‘Naked' short-selling alarms regulators

With Wall Street in upheaval, the Securities and Exchange Commission is planning measures to rein in aggressive forms of short-selling that were blamed in part for the demise of Lehman Brothers and that some fear could be turned against other vulnerable companies.

During emergency meetings between federal officials and investment bank executives over the weekend, SEC Chairman Christopher Cox indicated to the bankers that the agency plans in a few days to impose new protections against abusive “naked” short-selling, a person familiar with the matter said Monday.

Naked short-selling occurs when sellers don't even borrow the shares before selling them, and then look to cover positions immediately after the sale.

The person spoke on condition of anonymity because the SEC actions haven't yet been officially announced.

The measures likely would include removing an exception for market makers in options on stocks from rules restricting naked short-selling, and a tightening of antifraud rules related to that activity, according to the person familiar with the matter.

Those two measures could be put in place administratively by quick approval of the SEC commissioners. Another change, reducing from 13 to five the number of days that short sellers would have to deliver stocks after an initial failure to do so, would require a public meeting and formal vote to propose it as a new rule.

Short sellers bet that a stock's price will fall so that they can profit from it. They borrow shares of the stock and sell them. If the price drops, they buy cheaper actual shares to cover the borrowed ones, pocketing the difference.

Some investors contend that naked short-selling, if left unchecked, would have given hedge funds and other aggressive short sellers an unfair advantage to move on to other attack victims after Lehman Brothers Holdings Inc. Merrill Lynch & Co. – being bought by Bank of America Corp. in a $50billion shotgun deal – or giant insurer American International Group Inc., which Monday was allowed to transfer money from its subsidiaries in order to stay in business, were likely targets.

The investors have clamored for the SEC to institute another emergency order similar to its ban from mid-July to mid-August against naked short-selling of the stocks of mortgage finance companies Fannie Mae and Freddie Mac, and 17 large investment banks – including Lehman, Merrill and Bank of America.

The SEC's temporary order required short sellers to actually borrow shares before selling them. By law, it could not be extended beyond Aug. 12. Cox has said the order helped prevent potential “distort and short” manipulation of stocks, which occurs when rumors and misinformation are used to drive down the price of a stock that has been sold short.