A Short Summary of Short Selling Regulations


On July 15, 2008, the SEC issued an emergency order barring naked short sales of the stock of Fannie Mae, Freddie Mac and 17 financial firms, including Lehman Brothers, Goldman Sachs, Merrill Lynch and Morgan Stanley. This action further intensified the media’s focus on short selling. The emergency order, however, represents only the latest in a line of SEC regulatory and enforcement actions aimed at addressing problematic short selling activities.

A short sale occurs when a seller sells a security it does not own, requiring that it make delivery with a security

borrowed by it or on its behalf. Whether executed as a hedge or for speculative purposes, the profitability of a

short position depends on the seller’s ability to buy in shares to cover its short position at a lower price than the

price at which it effected the original short sale. Short selling has important positive market effects, but also may

be manipulative. One form of manipulation is the “short and distort” scheme, the inverse of a “pump and dump” scheme, in which a company’s stock is shorted and fraudulent negative information about that company is disseminated in order to drive down its stock price. Such schemes recently have received attention from the SEC’s enforcement division, as have shorting activities of hedge fund investors in PIPE transactions. As recently as April

2008, the SEC charged a trader with securities fraud and market manipulation for intentionally disseminating a

false rumor in connection with short selling activities. The SEC’s longstanding concern with shorting activities is

evidenced by its recent amendments and proposed amendments to short selling regulations. In light of the increased attention on shorting, additional changes are likely. In order to understand the direction of regulatory changes, a short summary of existing and proposed shorting regulations may be useful.

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