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September 17, 2008

SEC May Bring Back Price Tests

By Peter Chapman

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  • SEC May Bring Back Price Tests

Five years ago, when the Securities and Exchange Commission was crafting Regulation SHO and pondering the fate of the industry's price-test rules, it initially decided to replace the rules with a uniform bid test.

Traders who wanted to sell short would be able to do so only if the sale price was at least 1 cent above the consolidated best bid.

In the end, however, after much study and debate, the SEC decided price tests were ineffective and unnecessary. In July 2007, it eliminated the existing rules, but chose not to introduce any new ones.

The regulator reasoned that the transparency of the marketplace and the robustness of regulatory surveillance were enough to deter and/or catch those short sellers illegally abusing the trading tactic.

Also, the SEC felt comfortable that the general anti-fraud and anti-manipulation provisions of federal securities laws would prohibit activity designed to illegally drive down a stock.

But that was then and this is now. As Traders Magazine went to press, financial stocks continued under pressure. Short selling had reached record levels. The SEC is under pressure to do something and may be reversing course on the need for a price test.

At a hearing of the House Committee on Financial Services in July, SEC chairman Christopher Cox announced that the regulator was studying whether it would be feasible to institute a price test. He wondered aloud whether it would be best to limit shorting to sales at a price at least 5 or 10 cents over the last trade or current quote.

"Should there be a test that does work?" Cox asked. "Should there be something that is meaningful? If it can't be a tick because a tick is now just a penny, and even when a stock is dropping like a stone it tends to-to drop with, you know, penny upticks along the way-is there a price test that could work with an increment of a nickel or a dime or what have you? And this the SEC is carefully studying even now."

Cox's comments come at a time of surging short sales. The number of New York Stock Exchanges shares sold short was 18 billion as of mid-July, the exchange reported. That represented a "record" 4.86 percent of all NYSE shares outstanding. Indeed, it's almost double the amount of shares sold short as of mid-February 2007. Then, short interest was equal to 2.8 percent of all outstanding NYSE shares.

The financial stocks are under the greatest duress. Morgan Stanley recently reported short interest in banking stocks was about 11 percent at the end of the second quarter.

Cox's musings about 5-cent and 10-cent increments hark back to the SEC's 2003 proposal of a 1-cent increment. Then, the idea was roundly criticized by many in the industry. They believed the form of the proposed rule contradicted the objectives of the 1938 uptick rule.

That rule, which barred traders from shorting unless the last trade was higher than the previous one, was designed to limit short selling in a declining market, the SEC's detractors noted.

The SEC's bid-plus-a-penny proposal would do that but also make it difficult to short in a rising market, they said. That would violate one of the rule's three objectives.