WASHINGTON – Today, Senator Carl Levin, D-Mich., Chairman of the Permanent Subcommittee on Investigations; Senator Charles Grassley, R-Iowa, Ranking Member of the Finance Committee; and Senator Arlen Specter, D-Penn., Chairman of the Judiciary Subcommittee on Crime and Drugs, released a Government Accountability Office (GAO) report analyzing recent actions taken by the Securities and Exchange Commission (SEC) to curb failures to deliver securities and manipulative naked short selling.
Senator Levin said: "Naked short selling enables unscrupulous traders to manipulate the stock market and can directly damage U.S. companies and the shareholders who own them. This report confirms that the SEC should consider and implement an arsenal of weapons to combat abusive short selling. A requirement that short sellers must borrow shares before engaging in a short sale would go a long ways towards ending this abusive practice. Although decreasing the number of failures to deliver is certainly not the only measure for success in fighting abusive short selling, I note that when the SEC issued a temporary preborrow requirement last July on a limited number of stocks, the number of new failures to deliver in those stocks dropped by 78%."
Senator Grassley said: "Private property and voluntary exchange are the cornerstones of a free market economy. Shareholders are part owners of the corporations in which they invest. Shareholders must have the right to determine the terms and conditions under which they will lend their securities to others. Naked short selling without regard to the number of shares outstanding or the lending conditions placed on the available shares is a violation of property rights and deprives shareholders of the value of their ownership. Unless the SEC can develop an appropriate alternative, a strict preborrow requirement may be the only way to adequately protect shareholders' rights."
Senator Specter said: "As this GAO study establishes, the SEC is capable of enforcing pre-borrow and delivery rules when it so desires. For modestly capitalized companies, short selling stocks and then failing to deliver the shares results in phantom or fraudulent shares and can be a death knell. We need an SEC that will protect investors in all companies—including those would-be targets of naked short selling. I join Senators Levin and Grassley in calling for needed regulatory reform."
A "short sale" occurs when a person sells a borrowed stock. The person then will "cover" the position by buying the stock back, and returning it to the lender. If the stock price falls in value, then the short seller could profit by selling for more than it cost him to repurchase — selling high and then buying low. As the GAO report notes, "[i]n general, short selling is used to profit from an expected downward price movement, provide liquidity in response to unanticipated demand, or hedge the risk of a long position … in the same or related security."
However, because short sellers may profit on the decline in a company's stock price, they may seek ways to drive downward the stock prices in the companies in which they invest. And while most short selling is legal, some is not. As the GAO report notes: "short selling also may be used to illegally manipulate the prices of securities. Generally speaking, it is prohibited for any person to engage in a series of transactions to create actual or apparent active trading in a security or to depress the price of a security for the purpose of inducing the purchase or sale of the security by others."
Naked short selling refers to selling short without having borrowed the securities to make delivery. Selling shares that are not in the seller's actual possession may create an artificial downward pressure on the share price of the stock by flooding the market with sales.
Failures to deliver (FTD) occur when the seller of an equity security does not deliver the security to the purchaser within the required settlement period. Although FTD can be caused by mechanical errors and processing delays, they also result from naked short selling. The GAO report states that FTD "may undermine the confidence of investors, making them reluctant to commit capital to an issuer that they believe to be subject to such manipulative conduct."
In 2004, the SEC issued Regulation SHO to address large and persistent FTD and manipulative naked short selling. In 2008, the SEC took additional actions to restrict naked short selling. In July 2008, in the midst of the current financial crisis, the SEC issued an emergency order that restricted short sales in the publically traded securities of 19 large financial institutions, unless the seller had borrowed, or arranged to borrow, the security prior to the sale, and required delivery of the security on the settlement date. Almost immediately, the order was amended to except market makers engaged in market making transactions and the sales of restricted securities. This preborrow requirement expired in August.
Out of concern that Regulation SHO's locate and close-out requirements had not gone far enough to reduce FTD and curtail manipulative naked short selling, the SEC issued an emergency order in September 2008 that temporarily increased delivery requirements on all short sales, implemented an antifraud rule regarding short sales, and eliminated an exception for options market makers from the close-out requirement. Based on continued concerns of market conditions, the SEC also temporarily banned all short sales of approximately 800 financial institutions. The enhanced delivery requirement was subsequently adopted as an interim final temporary rule set to expire on July 31, 2009.
GAO analyzed FTD data from January 2005 through December 2008, and found that the SEC's actions last September resulted in a significant decrease in the number of securities with large FTD. GAO also found that staffs of both the SEC Enforcement Division and the Financial Industry Regulatory Authority (FINRA) conceded that "market manipulation is difficult to detect and successfully prosecute, and the potential damage to an individual company could be severe." Further, the SEC Trading and Markets and FINRA staffs agree that the potential for market manipulation is possible even under the current temporary rule requiring broker-dealers to close out FTD on the morning of the fourth day after a trade.
The GAO report further recommends that the SEC "finalize, in an expedited manner upon finalization of the temporary rule, the revised 1994 Prime Broker Letter (SEC staff guidance that laid out the responsibilities of both the executing and prime brokers for trades they executed and settled on behalf of their clients), and develop a process that allows Commission staff to raise and resolve implementation issues that arise from SEC regulations, including interim final temporary rules, in a timely manner."
The GAO report can be found online at http://levin.senate.gov/newsroom/supporting/2009/report.GAO.060309.pdf