It seems all but certain that the Securities and Exchange Commission (SEC) will soon assume a much more aggressive attitude toward policing short selling in the stock market. To understand why, it helps to first understand exactly what is and is not short selling. Short selling is when you “borrow” a share that is valued at, say, $100 and sell it to somebody else at that price. Then once the share’s value drops, say to $50, you buy a share for $50 and return to the person you borrowed from at the outset. (You only have to return a share, not its value when you borrowed it.) The $50 difference between the price you sold the borrowed share at and its price when you bought it is your profit. It can be a bit tricky to be sure, but advocates claim, with justification, that short selling is one way the market quickly identifies over-valued stocks and thus encourages more realistic pricing.
The SEC is looking at restoring in some form its “uptick” rule first adopted during the Great Depression. This would bar investors from shorting stocks that closed lower the previous day. The idea is to provide a break on downward movement of stock prices that can encourage panics. The agency began thinking of dropping the uptick rule during the Clinton administration, but didn’t actually do so until July 2007. The economic meltdown that began in the fall of 2008 has spurred the SEC to consider restoring the rule. The agency has received nearly a thousand comments in recent weeks encouraging it to do so.
One of the proposals being weighed by the SEC would bar selling a share at price lower than “the national current best bid” as a means, according to the agency, of preventing “short sellers from driving the market down” or “to accelerate a declining market.” This is a reasonable approach that would likely preserve legitimate short selling while minimizing its abuses. But there is an obscure realm of short selling where the SEC should focus its considerable investigative and enforcement powers. There is evidence that unscrupulous plaintiffs attorneys have used short selling to drive down the share price of a corporation the firm has targeted in a class-action lawsuit. The falling share price is mis-represented as a measure of damages caused by alleged corporate wrong-doing in the suit. In a 2004 case, for example, a federal district court judge pointed to efforts by the infamous Milberg Weiss plaintiffs firm in which it was “short more than 500,000 shares” of the Terayon Communications System, Inc. it was suing. Investors rightfully wonder how many more Terayons there are and if anything is being done to insure there will be no new ones.
