SEC: What are you thinking?

The Securities and Exchange Commission approved in a 3-2 vote a measure to limit the ability of investors to short sell. The rule will not allow the short selling of a stock that has fallen 10% in one trading session, and shorting of the stock will not be allowed for two business days – the day of the decline and the following trading session. The argument is that short selling puts extra, unnecessary, speculative downward pressure on a stock price, and the SEC expects this new curb to put a halt on this downward pressure for stocks whose prices have fallen drastically. However, despite the expertise the SEC is supposed to possess, a lack of understanding of the fundamentals of short selling and failing to recognize the true underlying reasons for the stock price declines have led the SEC to enact a rule that will do no good.

Short selling, in simple form, is performed by an investor who borrows a share of a stock, then resells it to someone else, hoping to buy back that share of stock at a lower price and return it to the lender, making a profit on the difference. For example, an investor could borrow a share of GE at $10 a share from a broker, and sell it to someone else for that same price of $10 a share. The investor then owes the broker one share of GE. If the price of GE stock falls to $8 per share, the investor can buy back that share of GE in the market, then return the purchased share to the broker, fulfilling his or her debt obligation. The investor sold the share for $10 and bought it for $8, netting a $2 profit. In brief, a short seller profits from a decline in stock price.

The SEC has been under pressure to make changes in light of the recent financial crisis and downward pressure on financial stocks in particular. The bearish and speculative nature of short selling has caused critics to concentrate their energy, and thus the focus of the SEC, on implementing new regulations to curb its use. Despite popular belief and understanding, an actual short sale will not cause a stock price to fall. The share of stock is borrowed, sold to another person, and the investor has completed the short sale. The net result is that a share of stock has been purchased, no shares of stock sold…no actual selling took place! This not only does not cause downward pressure, it is actually bullish. A share of stock has been purchased, which will help lift the stock price.

The SEC takes issue with short selling, because it communicates a bearish sentiment on a stock. If a large number of investors are short a stock, the investment community reads this as a negative outlook on a stock. Investors seeing negative outlooks will tend to reevaluate their position, and more investors will hop on the bearish bandwagon. The problem with the SEC trying to fix this is that it is not the short selling that needs to be looked at, it is the actually company that is the problem. As Peter Boockvar writes, perhaps there were more reasons to explain the rapidly falling stock prices of the world’s largest financial institutions than the fact their stocks were shorted. Investors short a stock when they expect it to fall.Although it may make more investors believe the stock is a sell, there must have been something about the company to generate the initial increase in shorts on the stock. Maybe it was the subprime lending, exorbitant leverage, and investments in high-risk securities by the financial institutions that caused massive losses and crashing stock prices? SEC, take another look.