SEC takes aim at abusive short sales again

WASHINGTON - New rules governing the conduct of people who profit from stock declines were issued by the U.S. Securities and Exchange on Wednesday as shares of major financial institutions plummeted on fears of a global credit crunch.

The three SEC rules cover shares of all publicly traded companies and follow a brief emergency rule this summer that was aimed at curbing abusive naked short selling in 19 major financial stocks.

Under a measure that takes effect Thursday, short sellers and their broker dealers must deliver securities by the close of business on the settlement date, three days after the sale.

The SEC's action comes after two turbulent days in which investment bank Lehman Brothers Holdings filed for bankruptcy and U.S. authorities organized an $85 billion rescue plan for insurer American International Group.

CNBC television reported the SEC was meeting on Thursday to consider further action on short selling after heavy lobbying from the two major remaining investment banks, Goldman Sachs and Morgan Stanley, as well as from New York Democratic Sens. Charles Schumer and Hillary Clinton.

A source briefed on the matter said the commission met this afternoon to discuss the new rules. It was not clear whether the SEC would take further action.

Broker-dealers failing to comply with the new delivery requirement will be prohibited from further short sales in the same security unless the shares are pre-borrowed.

"It is a game changer," said Doug Kass, who heads hedge fund Seabreeze Partners Management Inc, who has delivered double-digit returns this year by selling stocks short, including those in ailing mortgage companies.

Columbia Law School professor John Coffee said the rules were a far bolder step than the SEC was willing to take last week. "Lehman and AIG seem to have given (the SEC) religion on this topic," he said.

The SEC also immediately adopted a rule that deems it fraudulent for customers to deceive broker-dealers about the intention or ability to deliver securities in time for settlement.

Kass said that may push out some players who have recently piled into betting that stock prices will fall.

A third rule requires option market makers to deliver securities by settlement date.

"These several actions today make it crystal clear that the SEC has zero tolerance for abusive naked short selling," SEC Chairman Christopher Cox said in a statement.

The SEC had been under pressure to broadly crack down on manipulative trading. In particular, the American Bankers Association, which represents banks of all sizes, had been lobbying banking regulators to lean on the SEC.

Broker-dealers and the investment community scrambled to understand how the new rules would work.

"It is going to be impossible to comply with the new rules because no one has seen them," said Michael Trocchio, a lawyer at Bingham McCutchen LLP who advises broker-dealers on compliance issues.

Short sellers arrange to borrow shares they consider overvalued and sell them in hopes of making a profit when the price drops. It is a legitimate form of trading that can prevent stocks from being overvalued, but often blamed when a company's shares fall.

A "naked" short sale occurs when an investor sells stock that has not yet been borrowed.

Broker-dealers will sometimes accidentally fail to deliver stock to investors who have arranged to borrow it. If this is done intentionally, it is already illegal.

In July, amid sharp market declines, the SEC issued a temporary rule to curb illegal naked short selling in 19 major finance stocks, including Lehman Brothers and mortgage finance giants Freddie Mac and Fannie Mae which have since been seized by the government.

The rule ended mid-August and was criticized by hedge funds, short sellers and the broker-dealer community.

Bill Rhodes, president of Rhodes Analytics, was critical of the SEC's new rule concerning deception of broker-dealers.

"They need to be careful how they apply that... an honest investor could end up being caught in that," Rhodes said.

Although effective on Thursday, the SEC will open a 30-day public comment period for the rule on delivery of securities.