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January 2, 2007

Price Test Rules for Short Selling Go Under the Microscope

By Peter Chapman

Larry Harris, a professor at the University of Southern California's Marshall School of Business, replied: "The pilot demonstrates very conclusively and very clearly that if the tick rules were dropped that, essentially there would be no difference in the markets that you would be able to identify."

The assembled experts were unanimous in their recommendations.

"I would recommend the SEC and the exchanges eliminate the uptick rule and the bid price rule," Ingrid Werner, a professor at the Fisher College of Business at Ohio State University and an author of one of the studies, told the assembled SEC officials.

Werner's sentiments were largely echoed by the seven other college professors in attendance as well as two industry executives from Bear Stearns and Goldman Sachs.

"Based on the evidence, I'd get rid of the tick test definitely on the large-cap and mid-cap stocks," George Sofianos, a vice president of equity execution strategies at Goldman, told the SEC. "There is little evidence about the small cap stocks at this point."

When Reg SHO was first proposed, the SEC had no intention to completely eliminate price tests. The plan was to replace the tick test of Rule 10a-1 with a new bid test.

The regulator's proposed Rule 201 would have required traders to short stock at a price no less than one cent above the consolidated best bid at the time of the trade.

Bid Test

Both the tick test of Rule 10a-1 and the NASD's bid test are designed to prevent traders from selling short when markets may be in decline. But of the two, the NASD's bid test is considered less restrictive.

With the NASD bid test, traders can only short stock when the most recent bid is unchanged or higher than the previous bid. With the tick test, traders can only short stock when the most recent last sale price is unchanged or higher than the previous last sale.

Neither test has completely prevented Wall Street pros from shorting. The NASD bid test is largely toothless because to date it has only been enforced by Nasdaq. Traders could easily short Nasdaq securities on Archipelago or INET.

The tick test for listed securities has not been a substantial impediment either. For the more actively traded stocks, there are simply more ticks available.

"We're not preventing any of the professionals from shorting by the uptick rule," Richard Lindsey, president of Bear Stearns Securities, told the SEC. Lindsey called the rules a "hassle" and a "minor inconvenience."

Owen Lamont, a finance professor at Yale University and portfolio manager with DKR Fusion, agreed. "The price test rule is fairly harmless," he told the SEC officials. "It is a mild form of petty harassment." Lamont said he would like to see the rule abolished.

Small Caps

At this juncture, the SEC appears undecided. The studies presented during the roundtable mostly looked at large-cap and mid-cap stocks.

"Have you analyzed the different effects of lifting the restrictions on large-cap versus small-cap or on high-price stocks versus low-priced stocks?" SEC Commissioner Annette Nazareth wanted to know.

The studies also took their conclusions from data in the aggregate. Extreme cases such as securities with sharply declining prices were not analyzed.

"Each of the pilot studies excluded stocks that might be considered outliers, stocks that might have things that were unusual going on, for example, stocks that didn't make it into the Russell in 2005," Amy Edwards, an OEA financial economist, pointed out to the academics. "Have you really deleted the most interesting results from your test?"

Many on the panel agreed that more research was necessary.