The Latest Wachtell Memo on Short Selling: Did it Move the SEC?

[WSJ_law_blog]

The big news on Wall Street today is the SEC’s announcement that it will attempt to curb improper short-selling in the stocks of struggling Fannie, Freddie, as well as those of 17 financial firms, including Goldman, Lehman and Morgan Stanley. Here’s a handy story from the WSJ’s Kara Scannell and Jenny Strasburg, as well as the proposed rules.

First of all, what the heck is short-selling? A primer, for those curious: Short selling, the WSJ explains, is a legitimate trading strategy in which traders aim to profit from falling stock prices. In a short sale, a trader borrows stock and then sells it, in hopes it will later fall in price. If it does, the short seller then buys the stock in the open market at the lower price, returns what was borrowed, and pockets the difference. The SEC said Tuesday’s move aims to stop “unlawful manipulation through ‘naked’ short selling” — the practice of selling stock short without taking steps to borrow it.

So what prompted the SEC’s move? We’re not sure, but at least two influential folks urging reform, Wachtell Lipton’s Ed Herlihy (pictured) and Theodore Levine, recently weighed in with this client memo, which encourages the SEC “to undertake additional bold measures to constrain abusive short-selling and rumor-mongering.” Click here for a Dow Jones story on the memo.

So far, there’s much chatter, apparently, over whether the SEC’s plan, which is expected to go into effect on Monday and will expire in 30 days, will actually work. But based on the history of efforts to curb short selling, prospects don’t look good.

• In 1733, in the aftermath of the South Sea Bubble, the British House of Commons banned what today would be called naked short selling. The law remained in force for more than 150 years, even though, as financial historian Charles Duguid noted in 1901, “it was at no time seriously operative.”
• In 1792, the New York state legislature banned short selling. Five weeks later, two dozen stockbrokers banded together to sign the Buttonwood Agreement, which created what became the New York Stock Exchange, where short selling occurred with abandon.
• In the 1990s, Hong Kong temporarily banned short sales, and the Malaysian finance ministry proposed that anyone caught short selling should be punished by caning. Neither measure prevented those markets from falling during or after the 1998 Asian crisis.

“In the near term, short sellers may see some marginal increase in their cost of borrowing, as brokers adjust their operations,” said Laurel FitzPatrick, a partner at Ropes & Gray who advises hedge funds. “Ultimately, neither this rule, nor the SEC’s indications that they are looking to bring enforcement cases against sellers spreading rumors, will reduce short selling if sellers believe a stock is overvalued.”