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Friday, April 2, 2010

The Uptick Rule: SEC Limit on Short Selling Reconsidered

Gary Shorter
Specialist in Financial Economics

Historically, in much of the popular lore surrounding short selling (borrowing stock with the objective of making a profit if its price falls), the activity has been unfavorably described as a destructive force for both stock markets and the firms whose shares are sold short. In the 1930s, due to concerns that a concerted kind of manipulative short selling known as a bear raid had contributed to the stock market collapse, federal securities regulations were adopted that restricted short selling. Known as the uptick rule, the restriction essentially forbade short sales on stocks unless a stock's previous price movement had been upward. 

By contrast, modern economics orthodoxy generally views short selling to be a beneficial economic force. Among the benefits ascribed to shorting are its ability to (1) counter an unwarranted, speculative upward price pressure in stocks, and even help uncover and expose fraudulent issuer activities; (2) enable an entity to hedge the risk of a stock position owned, thus protecting against price declines; and (3) provide liquidity in response to buyer demand. 

This perspective received added credibility after a Securities and Exchange Commission (SEC) based pilot program found no significant adverse economic outcomes when a sample of stocks were not subject to the uptick rule. In June 2007, the agency voted to rescind the uptick rule. 

In the aftermath of the repeal, there was concern over the role that the repeal may have had in exacerbating stock market volatility. Months into 2008, in the midst of a deepening financial crisis, officials at a number of large financial firms claimed that short sellers were responsible for their falling stock prices. Responding to what he called the need for a temporary timeout in the midst of abnormally functioning financial markets, SEC Chairman Christopher Cox banned short selling of stocks in nearly 1,000 financial firms between September 19, 2008, and October 3, 2008, a decision he later indicated regretting. 

In early 2009, House Financial Services Committee Chairman Barney Frank and Senate Banking, Housing, and Urban Affairs Committee Chairman Christopher Dodd reportedly expressed hope that the SEC would reinstate the uptick rule. Among those in the private sector also supporting reinstatement were the entrepreneurs Charles Schwab and Steve Forbes. In addition, several major stock exchanges (including BATS Trading, the New York Stock Exchange, and Nasdaq) jointly wrote to the SEC, urging it to consider adopting a modified uptick rule. Still, a number of studies, including an internal SEC study, raised doubts about charges that the uptick rule's repeal had a deleterious market impact. On April 8, 2009, the SEC issued several uptick rule-related reform proposals. Later, on February 24, 2010, the SEC adopted an alternative uptick rule in which a security-specific circuit breaker is triggered if a stock's price declines by 10% or more from the previous trading day's closing price. Short selling in the stock would then only be allowed if its price remains above the current national best bid for the remainder of that day through the next trading day. The SEC indicated that the reform would help market stability and help restore investor confidence in uncertain markets. Critics, including two Republican SEC commissioners and some securities industry and hedge fund trade groups, have questioned whether the SEC provided sufficient evidence that short selling has been harmful. They also indicated that recent SEC reforms curtailing naked shorting have reduced manipulative short selling and predicted that restricting short selling would have harmful market consequences. The investor confidence rationale used in part to justify the rulemaking was also greeted with skepticism. 

H.R. 302 (Ackerman) and S. 605 (Kaufman) would both require the SEC to reinstate the uptick rule.

Date of Report: March 24, 2010
Number of Pages: 17
Order Number: RL34519
Price: $29.95

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