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The SEC, the Ban on Short Sales, and A Vote of No Confidence in the Efficient Market: An Unprecedented and Possibly Unauthorized Action

By J. Robert Brown

The Commission has, for the next ten days, banned short sales, an extraordinary intervention by the government into the financial markets. The step impairs liquidity and represents a bureaucratic decision to interfere with the efficient market theory.

It is, therefore, worth taking a look at the statutory authority for the move. According to the adopting release, the SEC exercised its authority under Section 12(k)(2) of the Exchange Act.  See 15 USCS § 78l(k)(2).  As the agency described:

• the Commission is exercising its powers under Section 12(k)(2) of the Act.  Pursuant to Section 12(k)(2), in appropriate circumstances the Commission may issue summarily an order to alter, supplement, suspend, or impose requirements or restrictions with respect to matters or actions subject to regulation by the Commission if the Commission determines such an order is necessary in the public interest and for the protection of investors to maintain or restore fair and orderly securities markets.

The Section provides that the Commission may, "in an emergency," summarily take action with respect to "any matter or action subject to regulation by the Commission" that is, among other things, necessary "to maintain or restore fair and orderly securities markets" or to "reduce, eliminate, or prevent the substantial disruption . . . of the securities markets" 15 USC 78l(k)(2).  Interesting, particularly with respect to an independent agency, the president has the authority to terminate an emergency order.  See 15 USCS § 78l(k)(3).  An emergency is broadly defined as anything that might result in a "sudden and excessive fluctuations of securities prices generally, or a substantial threat thereof, that threaten fair and orderly markets". 

There are several things that are problematic about the SEC's actions.  First, the authority is historically unprecedented.  Section 12(k) has only been used only two other times and both times in a very discrete manner.  It was used back in July to restrict short sales in a specified list of financial institutions.  See Exchange Act Release No. 58166 (July 15, 2008).  But that order only applied to 19 firms, not the 799 firms in the latest efforts, and was only designed to restrict naked short sales, not all short sale.  The other instance was in a post-9/11 environment when the Commission allowed Amex specialists to also serve as floor brokers.  See Exchange Act Release No. 44797 (Sept. 16, 2001)("Amex specialists shall be temporarily exempt from Section 11(a) solely for effecting transactions when acting as floor brokers for Amex orders on the floor of the NYSE for accounts in which they have investment discretion"). 

Second, while the provision gives the agency the authority to address any matter subject to the SEC's regulation, it is unclear that this would apply to a type of transaction.  Thus, there is little doubt that the SEC can use the authority to affect the behavior of market makers or brokers or stop trading.  But the ban on short sales by the SEC prohibits "all persons" from engaging in the sales.  Is it really the case that the provision is broad enough to prohibit certain types of sales practices among private individuals?

Third, Section 12 provides that an order can be challenged in court but only as "arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law."  Arbitrary and capricious is a term of art that generally means there's an inadequate explanation in the record to support the decision.  While the case can presumably be made that there is a crisis in the market, the record supporting the Commission's decision is entirely devoid of any evidence that the crisis is a consequence of short selling.  The existence of a crisis, in other words, doesn't justify any response.

Barney Frank has indicated that he will look into whether the Fed, an independent agency, ought to be able to buy 80% of AIG (and rely on a fund of $800 billion to potentially make other purchases) without some oversight.  He also ought to look into whether the SEC's authority under Section 12(k)(2) is so broad (and not subject to oversight) that it can interfere in the markets in such a substantial and unprecedented way without oversight. 

Full post as published by The Race to the Bottom on September 19, 2008 (boomark / email).