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Short Sale Proposals: Key Questions

By Harvard Law School Program on Corporate Governance

The Securities and Exchange Commission will hold a roundtable at its headquarters in Washington, DC today to discuss issues raised by its recent proposals to restrict short sales. Questions will be directed to three main topics: 1) Market Changes and Investor Confidence; 2) Bid versus Tick versus Circuit Breakers; and 3) Lessons and Insights from Empirical Data. In anticipation of the roundtable, we have issued a memorandum entitled “Short Sale Proposals: Key Questions,” which focuses on the structure of the SEC?s recent proposals and the key questions raised by them.

In response to public outcries for a regulatory response to sharp declines in equity prices, on April 10, 2009 the SEC released a set of proposals to restrict short sales (the ?Release?). The proposals would reverse the SEC?s elimination ? after extensive economic analysis and policy debate ? of its prior uptick rule and other
short sale restrictions in 2007.

For nearly seventy years ? from 1938 to 2007 ? Rule 10a-1 under the Securities Exchange Act of 1934 generally prohibited short sales on listed stocks unless they occurred in a rising market (i.e., on an ?uptick?). Specifically, short sales were permissible at or above the last sale price, with short sales at the last sale price permitted only if the last different sale price was below the last sale price. From 1994 to 2007, Nasdaq maintained a ?bid test? for securities traded on its market. These rules were intended to prevent speculators from pushing down stock prices through short sales.

In response to clamor to restore the original uptick rule, the SEC has proposed, among other alternative approaches, a slightly updated version of the rule. Noting, however, that the operation of the market has changed dramatically since the abrogation of Rule 10a-1, the SEC also has proposed four alternative short sale rules to better accommodate the market realities of 2009. One proposal limits short sales into a declining bid price rather than a declining last sale price. The other three proposals employ ?circuit breakers? that are triggered by a specified stock price drop and either temporarily halt short sales altogether or institute price restrictions based on last sales or bid price.

The SEC?s proposals contain very limited exceptions. As written, these exceptions might not cover most convertible arbitrage and equity derivatives hedging as those activities are currently conducted. We have also issued a companion piece, entitled “SEC Proposed Short Sale Restrictions: Implications for Equity Derivates and Equity-Linked Securities,” which focuses on the particular implications of the proposals for equity derivatives and equity-linked securities.

The Release contains nearly 200 questions on which the SEC seeks comment. Also significant are the specific issues on which the SEC did not ask for comment, which may indicate the SEC is predisposed toward certain rule outcomes.

The memorandum entitled “Short Sale Proposals: Key Questions” is available here, and the memorandum entitled “SEC Proposed Short Sale Restrictions: Implications for Equity Derivates and Equity-Linked Securities” is available here.

Full post as published by The Harvard Law School Corporate Governance Blog on May 05, 2009 (boomark / email).