Jul 8, 2009, 1:37 p.m. EST
Senators press SEC to rein in naked short selling
Kaufman wants agency to take action on hedging abuse, or he may take action
By Ronald D. Orol, MarketWatch
WASHINGTON (MarketWatch) – A senator with close ties to the White House and hands-on experience in stock trading is leading the push to have the Securities and Exchange Commission take action against naked short selling, an abuse that he and other lawmakers argue was a key contributor to the financial crisis.
“If the SEC doesn’t move because they can’t get three votes, I will have to do something,” said Sen. Ted Kaufman, D-Del., in an interview with MarketWatch. “It is pretty clear that there are people in the marketplace driving down stocks in an abusive manner and something should be done about that.”
Kaufman, a long-time top aide to Vice President Joe Biden and a prominent figure in the Obama-Biden transition to the White House, replaced Biden in the senate when the Delaware lawmaker became vice president. Unlike most senators, Kaufman, who has an MBA from the Wharton School at the University of Pennsylvania, has experience with short selling investments and is familiar with a wide variety of securities trading strategies.
Kaufman and other lawmakers want SEC to launch a pilot program to study whether a pre-borrow requirement would end the problem of naked short selling. Kaufman blames naked short sellers for expediting the downfall of Bear Stearns and Lehman Brothers.
With a pre-borrow requirement an institution would be required to arrange formally to borrow shares, or “pre-borrow” before engaging in a short sale. In an emergency action last year, the SEC temporarily required hedge funds and other short-selling institutions to pre-borrow shares.
Naked short selling is the practice of selling a stock short without first borrowing the security or ensuring that the security can be borrowed as is done in a conventional short sale.
Without a pre-borrow requirement it is generally enough for a broker to determine that it has a reasonable basis to deliver the securities when an investor seeks to borrow shares for a short sale.
Kaufman says his staffers are in discussions with the SEC on the pre-borrow issue, but he would like to see action. He indicated that if the agency doesn’t take action he may consider introducing legislation on Capitol Hill that would require the agency to consider a pilot program on the issue. Kaufman also said he could consider seeking to have that provision attached to broader bank regulatory reform legislation that is expected to be introduced in the fall.
Kaufman and three other lawmakers on June 24 sent a letter to SEC Chairwoman Mary Schapiro seeking to have the commission establish a pilot program to study the pre-borrow requirement.
An SEC official declined to comment on the letter.
He argued that the SEC may be apprehensive about taking action against short-sellers, in part, because there haven’t been major problems lately. But he warns agency officials that there are legions of hedge funds with capital ready to take action should another concentrated downturn take place.
“If someone has made a lot of money in a particular endeavor, he will take that opportunity to do it again in the future,” Kaufman said.
Separately, under pressure from lawmakers and financial institutions, the SEC in April approved the release of five different proposals for reinstating the up-tick rule, a provision that would limit short selling.
The five SEC proposals, which were put out for comment vary from reinstating an old rule to creating a new rule that would only apply in severe market conditions. The SEC expects to adopt one or more up-tick rules by the end of summer.
The uptick rule, which was removed in 2007 after 70 years, allowed short sales only if the preceding sale boosted a company’s stock price by at least a penny. The uptick rule was designed to make sure short sellers couldn’t dominate trading in a stock to drive its price lower.
Kaufman said he supported bringing back the uptick rule or a variation of it known as a “bid test,” which allows short sales only after a potential buyer bid at least a penny more than the company’s stock price. He would like to see a bid test combined with another SEC proposal that would ban short selling in a particular stock for the remainder of the day if its share-price dips 10% or more. However, Kaufman argued that 10% is likely too large a drop.
“If it dips 10% that’s way too much,” Kaufman said.
Ronald D. Orol is a MarketWatch reporter, based in Washington.