SEC issues new rules on abusive short selling

NEW YORK -- Reacting to concerns that many financial stocks were losing value at an alarming rate due to aggressive bets by short-sellers who profit when prices fall, federal regulators on Wednesday acted to stem the abusive practice known as "naked short selling."

In an ordinary short sale, a short seller borrows stock and sells it, with the hope of buying it back later at a lower price to replace the borrowed shares.

In a naked short trade, the seller doesn't borrow the stock before selling it and doesn't deliver it to the buyer. As a result, naked short sellers can force prices far lower than possible than in a legitimate short transaction, the SEC said.

"These several actions today make it crystal clear that the SEC has zero tolerance for abusive naked short- selling," SEC Chairman Christopher Cox said. The agency's divisions, including enforcement attorneys and market inspectors, "will now have these weapons in their arsenal in their continuing battle to stop unlawful manipulation," he said.

The new rules take effect at 12:01 a.m. ET Thursday. They apply to all stocks.

An emergency ban this past summer on naked short selling applied to just 19 major financial stocks, such as Fannie Mae, Freddie Mac and 17 large investment banks.

In recent weeks, analysts have blamed aggressive shorting of financial stocks for exacerbating the decline of stocks such as Lehman Brothers, which filed for bankruptcy protection Monday.

Wall Street refers to these attacks on specific company stocks as "bear raids." The belief is that the massive selling of shares by short sellers has created a tremendous amount of downward price pressure on stocks that some analysts say has little relation to a company's economic fundamentals.

When the emergency ban was instituted this summer, financial stocks did get a positive bounce as selling pressure was temporarily relieved.

But as the financial crisis intensified, and the emergency rules expired, the practice of naked shorting has again proved a major negative for financial stocks.