At a roundtable discussion tomorrow (Tuesday), the U.S. Securities and Exchange Commission (SEC) will talk about restoring a rule that some believe could have mitigated the bear market in U.S stocks.
Tomorrow’s meeting, which will focus largely on short-selling, follows recent internal discussions in which SEC officials have talked about restoring the so-called “uptick rule,” a fairly straightforward securities regulation that many experts say could have blunted the steep sell-off that U.S. stocks experienced in late 2008 and early 2009. The uptick rule was abolished in 2007.
U.S. Federal Reserve Chairman Ben S. Bernanke is a proponent of the uptick rule’s restoration.
“If the rule is to be restored, it should apply to all equally, including market makers as well as professional traders and individual investors,” Bernanke said during a question-and-answer session with the House Financial Services Committee in late February. “If the rule had never gone away it may have been helpful during this current crisis that we face.”
Rule Replacement Proposals
The old form of the uptick rule that Bernanke referred to basically held that a short-sale transaction had to be entered at a price that is higher than the price of the previous trade.
The rule, which was introduced in the Securities Exchange Act of 1934, was actually implemented four years later. It was designed to prevent short sellers from adding to the downward price momentum of an asset whose price was already under pressure and undergoing a sharp decline. The uptick rule was eliminated in June 2007.
On April 8, the SEC voted unanimously to open a 60-day public comment period and is now seeking investor input “on whether short-sale price restrictions or circuit-breaker restrictions should be imposed and whether such measures would help promote market stability and restore investor confidence.”
The agency developed five new proposals related to short selling and wants the public to file comments. The 60-day commenting period ends June 19, said Mary L. Schapiro, chairman of the SEC.
Two of the five proposals would involve a market-wide institution of the old uptick rule. The three others would create a “circuit breaker,” which is sometimes also referred to as a “collar.” These three would set restrictions on trading activity due to a freefalling stock price. As proposed, circuit breakers would be established for when the security has fallen 10%, 20% and 30%.
The five proposals consist of:
Proposal No. 1: Described as a “market-wide short-sale price test based on the last sale price or tick,” this proposal calls for a simple restoration of the uptick rule that had been in place for 70 years. This would help prevent short sellers from ganging up on a weak stock and pushing it down as far as they’re able.
Proposal No. 2: Described as a “market-wide short-sale price test based on the national best bid,” this proposal represents a slight modification to the uptick rule by making it more stringent.
Proposal No. 3: This proposal is similar to “limit days” in commodity markets. It prevents short selling on stocks that are enduring severe stress. If a stock drops significantly in a trading session, then it cannot be short sold for the remainder of the trading session. This rule would put a halt on short selling and prevent that stock from being pushed down even further – which could have the effect of crippling it, in a sense.
Proposal No. 4: A short-sale price test based on the last sale price of a particular stock for the remainder of the trading session. This would be imposed for a stock that has fallen a certain percentage during the course of a day.
Proposal No. 5: If a stock falls significantly in a trading session, this final option would call for the introduction of a “bid test.” This would mean that, for the remainder of the day, a short seller would have to place a transaction at the highest available bid.
The Fallout of the Rule’s Removal
The uptick rule (rule 10a-1) was established in 1938 – in the depths of the Great Depression that followed the 1929 stock market crash – during the administration of SEC Commissioner Joseph P. “Joe” Kennedy Sr. Kennedy, the first commissioner of the SEC, implemented the uptick rule after examining what role short-selling played in a 1937 stock-market break.
Short-sellers are essentially betting that a company’s stock will fall in price. They “borrow” the shares from another investor and sell them, reaping the proceeds at what they believe is a “high” price. If the price falls, as they expect, they can buy the shares back at a lower price (which is known as “covering” their short sale) and replace the block of stock that they borrowed.
Their profit is the difference between the proceeds from the initial short sale higher price and what they then had to spend to cover their short sale (as well as brokerage commissions).
With the uptick rule, the objective was to prevent groups of short-sellers from, in effect, ganging up on a stock for the solitary intent of driving it down as far as possible. In such a gambit, the short-sellers hope to create a steep enough sell-off to cause panic selling by the other shareholders, which would lead to a total freefall in the stock price.
Short-selling restrictions were removed from about one-third of the major listed stocks in a year-long study conducted in 2004. This test was conducted to see how much of an impact there would be from the uptick rule’s removal.
After a roundtable discussion about the results in September 2006, the SEC decided to eliminate rule, which it did the following July. According to the SEC, the uptick rule wasn’t really needed to prevent manipulation and actually seemed to reduce a stock’s liquidity.
“The general consensus from these analyses and [from] the roundtable was that the commission should remove price test restrictions because they modestly reduce liquidity and do not appear necessary to prevent manipulation,” the SEC reported. “In addition, the empirical evidence did not provide strong support for extending a price test to either small or thinly-traded securities not currently subject to a price test.”
However, when the uptick rule was eliminated, the U.S. stock market experienced a massive surge in volatility. Hedge funds took extreme advantage of the ability to not have to wait for an uptick in the price of a stock before they moved to sell it short.
Almost immediately after the uptick rule was abolished, investors began to clamor for its reinstatement. Indeed, throughout much of last year, politicians, investors and other public figures began pushing for the rule to be put back on the books.
In 2008, there was outcry from top public figures such as CNBC-TV’s “Mad Money” host Jim Cramer, as well as such elected officials as U.S. representatives Gary Ackerman, D-N.Y., Mike Capuano, D-Mass., and Carolyn B. Maloney, D-N.Y., as well as presidential candidate and U.S. Sen. John McCain, R-Ariz., who all pushed for reinstatement of the uptick rule.
The heavyweight mergers-and-acquisitions law firm Wachtell, Lipton, Rosen, & Katz may have best-summarized proponents’ desire to see the rule reinstated.
“Short-selling is at record levels,” the New York-based firm said in a statement. “We ask the SEC to take urgent action and reinstate the 70-year-old uptick rule. Decisive action cannot await a new SEC chairman – there is no tomorrow. The failure to reinstate the uptick rule is not acceptable.”
The groundswell of support for reinstatement of the uptick rule spilled over into the New Year, and even escalated as the markets whipsawed U.S. investors. On Feb. 25, for instance, Bernanke, the U.S. central bank chief, declared his support for the restoration of the uptick rule. On March 10, the SEC and U.S. Rep. Barney Frank, D-Mass., (and the chairman of the House Financial Services Committee) jointly announced plans to restore the uptick rule.
News and Related Story Links:
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Wachtell, Lipton, Rosen, & Katz:
Corporate Web Site.