Corporate Governance

The SEC, the Ban on Short Sales, and A Vote of No Confidence in the Efficient Market

By J. Robert Brown

We were treated to the Feds (and Treasury's) decision to purchase 80% of AIG, an extraordinary intervention by the government into the private sector.  This morning we see an equally unprecedented regulatory step, the decision by the SEC to ban short selling in almost 800 companies.   The ban is only for 10 days although it may be extended.  But even with the short term nature of the step, it reflects both panic at the SEC and an extraordinary lack of faith in the market.  

The SEC suggests that short selling is essentially manipulation.  As the release notes:

• Given the importance of confidence in our financial markets as a whole, we have become concerned about recent sudden declines in the prices of a wide range of securities. Such price declines can give rise to questions about the underlying financial condition of an issuer, which in turn can create a crisis of confidence, without a fundamental underlying basis.  This crisis of confidence can impair the liquidity and ultimate viability of an issuer, with potentially broad market consequences.
  

Short sales are a bet that stock prices will go down.  For every short sale, there has to be someone else on the other side of the transaction who thinks the share prices will go up.  In other words, short sales help achieve more accurate price equilibrium.  The transactions are necessary in an efficient market.  When companies release information, some participants may think it will help the prospects of a company and others think it will hurt.  Short sales allow the market to adjust to the information and obtain an efficient price.

By banning all short sales (as opposed to efforts to combat naked short sales), the SEC is merely removing liquidity from the market and impeding the market's ability to set an efficient price for a company's shares.  In other words, it is tantamount to a judgment by the SEC that the market cannot be counted on to accurately set a price.  It is a remarkable vote of no confidence in the efficient market theory, something that has been at the core of the SEC's approach to regulation for a quarter of a century.   

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