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April 1, 2010

Slowing Things Down

No More Hitting the Bid Under New SEC Short Sale Rule

By Peter Chapman

CLARIFICATION: This article, about the Securities and Exchange Commission's new short sale rule, stated that the regulator based its decision to approve the rule partly on comments by the Chicago Board Options Exchange and Getco that market makers typically sell by posting an offer. In point of fact, the two organizations were referring to cash equities market makers and not options market makers.


On Feb. 24, roughly one year after first proposing new rules to curb short selling, the Securities and Exchange Commission adopted Rule 201, or the alternative uptick rule. It prohibits traders from selling short by hitting the bid if a stock falls by 10 percent or more from its previous day's close. In the event a stock drops by that much, they will only be able to short by posting an offer an increment above the best bid.

Larry Harris

The intention is to slow down the shorts as well as the descent of the stock. The rule will remain in effect for the remainder of that trading day, plus the entirety of the following day. It will go into effect on May 10, 2010. The industry will have six months, or until Nov. 10, to comply.

In its proposal, the SEC presented six possible rules, ranging from an outright ban if a stock fell precipitously, to a return of the uptick rule that was rescinded in 2007, to the one it finally adopted. Although the industry criticized all six candidates as unnecessary and detrimental to market efficiency, it grudgingly conceded the alternative uptick rule was the least bad choice.

SEC chairman Mary Schapiro said that the new rule is intended to "preserve investor confidence and promote market efficiency." At least one former SEC official disagrees. Larry Harris, an SEC chief economist from July 2002 to June 2004, told Traders Magazine the new rule will do the opposite. Investors who buy a stock once it falls under Rule 201 may be overpaying, Harris argues. That's because the shorts have been temporarily slowed and the stock hasn't reached its natural bottom yet.

"You have a massive loss of confidence when an investor buys a security that is overpriced," Harris said. "They'll end up losing another 10 percent or whatever. That's a huge investor confidence issue."

Rule 201 has many facets. We explore the main ones below.


How Frequently?

Very few stocks drop by 10 percent or more on any given day. The SEC determined that, on an average day, only 3.4 percent of National Market System stocks would have been affected by Rule 201 in the eight and a half years between the full adoption of decimalization on April 9, 2001, and Sept. 30, 2009. Because Rule 201 carries over into the next day, the total number of stocks that would have been impacted by the rule on an average day during the period rises to 6 percent. The averages mask the extremes, of course.