts measures it proposed that would curb or even eliminate short selling.

The predictions might be farfetched - and most think shortselling is unlikely to be banned - but how the SEC acts could have major repercussions for trading firms.

The Securities and Exchange Commission knows the territory. Short selling is sometimes controversial. But it is perfectly legal and, generally, it is used sensibly by many investors.

It is a practice in which an investor borrows and then sells stock, hoping he can buy the shares back later at a lower price and then repay' the lending broker. The investor makes a profit if the share price is lower, a loss if it is higher.

Whether a profit or loss, the rules that govern short selling could get overhauled if the SEC adapts some of the measures it proposed in late 1999. And the regulators are closely watching how short sales are used.

In the current bear market, short sellers are an easy target. "Short selling is often viewed as burning the flag," said Joel Milazzo, an institutional trader for Raymond James. "It's probably something you do not want to mention to your friends."

When short selling was introduced to the anything-goes Dutch stock market in the 1600s, it did not take long until the government outlawed the practice. Whenever there is a bear market, short sellers are an easy target.

This was certainly the case during the bear market of the early 1930s. With stocks down more than 80 percent, short sellers became an object of scorn.

And there were certainly many examples of abuses. One of the most notorious was Albert Wiggin, the CEO of Chase National Bank. In the summer of 1929, he shorted 42,000 shares of Chase stock. True, it was a shrewd business decision. But it ultimately backfired, as Wall Street would be under intense scrutiny for decades.

The result was wide scale federal securities law reforms. In the Securities Exchange Act of 1934, Congress legislated clause 10(a), which gave the SEC regulatory powers over short selling. In it, short selling was defined as the sale of a security that the seller does not own or that the seller owns but does not deliver.

However, it was not until 1937 - after another big fall in the market - that the SEC used its powers under 10(a) and drafted 10(a)-1. It instituted the so-called plus tick and zero-plus tick rules, which apply to listed stock exchanges. The SEC believed that the rules would prevent undue pressure on stock prices or even manipulation.

As the memories of the Depression receded, the SEC began to investigate the effectiveness of the short sale rules. In 1963, the SEC conducted a study that indicated that the volume of short selling did increase in falling markets. Then again, the short sale rules were ineffective in preventing the problems that the rules were meant to prevent. But the studies were tentative, because data collection for short selling was inadequate.

Thirteen years later, the SEC published another study. Again, it complained about inadequate data collection. The SEC proposed a temporary suspension of the short sale rules, but it was abandoned in 1980.