Taking Sides: SEC faces a critical deadline on new short-selling rule

Sept. 11, the day terrorists attacked the World Trade Center and the Pentagon, will forever be remembered for its shock and horror.

But as bad as the attacks and ensuing destruction were, our anger was stoked even more by news reports suggesting that the perpetrators may have sold certain stocks short in advance of the attack to profit from their crimes.

Such an act would be particularly cold-blooded, and in the days following the tragedy, the Securities and Exchange Commission began an investigation to find out whether those dark suspicions were true.

Short-selling, of course, has long been considered a legitimate investment strategy to hedge against a market downturn.

But many companies – especially those that have watched their stock price plummet – consider short-sellers to be on par with vultures. They’ve complained for years that short-sellers purposely gang up on a company to profit by manipulating its stock price downward.

call for action

The SEC finally heeded those concerns and began reevaluating rules that govern the practice. That was two years ago. That issue remained on the back burner until the Sept. 11 attacks. Now the pressure is on again for some action.

In a letter to the SEC two weeks after the attacks, Rep. John LaFalce, D-N.Y., the ranking minority member on the House Financial Services Committee, ordered the agency to examine the links between short-selling and recent volatility in the stock market.

up tick nixed?

Against that backdrop, the SEC in the next week or two is expected to finally release its proposed changes to the rule.

According to a recent report in The Wall Street Journal, the agency is actually leaning toward a slight easing of restrictions.

Right now, short-selling is prohibited if the last price movement of a stock is down. That is known as the “uptick” rule. The SEC is expected to change that to allow short-selling if the most recent bid to buy a stock is higher than the best-bid offer before it. That is called the “best-bid” test.

According to the experts, that is a slight easing of current standards but should still provide protection against manipulation.

The best-bid test would apply to all but the top 100 or so most actively traded stocks. The SEC intends to free the top stocks from any restrictions under the theory that they are virtually impossible to manipulate.

Deadlines loom

Aside from the pressure created by the Sept. 11 attacks, the SEC is facing another deadline. Next month, trading is slated to begin in single-stock futures.

They’ll hit the market free of any short-selling curbs, and some concerns have been raised that they’ll be used to avoid curbs on the stocks themselves.

The SEC seems to be taking the right approach to the issue, but as news reports have pointed out, time is of the essence. The commission needs to have the rules in place no later than Christmas.

To meet its own requirement to allow a 30-day period for public comment, that means the new rules need to be published in the next few weeks.

Unfortunately, the agency is better known for its foot-dragging on both the short-selling rule and single-stock futures. It took an act of Congress to break the logjam on the latter.

Further delay could be extremely problematic for the market. This is one case in which newly minted SEC Chairman Harvey Pitt needs to get personally involved. If he can keep the agency on track, he will be making a major contribution to more-efficient markets right off the bat.