Hedge funds went one too far.

Long overdue, and only coming after the hedge funds went one too far. The article suggests a direct relationship between naked shorting of Morgan Stanley (and perhaps Goldman Sachs as well), and the new rules which came with amazing speed.

It’s somewhat ironic as the investment bankers (or what’s left of them) were certainly not only innocent victims. But the last two standing (Goldman has little exposure to sub-prime stuff, hard to imagine how they won’t survive) have friends in powerful places.

We would have been happy if they just started to enforce their existing rules, but these new rules are better weapons, especially the end of exemption for options market makers and the new disclosure of short positions on a daily basis (this has not been approved yet, and it might not).

When it will, we’ll finally know who the perpetrators are that got InterOil 520 consecutive trading days with failures to deliver (that is, shares short that have not been borrowed, and hence not been delivered).

SEC May Require Disclosure of Hedge Funds’ Short-Sale Positions

  • By Jesse Westbrook. Sept. 18 (Bloomberg) — The U.S. Securities and Exchange Commission may require hedge funds to disclose their short-sale positions and plans to subpoena the funds’ communication records in an effort to stem turmoil in stock markets.
  • Hedge funds and investors managing more than $100 million in securities would be “required to promptly begin public reporting of their daily short positions,” Chairman Christopher Cox said in a statement late yesterday. The agency will obtain “disclosure from significant hedge funds” regarding “past trading positions in specific securities,” Cox said.
  • Lawmakers including U.S. Senate Banking Committee Chairman Christopher Dodd and executives such as Morgan Stanley Chief Executive Officer John Mack say short sellers may have contributed to the market crisis by spreading false information and using abusive tactics to attack companies. Hedge funds argue that poor business strategies are to blame, not short sellers.
  • “A lot of hedge funds don’t like being forced to disclose their long portfolios, so they’re really not going to like this,” said Sean O’Malley, a former SEC lawyer and now a partner at Goodwin Procter LLP in New York. “There is going to be some push back from hedge funds, but they may not get any sympathy in the current market environment.”
  • The five SEC commissioners must approve the rule, which would be adopted on an emergency basis, for it to become binding. Hedge funds, which are private pools of capital whose managers participate substantially from any profits on invested money, prefer to keep their positions secret to prevent other traders from stealing their strategies.
  • Subpoenas. The SEC didn’t say whether the rule would apply only to common shares or whether it would effect options and other securities holdings. SEC spokesman John Nester didn’t return an e-mail seeking comment.
  • The agency’s plan to subpoena communication records will mark the second time the regulator has sent information requests to hedge funds in three months. In July, the SEC subpoenaed hedge-fund managers and Wall Street’s biggest firms seeking evidence they were manipulating shares of financial companies.
  • The Financial Services Authority in the U.K. required hedge funds and other speculators to reveal short positions in June equaling 0.25 percent or more of a company’s shares during rights offering.
  • Short sellers try to profit by betting stock prices will fall. In a traditional short sale, traders borrow shares from their broker that they then sell. If the price drops, they buy back the stock, return it to their broker and pocket the difference.
  • Tougher Rules. The SEC earlier yesterday stiffened rules against so-called naked shorting by adopting two regulations that pressure traders and brokers to actually deliver borrowed shares to buyers. A third rule makes it a securities fraud when sellers deceive brokers about delivering borrowed shares to buyers.
  • The SEC is targeting naked selling, in which traders never borrow shares from their brokers, amid concern investors are using such abusive tactics to flood markets with sell orders and drive down stock prices.
  • “Naked short-selling has become the scapegoat, but the fundamentals of how these businesses were run is what caused these issues,” said Stephen Ehrlich, CEO of New York-based Lightspeed Professional Trading LLC, which makes trading systems for hedge funds and professional traders. “The problems roiling the market and financial stocks are not going to change with less short-selling.”
  • Morgan Stanley, the second largest U.S. securities firm, tumbled the most ever in New York trading yesterday after a government rescue of American International Group Inc. failed to ease the credit crisis. In a memo to employees, Mack, 63, said the management committee is “taking every step possible to stop this irresponsible action in the market.”
  • Morgan Stanley. “There is no rational basis for the movements in our stock,” wrote Mack, who added that he contacted Cox and Treasury Secretary Henry Paulson. “We’re in the midst of a market controlled by fear and rumors, and short sellers are driving our stock down.”
  • Morgan Stanley and Goldman Sachs Group Inc., both based in New York, are seeking to avoid runs on their shares that helped trigger emergency sales of Merrill Lynch & Co. and Bear Stearns Cos., and the Sept. 15 bankruptcy of Lehman Brothers Holdings Inc.
  • Democratic New York Senators Hillary Clinton and Charles Schumer urged the SEC yesterday to impose a temporary ban on short-selling of all financial stocks, saying it would “help restore a measure of stability to our financial markets.”
  • In July, the SEC instituted an “emergency” order that restricted short-selling in Lehman, Fannie Mae, Freddie Mac and 16 securities firms. The order, which expired last month, required investors betting on a decline in stock prices to arrange to borrow shares before completing a short sale.

For the effects on InterOil, there remain a few questions:

  1. Since the defences of the shorts have been quite weakened by the new rules, they won’t be able to fight of any significant buying wave. More than that, they might very well be forced to join that buying wave to limit the damage
  2. We think that, for the new rules to really take effect, one more positive news item might be required. We’re fairly sure the next quarterly figures will be good as well, confirming the turn-around in the refinery, but a definite game changer would be a deal or a third party assessment of their resource (as long as that is not too disappointing). We know that there is a lot of money waiting on the sidelines for that
  3. Another possible trigger: how will the SEC deal with existing large unsettled trades. They might focus more on financials, and give others a little bit more time as they do not want to cause bankruptcies in hedge fund land as well, perhaps. But the more strict they will be, the more likely a self-triggering short squeeze will ensue.