- The SEC sharply escalated its verbal war against naked short selling in July 2008 when the chief executive officers of some of the world’s largest investment banks frantically sought protection from Congress and the SEC in relation to the naked short selling which was contributing to the collapsing prices of the stock of those banks. For the first time, it was not merely stock of smaller public companies which was being ravaged by naked short selling. Instead, naked short selling was perceived as a contributing cause of the failures of the nation’s oldest and biggest investment banks: Bear Stearns,[20] Merrill Lynch,[21] and Lehman Brothers.[22]The warning by the Pollack Study two decades earlier that naked short selling “carries the potential for serious problems, particularly in the event of crisis market conditions” seemed to be coming true.[23]
- The voices of the CEOs reached a crescendo in September 2008 after three international and venerable U.S. investment banks (Bear Stearns, Merrill Lynch, and Lehman Brothers) had failed, leaving Morgan Stanley and Goldman Sachs teetering on the edge of the abyss. Time magazine quoted from a memo that John Mack, Morgan Stanley’s Chief Executive Officer, had sent to employees: ‘“What’s happening out there? It’s very clear to me — we’re in the midst of a market controlled by fear and rumors, and short sellers are driving our stock down,’ fumed John Mack.”[24] On September 17, 2008, Barron’s reported: “[T]he Securities & Exchange Commission’s head Christopher Cox is investigating naked short selling of shares of Morgan Stanley and Goldman Sachs after receiving calls from Morgan Stanley CEO John Mac [sic] about improper short-selling that was responsible for the stock’s nearly 30% decline today.”[25]
- The pleas of the banks’ CEOs brought instant credibility to the notion that naked short selling could destroy public companies, even huge ones if the time was ripe. But the failing banks had special credibility. Bear Stearns, Lehman Brothers and Merrill Lynch all had their own proprietary desks manned by astute traders who had the skill and technology to recognize naked short selling. Each bank also had affiliated broker-dealers whose traders made markets in thousands of public companies. No one was better equipped than the traders in the banks’ brokerage firms to recognize that the banks’ stocks were in the crosshairs of traders who were pulling the trigger on naked short sales. More than likely, these banks through their proprietary desks and affiliated brokerage firms had pulled the trigger on naked short selling aimed at other public companies in the past.
- The SEC quickly recognized the credibility and urgency of Morgan Stanley’s and Goldman Sachs’s pleas for help, particularly in view of the fact that three other banks had so quickly failed. Not surprisingly, Rule 203 had failed to deter naked short selling when that deterrence was most needed, during a financial crisis, just as the Pollack Study had predicted. The SEC responded with a series of emergency regulations and amendments to Reg SHO from July 2008 through July 2009 to stop or at least contain naked short selling.
- On July 15, 2008, the SEC issued an emergency order prohibiting any short sales in the stock of 19 financial institutions, including Lehman Brothers, Merrill Lynch, Morgan Stanley and Goldman Sachs). In the release accompanying this emergency order, the SEC directly linked the order to the naked short sales of Bear Stearns stock. The release begins with the following explanation for the halting of naked short sales:
False rumors can lead to a loss of confidence in our markets. Such loss of confidence can lead to panic selling, which may be further exacerbated by “naked” short selling. As a result, the prices of securities may artificially and unnecessarily decline well below the price level that would have resulted from the normal price discovery process. If significant financial institutions are involved, this chain of events can threaten disruption of our markets.
The events preceding the sale of The Bear Stearns Companies Inc. are illustrative of the market impact of rumors. During the week of March 10, 2008, rumors spread about liquidity problems at Bear Stearns, which eroded investor confidence in the firm. As Bear Stearns’ stock price fell, its counterparties became concerned, and a crisis of confidence occurred late in the week. In particular, counterparties to Bear Stearns were unwilling to make secured funding available to Bear Stearns on customary terms. In light of the potentially systemic consequences of a failure of Bear Stearns, the Federal Reserve took emergency action.[26]
- In issuing another emergency order in September 17, 2008, the SEC expressed even greater alarm how naked short selling had “exacerbated” other factors in causing the widening collapse of the securities markets. The SEC issued a protective stay on short sales trades in the stock of more than 900 banks, insurance companies, and securities firms. The SEC explained the rationale for the broadened stay with these words:
The Commission continues to be concerned that there is a substantial threat of sudden and excessive fluctuations of securities prices and disruption in the functioning of the securities markets that could threaten fair and orderly markets. As evidenced by our recent publication of an emergency order under Section 12(k) of the Securities Exchange Act of 1934 (the “July Emergency Order”], we are concerned about the possible unnecessary or artificial price movements based on unfounded rumors regarding the stability of financial institutions and other issuers exacerbated by “naked” short selling. Our concerns, however, are no longer limited to just the financial institutions that were the subject of the July Emergency Order. In addition, we have become concerned that some persons may take advantage of issuers that have become temporarily weakened by current market conditions to engage in inappropriate short selling in the securities of such issuers.[27]
- On October 14, 2008, as the financial crisis deepened, the SEC released an interim amended version of Reg SHO to stop naked short selling (Exchange Act Release No. 58773). The summary to the release announcing the interim rule explained its purpose as follows:
The Securities and Exchange Commission (“Commission”] is adopting an interim final temporary rule … to address abusive “naked” short selling in all equity securities by requiring that participants of a clearing agency registered with the Commission deliver securities by settlement date, or if the participants have not delivered shares by settlement date, immediately purchase or borrow securities to close out the fail to deliver position by no later than the beginning of regular trading hours on the settlement day following the day the participant incurred the fail to deliver position.[28]
- In the same release (Exchange Act Release No. 58773), the SEC revised its description of how naked short selling could harm public companies. The SEC no longer described the harm caused by naked short selling as a perception held by public companies and their investors. The SEC described the harm as real. On October 14, 2008, for the first time, the SEC described how naked short selling inflicted harm on public companies as follows:
To the extent that fails to deliver might be part of manipulative “naked” short selling, which could be used as a tool to drive down a company’s stock price, such fails to deliver may undermine the confidence of investors. These investors, in turn, may be reluctant to commit capital to an issuer they believe to be subject to such manipulative conduct.[29]
- On the same date, October 14, 2008, the SEC issued a separate release announcing another amendment to Reg SHO eliminating the options market-maker exception and narrowing the bona fide market-maker exception, all to contain naked short selling. The summary to the 2008 amendment explained the purpose of the amendment as follows:
The Securities and Exchange Commission (“Commission”] is adopting amendments to Regulation SHO under the Securities Exchange Act of 1934 (“Exchange Act”]. The amendments are intended to further reduce the number of persistent fails to deliver in certain equity securities by eliminating the options market-maker exception to the close-out requirement of Regulation SHO. As a result of the amendments, fails to deliver in threshold securities that result from hedging activities by options market-makers will no longer be excepted from Regulation SHO’s close-out requirement. The Commission is also providing guidance regarding bona fide market making activities for purposes of the market-maker exception to Regulation SHO’s locate requirement.[30]