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 in a legitimate short transaction, the Securities and Exchange Commission 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 today. They apply to all stocks.
The SEC also said that its enforcement division intends to obtain disclosure from large hedge funds and other institutional traders of their past trading positions in specific stocks. It said it is considering requiring hedge funds and large investors to disclose all short-trade positions.
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 including Lehman Bros.
In recent weeks, analysts have blamed aggressive shorting of financial stocks for exacerbating the decline of stocks such as Lehman, which filed for bankruptcy court protection Monday. Late Tuesday, the Federal Reserve reversed course and organized an $85 billion rescue plan for insurer American International Group.
Wall Street refers to these shorting attacks on specific company stocks as "bear raids." The belief is that massive selling of shares by short sellers has created a huge amount of downward price pressure on stocks that may have little relation to a company's fundamentals.
When the emergency ban was instituted this summer, financial stocks did rebound as selling pressure was temporarily relieved. But as the financial crisis intensified, and the emergency rules expired, naked shorting again proved a major negative for financial stocks.
Under the new rules, for example, short sellers and broker-dealers have to deliver securities by the close of business on the settlement date, three days after the sale. Those who don't will be banned from future short sales in the same security unless the shares are borrowed in advance. "It is a far bolder step than the SEC was willing to take last week," John Coffee, a professor of securities law, at Columbia Law School, told Reuters.