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Why the SEC should not further restrain short selling

By Harvard Law School Program on Corporate Governance

The hedge fund coalition that I chair, the Coalition of Private Investment Companies (CPIC), recently submitted a comment letter to the Securities and Exchange Commission (SEC) in which we laid out our case for why the Commission should drop proposals to further restrain short selling. Under consideration by the regulator is a series of proposals that range from a ?national bid test? to ?circuit breakers,? which, if triggered, halt short selling transactions.

The SEC has repeatedly acknowledged the benefits of short selling, from improving liquidity in capital markets to enhancing price discovery, and, in the past, the agency has expressed reluctance to restrict an investment strategy that serves as a necessary counterweight to unbridled optimism. But, it has departed from this traditional view in a variety of efforts ? some misguided ? to address the circumstances of the largest market drop in decades. When the SEC imposed bans on short selling last summer, investors? interests were harmed as market quality deteriorated, including higher transaction costs through wider spreads. (More information about short selling is available here.)

Our letter emphasizes, as Commissioner Kathleen Casey did when the SEC announced its newest short sale rule proposals, that the SEC must provide empirical evidence that validates the necessity for action and demonstrates the benefits investors would receive in excess of the harm done from new restraints on short selling.

In proposing several regulatory ?speed bumps? on short selling, particularly in down markets, the SEC emphasized two considerations that will guide its decision: that ?naked? short selling is a problem demanding regulatory attention and that one cause of the low level of investor confidence is the prevalence of short selling and its role in the fall in stock values.

In our letter, we point to actions already taken by the SEC to eliminate ?naked short selling,? which occurs when an investor has failed to have identified or gained commitment for stocks they have shorted. Our industry, including myself, supported those actions. As a result, there has been a further decline in the already very low level of naked short selling that does occur.

As to investor confidence, it is on the rise again albeit it in fits and starts, according to several polls, including that produced by State Street Bank. To gauge investors? thinking, the State Street survey looks at several macro- and microeconomic factors, which do not include short selling. Given this, we questioned the link the SEC has suggested between the prevalence of short selling and low levels of investor confidence. In another comment letter, an Ohio State University Professor Ingrid Werner similarly questions the link. She concludes that ?there appears to be no evidence supporting the hypothesis that high levels of short selling activity contributed to low levels of investor confidence during the recent financial crisis.?

Removing information from the markets ? whether it be by posing barriers to short selling or by rolling back mark-to-market accounting standards ? as a means to promote ?investor confidence? is a terrible precedent.

The full text of the CPIC letter is available here.

Full post as published by The Harvard Law School Corporate Governance Blog on July 02, 2009 (boomark / email).